On-Demand: Tax Provision Preparation 101

So really, the intent is, if you are in charge of preparing your provision that is going to your auditor or if you have a third-party provision preparer for internal control purposes, you are responsible for reviewing your provision, or if you're on the market for a third-party preparer and you wanted to call EisnerAmper, feel free to reach out to Tom and I after the webinar today. The goal is for everyone to get a little bit more comfortable with the tax provision process. With that being said, I'll pass it over to my co-presenter, Tom Cardinale, to go through the agenda.

Tom Cardinale:Thank you, Allie. Good afternoon, everyone. Touching on the agenda, we'll be discussing on, what is a tax provision? What are all the components that make up a tax provision? Then we're going to go over some of the mechanics of a provision, which Allie will be taking charge of; a current provision, deferred provision, a little bit about an effective tax rate, which is a key component of a provision. What is the federal and state effective tax rate?

Then we're going to go through some tax adjustments. Knowing how to do a provision is not much help without understanding some of the fundamental book-to-tax differences that we run into with tax provisions. Both Allie and I are going to give you an overview of some of the most common, temporary differences that we see as we're preparing a tax provision. Later on, I'll be weighing in on some 2021 considerations, especially during this pandemic. Congress, as you have seen and heard, have not been shy to update various tax law provisions relating to the pandemic trying to offer relief to businesses.

A lot of that has some major implications on your tax provision process. So we're going to go over some of those changes that are impacted by the pandemic on top of some internal controls that you may be considering. Then we'll top it off with tax risk areas. You don't need to be experts in these areas, but it's important to just know that they're out there and at least to be a mind jogger as you go through the provision process that you could take up to the next level, or more importantly, with your tax advisors.

Starting off, what is a tax provision? That sounds so elementary, but it is important to understand, what are we trying to do in the tax provision process? Number one, and this is just the basic starting point, is understanding that a provision is for income taxes only. It's not a provision for all taxes. It's taxes substantially or entirely measured by net income. So it's income taxes. The first point is we want to recognize and record what is our expected income tax liability going to be for our business, both from a federal and state level.

Meaning, let's look at a snapshot of our tax return that we have yet to do. What is our liability is going to be for federal and state and local? The more complex area is recognizing what our deferred tax impact is. And that's not on future income of the company, it's only on the impacts of your temporary differences. Temporary differences is exactly as it sounds, book-to-tax differences that will eventually reverse in the future. But we need to know, what is that tax impact going to be in the future?

Are you going to get more deductions or are you going to accelerate income? That's what drives your assets and liabilities, kind of the good guy-bad guy approach, right? Finally, and arguably most important, we want to provide disclosures, adequate, detailed disclosures to investors and the readers of financial statements that are not tax expert. So they're relying on good, thorough, understandable footnote disclosures in the income tax covering not only what your balance of your provision is and the actual numbers, but they want to know, are there any uncertain tax positions you may have?

Are there changes in tax law that are impacting the company's tax impacts? NOL carryback claims. Now, NOL carryback claims are technically expired right now, but as you know, Congress is not shy to open up the valves and say, "We're going to allow carryback claims again," like they do it with the CARES Act. So if you do have a carryback claim, that is a required disclosure in your footnote. On to entity type and how does a tax provision impact what kind of entity you have? Obviously, an income tax provision is mostly catered to C corporation groups.

You pay taxes to federal level, you pay tax at the state level, so we're capturing all the tax impacts of that. But as for pass-through entities, S Corps, partnerships, and LLCs, there is no federal tax paid at that entity level. It's paid at the shareholder level or the partner or the member level. However, just a little note on LLCs is never assume if you just see those three letters after a company name that, "Okay, good, I don't have to worry about a tax provision." You can be an LLC for legal purposes, but you can elect, for tax purposes, to be taxed as a C corporation by filing a Form 8832.

There are some cases where we've done tax provisions full-blown for LLCs. In terms of the state level, it gets a little more complicated. Again, for corporations, tax is paid at the state level, no problem. But for pass-through entities, every state is getting more creative in how they are taxing pass-through entities. You may have heard recently about the SALT workaround, the state and local tax deduction workaround, which is a personal tax concept, an itemized deduction limit.

I think a majority of states now have been imposing a state-level entity-level tax so that the members and the shareholders themselves can get a credit on that and basically acts as a workaround, because from a federal perspective, there's no deduction limit on state income taxes from a business perspective. The AICPA is still not decided on a national level. We've taken a position on our firm that any pass-through entity taxes is a business-level tax deduction, so it would be considered part of your income tax provision.

Although, again, it's not a national standard yet, I think it's leaning, it's going toward that route. But that is something to consider if you're doing a provision for a pass-through entity. You should ask the business and the CFO, are you planning to do an election for the pass-through business entity tax? If you are, you're already considering a tax provision that you need to prepare.

Lexi D'Esposito:Polling question one, what type of entity are your financial statements prepared for? A, C Corp. B, S Corp. C, partnership. Or D, LLC. Please remember, in order to qualify for your CPE certificate, you will need to remain logged in for at least 50 minutes and respond to three out the four polling questions.

