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On-Demand: Tax Provision Preparation 201

Nov 1, 2022

Join EisnerAmper to learn the intermediate areas of preparing an income tax provision.


Thomas Cardinale:Thank you Bella, and welcome everyone to part two of our intermediate provision series. Special welcome to those who attended our first program back in January. Today, Allie and I will take you through a deeper dive through some provision mechanics and also some special tax adjustments that we tackle often with provision work day in and day out. So let's go right into it. Here's our agenda for today. I'm going to first take you through the rate reconciliation, then Allie's going to talk about the income tax payable wreck and receivable. We're going to go through the R&D capitalization rules, which have hit the tape effective this year.

We're going to look at tax treatment of various stock based compensation, incentive stock options, non-qualifieds. We're going to go through naked credits, definitely one of the more technical areas of provision. So we're going to go through an example on how that works and then we're going to end it with state conformity and some mind joggers. The mind joggers if we have time, we just want to go over some various tax provisions that have changed for this year, whether it was from the Tax Cuts and Jobs Act, or some related pandemic relief provisions that are impacting provisions today. All right, we're going to start off with a polling question. Did you attend a tax provision 101 seminar taught in January?

Alexandra Colman:So we did 101, this is 201. Fingers crossed for an upcoming 301.

Thomas Cardinale: Okay. About a third of you intended in January. Welcome all new people, but the other two thirds, so very good. So let's dive right in now to our first topic of provisions: rate rec, the rate reconciliation. this is one of the areas that I feel is one of the more underrated areas of provisions because although it's more mechanical, it really tells the story behind the scenes of what tax expense we're putting on a P&L versus what we're doing on the provision with all the tax adjustments movements, valuation allowance deferred and temporary differences.

And it really helps the financial statement reader understand, especially the novice reader that's looking through say a public company 10K, and is it just a basic example? If there was pre-tax income of a million dollars and the tax expense for this company showed 320,000, a novice financial statement reader would say, "Why is the tax rate 32%? I thought the US corporate rate was 21%." Well, the answer to that is you do a rate rec and for public companies this is a required disclosure in the body of your footnotes. For private companies, it is not required, but it is still optional.

So how do we get to that 320,000? What kind of items impact going from that 21% statutory rate to the 32% we just showed on that example? So some of the most common items are permanent differences. Permanent differences as we talked about in January, do not reverse. They could be tax exempt income items, they could be non deductible items, officer's life insurance, business meals, which happen to be fully deductible through the end of this year but are going back to 50% next year. State taxes, state and local income taxes get commonly missed. That is part of your rate rec. The deferred state tax expense also; differences in foreign tax rates if you're a global group and you're in it... Almost every country in the world has their own tax rate, right? If net income includes both US tax and a foreign subsidiary with its own local tax computation, that difference in tax rate is going to be a rate rec item.

If a company is fully reserved on their deferred tax assets, the change in the valuation allowance from beginning of year to end of year, that impact is going to be a rate rec item. Tax charges to equity or OCI, your deferred tax asset or liability could have some items in there that need to be tax affected, not to your P&L but to equity. Think of unrealized changes in foreign currency exchange rates or like an interest rate swap contract or something like that. And federal credits. If you're utilizing a federal credit, say the R&D credit in the current year, that's impacting your current provision tax expense, that's going to be a rate rec item. It's going to effectively reduce your 21% effective rate.

So one item you may not see in here is your general temporary differences. Why is that not a rate rec item? Well, if the company's not fully reserved, remember that temporary differences, as we discussed in our first program, offsets each other between current and deferred. Whatever the current impact is on your temporary differences, the inverse will happen on your deferred. So they kind of are offsetting forces that net to zero for the most part, therefore it's not going to be a rate rec item. However, if you're fully reserved, the change in valuation allowance is going to be a rate rec item because that's a one-sided hit on the deferred side.

So I thought it best to just show you a numbers example of how a rate rec works. This is granted of more basic one and it can get very complex, but you need to see the inner workings of how it works from the example. So the tax at the statutory rate is always your starting point. We have a million dollars of pre-tax income, in our example, we apply the 21%; corporate rate, $210,000 of tax expense. That's the expectation of some financial statement readers. So how do we get to that 320? Well, as I talked about before, permanent differences. Say we got 50,000 here, we apply the 21% rate to that so the impact is 10,500. We're adding to the tax expense $10,500 as a result of permanent differences. State taxes, this is already tax affected.

