What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax Potential Financial Reporting Implications of Changes to Partnership Examinations New rules for IRS examination proceedings of partnership entities may have financial reporting implications. As entities assess the effect of the new rules, questions may arise concerning potential accounting for income taxes issues, including the characterization of an obligation as an income tax of the partnership, accounting for tax elections, accounting for changes in tax laws, accounting for uncertainty in income taxes, and the effect on financial statement disclosures. This article is intended to summarize the potential impact of the new tax law and provide an overview of several accounting for income taxes considerations under U.S. generally accepted accounting principles ( U.S. GAAP ). January 6, 2016 by Jenna Summer, Katie LeBlanc, and Ashby Corum, Washington National Tax Jenna Summer and Katie LeBlanc are senior managers in and Ashby Corum is the partner-in-charge of the Accounting for Income Taxes group in Washington National Tax ( WNT ). Highlights of the Partnership Audit Changes in the Budget Act On November 2, 2015, President Obama signed into law H.R. 1314, the Bipartisan Budget Act of 2015 (the Budget Act ). The Budget Act includes new rules for partnership audits and adjustments as well as other provisions relating to various other matters, including budget enforcement. The new audit and adjustment regime generally provides for assessment and collection of any imputed underpayment of tax at the partnership level; 1 thus, even though partnerships are pass-through entities, they could be subject to an entity-level tax. However, the Budget Act also allows certain qualifying partnerships that issue 100 or fewer Schedule K-1s to elect out of the regime. 2 The Budget Act allows the partnership to elect to not make the payment of tax on the imputed underpayment amount, but to have the imputed underpayment amounts taken into account in the current year by those partners that were partners in the year to which the adjustment relates in accordance with rules to be established by the 1 An adjustment that does not result in an imputed underpayment generally is taken into account in the adjustment year as a reduction in non-separately stated income or an increase in non-separately stated loss reported to the partners. 2 Section 6221(b). The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 Potential Financial Reporting Implications of Changes to Partnership Examinations page 2 Secretary of the Treasury ( Secretary ). 3 Additionally, the Secretary is authorized to create procedures that, if a partner files an amended tax return that takes into account all adjustments allocable to that partner and pays the tax, would reduce the tax owed by the partnership accordingly. 4 The imputed underpayment is generally determined by identifying the net adjustment for the reviewed year and multiplying the amount by the highest rate of tax in effect for the reviewed year. Under the existing rate structure, the individual rate of 39.6 percent is considered the highest rate and therefore appears to be the default rate for computing the imputed underpayment. However, the Budget Act authorizes the Secretary to establish procedures under which the imputed underpayment amount may be modified to more accurately reflect the amount owed, if the partnership can substantiate a lower tax rate or demonstrate all or a portion of the imputed underpayment is allocable to a partner that would not owe tax (for instance, a tax-exempt entity or the partner has already paid the tax), amongst other applicable adjustments. The new regime is generally effective for returns filed for partnership tax years beginning after December 31, It is not yet clear how or if state and local taxing authorities will respond to the new regime. See the KPMG Report: Preliminary Analysis of Partnership Tax Changes in Budget Act for a more thorough initial analysis of the Budget Act. Accounting for Income Taxes Considerations The enactment of the Budget Act presents a number of complex accounting for income taxes considerations that should be analyzed in order to determine the appropriate financial reporting impact of the change in tax law, if any. Some of the considerations include whether an obligation under the Budget Act is an income tax of the partnership, the impact of elections, accounting for the changes in tax law, accounting for uncertainty in income taxes, and impacts to financial statement disclosures. Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). 3 Section Section 6225(c)(2). 5 Although the law provides that a partnership may elect into the new regime for periods beginning before January 1, 2018, in accordance with the manner prescribed by Treasury, it is currently unclear as to how an entity is able to elect into the new regime for tax years beginning before January 1, 2018.

3 Potential Financial Reporting Implications of Changes to Partnership Examinations page 3 I. Application of ASC 740, Income Taxes, to the Regime Under the new regime, consideration should be given as to whether the imputed underpayment assessed at the partnership level is an income tax of the partnership under ASC 740, Income Taxes, or an expense paid on behalf of the partners. ASC 740 indicates that it applies to federal income taxes based on income. 6 The literature goes on to provide various examples of income tax payments made by partnerships and S corporations and considers whether those payments should be viewed as income taxes of the entity and accounted for based on the guidance in ASC 740 or viewed as transactions with owners. 7 In an example, when a jurisdiction has no provision for the owner to file tax returns and the laws and regulations do not indicate that the payments are made on behalf of the partners, then the income taxes are attributed to the partnership and are accounted for as an income tax expense of the partnership. In another example, when an owner may file a tax return and utilize the payment made by the partnership as a payment against the owner s income tax, then the income tax is attributed to the owners and the payments made by the partnership are treated as a transaction with the owners. Under the Budget Act, if the partnership does not elect out of the regime, the owners do not have a filing requirement upon assessment and the laws and regulations do not appear to indicate that the payments are made on behalf of the partners. Additionally, if a partner chooses to file an amended tax return, it reduces the payment made by the partnership, but does not result in a payment made by the partnership being used as a payment by the partner. Accordingly, the authors would expect partnerships to generally conclude that the assessment to the partnership would be presented as an income tax of the partnership subject to the provisions of ASC 740, absent an applicable election out of the regime. II. Accounting for Elections Out of the Regime The measurement of current and deferred tax balances as well as the conclusions surrounding the accounting for uncertainty in income taxes, should be determined based upon management s expectations as to whether elections will be made and effective for the respective period for elections that are primarily within the control of management. 8 6 ASC ASC through ASC

