Question

ABC Co. took four tax deductions on their 2016 tax return that have issues that could result in some or all of the deductions being disallowed if ABC’s 2016 tax return is audited. ABC believes the deductions are justifiable but knows that tax law related to each item is unclear. Information about each deduction follows: 1) Amount of deduction $500,000 ABC’s probability full deduction will be allowed 60% ABC’s estimate of potential deduction being allowed 500,000 60% 400,000 30% 250,000 10% 2) Amount of deduction $800,000 ABC’s probability full deduction will be allowed 40% ABC’s estimate of potential deduction being allowed 800,000 40% 650,000 30% 500,000 20% 400,000 10% 3) Amount of deduction $300,000 ABC’s probability full deduction will be allowed 30% ABC’s estimate of potential deduction being allowed 300,000 30% 250,000 15% 200,000 40% 125,000 15% 4) Amount of deduction $900,000 ABC’s probability full deduction will be allowed 45% ABC’s estimate of potential deduction being allowed 900,000 45% 800,000 40% 650,000 15% ABC’s 2016 tax rate was 25%. ABC is a calendar-year company. During 2017, ABC Co. received notification that its 2016 tax return was being audited. At December 31, 2017, the IRS had verbally communicated their findings on deductions 1 – 3. Their findings were as follows: Deduction 1 $120,000 disallowed Deduction 2 no disallowance Deduction 3 $80,000 disallowed Deduction 4 was still under examination at December 31, 2017. Prior to December 31, 2017, ABC and the IRS formalized their agreement on deductions 2 and 3 by signing IRS Form 906, “Closing Agreement on Final Determination Covering Specific Matters.” ABC is disputing the IRS’ findings related to deduction 1. 1. What amount if any liability should ABC recognize at December 31, 2016 related to the tax effects of these four deductions? (ignore possible interest and penalties) 2. Can ABC assert an “effective settlement” for any of the deductions taken on the 2016 tax return at December 31, 2017? 3. What amount of liability should ABC report at December 31, 2017 related to the 2016 deductions assuming ABC has not changed its assessment of deduction 1 or 4? Provide authoritative support for your answer where necessary.

Answer 1

Answer to Part 1

At December 31, ABC company will account for probable amount which it is expecting to get disallowed. Accordingly, based on the probabilities in 2016 at a tax rate of 25%, an amount of $87812.5 needs to be provisioned for.

Answer to Part 2

ABC can assert effective settlement for Deduction amount of $300,000 since ABC and the IRS formalized their agreement on deductions 3 by signing IRS Form 906 prior to Dec 31,2017.

Answer to Part 3

Amounts of liability which needs to be reported w.r.t. Deduction 1 to 4 should be as follows:

Deduction 1: Deduction 1 is still being disputed and no agreement was signed. ABC has received a verbal communication that $120000 may be disallowed and hence the provision amount at 31 Dec 2017 should stand at $30000 i.e. 25% on $120000 as against $13750 which was provided for in 2016. Additonal provision required in this regard is $16250.

Deduction 2: With respect to this deduction a verbal communication has been received that there is no disallowance and agreement also signed. No provision required at 31 Dec 2017 w.r.t. this deduction item.

Deduction 3: With respect to this item, an amount of $73750 was only allowed at 2016. However a verbal communication for Rs80000 has been received and additional provision of 25% on $6250 was required. However IRS Form 906 is already signed in this regard.

Deduction 4: This deduction is still under review and the provision of $19375 which was provided in 2016 holds good. No additional provision at Dec 31, 2017 is required in this regard.