We computed in our example a hundred thousand dollars of state income taxes, but why do I have 79% and the tax rate column? Well first it's already tax affected, but then you have to consider that state taxes are a federal deduction. So we multiply it by 79% and hence get 79,000 impact to the rate rec. In our example, we have a foreign subsidiary, we have a Japan subsidiary and their income contribution to the million dollars of income is 250,000. The Japan corporate rate is 30.6% and the US is 21, so that delta, the 9.6% times the Japanese subsidiary pre-tax income, is going to impact the rate rec by 9.6% or two $24,000. And then lastly, I just have an R&D credit taken a current year usage credit of 3,500. That's already tax affected, so you don't have to have a tax rate or a tax benefit rate in the tax rate column. So you add up all those items and you get to 320,000.

This level of detail is not required to be in the footnotes, usually percentages but the provision preparer has to have this level of detail. It's a sanity check. And if they can't get it to reconcile and many times we can't get it to reconcile, we'll usually have a plug, unreconciled difference that gets to our P&L rate. That could be a prior true-up, it could just be a tax rate error, it could be any number of things. So your true up you always want to make sure is a low number. We always try to get it perfect as we prepare provisions, but that's not always the case.

Here, this happens to be Google's rate reconciliation in the last three years from '19 to '21. You could see that three or four of these items I had in my example too, they have a research credit as you could see as drastically lowering the effective rate by one and a half to two and a half percent. What I find interesting is line two. I did the example before of the Japanese rate, but look at the drastic change from 2019 to '21. They seemed to be in very favorable tax jurisdictions in 2019 that drove their overall tax rate down to 13.3%.

You could see I was really ramping up and now it's actually 0.2 positive. So what that states is that the US rate is more impactful on a global basis than it was in the past. Stock based compensation, because that's a negative, that's just probably a windfall tax adjustment. Fair market value of stock options go up, the recipient exercises it, there's a windfall and it's an additional tax deduction to the company. So that's why I have a negative there and state and local taxes at the bottom, 1.1%, pretty consistent. That's what you look for too with state taxes is usually fairly consistent, but you're never going to be like absolutely perfect year over year.

Other considerations to the rate rec, disclosures, when you're disclosing the movements it can be done either in dollars or percentages. The latter is easily more popular, that's probably over 90% of disclosures are in percentages. If you're a public company out there, remember the 5% rule. If a rate rec item has a tax affected impact of 1.05% or more, which is 21% of 5%, it must be a separate line, it cannot be buried with another item. So there might be some items you don't want your financial statement readers to see. It's like, "Can we just group this with this credit or or state taxes?" But if it has a result of 1.05%, it must be its own line item.

One thing to note too is companies are near break even and you have significant tax adjustments. The rate rec could have huge swings and percentages. If you're near breakeven, you could have a thousand percent that you need to reconcile or more, but that should be expected. So that can induce the decision when a company wants to use the annual effective tax rate when they're doing their interim provisions or the discrete actual method. If you're near breakeven and you have huge swings in your temp differences, you may want to consider the discreet method, otherwise your numbers are going to be all over the place. So that's the rate rec. And now I'm going to turn it over to Allie to go through the payable rec. Allie, take it away.

Alexandra Colman: Thank you Tom. So hello everyone. I'm sure when you saw the agenda and you saw that income tax is payable or receivable is a 201 topic, you probably were not expecting that. But it's honestly one of the areas of the provisions that when I'm reviewing a provision that I see the most issues. That's because a lot of times companies compute the current period tax expense and they say, "Okay, I have $200,000 worth of current taxes for this year, so I'm just going to debit tax expense and credit my payable. The end." Unfortunately, it's not that easy. So the income tax payable receivable balance should be validated at the end of every year. And the way that we go about doing that is most of you probably receive requests for your general ledger detail of your tax accounts. Sometimes I'm greedy and I ask for the full general ledger and my clients say, "Allie, I can't even put that in an email. It's too big and that's fine."

But generally we like to get the tax account detail. Those accounts would be your deferred tax asset and liability account. It would be any prepaid income taxes account, accrued income taxes, income taxes payable, anything on the balance sheet that would have an income tax component. And then I also request the offset, so I usually like to look at the P&L as well, so your income tax expense or income tax benefit accounts. With that data, I then basically make a summary and I say, "Okay, what were my extension payments that were made during the year? What were the estimated tax payments this year?" I'm able to see if there were any notices that were paid during the year. That's always helpful because sometimes my clients will just get a notice and say, "It's not worth sending it to you, we're just going to pay the difference and call it a day."

It's also beneficial for us to get this information because that way then we're able to confirm that the tax estimates that were provided actually went through. I'm sure everyone on the line has had the issue of your bank blocking a payment, whether it's your extension payment or an estimated tax payment. On our side or your tax preparer's side, they won't know necessarily that those payments didn't go through. So you really get a full picture of the cash payments that were made related to income taxes by looking at that GL detail and that impacts what's sitting in your end of the year payable or receivable balance. Another thing that we look at is I need to see if there were any over accruals of tax or under accruals of tax in prior periods. Usually this is something that's looked at at the year end provision because especially for the calendar year filers on the phone, if you're a December 31st year end, your tax return is due October 15th, which falls into Q4. So you wouldn't do those RTPs in your Q3 provision unless your tax returns were filed by September 30th.

