Supreme Court Certiorari Decline Paves Way for IRS Proposal of Important Tax Return Disclosure
Proposed Schedule UTP requires taxpayers to report areas in which the IRS can easily assert additional taxes are owing. We explain the accounting rules and legal privilege issues.
In its Announcement 2010-30 issued In April 2010, the IRS issued a proposed Schedule UTP (Uncertain Tax Positions Statement) and related instructions. If completed properly, the proposed schedule will report areas in which the IRS can easily assert additional taxes are owing. In so doing, Schedule UTP will make the IRS auditors far more efficient because it contains information that the auditors currently have to determine themselves. If the number of auditors remains constant, the IRS will be able to audit more taxpayers, more tax years, and more issues.
FIN 48 Provides the Starting Point
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, entitled “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 has been applicable to public companies since 2007 and non-public companies since 2009. Under FIN 48, the taxpayer must reserve (meaning, establish a liability for taxes) 100% of the uncertain tax position unless it is more likely than not that the tax position would be sustained if the taxpayer litigates the issue. This determination is based on the legal authority only, and assumes the IRS audits the return with full knowledge of all relevant information.
Even if a tax position is more likely than not correct, a portion of the tax benefits may still need to be reserved in the financial statements. Unless the probability is greater than 50% that the IRS would concede the entire amount at issue, the taxpayer must reserve any amount of the total tax liability to the extent that a settlement of the position is likely. This second step takes into account the likelihood that the taxpayer will settle, rather than litigate. In other words, even if the taxpayer would likely prevail by litigating the position, unless it is more likely than not that the IRS would fully concede the issue prior to litigation, a reserve must still be recorded simply because the position is uncertain and the taxpayer takes a practical approach in determining whether litigation is cost-effective. See The FASB’s Gift to the IRS for additional information and our suggestion regarding how certain companies can avoid this problem.
The financial statements show only the aggregate liability recorded, and do not show the amount of reserve by individual tax position. However, the underlying records supporting the financial statements contain this detail. These tax accrual work papers normally contain a description of the relevant facts, the expected IRS contrary position and rationale, legal analysis, assessment of the risks, and the likely settlement amount. If given to the IRS, these tax accrual work papers provide the IRS with both identification of specific issues and negotiating leverage from knowing the taxpayer’s evaluation.
Taxpayers claimed that these tax accrual work papers are protected from disclosure because of legal privileges. However, the First Circuit gutted this privilege claim. See First Circuit Applies New Standard Restricting Work Product Privilege for additional information. On May 24, 2010, the Supreme Court declined certiorari of the Textron ruling. In terms of the monetary amounts involved, and the sweeping effect over most business taxpayers, perhaps the most important decision of the current Supreme Court term was its decision to not review the First Circuit’s 3 to 2 Textron decision.
Schedule UTP Content
Proposed Schedule UTP would disclose details of all transactions for which an accounting reserve under generally accepted accounting principles (GAAP) has been recorded, as described above for FIN 48. However, positions for which no reserve is recorded under GAAP also need to be disclosed in Schedule UTP. Specifically, if no financial statement reserve is required because (i) the taxpayer’s intention is to litigate, and (ii) the taxpayer has more than a 50% chance of prevailing, the uncertain tax position still must be disclosed on Schedule UTP.
There can be little doubt that Schedule UTP information will significantly affect the manner in which the IRS operates. Schedule UTP is a roadmap of items available for audit and adjustment. Simply because a position is listed on Schedule UTP, the taxpayer will have admitted that it will concede at least a partial adjustment upon an IRS challenge. Based on the taxpayers’ own assessments, the IRS will almost certainly initiate an audit for the vast majority of items listed on Schedule UTP.