Tom Cardinale:I'll take this time to answer a quick question. Is the Texas margin tax considered an income tax? That's an outstanding question. For years, this was actually a big debate among provision preparers like Allie and I. Initially, we were saying no to that because it's pretty much a gross receipts tax less a specific margin calculation. However, the AICPA came out sometime later and said the Texas margin tax is substantially measured by net income. By that coded language, it means that it technically is a tax that should be in your current tax provisions. However, Texas does not recognize temporary differences, so you would not include taxes for your deferred taxes. You would only have it on your current tax provision.

Allie Colman:Tom, one other point that I wanted to mention since I know we have a lot of financial services people on the line today that do have LLCs, I have been spending quite a bit of time lately doing some UBT provisions because especially in our area, we have a lot of LLCs that are present and nexus in New York City and we all know that they have that UBT tax that is imposed. That's just a prime example that real life working on it now.

Lexi D'Esposito:All right, great. We are now going to close this poll and share the results.

Tom Cardinale:All right. A great balance. About half of the attendees are associated with C Corps and the rest are associated with pass-through. That's great. We wanted to cover everyone here because as I just went over, provisions can impact any type of business. All right.

 I'm going to now pass it back to Allie to go over some mechanics of the provision.

Allie Colman:Thanks, Tom. This is the part where Tom said it gets a little bit hairy, if you will, deferred tax assets and liabilities. As Tom mentioned earlier, deferred tax assets and liabilities are generated from those temporary differences, those items where it's merely timing of whether the book event and tax event happens. So if we know that there is going to be future taxable income related to this event, meaning for tax purposes I took my deduction prior to that of book, or under GAAP the income is recognized prior to when the income needs to be recognized for tax purposes, that creates a deferred tax liability.

A deferred tax asset is the exact opposite. That's when we have future tax savings. So if there is a book deduction that occurs prior to when I take my tax deduction, or if I'm recognizing revenue for tax purposes earlier than I'm recognizing revenue for book purposes, that creates a deferred tax asset. Frequently, the corporate group here gets, what is a deferred tax? Why do we need to bother with deferred taxes? So let's just look at this very simplistic example in a world, a crazy world, where there are no deferred taxes.

As you can see, in year one, there's $150 of income that's recognized for book purposes that isn't recognized for tax purposes yet. In year one, we would've pre-tax book income of $250 and we end up with taxable income of $100. We're assuming a 21% tax rate. The current tax expense would be $21. Again, in this crazy world, there would be no deferred taxes. So my total tax expense of $21 compared to my pre-tax book income of $250 would give me an effective tax rate of 8.4%, very low.

Investors, audit committees, they would say, "You must have EisnerAmper as your preparer as you're doing great tax planning to get this amazing effective tax rate." Then year two comes around and that income becomes taxable. So for book purposes, they have $100 of pre-tax book income. We're recognizing that income for tax in year two. So my taxable income becomes $250, times my 21% rate is $52.50. That effective tax rate is 52.5% in year two, which is crazy. That's much higher than year 21% and that would again cause a lot of explaining that you would need to do.

So without deferred taxes, there's really no predictability of your effective tax rate. It's all over the place. It looks like a heart rate monitor. Then you go to the great world that we actually do live in of reality where we do have deferred taxes and what changes in this situation is this $150 that we are recognizing into income for tax purposes after that of book creates a deferred tax liability in year one. So, I would credit deferred tax liability on my balance sheet and I would debit deferred tax expense. The $150 times 21% gets you $31.50.

So, nothing changes with my current tax expense calculation. I'm still expecting to see $21 of tax due on my tax return. But I need to account for my future deferred taxes that I'm going to have. So, my total tax expense in year one is 52.50 over my pre-tax book income of $250. That regulates my rate. It makes it 21%, exactly what everyone was expecting. In year two, that deferred tax liability, that $150 that I knew that I would recognize into income for tax purposes at some point, that reversal happens in year two.

I would debit my deferred tax liability and credit deferred tax benefit for 31.50. Meaning in year two, I end up with total tax expense of $21. $21 over your $100 of pre-tax book income gives you 21%, exactly what everyone is looking for. Deferred taxes make your rate more normalized, more explainable. It's really matching the economic impact of what's running through your financial statements in the year that it occurs. As I mentioned, yes, it helps with the matching principle really.

Then we have a rate reconciliation. Again, as Tom said, this is one of the more daunting areas of a tax provision, is reconciling your rate. The rate reconciliation is really intended to tell the reader why your rate is different than the statutory enacted rate at that time. Right now, if you're preparing a US financial statement, you would start at a 21% rate. As we mentioned, as we just saw on that prior example, temporary differences shouldn't impact your overall tax rate.

There's a current and deferred impact related to those items. Permanent items, on the other, hand would impact my rate because there are certain items, I'm sure you're all familiar with meals and entertainment, the new transportation fringe benefits, any potential impairments on component to goodwill. All of those things are items that are going to permanently impact your tax rate. There's no future benefit or future income coming your way. Again, as I just mentioned, it's really important to remember that your rate reconciliation is based on the jurisdiction where the financial statements are prepared.