But anyway, we look at how much tax did we accrue on the provision versus how much tax was actually due with your tax return. If you under accrued your tax, meaning if on the provision I said let's accrue a hundred dollars, you file your return, you end up actually owing $150, that $50 difference, you are entitled to that expense. You're just going to increase your current period expense in 2022 even though it was tax related to your 2021 filing and vice versa. If I over recruit on your provision, that's going to reduce my current period expense that I'm booking.

Some best practices would be running all of your tax payments and notice payments through the payable. You really want to keep your expense account clear outside of any interim provisions that you're booking as a result of your quarterly filings. And also just making sure, inputting a memo, it really doesn't take much time when all those cash payments are getting made throughout the year, but I kind of feel like Nancy drew on the other end. Sometimes when I'm looking through the general ledger and I see a payment made Alabama June 15th, I'm like, "I hope that was an estimate, a Q2 estimate." But I'm not quite sure what that is, and then we need to go back and ask those questions because it's important for us to know which period each cash tax payment relates to.

So at the end of the day, your tax payable or receivable should actually equal the amount of cash that you expect to pay or the amount of cash that you're expecting to receive as of December 31st of that filing year. So we're talking about your 2022 provision that's coming up. If you look at the 2021 tax returns that were filed and compile all of those overpayments, you add to that any 2022 estimated tax payments that were made during the year, and you subtract from that the accrued taxes that we're computing for the current year, that would be your ending payable or receivable balance. Notice that, no pun intended, there are no notices in this equation because at this point, if you've paid a notice, you already paid it, it shouldn't be sitting in your balance sheet. That should impact your tax expense for the current year potentially, maybe interest, maybe penalties, but those balances need to be washed out and removed from your payable and into your income tax expense account.

So if you look at this very basic example of these three states here, we compute the tax liability in each of our provisions. We look at the overpayment from the prior year, any estimates that were made during this year, and then you roll in your tax liability that we're computing for the current year and then that's how you compute your receivable or payable balance. You'll notice in this example that Massachusetts, when the 2020 tax return was filed, we actually over accrued taxes by $285. That under/over accrual does not go into my ending receivable or payable balance. In fact, it really just impacts my current period tax expense.

So if you look at this example from a real life client, a real life company, this shows it's very important to look at the GL detail because what I was able to find was that there were certain extension payments that were missposted. We know that unfortunately things like that happen and we want to make sure that we're getting credit for all the tax payments that were made during the year. So we roll forward our payable balances, through that process, we are able to identify if there are certain payments that we think are missing based on the information that we provided. "Hey, we thought that we told you to make this $4,600 estimate to New York, I don't see it in your tax payable. Did you make that payment?" And then we're able to really scrub the GL detail to make sure that things are in the proper accounts.

You'll also notice there are certain things like Delaware franchise taxes that those accruals are sitting in the income taxes payable account. And while that may be fine for your GL, that doesn't give me as the tax provision preparer, a clear view of what actually I'm expecting for income tax purposes in terms of a payable. So at the end of the day, after all of the ins and outs of what is booked for book purposes, we then make some reclasses for tax purposes. We're taking extension payments that are running through the P&L and putting that into the payable. We then book the current period tax entry where we're crediting the tax payable and debiting the expense, which if you had not done the payable validation, that might be the only component that you're doing and you're rolling forward historical over accruals and notice payments that really aren't payables or receivables at the end of the day.

And then you essentially are reclassing your prior year under accrual or your prior over accrual out of the payable and reducing your current period tax expense. So at the end of the day, I would expect that my income tax is payable based on the computation that was on the last slide. I am expecting a receivable of 71,932. When you go through and do that analysis, the simple equation of the overpayments, the estimates net of your year liability that you're expecting, in this situation there's a fin 48 reserve that's impacting my payable computation, but based on the facts, I would expect a receivable of 71,928 and $4 off. But I think that's a pretty good payable that I'd be willing to sign off on and it would give a clear view to your reader of what your actual income tax payable or receivable is at the end of the year. So I hope I did some convincing of not just booking that current period expense and that actually it's worthwhile to look at the GL detail. So our next polling question actually, who will you be rooting for in the World Series?

Alexandra Colman: I was just throwing in the fun fact that I'm actually originally from the suburb Philly area, so go Phillies. I'm sure there's a lot of just... I know I live in New Jersey now, I'm used to being around Yankees fans, so I apologize to all of you on the line. But yeah, we're going to be wearing red in this household this weekend.

Alexandra Colman: All right, Ken, agreed. Go Phillies. Yeah. Oh, go Eagles, I'm down for that too. Oh and yes, if you've given up on baseball and follows for... I can fan and cheer for the six and oh Phillies or Eagles, sorry.

