How ASC 740 Applies to State Income Taxes

What effect do federal and state tax differences have on 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 state combined 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 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 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 since they reduce state income taxes and, therefore, an increase in future federal income.

Enacted state law and rates

Companies may encounter state tax law changes that impact the income tax provision. ASC 740 requires companies to account for income tax rate and law changes in the period in which the law is enacted.

A state tax rate change will often require a company to “re-price” its deferred tax assets and liabilities, resulting in a deferred impact on the effective rate.

If a law change occurs 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 in the law.

ASC 740 requires companies to calculate income tax provisions for each jurisdiction in which it is subject to tax. However, due to apportionment and state rates being much lower than the federal rate, state income taxes tend to be relatively small compared to the federal income tax liability. Therefore, situations arise where a company uses a blended state rate to account for all or a portion of its state income tax provision. The decision to use a blended rate should be evaluated as facts change.

Pass-through entity taxes

Historically, pass-through entities are not subject to 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 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, the inconsistent nature of taxes on pass-through entities at the state level means that some taxes will be within the scope of ASC 740 while others will be treated as a transaction with the owners.

Watch on-demand: ASC 740 States Overview Webinar

This webinar includes an overview of the basic concepts of accounting for state income taxes under ASC 740, including state taxable income, state modifications, state credits, and federal impact of state taxes.

What state tax-related disclosures does ASC 740 require?

Typically, the rate reconciliation disclosure presents state income taxes net of the federal benefit. Alternatively, the components of expense may show the state current and deferred expense on a gross basis and the federal current and deferred expense net of the state tax.