So yes, if you have a US financial statement, even if you have a UK subsidiary being computed within your worldwide financial statement, your rate reconciliation that you're computing is based on your 21%. On the other hand, if you have a UK company that's your parent with a US subsidiary, your rate rec is going to be based on the UK enacted tax rate. At this point is 19%. So just making sure that you remember that fact. Even if you have a worldwide financial statement, we need to be reconciling to the rate of the jurisdiction where the financial statements are prepared.

This is a very quick example, basic again. We have pre-tax book income of $100,000 dollars. We have an unfavorable depreciation, M-1, of $10,000, and impairment to component to goodwill of $30,000. So if you're doing your current tax expense of this top box on the right here, you can't see my mouse moving, but I promise I'm pointing, the pre-tax income is $100,000. We need to add back the impairment and the depreciation adjustments to get us to $140,000 of taxable income. Times the tax rate of 21% gives me current tax expense of 29,400.

However, remember we live in the beautiful world of deferred taxes. We have $10,000 of a deferred tax asset. Times 21% gives me a net deferred tax asset of $2,100. What would this look like when I'm booking my journal entry? You need to book your current tax expense at 29,400, and you would credit your income taxes payable, 29,400. You're going to have to pay that check this year. Then we need to record our deferred tax asset, $21,000 debit to the balance sheet, and a credit to deferred tax benefit in the P&L.

So your net tax expense between your current and deferred gets you to 27,300 of taxes. Your effective tax rate is computed by taking that total tax expense over your pre-tax book income of the $100,000, gives you an effective tax rate of 27.3%. Well, how did we get there? We had that permanent difference related to the impairment. So the $30,000 impairment charge that we added back times 21% created additional permanent tax this year of $6,300, which increases my rate by 6.3%, 6,300 over your pre-tax book income of $100,000.

Obviously, this is a very simplistic example, but it shows you your rate reconciliation of how we got from the 21% enacted statutory rate to the 27.3% that you're paying this year, which brings us to our next polling question.

Lexi D'Esposito:Polling question two. Why may a financial statement reflect a 0% tax rate? A, full valuation allowance and current year losses. B, the entity is a partnership where all taxes are paid by partners. C, the company doesn't want to pay taxes. Or D, A and B.

Please remember, in order to qualify for your CPE certificate, you will need to remain logged in for at least 50 minutes and respond to three out of the four polling questions. If you are unable to see or respond to the poll within the Slide widget, please refresh your browser now.

Allie Colman:We did get a question regarding state taxes. And yes, in my examples, we're being very basic and only considering the 21% rate. When you're computing your state effective tax rate, you are looking at the jurisdictions in which you have nexus. So even though you may have a company that you only have employees in one state, but because of the economic nexus rules you have income tax nexus in additional states where you're selling to, you would consider all of the states in which you file in when you compute your effective tax rate. Tom, do you have anything to add on that?

Tom Cardinale:No. I just answered a question on that in the attendee list. Yes, we are trying to keep this basic today and focusing on the federal, but when you consider your state effective rate, you're looking at states you are filing tax returns in because you have either economic nexus or physical nexus, and then you're apportioning that rate. Let's say you're in New Jersey, base, but you also have half of your sales going between New Jersey and California.

You would normally just do 50% of the New Jersey rate, which is 11.5% top rate and 50% of the California rate. So you would have basically a mixed, effective blended state rate. It's not just a case of just picking your home state and using that rate.

Allie Colman:Thanks, Tom.

Lexi D'Esposito:All right. We are going to now close the poll and share the results.

Allie Colman:All right, good. I know we didn't touch on valuation allowances today. We're teasing a 201, second class for you all to attend. But yes, the correct answer was A and B. Tom, now off to you on disclosures.

Tom Cardinale:All right. Thank you. Now we're going to talk about some income tax disclosures. Starting off with one of the more favorable changes made a couple years ago by the Financial Accounting Standards Board as part of what they call their Simplification Initiative, is how do you report the break down of your deferred tax assets on your balance sheet?

Used to be you would have two components where you would net all of your non-currents together, all of your currents together, and see if you had a net deferred asset and liability for each and you would report two items. But as part of the Simplification Initiative, you now report everything as one net non-current item. In just this simple example, we have a $7,000 deferred tax asset, an offsetting $6,500 deferred tax liability. So we are net with a $500 deferred tax asset that we would just have as one line item on our balance sheet.

When it comes to footnote disclosures, this is a critical area of the provision process. It's not so much on the exact numbers, but what are you telling your financial statement readers and your investors? There are a lot of requirements, and it's very important to note that as we go through several bullets, there's a separation between requirements for private companies versus public companies. Public companies, as you can envision, run by the SEC are going to have a lot more robust tax disclosures for your financial statement, income tax disclosures.

We're going to show you those specific ones between private and public as well. When it comes to deferred tax assets or your gross temporary differences, that's how you get to a tax asset or liability. What are your gross temporary differences? You would need to show a table of all those cumulative temporary differences, ultimately times your tax rate that gets you to your deferred tax asset or liability. You would need to show that in your financial statements.

If you have a valuation allowance, or we would call a reserve, meaning you have less likely a chance, less than 50% chance of recognizing deferred tax assets in the future, whether it's an existing tax loss history or other negative factors, that's determined company by company. When it comes to public companies, you have to be more detailed and disclose temporary differences and carry forwards that have a significant portion of your DTA. How is that measured? 5% or more of the gross DTA or DTL.