Thomas Cardinale: Anybody, but Houston is one of the responses. Some answers I can't say. We're trying to be cordial here. All right, so we got a lot of football fans out there. I'm kind of in that camp. I happen to be a Giants fan, but both Giants and Jets are doing well, so let's go.

Alexandra Colman: All right, Tom. Alrighty.

Thomas Cardinale: So moving on to R&D expenses. So this is a 2022 very major impacting item that was actually part of the Tax Cuts and Jobs Act. You remember all the way back to December of '17. One of the little talked about provisions back then because it was a time trigger was R&D expense capitalization, which would take effect January 1, '22 of this year. There's been several attempts to delay it, but ultimately that has failed due to the conflicts and partisanship in Congress. So we have this in effect and we've already done it through some quarterly provisions. We'll definitely tackle it at a year end. But if you have R&D expenses incurred in the US, you now must capitalize it over a five year straight line period for tax purposes. If it's foreign based R&D, if you're outsourcing R&D, that must be over a 15 year period. That's a major, major change.

The old rule was if it was a qualified Section 174 expense, you could just write it off in the year you incur it, nice and simple, and get a nice tax benefit. Now we have these heavy capitalization requirements. On top of that in the very first year for this year, all expenses are assumed to be mid-year. It's a mid-year convention, so your tax deduction for US expenditures is only going to be 10% of your spend. So what it essentially does is your US-based R&D is going to have a six year period and your foreign is going to have a 16 year period. The above rule also applies to website software development. Website software development used internally in a company is not per se pure R&D from a tax perspective because that gets it to the rules of a product, the betterment of a product, physiological scientific changes, but software development costs kind of followed Section 174.

So because it followed 174, all these three old options were either at a direct write off as R&D, a three or five year capitalization period are gone. If it's all US, you got to use the five year, so that could be a major change for those costs also. And just covering it again here, emphasizing it, the new capitalization covers software internal website. It repeals the old and there's the three options that was your choice. Almost all the time everyone took the first choice. If it was immediately allowed as a write off, then take it. And this was especially true in 2017 when the corporate rate was going from a 35% rate to 21, any option available to write off, we were taking that. So all of this is now gone, you have to capitalize over five or 15 years.

So how does that impact your tax provision? So here's just a very simple example. X Corp occurred 800,000 of US R&D costs, 300,000 of foreign. Let's assume a blended effective tax rate of 28%. How does that impact the current and deferred provision? Well, the current provision is going to have a major unfavorable adjustment. First, we have to add back that book deduction in grand total, which is 1.1 million, and then we're going to have a favorable adjustment of the capitalization piece, but it's only going to be 90,000 in year one as outlined at the bottom. You're going to have five years but times that 50% convention on 800,000, that's only 80,000 and then 300,000 divided by 15 times 50 is only 10,000. So you're only going to get 90,000 in that first year.

Then for deferred, you remember we're talking about temporary differences, gross current year temporary difference is 1.01 million, 1 million and 10,000, which is the difference between your current year book basis and tax basis. So that is going to be your gross temporary difference. Your deferred tax asset is that ending balance net of those two book and tax balances. So you got 1 million and 10,000 times a 28%, blended effective rate is a 282,800 DTA at year end. But the big question we always get, okay, you have all these new capitalization rules, what does that do to the R&D credit? Absolutely nothing.

The R&D credit computations are exactly the same. No matter which method you use, simplified method, the standard method, the two ADC deduction is still intact. So you could apply the full incurred qualified R&D expenses for the credit purposes. So if you're using contractors, you can take that at 65%. Anything specific to the R&D process, supplies, materials, you can use that. And of course allocated wages of your staff purely to R&D, you could also include. So that does not have to get capitalized for R&D credit purposes. So that was just a quick overview, simple, but it's a big change and now I'll kick it back to Allie.

Thomas Cardinale: There is a quick question we could answer real quick, what if for you're using a vendor, I assume that means a vendor for R&D purposes, that is qualified as an R&D expense? It all depends on where is the vendor and you want to be careful because it could be a foreign vendor, but they set up like a mailbox shop in the US. It goes by where the R&D's being performed so if you do use a vendor, if it's overseas, you got to use that 15 year capitalization, the US five year, but for R&D credit purposes it's at 65%. So good question.

Alexandra Colman: Oh wow. Okay.

Thomas Cardinale: Okay.

Alexandra Colman: Well, good to know. So I imagine most companies if you do have any stock issuing award, equity award issuances, it's usually more than one type so the various answer doesn't surprise me. But okay, for those of you that you don't have equity awards that you're dealing with, maybe one day you will and you can refer back to these slides. To everyone else, I do want to say that please download the slides because there are a lot of examples included in the equity compensation area in these slides that I put for you to refer back to because this is an area that gets a ton of questions and is often not computed properly, so just wanted to have a lot of things in here for your reference. So the first type of equity award we'll be starting with today is an ISO, an incentive stock option.

