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hello and welcome to this session this is Professor farad in which we will discuss uncertain tax position known as UTP now many students find this topic complicated or challenging I'm going to try to simplify this as much as possible without using the technical language so let's start by defining what is an uncertain tax position well it's a position when the company's decision is unclear about a tax situation and that position may not be accepted by tax Authority upon review or audit what does that mean it means the company is taking a deduction on their tax return or not including an income there so there's an income and they're not including this income or taking some sort of a tax credit whether you are taking a deduction you're taking a tax credit or not including an income the bottom line is you are trying to reduce your taxable income and by reducing your taxable income you are trying to reduce your taxes that's the whole purpose of taking this position it takes many form the question is what happened if you were audited what happened if the tax return was reviewed would this position be withheld in other words would that deduction goes through or would it be rejected by the IRS will that credit be honored yes you you this is a research and development credit and yes you did compute it properly you qualify for it or would that income that you considered non- taxable would it be considered taxable in other words you're not paying taxes on it now is it going to be taxable think of it think of this as like driving on a foggy Road navigating a foggy Road well guess what just as the fog obscure the way forward uncertainty in tax law makes it unclear whether a company decision will be accepted by authorities now if the rules if the law is clear-cut but it's yes or no then that's fine then uncertain tax position don't exist it's either clearcut deduction or it's not a deduction under certain circumstances the law the tax rules are not clear so that's why we do have this uncertain tax position now as a CPA candidate I'm going to go over some examples when the tax position may not be clear 100% but we don't have to worry about this in practice people in practice will have to deal with this situation maybe on a day-to-day basis from a CPA perspective you need to know how to account for an uncertain tax position so you take the company takes an aggressive position to reduce their taxable income what's an aggressive position either you took a deduction you took a credit and you're not sure if that deduction is in quote legitimate or there are certain taxable income that you're not including I know I'm repeating myself I just want to make sure you understand how does this uncertain tax position comes into play if the position later on is not sustained and retro retroactively disallowed so let's assume you were audited or the the tax return was reviewed and the IRS said no hold on a second we're not going to accept that position we're not going to accept this deduction as a deduction or you went to court and the court invalidate your deduction or your credit or there's a new regulation that clarified this deduction and said you know what it's not acceptable so some subsequent event occurred and now you know that that deduction that taxable that reduction in your taxable benefit was not in quote legitimate what do you have to do well if that happens let's think let's think of it just from a logical perspective so you took a position your taxable income went down two years later you find out that position that you took was not acceptable so what's going to happen your taxable income will go up and you might be incurred the penalties interest we're not going to get into this but you're you're going to have to pay your taxes and maybe with additional interest and penalties again I'm not get I'm not going into the interest and the penalties but the point is if this happens it means in the future you might have a liability what does that mean well think about contingent liability same concept if you are going to have a liability into the future if you think you're going to owe money what do you have to do today if you think you are going to owe money you have to book a liability and this is where this uncertain tax position takes place you took a deduction you took a credit then you would say okay I took this I'm not really sure if it's going to in the future it's going to be reversed or not well on on my financial statement remember you're going to have you took that position on your tax return that's fine you took your position and we're going to see when and how you take that position then from a financial statement what do you have to do on the financial statement you might have to book a liar ability and we're going to look at the rules but that's the big idea I'm going to show you an example I'm going to look at the rules first show you an example and work in McQ to kind of just get you familiar with what do you need to know for this topic on the CPA exam let's go ahead and get started before we proceed any further I have a public announcement about my Company forat lectures. forat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses my CPA material is aligned with your CPA review course such as Becker Roger Wy gleam miles my accounting courses are aligned with your accounting courses broken down by chapter and topics my resources consist of lectures multiple choice questions true false questions as well as exercises go ahead start your free trial today we're going to look at this situation from a US Gap not from a tax perspective from a tax perspective we are assuming assuming that you took the position from a gap from a financial statement perspective what would fby required well fby set up guidelines for company to decide if a tax position are likely to stand up to an audit and here are the rules basically this what they called test one companies need to figure out if there if there's more than 50% chance that their tax position whether you took a deduction or a credit will be accepted if the tax Authority checked or books so they would say okay think of it from a tax perspective if you were audited or if your tax return was reviewed with that position be accepted by the IRS if the an if the chance of that position more than 50% being accepted the answer is yes to test one then if it's yes then we're going to have to go to step two and book a liability determine if it's accepted how much of it is accepted if the if the answer is no it's not going to be accepted we stop if the IRS don't do that you should not be taking that position anyway in the first place but the question is would it be sustained if the answer is yes it will be sustained and you took that position then we're going to have to determine how much of a liability you need to book so if the company thinks it's more than 50% likely that their tax position were H up under audit they can record this as a benefit in their account reducing how much they owe in taxes or increasing their assets so if they think it's more than 50% they're going to take the deduction because