If it's 5% or more, you need to separately disclose that. You can't just mingle it in to a bunch of other items, especially other. It needs to be separately stated. Private companies, it's more relaxing. You have to show what are your most significant temporary differences? It could just be a short paragraph. More times than not, depreciation, intangibles. That winds up being, more times than not, as one of the key temporary differences with private. You want to show those temporary differences, carry forwards, but you don't have to show the exact tax effects of those items.

Finally, you need to disclose the expiration of NOLs and tax credits. Now, as you may note, since starting in 2018, NOLs have no expiration period for NOLs generated in '18 or later. But we have a long way to chew through some of those old NOLs because they work off of a FIFO basis. A lot of legacy NOLs that have the older 20-year expiration are going to be around a while, so you got to make sure you're disclosing that expiration period for those older NOLs. That applies to tax credits also.

You're continuing on with disclosures. Here is, again, a public company rule. If you have material amounts impacting your tax rate or your effective rate, you have to disclose those material amounts greater than 5% of the assets or liabilities of refundable income taxes, or taxes payable. Taxes included in your OCI. You don't have too often other comprehensive income, but you may have tax impacts of that. An example is foreign exchange, unrealized gains on foreign exchanges, gains or losses.

You wouldn't report the deferred tax impact in your P&L. You would report it as an offset, or almost as a contra tax against your OCI impact. And other related income statement disclosures; the significant components of your income tax expense, your current expense, your deferred expense. Some break it out as federal, state, foreign. That's a best practice to break it up by jurisdiction. Others I've seen just as current or deferred. You definitely, if you have foreign operations, want to separate your foreign versus domestic.

Onto the effective tax rate. Allie went through a mechanical example. But for public companies only, the SEC pushed this a few years ago to say, "Well, we really want to know the more material items that are impacting your tax rate, especially if it's an enormous amount impacting your rate." They define that as you have to separate your item, that is, if it's 5% or more of the statutory rate. As we know, the federal statutory rate is 21%.

As an example, if we're using a 21% rate and the tax impact of a particular item that's impacting your tax rate is 1.75% of pre-tax income or more (you see, like a divisor) you would need to disclose that as a separate line item on your rate rec table in your tax footnote. If it's immaterial, you can group them in other. Unrecognized tax benefits. The common code we'll use for this is uncertain tax positions. You may have heard that terminology more. An uncertain tax position is any tax position.

It could even be your decision on whether you file a state tax return or not. It's a tax position that based on the technical merits and the all-pervasive evidence of a tax position, it's more likely to not be recognized if challenged on the merits by a relevant taxing authority. So if you got to hit that 50% comfortable level, if you're over 50% comfort level or sustainability, you don't have an uncertain tax position and you could also weigh materiality as well.

But one of the items we see as provision preparers is estimates of certain major or material tax positions, say an R&D tax credit. May take a while to do an R&D tax credit and a company for now wants to just base it off prior year as an estimate. That may not be sustainable if under an audit. So they may take a portion of that and reserve it as an uncertain tax position, saying, "We don't have really all the evidence of it yet, so we're going to reserve it."

If you have such a case and it's material, all of these bullets here you need to make part of your roll-forward in your tax disclosure of uncertain tax positions. It's a roll-forward of your uncertain tax benefits from the beginning of the year to the end of year that's public only. Interest and penalty needs to be included as well, at least the interest on it. The total amount of the penalty and interest on those uncertain positions.

Any reasonable possible significant changes in the next 12 months that could influence that uncertain position. And tax years still open for examination, meaning audit. Most federal and state statutes follow a three-year rule of statute limitations for examinations, but it can go as far as six years.

Lexi D'Esposito:Who will win the Super Bowl? A, Los Angeles Rams. B, Cincinnati Bengals. Or C, Tom Brady will come out of retirement for the Vince Lombardi Trophy. Please remember, in order to qualify for your CPE certificate, you will need to remain logged in for at least 50 minutes and respond to three out of the four polling questions.

Tom Cardinale:A couple of questions here. In New Jersey, is the 2.5% corporate surtax only for income in excess of one million or for all New Jersey. It's a New Jersey apportioned income, not on 100% of your income. Another question, what happens if you have nexus in multiple states where some have a zero state tax? Well, good for you. You have a zero tax rate if you're doing business, say in Nevada. It doesn't have an income tax. Or Wyoming or Washington state. You have a zero rate. If you have significant business going to that state, that's going to lower your state effective rate.

Allie Colman:And we just got, how do you know when your tax returns are still open for examination beyond three years? Well, most times I see this when you have a company that has a net operating loss carry forward. The statute of limitations for those years do not begin until you use the net operating loss from that period. Let's say you had a loss on your 2016 return and you carried it forward until 2021, that three-year period starts in 2021 when that return is filed and you use that NOL carry forward. In addition, if you were under an IRS audit and you signed a waiver to extend your statute of limitations, that's another time when it may be beyond three years.

