ASC 740-10-25: Recognizing Uncertain Tax Positions

The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 740 governs how companies account for income taxes. This standard addresses both current taxes payable and deferred tax assets and liabilities that arise from differences between financial accounting and tax laws. Companies often take positions on their tax returns where the final outcome is uncertain until it is reviewed by a taxing authority or the time for an audit has passed. The principles within ASC 740-10-25 dictate how and when a company can recognize the financial benefit of such an uncertain tax position.

The More-Likely-Than-Not Recognition Threshold

The core of accounting for uncertain tax positions is the more-likely-than-not (MLTN) recognition threshold. The standard states that a company can only recognize the financial benefit of a tax position if it has a greater than 50 percent likelihood of being sustained upon examination. This evaluation must be based on the position’s “technical merits,” supported by sources of tax law such as statutes, regulations, and relevant case law.

In applying this standard, a company must presume that its tax position will be audited by the relevant authority, such as the Internal Revenue Service (IRS), which will have full knowledge of all pertinent information. The possibility that a return may not be selected for audit, the “audit lottery,” cannot be considered in the assessment. This ensures that recognition is based on the strength of the position itself, not on the chances of it going unnoticed.

The analysis requires a company to first define the “unit of account,” which is the specific tax position being evaluated, like a single deduction or a broader tax strategy. Each position must be evaluated on its own, without offsetting it against other uncertain positions.

For example, if a company claims a $500,000 tax credit, it must assess whether there is a greater than 50 percent chance that the full credit would be upheld. If an analysis of tax law indicates a 65 percent probability of success, the position meets the MLTN threshold. Conversely, if the analysis suggests only a 40 percent chance of success, the position fails the threshold, and no benefit can be recognized initially.

Applying the Two-Step Approach

The evaluation of an uncertain tax position follows a two-step process that separates recognition from measurement. The first step is recognition, where a company evaluates whether a tax position has a greater than 50 percent chance of being sustained upon examination. If the position fails to meet this threshold, no tax benefit can be recognized, and the company records a liability for the unrecognized tax benefit.

If a tax position meets the MLTN threshold, the company proceeds to the second step: measurement. This step determines the actual amount of the benefit to record. The standard requires recognizing the largest amount of tax benefit that has a greater than 50 percent cumulative probability of being realized upon ultimate settlement with the taxing authority.

To illustrate the measurement step, consider a company that has met the MLTN threshold for a $200,000 tax deduction. Management develops a table of possible outcomes and their individual probabilities.

| Possible Sustained Amount | Individual Probability | Cumulative Probability |
| :— | :— | :— |
| $200,000 | 15% | 15% |
| $150,000 | 30% | 45% (15% + 30%) |
| $120,000 | 40% | 85% (45% + 40%) |
| $50,000 | 10% | 95% (85% + 10%) |
| $0 | 5% | 100% (95% + 5%) |

In this scenario, the analysis starts with the highest possible benefit. The cumulative probability of realizing at least $120,000 is 85%. Since this is the first level that exceeds the 50% likelihood, the company would recognize a tax benefit associated with a $120,000 deduction in its financial statements. The difference between the benefit claimed ($200,000) and the benefit recognized ($120,000) creates a liability for the unrecognized tax benefit.

Identifying and Documenting Tax Positions

Before applying the two-step approach, a company must identify its uncertain tax positions and prepare thorough documentation. This involves a review of all material tax positions for tax years that are still open to examination by taxing authorities. Common examples of uncertainty include:

• Whether specific activities qualify for the research and development (R&D) tax credit under Internal Revenue Code Section 41.
• State tax nexus, where a company must determine if its presence in a state is significant enough to require filing an income tax return.
• Transfer pricing policies between international subsidiaries, which must adhere to the arm’s-length standard of IRC Section 482.
• The deductibility of business expenses under IRC Section 274, where entertainment costs are disallowed while most business meals are 50% deductible.

Once a position is identified, detailed documentation must be created to support the accounting conclusion, often in a technical memorandum. This document outlines the specific facts and circumstances of the position. It must include citations to relevant tax law, Treasury Regulations, IRS rulings, and applicable court cases, presenting an objective analysis of both supporting and contrary evidence.

The memorandum should clearly articulate the rationale for the unit of account chosen and the basis for concluding that the position meets the more-likely-than-not threshold. It must also detail the measurement analysis, including the table of potential outcomes and cumulative probabilities used to determine the amount of the benefit recognized.

Subsequent Recognition and Measurement

The accounting for an uncertain tax position does not end with the initial assessment. Companies must re-evaluate their positions at each reporting date to account for new information or events. A change in judgment may be required if new information becomes available, such as a new court ruling, legislative changes, or the discovery of new facts.

If new information causes a previously unrecognized position to now meet the MLTN threshold, the benefit should be recognized in the period the change occurs. Conversely, a previously recognized tax benefit must be derecognized if it no longer meets the MLTN standard. This derecognition results in an increase to tax expense and the related liability in the period the threshold is no longer met.

The final resolution of an uncertain tax position occurs through settlement with a taxing authority or the expiration of the statute of limitations. When a company settles an audit with the IRS, the liability for the unrecognized tax benefit is reversed, and any difference between the recorded liability and the actual settlement amount is recognized as an adjustment to tax expense. If the statute of limitations expires, which for federal purposes is generally three years under IRC Section 6501, the uncertainty is removed, and the company can recognize the full benefit.