they think it's more than 50% and on the financial statements they have to book a they might have to book a liability if the chance is less than 50% they should not include this potential benefit in their financial record because there's no chance of that taking place and if that's the case they should not even take take the deduction on the tax return here what we assume we assume an audit it's going to take place and making these decision companies will assume we're going to be audited we don't assume well there's a low chance of being audited we're going to assume we're going to be audited our filing will be audited and if the company decides its tax position is likely to be approved it means more than 50% then they need to figure out how much to adjust their tax asset and liabilities in their financial record yes there's more than 50% it will be approved but they have to determine sometime what's going to happen the IRS May accept part of it maybe they accept 60 70 80% of that deduction and the remainder they said no it's not acceptable or between the client and the IRS they may come to an agreement the IRS might say look uh you know the law is vague um let's cut this deduction in half and we'll accept half of it or you might tell the IRS look I'm willing to take 60% or 40% of that deduction and if they agree the government would settle so there's also that that that that probability that you might go into a settlement with the IRS you have to take that into account so in essence what you're doing you are being cautious and realistic with Tax Claim ensuring that companies only account for the benefits that they are fairly confident they will be allowed to keep after a potential audit so they have to think like if we are audited we might have to settle and get less of the deduction so how much will we get this is what we're going to book and this is what we'll see in the example now you might say what are those disputes you might get into a dispute for the IRS for many reasons and once you have a dispute you might have this situation un certain tax position you might be claiming a deduction taking a business expense or a donation to lower your taxable income and that could be questionable well you could be choosing to file a not to file a tax return in certain areas in other words not pay taxes in certain areas to the lack of business presence that could you know arise to a task task tax dispute with that Authority you could be allocating income across different region across different state to optimize taxes which is transfer taxes and that could raise some questions by the IRS you might be deciding to report certain income of active versus passive ordinary versus Capital that could also arise some tax dispute you could be opting not to not to report certain income deemed non- taxable you think it's non- taxable and classify certain transaction or entities as tax exempt and they may not be well that that might arise to a tax dispute the reason I'm giving you all these options to just I want you to think that why would a tax dispute occur the most the classic one and the easiest one to understand is you took a deduction and the IRS might question this deduction so these position that are listed here they carry some level of uncertainty and the risk of dispute with the tax and Authority so let's take a look at it let's start to kind of put this down in Practical terms so let's assume you are preparing your tax return and it's a corporation they're preparing their 1020 let's assume they took a deduction of a $100,000 that deduction is not 100% clear the law is not 100% clear there's some ambiguity about this deduction um it should be considered an asset it should not be considered a deduction uh we're not sure there's some ambiguity so if the chance of this deduction surviving a a review or an audit by by the IRS is less than 20% you know don't take the deduction we stop if there's any less than 50% if the chance of the deduction surviving a review or an audit by the IRS is more than 50% you're going to take the deduction that's fine and you have to do something on the financial statement now when you make this analysis you take into account the current tax law regulation and any relevant court cases you want to make sure if you took a deduction it's going to stand at least you have more than 50% now how much is this going to be how much of a deduction you are going to take well you're going to take the deduction of 100,000 but on the financial statement you have to determine how much you should book as a liability so yes you took the deduction on the tax return because there's more than 50% you think it's going to survive but how much you're going to take on the financial statement so what you have to do here you have to determine how much is the benefit that's going to be taking net well this is what's called step two so this is step one so we took step one and step one we said yes there's more than 50% chance step two is how much well we're going to evaluate the range of possible outcome a possible outcome between the dispute between you and the IRS and select the amount that has the greater than 50% chance likelihood of being accepted by tax and Authority the best way to illustrate this is to look at a complete example okay let's look let's take this 100,000 and put it in an example so Tech Innovation which prepared its year one tax return and decide to take this 100,000 questionable deduction this deduction would result in a savings of 21,000 given a tax rate of 1% so if we took the deduction the deduction reduced our taxable income by 100,000 as a as a result gave us a tax savings of 21,000 now the company believe there's greater than 50% chance that if audited this tax deduction will be sustained as file meeting the more than likely than not test which is the test one so we think there's more than likely a chance that this deduction will be with will stand and we'll have a deduction of 21,000 now there's more than 51% chance right but there's a chance where we we might lose it all together there's a chance the ARs might say we're going to give you half of it or 75% or 40% or you may just settle with them just you know what give me 40% of that deduction okay so Tech Innovation also anticipate if challenged it would be likely end up negotiating settlement and we're going to below we're going to look at the assessment of the potential outcome so what would Tech Innovation decides to do they would say okay here are the probabilities there's a 20% chance that we will get the full savings the 21,000 the full savings now these probabilities now remember there's a more than 51% it will be acceptable yes so please don't confuse the greater than 50% chance more likely then not test with the probabilities first the test one this is test one test one is saying is there more than 51% chance we can take the deduction this is test one the answer is yes or no in test two there's various probabilities the first probability is there's a 20% probability that the IRS will accept our position 100% there's a 20% probability and so far the cumulative probability is 20% the IRS accepting