Tom Cardinale:We've got a quick question. Is the Oregon CAT considered an income tax? I don't know if you meant Ohio or if Oregon has its own commercial activities tax. But no, the answer is no. It's a kind of a retail-level tax, almost akin to a sales tax, so that's not an income tax.

Allie Colman:Yeah, I think Ohio.

Lexi D'Esposito:Okay. Now we are going to close this poll and share the results.

Allie Colman:Thought we'd have some Tom Brady fans in the audience today.

Tom Cardinale:Wow!

Yeah, we do. All right, Allie going to kick it back to you.

Allie Colman:Sure. I just saw one other question can come in that I figured I would touch on. Is the IRS very far behind in its enforcement activities? Yes, that is absolutely true. They are behind in all activities, getting refunds out if you did a carryback claim or even any employee retention credits. The IRS is very bogged down.

So let's discuss the mechanics of a provision. This is very, again, basic of the steps that we do when we're preparing or reviewing a tax provision. And really, step one, assuming you're not a first-year company or a first-year provision, the first thing you're going to do is roll forward your provision. You're going to take last year's ending balances on your deferred schedule and make them this year's beginning balances.

The first thing that I do after that is I make sure that those beginning balances, once tax effected, agree to my prior year financial statement. As you know, as provisions can be, there may be some last-minute adjustments, some audit entries that get booked and we are on version two or version three of a provision. So you want to make sure that your starting point is correct. So if you're a public company, compare it to your file 10-K, or if you're a private company to your financial statement and your income tax footnote.

Next, I complete my current provision for each jurisdiction. You start with your pre-tax book income and then you'll put your permanent and temporary items through to get your current year taxable income. Then you determine your true-ups. Some of you may be familiar with the term return-to-provision or an RTP. There are certain estimates that are taken at provision time. Maybe you didn't accurately compute your depreciation, or you estimated how much of your payroll accruals would be paid within two and a half months.

And certain things we're not accurate, the provision, but when we file the tax return, we true those numbers up. So what you need to do is you need to compare your return that was filed to the current provision that was computed when you did the provision. Any of those adjustments would be considered a true-up and should impact your deferred taxes, assuming they relate to temporary items. The activity of the current provision related to temporary items should flow into the deferred tax asset or liability roll-forward.

You should validate your ending deferred balances. This is a big issue that we see when we take on new clients, is that when you are looking to validate your end-of-year provision, it's historically just been rolled forward. You take your prior year ending plus your current year activity equals this year's ending, and you roll and roll and roll. You don't double check that there maybe was a chance that three years ago someone transposed a number when they put in a true-up and you've been historically carrying forward this discrepancy.

So you need to really make sure that you're independently validating those ending deferred balances. In addition, we compute the taxes payable or receivable for the year. The way that we do that is you look at your prior year overpayments from the tax returns that were filed, you add to that any estimated payments that were made during this calendar year, you subtract from that any current year tax liability that we're computing in the provision, and then you get your end-of-the-year year receivable or payable.

A common mistake I'll see regarding the payable or receivable is, if you have someone that makes an estimated payment in January of the next year and they didn't make the payment by December 15th, that payment should not be reflected in your calendar year-end, in my example, receivable or payable, because as of 12/31 of the date of the issued financial statement, that payment was not yet made. So we need to reflect that that payment is coming in the next year. Next, I look at the rate reconciliation for reasonableness.

Then lastly is, once you book your tax entry, you should make sure that your ending balances on the trial balance agree to what was expected in the provision computation. There's a lot of times that we know that the trial balance is moving until the audit is complete. So maybe you realize that you accidentally booked a sales tax liability in the income tax line. Or you found Florida unemployment tax sitting in your income tax's payable account, and when I gave you my entry, I accounted for that, but you already moved it.

So once you book my tax entry, your ending balance won't agree to what we were expecting. So very, very important step. I am aware that most of you are probably squinting at this slide. There is a Materials button on the left-hand side of your screen, or you can click and drag the corner so you can see this slide bigger. But this is a real-life client book-to-tax reconciliation. This is a current provision. Tom and I are going to spend some time and talk through some of the book-tax differences and how we compute those.

Permanent items. Meals and entertainment. There are expenses related to meals and entertainment that are perfectly deductible for book purposes because they're business-related expenses that the IRS has deemed to be non-tax, but non-deductible. Meals are 50% non-deductible and entertainment expenses are fully non-deductible. Transportation fringe benefits. Now that people are starting to commute back into their offices, you may offer a pre-tax commuter benefit. Though to the extent that those transportation fringe benefits are non-taxable to the employee, they are also so non-deductible to the employer.

So if they're running through your P&L, they are not deductible as a permanent item. If you issue incentive stock options or if you have employee stock purchase plans, any book expense related to those type of stock-based compensation are added back as a permanent adjustment. Those areas of stock compensation will never be taxable to the recipient, so the company will not get a deduction. Of course, never say never. The disqualifying disposition occurs if you issue incentive stock options to your employees.

In order to qualify for an incentive stock option, once they exercise this option, they have a minimum holding period of one year. If the holder sells their option, sells their stock prior to one year of holding it, then it becomes a non-qualified option and becomes taxable to that individual and the company then gets a tax deduction and also has an additional filing requirement, Form 3921. Lastly, stock compensation windfalls.

