IRS Announcement 2010-30 revealed the draft Schedule UTP for reporting Uncertain Tax Positions. The finalization of the Schedule seems to be on a fast track as comments must be submitted by June 1, 2010. The IRS proposes to require the Schedule for corporate return years beginning on or after December 15, 2010. The reporting required by this Schedule could bring about the most significant change in corporate tax reporting since the creation of the 20 percent substantial understatement penalty. It is potentially much more significant than recent the codification of the economic substance doctrine.
The Nature of the Filing
Up to now taxpayers have been invited to inform the Internal Revenue Service (IRS) of “tax shelters” or uncertain positions they were taking on their returns in order to avoid or reduce potential penalties. Therefore, such reporting has been “optional” in the sense that failing to report was not the failure to file a required form. The reporting that will be required by Schedule UTP is not optional. If the taxpayer fits the category described in the Schedule’s instructions, it must complete the Schedule and attach it to its Form 1120. Intentional failure to file the Schedule will be a serious error by the taxpayer.
The function of the Schedule is to remove the “audit lottery” from consideration by taxpayers and to give the IRS auditors a roadmap to identify the tax positions about which the taxpayer has sufficient doubt to record a reserve (and in certain other cases). In a change from prior audit practice, the IRS will not be seeking to learn the size of the reserve, although the Schedule does ask the size of the maximum tax adjustment if the taxpayer is wrong about its tax position as reported.
Which Taxpayers Will Have to File Schedule UTP
The IRS has chosen not to require filing by all entities and so partnerships, including limited liability companies treated as partnerships, no matter how large, will not be required to file the Schedule. Individuals will not be required to file the Schedule. It must be filed by a corporation that:
- Files a Form 1120, 1120 F (foreign corporations), 1120 L (life insurance companies) or 1120 PC (property and casualty insurance companies). Announcement 2010-30 implies that other entities — such as real estate investment trusts, regulated investment companies, S corporations, partnerships or tax-exempts — enjoy only a temporary reprieve and will eventually be subject to Schedule UTP.
- Has gross assets that at least equal to $10M as shown on Form 1120, Part 1, Box D (or similar parts of other Form 1120 returns).
- Issues (or is related to a party that issues) an audited financial statement reflecting the taxpayer’s operations for any part of the tax year. The audited financial statement can be based on regular or modified GAAP or IFRS but is treated as an audited financial statement if an independent third party expresses an opinion on the statement and the applicable accounting standards require reserves for uncertain federal income tax positions. A financial statement records a reserve either by increasing tax liability, decreasing a refund, reducing a deferred tax asset or increasing a deferred tax liability with respect to the tax position. Reporting need be made only once, upon the initial recording of the reserve.
- Has one or more uncertain tax positions that must be reported.
Uncertain Tax Positions
The Schedule did not have to define uncertain tax positions, in contrast with the statutory definitions of “tax shelters,” and other penalty-related positions, because it relies on the U.S. Generally Accepted Accounting Principles (GAAP) or other financial statement audit standards to do that work in identifying the reserve. However, the Schedule’s instructions add two cases in which the taxpayer must report uncertain tax positions for which it does not record a reserve, if:
- A reserve would have been recorded but for the fact that based on past IRS administrative practice and precedents with the taxpayer or similar taxpayers the IRS is known not to challenge such tax positions on audit. The Schedule provides a special box that must be checked if this is the basis for the position. Or …
- A reserve was not recorded even though the taxpayer determined that the probability of settling the issue with the IRS was less than 50 percent.
These two additional cases may turn out to be the most difficult part of completing the Schedule. On the one hand the taxpayer cannot rely on the IRS’s administrative practice to avoid reporting; but on the other hand if it knows the IRS will take an unreasonably harsh view of a position it must report it even if the taxpayer is fairly certain it will win. An example in the instructions shows a taxpayer with a 60 percent chance of prevailing in litigation, which still must report an unreserved tax position on the Form because it knows the IRS probably will not settle the issue if audited.
Details of Reporting
Several important sub-issues are addressed in the instructions:
- An uncertain tax position is not limited to a line item on a return but rather must be pushed down to identify the “unit of account” in which the reserve is recorded. Several units of account may enter into a single line item.
- If the reserve is recorded or the decision on the reserve is made within 60 days before the actual filing date of a return the taxpayer has a choice to push the reporting into the next year and onto the part of the Schedule that reports prior year positions.
- Affiliated groups need not identify the group member to which the uncertain tax position relates.
- The uncertain position may not initially have been taken by the taxpayer, as for example in the case of a corporation that invests in a partnership or other flow-through entity that reports an uncertain tax position for which the corporation records a reserve.
- When an uncertain deduction creates a net operating loss (NOL) carryforward and no reserve is recorded in the year the deduction is claimed it does not have to be reported — but it does have to be reported for the year in which the NOL is used and the reserve is recorded.
- The taxpayer is not supposed to use the Schedule to argue the position. Rather the description must be “concise” by identifying:
- The tax position and
- The nature of the uncertainty.
The instructions give examples that basically describe a transaction in one or two sentences, state in one sentence the tax position taken with regard to the transaction and state in one sentence the “issue” or nature of the uncertainty. The taxpayer is not required to report the degree of uncertainty.
- The Schedule will look like a roadmap to the auditor: number of the position; primary code section; temporary or permanent; EIN of pass-through entity from which the position was derived; check if no reserve due to IRS administrative practice; maximum tax adjustment (except for valuation or transfer pricing positions); year of the original position.
What to Do
It is highly likely that the IRS will finalize this reporting requirement for tax years beginning on or after December 15, 2010, which means that corporations will begin to file these reports in less than two years. However, beginning as early as next January taxpayers will begin to record reserves or decide not to record reserves and thereby trigger a reporting obligation. Therefore, it is not too early to begin to consider how this Schedule UTP will affect both corporate tax planning and reporting.
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