How do differences between federal and state income tax impact the ASC 740 income tax provision?
Certain states do not allow taxpayers to file consolidated tax returns. Consequently, many companies must file a separate return for each entity that conducts business in a particular state.
Some states allow entities to file combined returns, also known as unitary returns. However, the filing groups in these combined returns may be based on different principles than those governing federal consolidated returns. As a result, there are situations where a combined state return may include entities that are not included in the federal group or exclude entities included in the consolidated federal return.
State net operating losses and tax credits
State net operating losses (NOLs) are accounted for as deferred tax assets, similar to federal NOLs. However, they often differ in the carryforward or carryback (if any) period and whether the carryforward is based on modified state income prior to apportionment or after apportionment. Due to budget issues, some states have enacted laws suspending or limiting the use of NOLs.
Many states allow taxpayers to offset their state income tax liability with credits. These tax credits tend to relate to research and development expenditures, job creation initiatives, and certain industries in the state.
State NOLs and credits are recorded net of the federal benefit because they reduce state income taxes and, therefore, create an increase in future federal income.
Changes to state tax laws and income tax rates
Companies may encounter state tax law changes that impact the income tax provision. ASC 740 requires companies to account for changes to state income tax rates or laws during the period in which the law is enacted.
A state tax rate change will often require a company to “reprice” its deferred tax assets and liabilities, resulting in a deferred impact on the effective tax rate.
If a law changes after the end of a reporting period but prior to the release of the financial statements, the company must base its income tax provisions on the law in effect as of the balance sheet date. However, it should disclose any material impact of subsequent changes to the law.
Pass-through entity taxes
Historically, pass-through entities are not subject to state income tax because the tax consequences of transactions within the pass-through entity “flow through” to its owners. However, an increasing number of states have started embracing an entity-level income tax on pass-through entities.
Pass-through entities that issue GAAP-based financial statements must be mindful of the consequences of a state’s pass-through entity tax on its tax provision.
The first step is to determine whether the pass-through entity tax is within the scope of ASC 740. This means the tax:
- Must be paid by the pass-through entity alone
- Must be based on taxable income
Unfortunately, because state pass-through entity taxes are inconsistent, some of those taxes will be within the scope of ASC 740 while others will be treated as a transaction with the owners.