So it's important to know that an option is just that: it's an option to purchase stock. The difference between an ISO and a non-qualified option when you're looking at it from a tax perspective is when there is book expense related to these ISOs that was going to be added back as a permanent difference. So that's something that it's called an incentive stock option for a reason, right? The recipient of the incentive stock option upon exercise generally does not have any tax liability that they need to pick up, ordinary income tax liability, so therefore the company is not ever be entitled to an income tax deduction. So if you are looking at your stock based compensation expense running through your P&L for the year, whatever portion of that is related to the vesting of ISOs, you want to make sure that you're adding that back as a permanent item.

To bring it back to where we started today, that would also show up on your rate reconciliation as a permanent difference. Of course in tax there's always an exception to every rule. So with ISOs there are certain times a disqualifying disposition and you need to... A disqualifying disposition occurs if you don't hold on after you exercise your option. If you sell it too quickly and your holding period is less than one year, then that's a disqualifying disposition and the individual who does that actually does need to pay ordinary income tax on that ISO. So when a disqualifying disposition occurs, the company then gets a permanent favorable deduction. That's not something that you can predict, which is that's why it's like, "Oh, but it's essentially reversing." Inherently ISOs are not deductible, so when the expense is taken for book purposes, it's added back permanently and if a disqualifying disposition occurs, that also is a permanent favorable deduction going the other way.

Again, I mentioned there are a lot of examples that I have in here, so I'm going to skip through most of them, but really just there for your reference. So now let's talk about the other type of common award that is an option and that would be your non-qualified stock options. I alluded to the fact that the difference between ISOs and non-qualified is that an ISO is added back permanently. A non-qualified option is added back temporarily, so when you add back any stock based compensation related to non-qualified stock options that's taken for book purposes, that's going to create a deferred tax asset for us. So we will have an unfavorable M1 as these non-qualified stock options are vesting for book purposes.

When the exercise occurs, that's when the fund happens for tax purposes. So when an employee exercises a non-qualified stock option, that's a triggering event. And the difference between the fair market value that is on the exercise date, when you compare that to the exercise price, that difference or intrinsic value is reported as stock as compensation to them on their W2 because the employee is paying tax on that income, therefore the employer is entitled to a deduction. So that's why non-qualified stock options are temporary in nature because eventually the company will get both a book and tax deduction for those non-qualified options.

Again, always an exception, so let's talk a little bit about what Tom alluded to earlier, windfalls and oppositely shortfalls. So in the example that we have an employee that received non-qualified stock options and for book purposes there was cumulative book expense based on the grant date fair value, there was an expense of $500 over the course of these non-qualified options vesting. When this employee then exercises the option, they end up paying tax of a fifth and $750. So the company's entitled to a $750 deduction because that's how much income the employee is picking up and paying tax on. However, if you look at this employee in a bubble, they would've created a deferred tax asset for stock-based compensation related to the non-qualified options of only $500. So if at the time of exercise I take a $750 temporary deduction and reverse that deferred tax asset, I'll end up with a deferred tax liability of $250 that's never going to reverse.

The company is never going to get that $250 deduction for book purposes. So that $250 difference of a windfall is permanent in nature and ends up on the rate rec as Tom showed on Google's rate reconciliation. So it's very important to look at when there's an exercise of non-qualified options, what the cumulative book expense was related to the options that were exercised. That portion is going to be reported as a temporary item and reverse out that deferred tax asset that was set up in the year the book expense occurred and any excess over that that the employee then had to pay tax on would be reported as a windfall. A shortfall is really just the exact opposite set of facts. If the fair market value on the exercise date is actually lower than when the options were issued, then let's say we had a $500 deferred tax asset, same example, but the employee only picked up income of $300.

I still need to fully reverse my deferred tax asset of $500, but that $200 difference is actually going to be a permanent unfavorable deduction. So $200 is going the other way, so I really only net am entitled to that $300 deduction that the employee paid tax on. Something I know everybody's probably working on their queues right now, any windfalls and shortfalls that your company has is going to be reported as a discrete item when you're doing your quarterly provisions, and that's because you can't predict when employees are going to be exercising their options and you also can impact what the fair market value is going to be when that exercise happens. So just something to note, that quarterly tax provision, those windfalls and shortfalls are discreet and are not going to impact your annual effective tax rate that you compute at the quarters.

Again, some more examples for you to walk through because I know we all love reading about taxes in our free time. But the last type of stock that we're going to talk about equity award is restricted stock. Restricted stock is different than options in the fact that you have stock. You were given stock, there's not an option to buy, it's just really a period of time needs to lapse or a certain triggering event needs to occur in order for this stock to have some value but you did get stock on day one. So very similar to non-qualified options, when the book expenses incurred related to these restricted stock units or restricted stock, that's added back as a temporary item and creates a deferred tax asset.