If your stock of your compaIny has a fair market value that is greater than that of when it was granted. So Let's say you have a company, a startup, and you issued stock, your founders have stock options, and they were worth a nickel, a penny even, the exercise price was a penny, and now the stock when they exercises is trading at 50, $60, the individual needs to recognize income for that intrinsic value of their options. The company gets a deduction for that because someone's paying tax, so someone's entitled to that deduction.

Sometimes, unfortunately, it goes the other way where your stock price plummets and you may have a stock compensation shortfall. Those are both permanent adjustments. Temporary items. We have depreciation expense, of course. We know that our cost basis for book and tax purposes should generally be the same, so our depreciation would reverse. It's just a matter of timing. Maybe you took accelerated depreciation and have 100% bonus in year one. So those are temporary items.

If you sell any assets, of course, there's going to be a disparity between your book and tax basis because of the aforementioned depreciation, so that would be reflected on your current provision. Similar to depreciation is amortization. Your intangibles may have a different depreciable life for tax purposes than they do for book purposes. Then I'll pass it over to Tom to go through some additional temporary items.

Tom Cardinale:Thank you, Allie. Moving on to some other areas we've seen. The purpose of this example is to give you kind of a looking glass into provision items that Allie and I see all the time. We wanted to give you that picture to go through and understand how are the tax impacts of it, how is tax treated of a particular book item. Deferred payroll taxes. You may have heard this thing called the CARES Act, which seems ancient now, but it's almost been two years since that passed, believe it or not.

It included a provision to help distressed companies with cash flow control to defer the employer portion of their FICA taxes, their payroll taxes, and not have to pay that for a period of a two-year installment basis where they would pay 50% of that tax liability by December 31st of '21, the second 50% installment would be paid at the end of this year of '22. But that runs into a tax issue. Because of that long deferment or that long enjoyment of when you had to pay it, it pretty much does not meet the standards of economic, the all-events test of getting a tax deduction.

The all-events test normally tells you that a liability is identifiable in fact and it's estimated at the date of the balance sheet or the period you're doing. So by having this two-year deferral, you're not going to be able to get that deduction until you actually pay it, so it gets converted to a cash basis rule. So keep that in mind, if there's any business out there with this deferral option, that it is a temporary difference, flips year to year, but you don't get the full deduction on the incurring of the payroll obligation.

Accrued bonuses and commissions. This falls into the tax realm of deferred compensation. You may have these items as a valid book or gap deduction, but in the tax world, we use a lot of economic doctrine. Meaning, when is this really going to be paid? Is it really toward the prior year? Well, they give you a little time period. For most payroll-related items, you have up to two and a half months after year end to pay that item relating to the tax year in question and you can get a valid deduction.

If it's paid beyond the three and a half months- I'm sorry, the two and a half months, then you do not. You would get the deduction in the following year. So again, it's a beginning-ending concept. Bad debt expense. This is common on everyone. You have a reserve for bad debt, management estimates 2%, 5% of the outstanding account receivable is not going to be collectable, they set up a reserve account, and they hit bad debt expense. In the tax world, that has no economic value.

You're making a guesstimate. It's not identifiable. In fact, you're not meeting the all-events test. So that's, again, another temporary difference where we reverse, take a deduction of the beginning balance, and then we add back as income the ending balance. In this particular example, it was a pretty big hit. The next two are relating to, you may have heard of the lease changing going on. There's been a delay for private companies for another year.

Topic 842 dealing with GAAP accounting for leases, where if you have an operating lease, instead of the old rule where you would just put it as equipment lease on your profit and loss, you now have to recognize what's called an ROU asset, a right-of-use asset. Now, that gives you basis on a GAAP perspective, but from a tax side, you have zero basis. This is going to present you with a brand-new tandem of a deferred tax asset and a liability.

You're going to have a deferred tax liability on the ROU asset because you have book basis, but zero tax basis, and you're going to have the exact inverted opposite, deferred tax asset, on the lease liability that you'll have for tax and zero for book. That's what these two items represent. Overall, they'll wind up washing each other out to zero at the end of the lease term, so it's a bit of a pain to track. But that is a tax adjustment.

Stock-based compensation. Very common when we're dealing with income tax provisions. Non-qualified options are the most common. The way the tax rule works is, if you're granting options to your employees, that would not be a valid deduction to the company until the options are vested and exercised by the individual. That's when it would become ordinary income to the recipient and that's when the employer would get a valid tax deduction.

If it's a restricted stock unit, it's a little bit different. Normally, it would be taxed to the recipient on the date of vesting, has nothing to do with exercising or selling it if it's a restricted stock unit, or just any equity unit that vests. If it's not an option and it's just an equity unit, it's taxable to the recipient upon the vesting date and it's also allowed as a deduction to the company on that date.

Small adjustments for deferred revenue. Deferred revenue, the only thing you should keep in mind is that if you have long-term contracts, multi-year, two, three, four, five-year, the tax rule on that is GAAP and tax are usually the same in year one of the contract execution and commencement. But in year two, for tax purposes, under the deferral method, you need to accelerate all that future advance payment you may have received as income in year two. So year one is the freebie year, year two is the recapture year for tax.