rather than 15,000 accepting rather than accepting then 21,000 accepting a 15 $15,000 savings there's a 32% probability of the IRS saying you know what rather than 21% we're going to accept 15,000 of savings and there's a 32% chance of that now the probability you have to add the probability the cumulative probability well 20% chance gave you a 20% probability there's a 32% chance a higher chance that the that the government might accept 15,000 15 gives you a $155,000 savings on this deduction well if that's the case your cumulative probability is 52% here's what's going to happen once you reach cumulative probability more than 50% this is the probability that you will assume it's going to be realized so although you took a deduction of 21,000 on your tax return but you are going to say look yes I took the deduction 21,000 if I'm challenged I can get away with 15,000 what does that mean well it means I took a deduction to day of 21,000 but I think this deduction this savings will be only 15 it means I am going to potentially lose think of it 6,000 6,000 of a deduction I'm going potentially I'm going to lose that why because there's more than 50% chance ing to my probability that I will settle with the IRS at 15,000 but right now I'm taking 21 what does that mean it means in the future I might lose the 6,000 of savings it means in the future I have to account for a liability because because I may end up paying more because I'm going to lose my savings then at $110,000 savings there's a 23% probability the cumulative now goes up to 75 and only a $5,000 savings at the 15% probability and at this point it's 90% and no savings which is they say you're out you're we're not going to give you any deduction there's a 10% probability that they would say you know we're not going to give you anything okay but what we did is we once we reach the more than 50% we stop there we take that high highest probability now what are we going to do then so what are we going to do now well based on this more than 50% probability for a financial statement perspective the company should recognize a tax savings SL benefit of only 15,000 well on the tax return we were benefited 21 on the financial statement we are going to take only 15 so this amount the 15,000 is the largest benefit that has a greater than 50% chance cumulative probability of being realized because once we reach more than 50 which is at this level was 52% to reflect this in our financial statement we must record a liability income tax liability adjustment originally with a full deduction the expected saving would have been 21,000 and this is exactly what we took on the tax return we took the full deduction but from a financial statement perspective we have to be conservative we have to tell the users yeah yes we took this deduction but there's a chance we might lose the 21,000 original savings and only recognize 15 it means we have to book an additional expense of 6,000 and book a liability called income tax payable unting tax position so this liability is like a special liability it's uncertain tax position so we took the deduction so on the tax return we're happy we took the deduction the deduction gives us $221,000 in savings on the financial statements we we're going to say you know what yes we took the deduction but there's a chance we could be audited if we're audited we think we can settle 415 and therefore we're going to lose $6,000 therefore from an income tax perspective from a financial statement perspective perspective we have to book an additional expense and book a liability of 6,000 now obviously if we're audited we have to pay back the IRS and on the tax return we just have we just simply have to pay the taxes that's you know that's on the tax return again remember what we're looking at here in this old UTP is the financial statement we're looking at Gap we're looking what we're doing with gap so when do you remove this liability of $6,000 that is income taxes payable UTP well one one scenario is you were audited and you settled the liability so the IRS audit you and they say you know what we're going to accept it and for Simplicity we're going to say um we accept it exactly for the 6,000 um that you thought you will so they accepted exactly what we thought they will therefore we debit so under those circumstances you debit income taxes payable UTP 6,000 and you credit cash 6,000 and this liability is gone and we end up paying the cash so that's one possibility they may they may settle for more than 6,000 for less than 6,000 just you would you were audited and settled the liability or the statutes of limitation expire after 3 years that said they can no longer go back and ask for this we we reverse this if that's the case we reverse this or there are new rules or regulation or court cases clarifying the ambiguity about that $100 deduction that we took that resulted in $21,000 in savings if the ambiguity is clarified to our favor it means this payable that we we thought we're going to pay would be no longer the case then we will reverse the entry let's assume it was in our favor it means well that's it we took the deduction we thought we're going to be responsible for 6,000 we're no longer responsible we're going to take the full savings or it was against you then you have to book an additional income tax expense of 15 credit income taxes payable of 15 and we might incur penalties and interest which is you know for taxes we don't want to get into this but the point is once the new new rules and regulation or court cases clarify that ambiguity if that happens as well let's take a look at this multiple Choice question from farat lectures. if a company's uncertain tax position is estimated to have multiple potential outcome the amount to recognize in the financial statement should be what simply put they're asking us here for test two how much you would record as a liability about this uncertain tax position is it the sum of all possible tax benefit no you don't add up all the possible tax benefit a is out the minimum amount and the range of possible outcome well not the sum and not the minimum you're you're not going to do you know the sum is everything and the minimum is the minimum the maximum amount that has more than 50% likelihood of being realized yes the maximum amount that have more than 50% likelihood as a cumulative probability of being realized that's what you will record in the financial statement a weighted average of all potential outcome no you don't get a weighted average so the answer is C you have to know how to book that test to the maximum amount that has more than 50% likelihood of being realized Choice C is the correct answer so what you have to do the company should recognize the largest amount of benefit that's more than 50% chance likely to be realized upon settlement and remember that 50% is the cumulative probability what should you do now you want to go to far hat lectures look at additional mcqs that's going to help you whether you're studying for your CPA exam accounting courses enrolled agent some other professional certification invest in your yourself good luck study hard and of course stay safe