4 Potential Financial Reporting Implications of Changes to Partnership Examinations page 4 Additionally, an entity s status may change from nontaxable to taxable or from taxable to nontaxable. The effect of an election for a voluntary change in tax status is recognized on the approval date or on the filing date if approval is not necessary. 9 If an entity is subject to the new regime and if the Secretary provides applicable regulations, the entity may elect to furnish to each partner in the reviewed year a statement of the partner s share of any adjustment to income, gain, loss, deduction, or credit resulting in the payment of tax being made by the partners. To apply the alternative mechanism for payment by the partners, the partnership would have to make the election no later than 45 days after the date of the notice of final partnership adjustment. Alternatively, and as referenced above, certain qualifying partnerships may affirmatively elect out of the audit regime for a tax year by making an election with a timely filed tax return for the tax year and providing other information and notifications under regulations to be issued by the Secretary. Neither election requires formal approval by the taxing authority. 10 A question arises as to whether the elections described above are in the nature of a change in the status of the partnership from taxable to nontaxable. It may be perceived that a partnership starts with a default classification as an entity that will be subject to tax on examination adjustments and that it can later elect out of that status. Alternatively, a partnership may view its ability to control whether the entity or its partners pay the tax as an election affecting the treatment of certain matters. The authors believe many partnerships will conclude that the elections described above do not change the overall tax status of a partnership and are more in the nature of an election. Accordingly, if an entity expects to affirmatively elect out of the regime for a tax year under either mechanism described above and the partnership meets the qualifications to make the election, then the authors expect many partnerships will consider the election in the measurement of its current and deferred income taxes including the conclusions surrounding the accounting for uncertainty in income taxes beginning in the period it has met all the requirements to make the election and intends to make the election. 9 ASC If an entity intends to elect out of the regime by either mechanism, it should ensure the partnership agreement or other arrangements do not restrict the ability to make such election

5 Potential Financial Reporting Implications of Changes to Partnership Examinations page 5 III. Accounting for Changes in Tax Laws In accordance with ASC 740, the calculation of current and deferred taxes is based on enacted tax laws and rates. An entity should not anticipate the effects of future changes in tax laws in estimating its current taxes or in measuring its deferred tax assets and liabilities unless those changes are included in currently enacted tax law. Current income taxes should be adjusted for changes in the tax law through the date of enactment in the period during which the tax law is enacted and deferred tax assets and liabilities should be adjusted for changes in the tax law during the interim period the law is enacted. The effects of changes in tax laws on deferred tax assets and liabilities are charged or credited to income tax expense as part of deferred tax expense or benefit of the period that includes the enactment date. The income tax effect of a change in tax law is recorded as a component of income tax expense in continuing operations even if the deferred tax balances related to a prior year or interim period gain or loss that was reported within discontinued operations or as an item of other comprehensive income. Under U.S. GAAP, the enactment date of the Budget Act is November 2, Accordingly, the financial accounting impacts of the Budget Act, if any, should be recorded during the period including November 2, 2015 (the fourth quarter of 2015 for a calendar-year entity subject to the Budget Act). As the new regime is not effective for tax returns filed for partnerships until tax years beginning after December 31, 2017, the authors anticipate most partnerships will have no impact as of the enactment date. However, there could be limited circumstances in which a partnership would have accounting implications prior to For example, if a partnership has uncertainty as to the tax basis of an asset or liability, it expects the tax basis to effect taxable income of the partnership in a future year when the partnership is subject to the regime, and it expects to assert the more favourable tax basis in its tax filings, then the authors suggest the partnership give further consideration as to whether accounting prior to 2018 would be appropriate. It is anticipated that regulations will be promulgated in the future to provide guidance around a number of matters in the Budget Act and to make certain provisions operable. The potential implications of those regulations should be considered as they are promulgated.