Charitable contributions. This mostly applies to loss companies. You're only allowed to deduct up to 10% of your positive taxable income. So if you're running into a loss, you have to carry forward those unused charitable contributions for up to five years. Unrealized foreign exchange. Anything unrealized, you may have mark-to-market adjustments, notional principle contracts, hedges, hedging contracts. Anytime you're booking unrealized fair market value adjustments, nearly all instances it's not recognized for tax, so you're just reversing it on here.

State tax accrual. This is likely relating to reserve. Many companies, you're going to go through some sort of examination or a challenge to your taxes. If it's at the state level and you want to book a reserve for estimated taxes due, that's not going to be deductible until there's a settlement of that examination. Again, it's a beginning and ending reversal that will eventually go to zero. I think that was it on that, right? All right.

Allie Colman:So back to me?

Tom Cardinale:Allie, take it back. Back to you. Yep.

Allie Colman:All right. As we mentioned earlier, the first step of what I would normally do, again, these are gross differences. My beginning balances should equal my prior year ending balances for the provision. They should not account for any true-ups or any adjustments that were made through the tax return. Those adjustments should run through this true-up column. These would pull from your return-to-provision work paper. Then the next step is making sure that your current year activity from your temporary items flows from your current to your deferred.

If you recall, if we go back a slide, and again, I apologize for the font, our total temporary items, this bolded line at the bottom here, shows that we have temporary items of 30,828,072. When you go to your deferred roll-forward, I would expect to see that same total, subtotal future deductible (taxable), that 30,828,072. Perfect, check. If those numbers do not balance your rate reconciliation won't work, because as we discussed, your temporary items should not impact your rate.

Whatever you compute for the current as a tax benefit or a tax expense related to your temporary items, there should be an offsetting deferred tax benefit. In addition, there are certain situations where we have other adjustments. This is really any prior period out-of-period adjustments, or balance sheet-only adjustments. Or as some people may say, a deferred-only adjustment would run through this column. Examples of things. I know stock compensation. Tom and I are fielding a bunch of those questions now.

But if you have any expirations of stock options that happened during the year of forfeitures and they're not running through your P&L for book purposes, they should no longer be sitting as a deferred tax asset because I'm never going to get a tax deduction if an option is no longer outstanding. But I also am not entitled to a current tax deduction for that now. So those items are deferred-only adjustments and I would expect to see that impact running through my rate reconciliation.

Next, what we need to do is once I have my beginning balances, my true-ups are in here, my current adjustments are here, I have my ending deferred balances. A lot of times what companies do is say, "Great, I'm done." But no, we need to validate and make sure that those ending deferred balances are correct. For items that are related to your balance sheet, accrued bonus, accrued commission. Yes, this example says bad debt expense. I apologize that's unclear. This is really the allowance for doubtful accounts.

But those types of adjustments, you can very quickly validate those by comparing them to your ending balance sheet balance. So, accrued bonus, assuming you do not have a bonus policy making accrued bonus fixed and determinable, for tax purposes, I've never taken a deduction for that liability before. So my tax basis and accrued bonus is zero. For book purposes, their basis in accrued bonus is 4.2 million. So 4.2 million minus zero gives me a $4.2 million deferred tax asset.

The 4.2, the 2.4, the 18 million, those should be very easy checks for you that those equal your ending balance sheet balances for each of those accounts. The more tricky areas of deferred attributes to validate, stock compensation. It's my favorite question to ask a client. Hopefully, you use a system like Carta, let's say, or Fidelity, and you need to track the cumulative book expense taken related to any unexercised options or unvested restricted stock. That cumulative book expense just hanging out there waiting for people to exercise those options, that should be your ending deferred tax asset.

Then we have depreciation and amortization. The way that's computed is like anything else. You compare your book basis to your tax basis. In this example, my book cost basis is around $6 million. For book purposes, they have accumulated depreciation of 2.6 million. For tax purposes, I have accumulated depreciation of 1.9 million. So the netbook value is 3.5 million where the net tax value is 4.1 million. Based on what I know today, I know that I am going to get in the future $620,000 more of deductions for tax purposes than they will for book purposes.

So I should have a deferred tax asset of $618,000. Again, I'm sorry for the back and forth, but just want to show you that that in fact agrees. My deferred 618,876 agrees to my 618. It's off by $2, rounding. We go through that same exercise for your intangible assets. Goodwill, to the extent it's not component to goodwill, and any capitalized startup costs. This is my client's favorite slide. It's the footnote in a nutshell. So your rate reconciliation is displayed at the top and then you have your tax affected deferred tax attributes scheduled at the bottom. This is exactly how it should be presented in your footnote.

Lexi D'Esposito:Polling question four. Have you adjusted your internal controls due to the pandemic? A, yes. Or B, no. Please remember, in order to qualify for your CPE certificate, you will need to remain logged in for at least 50 minutes and respond to three out of the four polling questions.

Allie Colman:I know a lot of people have probably already had to deal with this last year with adjusting your internal controls because you have people working from home. Do you have enough, I want to say bench power, if you will, if somebody calls out sick, if somebody gets COVID? Do you have the right procedures and backup plan in the event that that happens?