The difference is when the tax event happens for options at the date of exercise. For restricted stock, the tax event happens at the vesting date. So again, it's a W2 or getting reported on a 1099 is going to be the difference between the fair market value on the vesting date versus the fair market value... Just the fair market value of the vesting date. And when you look at what's reported on the W2 or the 1099 to the restricted stockholder, that's the amount of the deduction that you're entitled to for the employer purpose.

You keep seeing on some of these slides the 83(b) election. So if you have restricted stock and your employees make an 83(b) election, essentially what that means is the employee wants to be taxed now based on the value on the grant date rather than the future value when that restricted stock vests. So essentially what that employee is doing is they're making a gamble, they're betting that by the time my stock vests, I think that the value of my stock is going to go up and I don't want to pay ordinary income tax at that higher valuation, I want to pay my ordinary income tax on the valuation now.

Essentially, if an employee's doing that, they're betting on the company, right? That should make you feel good, they think that your company is going somewhere and the value is going to increase. The way that that works is the tax deduction then follows that timing and your tax deduction happens when the 83(b) election is made. And then as the book expense is taken in the future, as the restricted stock vest for book purposes, that's going to be added back as a temporary item to reverse the deferred tax liability that's taken in the year that the employee pays the tax on that income.

Again, you should know when your employees are making this 83(b) election because they need to give you a copy of the 83(b) election. It's also not the employer's responsibility to make the 83(b) election on behalf of the employee. That's something that the employee needs to do and mail on their behalf to the IRS and give the company a copy of. Again, another example for you to flip through. So next step on the docket is the very exciting. If you don't have a naked credit on your financial statements, I promise things are not about to get weird, Tom is just going to be talking about naked credits. Go ahead Tom.

Thomas Cardinale: All right, thanks Allie, and I agree with that. This is more boring than the title. I think we do have a polling question though.
Thomas Cardinale: And just as a little hint to our audience that may not be familiar with indefinite intangibles, goodwill, think goodwill. It's the number one probably item. I'd like to quickly answer question from the audience. The question is, if an employee is no longer with a company, when he or she exercises a non-qualified stock option, does the company still get a deduction? The answer is yes. As long as that employee earned it, because sometimes there's forfeiture requirements if they left before they have the right to exercise. But if you're assuming this employee can exercise the option and claim it is income, the company gets a corresponding tax deduction. But the number one question we get often is, do you pay them as a W2, as wages, or is it 1099 because they're no longer with the company? And unfortunately the answer commonly is you should pay them through the wages and as a W2. Even though they left the company and it seems a bit odd to do it that way, but more times than not, you get to that answer in just the reporting aspect of it.

Thomas Cardinale: All right, about a quarter of you have goodwill or some other indefinite lived in tangible, very common. This next area is all about how do we treat that such indefinite lived in tangibles for provision purposes. So let's first go through some of the fundamentals. What is a naked credit basically? Well, in almost all circumstances, a naked credit could arise for your tax provision when there's a company asset purchase. If you're buying another company and it's set up as an asset purchase and a portion of the purchase price allocated when you go through all the assets and the allocation of the price between buyer and seller, you have a significant portion or any portion that goes to goodwill. And in well over 90% of asset acquisitions, you're going to have that. Goodwill represents that future value of future business. It's got no life on; it's got no expiration so that's the most common and definite lived in tangible.

So the net result of a naked credit... This is what a naked credit is, it's a deferred tax liability on the balance sheet. If so, if you have a full reserve, if you're a company with a full reserve on your deferred and you buy up a company's assets and part of it is goodwill, you're not allowed to use that as future taxable income on a deferred basis. Meaning when it reverses and you have a full valuation allowance, you can't wipe out that liability, that deferred tax liability relating to the goodwill. So what you're going to have is basically a deferred tax liability in your balance sheet that sticks out alone that's relating to the goodwill even though you're fully reserved. It's very unpopular, normally it's unpopular because it's a phantom liability.

It's not a cash flow impact to the company, so there's always a little bit of fight back that, "Oh, do we really need to put this on there?" That is the rule because it is ASC 740 on a definite lived in tangibles, so you have to disclose on your balance sheet separately. But there's some good news. After tax reform came about at the end of '17, there was some indefinite lived benefits, tax benefits that came into play, right? The net operating loss carryforward changed from a 20 year life carryover to indefinite life and the new 163(j) rule, which is still limited to 30% of your tax bases EBITDA, but if you have any carryover, that lasts forever. Also, it's indefinite. So that allows you an opportunity to offset some of that naked credit, that liability in your balance sheet with some of the... you can call it a naked debit or a beneficial tax attribute. And I'm going to show you how that works with this example.