6 Potential Financial Reporting Implications of Changes to Partnership Examinations page 6 IV. Accounting for Uncertainty in Income Taxes The guidance on accounting for uncertainty in income taxes under U.S. GAAP prescribes a recognition threshold and a measurement attribute for income tax positions based upon an analysis of the technical merits of those positions; in other words, tax positions are analyzed under a twostep approach, recognition and measurement. The recognition step provides that an entity shall initially recognize the financial statement effects of a tax position when it is more likely than not 11 ( MLTN ), based on the technical merits that the position will be sustained upon examination. 12 If a position does not meet the MLTN threshold, a reserve is established for the entire tax benefit and the measurement step is eliminated. However, if the tax position meets the MLTN recognition threshold, it is measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement. 13 Any difference between this amount and the amount taken or expected to be taken in a tax return is referred to as an unrecognized tax benefit. 14 All tax positions are evaluated for recognition, derecognition, and measurement using consistent criteria. Throughout the evaluation of the recognition and measurement criteria, the entity would presume the taxing authority would examine the position and would have full knowledge of all relevant information. In other words, detection risk is not considered. Throughout the existence of a tax position, a taxpayer should continue to reevaluate the recognition and measurement of the position and determine whether there should be an adjustment to the benefit recognized. Accordingly, the tax position should be continuously assessed for subsequent changes to recognition and measurement based upon all available facts, circumstances, and information as of each balance sheet date. 11 A likelihood of more than 50 percent. 12 ASC ASC ASC

7 Potential Financial Reporting Implications of Changes to Partnership Examinations page 7 Authors Observation Partnerships that are subject to the regime and do not intend to elect the alternative mechanism, are not qualifying partnerships that affirmatively elect out or do not have the ability to make one of these elections, should evaluate tax positions that may include uncertainties to determine whether an unrecognized tax benefit is necessary in the financial statements. V. Financial Statement Disclosure Considerations An entity subject to the Budget Act may have additional financial statement disclosure requirements associated with income taxes that could have been previously inapplicable. An entity s policy for accounting for income taxes should be disclosed. As an extension of this, the authors believe partnerships should consider disclosing past elections or expected future elections as to whether they will be subject to the regime for the current year or any prior tax years open to examination. An entity shall disclose the nature of significant differences between the reported amount of income tax expense attributable to continuing operations and the expected amount of income tax expense. The expected amount of income tax expense allocable to continuing operations is typically zero for pass-through entities; accordingly, if a partnership recognizes significant income tax expense as a result of the regime it should consider disclosing such a reconciliation. Additional financial statement disclosures are required in conjunction with accounting for uncertainty in income taxes. If a partnership subject to the regime identifies and reflects unrecognized tax benefits within its financial statements, additional disclosures on interest and penalties and positions for which a change is reasonably possible within the next 12 months may be required. Further, entities that meet the definition of public entities 15 must disclose a quantitative rollforward of unrecognized tax benefits as well as the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate. These disclosures would be in addition to the disclosure of tax years that remain subject to examination by major tax jurisdictions, which partnerships commonly make today. 15 As defined within the Master Glossary of the Accounting Standards Codification

8 Potential Financial Reporting Implications of Changes to Partnership Examinations page 8 Example: Impact of Uncertainty in a Period Subsequent to the Effective Date Assume in 2018 Company AFIT, a calendar-year partnership, intends to reflect a deduction on the tax return for which the timing may be challenged upon examination and it is MLTN that the deduction would not be permitted until If Company AFIT does not intend to elect out of the regime, an unrecognized tax benefit equal to the amount of the deduction would be measured at a 39.6 percent rate (absent qualifying under any regulation for the use of a lower tax rate) and recorded in the December 31, 2018 financial statements. However, as the new regime only applies to the imputed underpayment, the benefit of the deduction in the appropriate period (2019) would be reflected at the partner level through either a reduction in non-separately stated income or an increase in non-separately stated loss (ordinary treatment) in the adjustment year. This treatment results in an unrecognized tax benefit and income tax liability on the imputed underpayment at the partnership level with the benefit of the later deduction recognized at the partner level. Conclusion What's News in Tax is a publication from the Washington National Tax practice of KPMG LLP ( KPMG ) that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The enactment of the Budget Act presents a number of complex accounting considerations that should be analyzed in order to determine the appropriate financial reporting impacts of the change in tax law. While partnerships remain pass-through entities generally not subject to federal income taxes, the new regime may cause additional analysis primarily around the entity s accounting for uncertainty in income taxes. The various considerations to partnership entities that require analysis have the potential to affect periods beginning with the date of enactment. Additionally, partnerships will need to closely monitor the new regime as implementing regulations are issued by the taxing authority and may need to reevaluate the appropriate accounting model for the regime as a result of the issuance of those regulations. Finally, partnerships may need to establish or change controls around the accounting for potential payments under the new regime. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.