Schedule UTP contains much of the information that would be in the tax accrual work papers. Schedule UTP disclosures include:
1. The primary Internal Revenue Code Sections involved
2. Whether the uncertain tax issue is permanent or timing
3. The identity of any pass-through entity that pertains to the issue
4. An indication if the tax position has no reserve because of the IRS’s administrative practices not to audit the issue
5. The maximum tax adjustment, calculated as described below.
6. A description of the uncertain tax position – The instructions for Schedule UTP indicate that the description should include (i) a specific description of the income, deduction or credit, (ii) the reasons that the position is uncertain, and (iii) the taxpayer’s rationale for the position.
The maximum tax adjustment (MTA) is calculated at 35% of the amount of the taxable income at issue (or if involving a tax credit, the amount of the credit). The MTA does not include the impact of any penalties and interest, or the impact of net operating losses or other tax offsets that would impact the actual payment to be made. Unlike reserves for GAAP reporting, the MTA does not consider the taxpayer's risk assessment, the chances of settlement, and the possible outcome of litigation. Accordingly, the MTA will often be different than the GAAP reserve for each reported position.
Legal Privilege Questions
Officially, the IRS has a policy of restraint that limits the circumstances under which it will request the taxpayer’s tax accrual work papers. From a practical perspective however, any claimed restraint will be removed with the collection of information required by Schedule UTP. Once the information provided by Schedule UTP is known, the IRS can further obtain what is needed to propose and litigate an adjustment through normal channels. From a practical perspective, there will be little left worth protecting under any privilege that might remain.
The IRS currently contends that Schedule UTP is not an automatic waiver of the work product privilege because Schedule UTP contains factual information, rather than opinions. Although the IRS contends that it is not seeking privileged information through Schedule UTP, the mere identification of an issue discloses privileged judgments. If the mere identification does not cross the privilege line, certainly disclosure of (i) reasons for the uncertainty and (ii) the taxpayer’s rationale reveals a legal adviser's confidential advice, mental impressions, conclusions, and opinions which are at the very core of what is protected by attorney-client privilege. Additionally, it is difficult to justify why the disclosure does not represent a general subject matter waiver covering other undisclosed communications and information covering the same subject matter.
The scope of Schedule UTP is quite broad. The only items that need not be disclosed are positions where the taxpayer believes there is established law supporting the tax position and no litigation is reasonably anticipated. Despite this belief, assume that the IRS challenges the position, contends that Schedule UTP was not complete, and proposes whatever penalties pertain to such nondisclosure. In this situation, the only way that a taxpayer can support its tax return and avoid the anticipated consequences of non-disclosure is to share its legal analysis. If the whole point of the analysis is that litigation was not reasonably anticipated, how can the otherwise-privileged analysis have been prepared in anticipation of litigation? The taxpayer is thus in a classic Catch 22, since the only way the analysis is privileged is if the legal work was prepared in anticipation of litigation. However, if privilege exists because litigation was anticipated, the issue should have been part of Schedule UTP. Either way, the taxpayer loses.
Most Business Taxpayers will Eventually be Affected
Initially, corporate taxpayers filing Forms 1120 (for regular C corporations), 1120 F (for foreign corporations), and 1120 L or 1120 PC (for life and property insurers, respectively), would be required to file Form UTP if they (i) have total assets in excess of $10 million, and (ii) issued audited financial statements. This Form UTP would be required starting with calendar 2010 tax returns. After 2010, smaller corporations and pass-through entities will almost certainly be required to prepare the same disclosures.
If Schedule UTP is not fully completed, we do not yet know whether the IRS will seek a new legislative penalty, rather than relying on existing penalties. The draft instructions state that taxpayers need not file Form 8275, Disclosure Statement, for tax positions disclosed on Schedule UTP. However, the IRS has not concluded whether Schedule UTP (i) will replace other disclosure requirements, or (ii) is adequate disclosure for avoiding accuracy-related penalties under Section 6662(d)(2).
The relatively short comment period for the new requirement is now over. IRS officials publicly stated that the IRS does not intend on backing down from this additional reporting.
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.