A Long Way to Go and a Short Time to Get There
The Financial Accounting Standards Board (“FASB”) issued Interpretation Number 48 (“FIN 48”) to standardize reporting of “uncertain” income tax positions on audited financial statements. FIN 48 applies to all organizations that require audited financial statements prepared in accordance with GAAP. Most tax-exempt organizations are required to be FIN 48 compliant for fiscal years beginning after December 15, 2007 (although those with public debt are already required to be compliant). All of this means that tax-exempt organizations that require GAAP-compliant financial statements must become FIN 48 compliant in short order. Further, any FIN 48 adjustments noted in an organization’s financial statements must also be disclosed on the new IRS Form 990. FIN 48 implementation will not be easy, but tax-exempt organizations can prepare now to better manage this important process.
Applicability of FIN 48
As stated, FIN 48 applies only to entities that require audited, GAAP-compliant financial statements. Any entity issuing tax-exempt bonds is already subject to FIN 48. This would include substantially all hospitals, colleges and universities. Other calendar year tax-exempt organizations will be required to comply for their 2008 fiscal years. Those with a June 30 year end must comply for the fiscal year ending June 30, 2009. Thus, many tax-exempt organizations are faced with almost immediate FIN 48 compliance.
Organizations that are subject to FIN 48 will be relieved to know that FIN 48 only applies to uncertain federal, state and local income tax positions. Thus, FIN 48 does not apply to property taxes, employment taxes, sales and use taxes, or excise taxes. Unfortunately the relief ends there because FIN 48 considers an organization’s tax-exempt status itself to be an income tax position. Thus, taxexempt organizations are required to report their tax-exempt status as an uncertain income tax position if any of their activities might threaten their tax-exempt status. The tax treatment of all income streams, including any unrelated business income and related deductions, will also be major reporting issues under FIN 48. In short, most tax-exempt organizations will have many income tax positions to account for under FIN 48.
FIN 48 Basics
FIN 48 compliance is complex, but some of its basic concepts can be understood by breaking FIN 48 down into four steps.
- Is it a Material Income Tax Position? FIN 48 only requires entities to specifically account for material income tax positions. FIN 48 considers a “tax position” to be any position taken on a tax return that affects the organization’s actual or potential income tax liability. Fortunately, FIN 48 is only concerned with material tax positions. While FIN 48 doesn’t define “material,” a taxexempt organization can estimate whether a tax position is material based on whether it is numerically material in relation to the organization’s other reported numbers. Ultimately, this will be determined by the independent auditor, so it is advisable to contact the auditor in advance to ascertain how the auditor will make this determination. FIN 48 applies the materiality threshold by reference to “units of account.” Unit of account is another undefined term, but it generally will be determined by the accounts the organization uses in reporting various income streams and deductions.
- Recognition and Measurement. After identifying its material income tax positions by units of account, the reporting organization must determine whether each position, on its individual merits, has a more-likely-than-not (“MLTN”) (at least 51 percent) chance of being upheld by the taxing authority in a tax audit. If a tax position satisfies the MLTN standard, it may recognize some or all of the resulting tax benefit on the financial statement. In its recognition analysis, the reporting organization may rely on GAAP approved legal sources but may not take into consideration the chance that the particular position might not be audited. The organization may also take into account administrative practices of the taxing authority, as well as treatment of the position in prior tax audits.
The reporting organization must also measure the amount of the tax benefit it can recognize as a result of satisfying the MLTN standard. The measurement analysis requires the reporting organization to estimate in dollars the largest percentage of tax benefit that the organization has a better than 50 percent chance of receiving upon ultimate settlement with the relevant taxing authority. This measurement must assume that the taxing authority has all relevant information. If the tax position is based on clear and unambiguous tax law, the entire resulting benefit may be recognized.
- Accounting Entries on Financial Statements. Tax benefits that cannot be fully recognized must be recorded in the financial statement by means of an “offsetting liability.” Tax penalties and interest must be included in the calculation of any such liability. If the tax benefit is ultimately upheld in a tax audit or the statute of limitations on the tax position expires, the tax benefit can then be fully recognized, and the offsetting liability is then eliminated.
It should be noted that most FIN 48 tax adjustments will be reported as one aggregate adjustment. However, if there is a substantial likelihood that an item included in a FIN 48 adjustment will change significantly in the next 12 months, an individual explanation of the item is required, which can effectively disclose the particular uncertain tax position and provide a potential “audit roadmap” to the IRS.
- Disclosure on Form 990. The new Form 990 specifically requires that FIN 48 adjustments be reported on the return. It is uncertain how the IRS will use this information. However, this highlights the importance of carefully managing the FIN 48 process and adjustments.
What Now? Develop a FIN 48 Compliance Strategy.
Many tax-exempt organizations have great concerns that FIN 48 “red flags” will invite an IRS audit. Such concerns may be well placed, but a sound FIN 48 compliance strategy can help minimize FIN 48 disclosures. What follows are some ideas that tax-exempt organizations should consider for implementing compliance with FIN 48.
- Build a Team of Tax Professionals – Every taxexempt organization should assemble a capable internal and external team of tax professionals. The team should assist in apprising the organization’s board of directors and senior management of the potential impact of FIN 48 on the organization’s financial statements. The team and management should develop the organization’s FIN 48 implementation strategy and oversee its execution.
- Take Inventory of Income Tax Positions – Each organization should immediately begin taking inventory of each income tax position it has taken or plans to take on its federal and state tax returns. As discussed, for tax-exempt organizations that includes state and federal positions regarding taxexempt status, executive compensation practices, unrelated business income, lobbying activities, joint ventures, etc. Memoranda of authority or other documentation supporting each tax position that can be provided to the independent auditor should be prepared. However, care should be taken to preserve the attorney-client privilege during this process.
- Conduct a Mock FIN 48 Audit – Tax-exempt organizations should consider conducting a mock FIN 48 audit of its income tax positions. This will assist in the recognition and measurement phase of FIN 48 compliance and help the organization identify potential problem areas.
In summary, tax-exempt organizations that must comply with FIN 48 may have a long way to go and a short time to get there. The time for preparing for FIN 48 is now. The good news is that most tax-exempt organizations still have time to prepare for compliance with the new standards.