So ABC purchases all the business assets of XYZ for $50 million. So on the purchase price we have 35 million allocated to the operating assets, let's say AR inventory, and 15 million is allocated to goodwill. ABC has a full valuation allowance and a 30% blended effective tax rate, so that's federal and state. What happens on day one you purchase the assets of the company? Well, on day one, the goodwill book and tax basis is exactly the same. It's whatever you allocate it to it. So there's really no deferred tax impact on day one, but the exception is transaction costs. If you have facilitative costs that go into a deal from the buyer side, you have to capitalize that, you can't deduct it. The more common practice or best practice that the IRS seems to accept is that you include those transaction costs with the tax basis of your goodwill.

So if anything, that's going to be your only difference on day one when you're recording the basis of goodwill. But what happened there for one year? So we go through one full year after that asset purchase, we got this goodwill and we're fully reserved for our deferred, we have evaluation allowance. So the tax write off we're going to be allowed one 15th, right? Because goodwill allows a 15 year tax write off. But generally speaking, except in limited circumstances, you can no longer amortize goodwill for book. So we're going to have after year one, a 14 million tax basis and a 15 million book basis, so that's going to leave a one mill gross temporary difference, a negative or a liability difference because we have less tax basis to take now in the future. So the starting point naked credit would be that 1 million temporary differences times a 30% blended tax rate is a $300,000 deferred tax liability that's going to be on your balance sheet. That's the naked credit.

After 15 years, let's say we fast forward 15 years, that goodwill is now fully amortized, right? We have no tax bases left, we took all the deductions on that 15 million, the naked credit's going to be four and a half million dollars because we still have that book basis goodwill of 15 million. That's there until you sell the company pretty much, so it could last forever, times 30%. So that four and a half million dollars conceivably could be in your balance sheet every year after that 15 year period. The only way to get rid of it would be, I mentioned selling the company, but hopefully the company has a string of taxable income years or other positive evidence that could bring up the position. Maybe it's time to reverse our valuation allowance that we could recognize all of these assets and liabilities, then it allows you to offset it against your others.

So here's an example, and again, we want to keep it simple and then we'll get a little more detailed in a bit. So ABC the buyer, let's say also has a 10 million NOL carryover and an interest limitation of 5 million. How does that impact the naked credit? So we had that gross 1 million difference after year one, right? 15 million book basis and 14 mil tax basis, but we have an NOL carryover offset. The new NOLs generated from 2018 and later have an indefinite life, and we're going to assume that in this case that these are newer NOLs in the last few years. You're limited though, if you use an NOL deduction in any given future, you're to 80% of your taxable income. So for provision purposes, we're allowed to use that limitation to offset this naked credit impact. So we have 800,000 offsetting the million, leaving us with only a negative 200,000 after the NOL offset.

So you tax effect that net amount at 30% effective tax rate and you get to 60,000. So that looks a lot better than 300,000 because prior to 2018, that's what the amount would've been. But with this new change to tax reform and indefinite NOLs, it's lessening the impact to report naked credits. So I'm switching the facts just a little bit now, what if the ABC buyer has no NOL carryover but has an interest limitation at 163(j) interest limitation of 5 million, how does that impact the naked credit? Well, we have that same 1 million difference. There's no NOL, so we could skip over line too. But the new rule on interest is that it's limited to the 30% EBITDA metric, right? So we can't just apply the full 5 million against the 1 million, it's limited to the EBITDA metric, which is 30%. So we can only use 300,000 in this example, leaving you adjusted difference of 700 and so our naked credit on the balance sheet in this example would be 210,000.

I have a little asterisk at the bottom: never forget the states. One of our senior partners always reminds us of that. Be mindful of states that do not conform to the Tax Cuts and Jobs Act. And that's not just on NOLs and interest limitations, it's on everything, right? Look at GILTI, look at the FDII deduction. States can have their own set of rules, so your state naked credit could be drastically different. Especially if you're in multi-state and you're portioning your income, you could have a drastically different state naked credit. This is primarily a blended rate example.

Alexandra Colman: Tommy, you just tee me up.
Thomas Cardinale: And that's how a naked credit works. There you go, did great into state tax conformity teed you up.
Alexandra Colman: You did.
Thomas Cardinale: Good.
Alexandra Colman: And quickly, we just have three people asking the same question. So if an impairment of goodwill, how does that impact the naked credit? If for book purposes, you are impairing your goodwill, that's reducing your book basis in the asset so therefore it would reduce the deferred tax liability. If it's a partial impairment or a full impairment, then you would need to reassess the DTL at that time, but it's definitely impacted by impairments. So state tax conformity to wrap us up. A lot of times I'll see tax provisions where they just take the federal balances for all of their deferred tax assets and liabilities and multiply that by their blended effective state rate and call it a day when they're validating their deferred. But unfortunately, as all of us are painfully aware, there are several state modifications that occur when we file your state tax returns and we want to make sure that those are being properly captured when we're doing the tax provision and computing those deferred tax assets and liabilities.

