IRS: What’s in Your Reserve?

Tax law and accounting collide as the IRS prepares to dig deeper into uncertain tax positions.
Marie LeoneAugust 24, 2010

The Internal Revenue Service is headed down the home stretch with respect to uncertain tax positions. Since June, it has been reviewing public comments on its controversial proposal to require more-detailed disclosures around tax deductions and credits that may not pass muster with the agency. The IRS plans to issue final guidance by the end of the year — in time for affected companies to include the new disclosure form with their 2010 tax returns.

If the bulk of the proposed guidance remains intact, companies with more than $10 million in assets that have identified uncertain tax positions will be required to file a new form, called Schedule UTP, with their annual tax returns. Uncertain tax positions include any position for which a company has created a reserve in an audited financial statement.

Under Schedule UTP, affected companies will have to provide the IRS with an itemized list of uncertain positions, plus the technical arguments supporting the positions, a “concise” description of the tax issues and the relevant tax-code sections involved, and the maximum tax adjustment possible should an entire deduction or credit be disallowed by the IRS.

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What’s unusual about the proposal is that it is based on U.S. GAAP instead of tax law, says Scott Wragg, managing director at CBIZ Tofias, a tax and accounting firm. Indeed, financial-statement reserves, which will trigger a Schedule UTP, are governed by an accounting rule known as Topic 740 (formerly FIN 48). But Schedule UTP will require “more work” of companies beyond what is currently needed to comply with Topic 740, adds Wragg. That’s because the accounting rule only requires disclosure of aggregate reserve amounts, not itemized data.

Companies contend that the new schedule will lead IRS auditors directly to tax positions that companies believe are weak, which is something of a flashback to 2006, the year FIN 48 was issued. At the time, public companies were appalled by the prospect of revealing their weakest tax positions in their financial statements, while private companies that used U.S. GAAP were considering accepting qualified auditor opinions just so they could avoid applying FIN 48. The aggregate requirement quelled most of those fears, but Schedule UTP is reviving them.

The practical implications will be that companies that have regular dealings with the IRS will address the issue head-on, while other companies may be pulled into government examinations for the first time, says Mike Dolan, a former acting director at the IRS and currently national director of tax policies and dispute resolution at KPMG. He says companies that are part of the IRS’s continuous examination program, for example, will “try to accelerate resolutions” for 2010. That is, they will work with the IRS to settle older tax disputes, and then adjust 2010 tax positions to reduce uncertainty.

In addition, some of these same companies will try to eliminate uncertainty altogether, thereby doing away with the need to file a Schedule UTP. That can be accomplished by obtaining a prefiling agreement or private-letter ruling from the IRS, two mechanisms the agency uses to rule on issues at the request of the taxpayer. Until now, prefiling agreements, which were introduced in 2000, have been used sparingly. The program, which costs about $50,000 to enter, was most popular in 2005, when 53 requests were made, 29 cases were accepted, and 19 agreements were closed. Last year only 28 requests were made, but participation may increase in light of the new disclosure rules, says Dolan.

Private-letter rulings are much more plentiful. For the week ending August 20, the IRS issued about 70 such rulings. The letters are prospective legal determinations made by the IRS chief counsel’s organization; the fee for a letter is $10,000 for most corporate taxpayers. (Prefiling agreements, which are IRS guidance, are applied to completed transactions and are based on existing law.)

The development of Schedule UTP is the latest chapter in a decades-long struggle between the IRS and corporate taxpayers over how much sensitive information related to uncertain positions should be disclosed. The IRS points out that the new proposal does not require companies to disclose their risk assessment or tax reserve amounts — information usually found in the highly confidential tax-accrual work papers — even though the agency won the legal right to force companies to produce those documents in a 1984 Supreme Court case ruling (United States v. Arthur Young & Co.).

The Supreme Court decision was met with such an outcry that the IRS instituted a “policy of restraint” with respect to uncertain tax positions. Essentially, the agency gave companies informal assurance that it would only demand the work papers in rare circumstances — and even then only with written permission from high-level officials at the service.

But since the Enron scandal and passage of investor-protection laws such as the Sarbanes-Oxley Act, the IRS has been modifying its policy of restraint to obtain more information about uncertain tax positions, says Wragg. The proposed Schedule UTP is the latest fruit of that effort. By Wragg’s lights, the IRS “saw an opportunity” when FIN 48 was issued and decided that Schedule UTP would piggyback on the aggregate disclosure. To be sure, by requiring companies to record details related to FIN 48 reserves, the IRS will gain a significant amount of insight into uncertain positions “without actually requesting the work papers” and violating the policy of restraint, he says.

But Wragg adds that it’s likely the IRS is motivated more by efficiency than by suspicion of underreported income. Noting that the agency has limited resources, he says the IRS won’t have to “dig as many dry holes” if it can use Schedule UTP to help evaluate the best candidates to audit.

Dolan suggests an additional motivation for launching Schedule UTP. The new form, he says, gives the government “visibility into a segment of taxpayers that they really have not examined in the past,” referring to companies that don’t regularly engage with the IRS. “At the end of the day, [the new schedule] may be a way for the government to identify entities and transactions that would never have been on its radar,” says Dolan.