Uncertain Tax Positions – Recent PATH Act Payroll Research Tax Credit Provides Opportunity and Complexity
Many startup companies are taking advantage of the PATH Act expansion of the federal research credit that allows qualified small businesses to designate up to $250,000 of the research tax credit as an offset to the employer’s portion of OASDI (social security) payroll taxes. However, this opportunity presents unique challenges for companies evaluating uncertain tax positions under ASC 740-10 (formerly FIN 48).
Non-Income Taxes
The PATH Act opportunity to offset payroll taxes is a significant opportunity for startup companies that are not paying income taxes due to net operating losses. When preparing these companies’ financial statements, it is important to note that payroll taxes are not based upon income, and therefore, the financial accounting for them is not governed by the tax accounting rules codified under ASC 740. The ASC 740 Master Glossary defines Income Tax as follows: Domestic and foreign federal (national), state, and local (including franchise) taxes based on income. In addition, it defines Taxable Income as the excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority. From these definitions, it is clear that the payroll tax would not be considered an income tax. Therefore, any payroll tax booked as well as any credit received against such a tax would be included in book income before income tax and considered above the line items.
Uncertain Tax Positions (Payroll Tax Credit Offsets up to $250,000)
Since payroll taxes are not covered under ASC 740, companies must look elsewhere for guidance on uncertain positions. ASC 450 (formerly FAS 5), which covers contingencies, provides the guidance necessary. ASC 450 defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. In addition, ASC 450 describes two criteria that must be met in order to accrue a charge to income for the contingency:
- Information available prior to issuance of the financial statements indicates that it is probable an asset has been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
- The amount of loss can be reasonably estimated.
Based upon the above, an uncertain position related to the $250,000 payroll tax credit would require an analysis to determine the amount expected to be overturned, if any, upon audit. If an amount can be reasonably estimated it would be booked as a charge against gross income as a contingent liability.
Uncertain Tax Position (Amounts above the $250,000 Threshold)
While analyzing a company’s research tax credit and payroll tax offset, a unique situation presents itself. Namely, what to do with the research credit amount above the $250,000 threshold? Since these amounts would be re-allocated back to a research tax credit offsetting income tax, an analysis of the uncertain tax position under ASC 740-10 is required in addition to an ASC 450 analysis. This results in the company applying two different accounting standards to its research tax credits. Below we will consider an example of a company with these circumstances.
Facts
- Company qualifies for the $250,000 payroll tax credit
- Company has $300,000 in research tax credits overall
- Company has a net operating loss and will carry forward any credit not used as a payroll credit
- After performing analyses under ASC 740-10 and ASC 450, the company believes it is probable that it will only receive 60% of the benefit.
What reserves should the company book?
Since the company is expecting a 40% reserve against the overall credit and can take the payroll tax credit in the current year (as opposed to the income tax credit, which will be carried forward due to NOLs), it would first apply this reduction to the income tax credit. This application would cause the remaining $50,000 ($300,000 less $250,000 refund) of research income tax credit carryforward to no longer meet the more likely than not threshold for recognition under ASC 740-10 and, therefore, the company cannot book an income tax benefit for any of the amount. Next, the remaining reserve would be allocated to the payroll tax. The amounts booked by the company would be as follows:
Overall reduction in credit = $120,000
Reserve under ASC 740-10 = $50,000
Contingent liability under ASC 450 = $70,000
Final Thoughts
It is important for companies to note the complexity around uncertain positions that involve the recently enacted PATH Act research payroll tax credit. The methods under ASC 740-10 and ASC 450 differ in how estimates are calculated as well as the disclosures required. A detailed review of the accounting standards is necessary for companies to ensure that the financial statements are presented accurately and adhere to the proper accounting standards.