The first thing you want to look at is generally whether the state conforms to the Internal Revenue Code or if generally they do not. So there are certain states that automatically conform to the Internal Revenue Code and they specifically have to come out and decouple what we call it from those new provisions that are written to the Internal Revenue Code. Those are the easy states, we like them. Then you have your static conformity states that say that they conformed to the Internal Revenue code as of a specific date. So there are some like California that say that, "If anything was in effect prior to 1/1/2015, we follow it, everything else we need to specifically say whether we do or do not." Florida, Michigan, Texas, there are other states that fall into that static conformity rule, but it's very important, especially if you have states that have conformity prior to the Tax Cuts and Jobs Act or the CARES Act provisions. Those will really take a lot more scrutiny and look.

Then you have selective conformity states. Those states say that, "We conform the Internal Revenue Code, but only for these two years or for only the specific period of time." So they're very selective in the periods in which they conform the Internal Revenue Code. And then you have states that have no defined conformity where we just are constantly looking for updates on their Department of Revenue to come out and tell us if they're going to follow the GILTI provision or how they're treating the FDII deduction. My home state of New Jersey falls into that and Pennsylvania as well, so we're constantly waiting for those governments to come out with how they're going to be treating the internal revenue changes as they occur.

Another important thing to look at is whether the state is a Line 28 state versus a Line 30 state. So a Line 28 state is your taxable and income prior to NOL or special deductions like the FTI deduction or the dividends receive deduction. So the Line 28 states come before that, but Line 30 states, those are after net operating loss and after special deduction. So you're generally going to have a lower starting point when you're doing your state tax computation if it's a Line 30 state versus a Line 28 state.

So just some examples in the last few minutes of the presentation of what generally I expect to see separate deferred for federal and state. The most common is the accelerated depreciation. Your fixed asset deferred generally should have a federal deferred and a separately computed state deferred. And why is that? If you're a manufacturer and you incur a ton of CapEx expenses and you've taken bonus depreciation on all of those expenses that you've made, your tax basis is zero for federal purposes. So you're going to have a deferred tax liability equal to that of your book basis in your fixed assets. However, if you have a state that does not conform to bonus depreciation, you probably have a very significant basis for tax purposes for states. So we should maybe have lesser a deferred tax liability or in some cases even a deferred tax asset in instances where you have a federal deferred tax liability. So that's something that you should really be looking at.

I'm not suggesting that for every single state, if you're in all 50 states, that you need to compute a fixed asset deferred for each of them, that's kind of crazy. Generally best practice is I'll look at the states that comprise the majority of the effective tax rate and see what the state conformity is for those states and then come up with a reasonable deferred based on those assumptions. Then, as Tom just teed me up for is 163(j). So most of my clients with the 163(J) limitation, I have a similar role forward that I do for their net operating losses. Because if you recall, the 163(J) limitation has gone through a ton of changes. It went from 30% of adjusted taxable income to 50% of taxable income for two years. Not all states that follow federal 30% adopted the 50% conformity.

In addition, in 2020, you were able to elect to use your 2019 adjusted taxable income when you're doing your 2020 computation. Some states didn't follow that and it's not consistent. It's not like you can take a group of states and say you fall in one of three buckets. It unfortunately doesn't work like that. So a best practice for 163(j), like I mentioned, is kind of doing an NOL like tracker for your 163(j) limitation. And in our last minute the other one I see most often is GILTI inclusion. This one goes the other way. So generally for GILTI, it's not going to result in a deferred tax asset or liability, so I'm not too concerned about that. It's more so when you're doing your current state tax computation. If you have a very significant GILTI inclusion because your CFCs are very profitable, but for a state tax purposes, that GILTI income is not taxable, You might be prepaying and making estimates or accruing for taxes in states that doesn't exist.

So you just want to make sure that if you do have a GILTI inclusion that you're accounting for the fact that some states might treat that as a dividend and you might get the dividends received deduction and not have to pay tax on that GILTI inclusion. So at 12:59, Tom and I are always very conscious of time. I'll just leave this mind joggers up here for a second, but we just thank you very much for attending. We find that tax revisions is an area that we both love to talk about, so if you guys have any additional questions or questions that we didn't get back to you on in this Q&A, we'll be sure to reach out. And before you log off, if you would be interested in attending another provision webinar, like I said, maybe a 301, let us know. We would gauge based on interest whether or not that's something that we'd do. But thank you very much everyone for attending and participating and yeah, have a good rest of your week.

Thomas Cardinale:Take care everybody. Thank you very much.

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