The question that we got twice is regarding extension payments for the prior year, how are those treated in your payable? Those would be reflected in your prior year overpayment. In the computation, I mentioned it was prior year overpayment plus current year estimates minus current year tax liability. Those extension payments should be reflected in your prior year overpayment.

Tom Cardinale:Yeah, I got that question too, Allie. I think what they want to know is what account to hit. If you have any payment activity, refund activity, you should be putting it to your payable account, your balance sheet account, not to your profit and loss tax expense account. You handle the tax expense account from when you're computing your actual provision. But all the activity you're getting, cash payments out, cash payments in, should be running through your tax payable account.

Lexi D'Esposito: Okay. We are now closing this poll and sharing the results.

Tom Cardinale:Right. Most of you have had some impact. We have as a firm as well. And that touches on our last couple slides here, is how is the pandemic impacting the tax provision process? It seems to have impacted everything, and provisions certainly weren't untouched, your internal controls. If you have people working from home and you have bifurcation of duties with the provision process, how are they being checked on? How are they being reviewed?

Yes, of course you could have your collaborative online with your modeling and your showcasing of the work papers you could walk through, but it's all in the end a little bit different. So you have to make sure you're updating your internal controls, especially if you're a public company, to your provision process. The PPP loan, this was a big deal during the pandemic, trying to give relief to companies by offering loans with the capability to convert it into a non-taxable grant.

That was a deal for many companies. And it's part of your tax provision because if you had a forgiven loan and we see that big income item hit the GAAP P&L, that's not taxable. That's one of those items we love to give good news to clients, is the PPP loan is fully non-taxable unforgiveness and any expenses you use from PPP loans is 100% tax deductible. The payroll tax deferrals, I touched on before, make sure that's set up as a temporary difference.

The interest expense limitation. This has been like a volleyball here. It started with 30% tax basis EBITDA limit on your deduction, then it went to 50% as a temporary relief during the pandemic. Now we're back to 30% tax EBITDA limit on your annual expense limitation and any unused amount just gets carried forward. No expiration on that. The NOL carryback claims, yes, you're no longer not allowed to do NOL carrybacks, but the CARES Act opened it up for three years, tax years '18, '19, and '20 only, and you could do up to a five-year carryback.

If you had any carryback or plan to do in the future, if Congress allows it to happen again, make sure you're disclosing that as part of your tax disclosures, income tax disclosures. I think we had a question on this before about business meals. As part of the I think it would ARPA, if I remember the tax act. They wanted to relieve the hospitality industry during the pandemic. So to try to reinvigorate businesses for restaurants, they said, "Well, why don't we make business meals temporarily 100% deductible for the next two years."

So from January 1st, 2021 through December 31st of this year, note that all business meals are 100% deductible. You still have to have the statutory items, business discussion, the receipt in some cases, who attended, but that is a 100% allowable deduction. Last slide is more mind joggers for the whole audience, things to be aware of. What are tax risk areas? What is the IRS looking at? On a global basis, what are things being looked at? When we talk about international operations, transfer pricing is very big. And that's not just US, that's global.

So if you have intercompany transactions among a global group, you need to make sure you have good arms-length policies to meet the Section 482 standards. Your GILTI and FDII computations. Those are still extremely complex. If you have especially profitable foreign operations, with respect to the GILTI, you need to make sure you're scrubbing that good. Changes in ownership. Section 382. We've been seeing merger and acquisition activity really increase in our firm.

This is where Section 382 could kick in because if your corporation has an ownership change of greater than 50% in a generally a three-year test period, it severely limits the NOL usage going forward. So you want to make sure you're looking at any substantial changes of ownership in a corp that has NOL carryovers. Indefinite-lived intangibles. We always throw that out there. Even though this is part of what we could be doing in the future, a 201, a tax provision session, if you're buying intangibles that are considered indefinite-lived, so goodwill. If you buy assets of a company, it's goodwill.

You would normally have tax basis in that, but no book basis. So that could present what we call a naked credit in the provision industry where you have a stuck deferred tax liability in your balance sheet even if you're fully reserved. Business combinations. Setting up your deferred tax liability for goodwill, you could have a tax basis difference because the tax basis immediately after acquisition does an equal book because you would have carryover or legacy tax basis.

But book purposes, it's fair market value. What did you pay for it? So, you're going to have that opening difference of the stock acquisition set-up. Then R&D activities. We wanted to put this out there because there are changes recently for your tax accounting. Of course, make sure it's properly documented and is a qualified US activity if it's going to be an R&D qualified credit. However, starting in 2022, note that R&D costs must be capitalized for tax purposes over a five-year period.

You no longer get the Section 174 direct write off. So that started. It was proposed to be delayed in the Build Back Better bill. That did not pass, so effective five weeks ago, all R&D costs for tax purposes must be capitalized for five years.

Lexi D'Esposito:Thank you for taking the time to join us. We hope you enjoy today's presentation on Tax Provision Preparation 101. A special thanks to our speakers today for delivering this insightful program. If you have met the CPE requirements, you can now download your CPE certificate in the Certification widget on your screen. You will also receive an email later today with a link to download your certificate.

Allie Colman:Thank you, everyone.

Tom Cardinale:Thank you. Take care, everybody.

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