Bricks & Mortar Co. (the "Company"), an SEC registrant, is a manufacturer of construction equipment. The Company has been in business for more than 50 years, operating profitably for the past 25. In addition, it has an applicable tax rate of 40 percent and no unused tax loss or credit carryforwards. The Company's fiscal year ends on December 31.
In prior years, the Company determined it had no uncertain tax positions that required recognition under ASC 740. The last date of payment of fiscal year 2011 tax is March 17, 2012, for purposes of accruing interest and penalties under the tax law.
The Company is preparing its financial statements for the year ended December 31, 2011. In determining the amount of its 2011 tax provision, the Company has prepared a draft of its 2011 tax return.
The Company's tax working papers indicate that its preliminary tax balances, on an "as-filed" basis (i.e., before financial reporting adjustments), are as follows:
-Balance sheet accounts
Current tax liability $2,000 [1]
Deferred tax liability $ 800 [2]
-Income statement accounts
Current tax expense $2,000 [3]
Deferred tax expense $ 200 [4]
[1] Agrees to tax-owed line item in draft tax return
[2] Relates to fixed asset temporary differences only (book basis of $100,000 and tax basis of $98,000)
[3] Agrees to tax provision rollforward
[4] Agrees to deferred tax provision working papers
Management has identified two deductions, taken in its draft 2011 tax return, for which the tax law is not clear as to whether those tax positions should reduce the Company's 2011 tax liability. The Company is evaluating these tax positions for financial reporting purposes. Management is highly confident that all other tax positions will be sustained by the taxing authority upon examination and that 100 percent of the deductions claimed in the tax return should be reflected in the financial statements because they are based on clear and unambiguous tax law.
For Issues 1 and 2, assume that each of the tax positions has substantial authority for the purpose of determining whether penalties may be assessed.
Issue 1 Facts:
As a result of implementing a certain tax strategy, the Company has included a $100 deduction in its draft tax return, resulting in a $40 reduction to taxes payable. There is uncertainty over whether the tax strategy is sustainable under the tax law and therefore over whether the additional $100 is deductible for tax purposes.
Management asserts that there is a 40 percent chance that the tax position would be sustained if taken to the court of last resort. However, on the basis of its past experience in negotiating settlements with the taxing authority, management believes that if it were to negotiate a settlement with the taxing
authority rather than take the dispute to the court of last resort, it would have an 80 percent cumulative probability of realizing at least $10 of benefit, (i.e., the Company believes it has a 10 percent chance of realizing $40 ($100 × 40%), a 40 percent chance of realizing $20 ($50 × 40%), a 30 percent chance of realizing $10 ($25 × 40%), and only a 20 percent chance of realizing no benefit).
The sustainability of this tax position does not affect the tax bases of the Company's assets or liabilities. This tax position meets the substantial authority threshold for determining whether penalties may be assessed.
Issue 2 Facts:
The Company has taken a tax deduction in its draft tax return in the amount of $100, resulting in a $40 reduction to taxes payable. Management has obtained a tax opinion from a law firm at a 65 percent level of confidence that the tax position is appropriately deductible under the tax law and concluded that the tax position meets the more-likely-than-not recognition threshold. Management asserts that it would negotiate a settlement with the taxing authority in the event of a dispute. In the event of a negotiated settlement with the taxing authority, management asserts there is a 35 percent probability that it would sustain the full $40 ($100 × 40% tax rate) tax benefit, a 35 percent probability that it would sustain $32 ($80 × 40% tax rate) of the tax benefit, and a 30 percent probability that it would sustain $24 ($60 × 40% tax rate) of the tax benefit.
This tax position does not affect the Company's tax bases of its assets or liabilities.
Requited:
Issue 1: Determine the adjustments required to the Company's preliminary 2011 financial statements. Justify your position. If an adjustment is necessary, record the appropriate journal entry.