Presented by Robert Schwarzmann and Adam Polakov
1
Agenda
Tax
Landscape
Accounting for Income Taxes
 Basics of Accruing Income Tax Expense
 Deferred Taxes (ASC 740)
 Footnote Disclosures and Valuation Allowance
2
Tax Landscape

Expiration of Bush Tax Cuts
Patient
Protection and Affordable Care
Act
Election Year
3
Bush Tax Cuts Sunset – 12/31/2012
Marginal
income tax rates return to pre-2001
levels
Tax Brackets (2012 Dollar Amounts)
Unmarried Filers
But Not
Over
Over
Married Joint Filers
But Not
Over
Over
Marginal Rate
2012
2013
$0
$8,700
$0
$17,400
10%
15%
8,700
35,350
17,400
$70,700
15%
15%
35,350
85,650
70,700
142,700
25%
28%
85,650
178,650
142,700
217,450
28%
31%
178,650
388,350
217,450
388,350
33%
36%
35%
39.60%
388,350 ...
388,350 ...
4
Bush Tax Cuts Sunset – 12/31/2012
 Capital Gains tax rates will return to pre-2001 levels
 Capital gains currently taxed 0 percent for taxpayers in the 10 and 15 percent
brackets and at 15 percent for all others.
 Will increase to 10 percent for taxpayers in 10 and 15 percent bracket and 20 percent
for all others.
 Qualified Dividends will be taxed as ordinary income
 Qualified Dividends are currently taxed at the same rates as capital gains
 Tax rate on Qualified Dividends increases to 43.4% with addition of 3.8%
Investment Income Tax
 The
estate tax will be restored with an exemption level of $1
million and a top tax rate of 55%
 Child
care credit decreases to $500 from $1,000
5
Bush Tax Cuts Sunset – 12/31/2012
 Return
of the “marriage penalty” on jointly filed taxpayers
 Joint filer’s standard deduction returns to 167% of individual standard
deduction
 End
of accelerated “50% bonus” depreciation deductions
 Section
179 expensing limitation - $25,000; $200,000 qualified
asset additions (currently 125,000; 500,000)
 The
2% FICA payroll tax cut is expiring
 Alternative
Minimum Tax (AMT) patch expires
6
Affordable Care Act – New Taxes
 Investment Income Tax
 3.8% Medicare Tax on

Investment Income
Impacts individual taxpayers with AGI > $200,000 and joint filers with
AGI > $250,000
 How does the Act define Investment Income
 Dividend Income (Tax rate on Qualified Dividends increases to 43.4%)
 Interest Income
 Rental Income
 Royalties
 Short and Long Term Capital Gains
 Passive Income from K-1’s where the taxpayer doesn’t materially
participate
 Gain from the sale of a primary residence (exceeding exclusions)
 Gain from the sale of a 2nd home
7
Affordable Care Act – New Taxes
 Certain Income is exempt from the Act
 Tax-exempt Income on municipal bonds and securities
 Payouts from Regular or Roth IRAs
 Payouts from 401(k) or pension
 Social Security Income
 Life Insurance Proceeds
 Pass-through business income on which taxpayer is
remitting Self Employment taxes
8
Affordable Care Act – New Taxes
 Computation
 The new Medicare tax is computed as 3.8% on the lesser of


1) Investment Income or
2) the excess of AGI over the income threshold
 Example
1
 A joint filer has $400,000 of AGI including $240,000 of W-2
wages and $160,000 of investment income
 Because the excess of AGI over the income threshold ($400,000 $250,000) of $150,000 is less than investment income of $160,000,
the tax is based on excess AGI.
 Additional Medicare tax is $5,700 ($150,000 x 3.8%)
9
Affordable Care Act – New Taxes
 Example
2
 A single filer has W-2 wages of $260,000 and dividend income of
$100,000. AGI equals $360,000.
 Because the excess of AGI over the income threshold ($360,000 -
$200,000) of $160,000 is greater than investment income of
$100,000, the tax is based on investment income.
 Additional Medicare tax is $3,800 ($100,000 x 3.8%)
10
Affordable Care Act – New Taxes
 Example
3
 A single filer has $285,000 of income from the following sources:





IRA payouts of $80,000
Social Security payments of $60,000
Dividend income of $40,000
Long Term Capital Gains of $30,000
Tax Exempt interest income of $75,000
 AGI is $210,000 and Investment Income computed under the Act
is $70,000
 Additional Medicare tax is $380 ($10,000 x 3.8%)
11
Affordable Care Act – New Taxes
 Example
4
 A joint filer purchased a home 30 years ago in New York City
for $250,000 and sells it in 2013 for $2 million. The joint filer
also has W-2 wages of $100,000.


Investment Income is $1,250,000 ($2 million less $250,000
cost basis less $500,000 exclusion)
AGI > $250,000 is $1,100,000 ($1,350,000 less $250,000
exclusion)
 Additional Medicare tax is $41,800 ($1,100,000 x 3.8%)
12
Affordable Care Act – New Taxes
 Payroll Taxes
 .9% Medicare Hospital Insurance Tax on Ordinary Income


Impacts individual taxpayers with Ordinary Income > $200,000
and joint filers with Ordinary Income > $250,000
Assessed on the employee portion of Medicare
 How does the Act define Ordinary Income?


W-2 wages
Pass-through business income on which taxpayer is remitting self
employment taxes (Schedule K-1, Schedule C business income)
13
Affordable Care Act – New Taxes
 Withholding

Employers are required to withhold additional
Medicare Tax

Employers are not required to consider a spouse’s
wages or whether the employee earns wages at a
second job

Because tax on “employee portion” of Medicare, self
employed persons will not be able to deduct one half of
this tax from AGI
14
Affordable Care Act – New Taxes
Example
 A joint filer earns $375,000 in W-2 wages and
$150,000 of pass-through income from a business
that is subject to self employment taxes
 Ordinary Income subject to the .9% Medicare tax is
$275,000 ($525,000 ordinary income less
$250,000 exclusion)
 Additional Medicare tax is $2,475 ($275,000 x
.9%)
15
Affordable Care Act – New Taxes
 Medical
Expenses
 Itemized Deduction

The medical expense “floor” increases from 7.5% to 10% of AGI
 (minimum amount of medical expenses that must be incurred
before getting a tax deduction)
 Healthcare Flexible Spending Account contributions limited
to $2,500 (pre-tax)
 Penalty for nonqualified distributions from Health Savings
Accounts increases from 10% to 20%
16
Mandatory Health Care Coverage

Effective January 1, 2014, large employers will be assessed excise
tax penalties if any of the following are applicable:
 Does not offer coverage for all full-time employees
 Offers minimum essential coverage that is unaffordable (i.e., the
employee contribution is > 9.5% of the employee’s household income)
 Offers minimum essential coverage where the plan’s share of the total
cost of benefits is less than 60%
(Minimum essential coverage is defined as the
large employer covering at least 60% of the cost.)
 Any full-time employees are certified to have purchased health
insurance through a state exchange and qualified for a tax credit
17
Mandatory Health Care Coverage
Penalty
if Employer does not offer a Health Care plan
to all employees
 An employer has 75 full time employees (FTE’s) and one employee
is not covered by the group policy and the employee receives health
coverage assistance
 The tax would be based on 45 employees (75 FTEs less a 30
employee predefined minimum threshold)
 For each month the employee is not covered, the tax is computed as
follows:



1/12 x $2,000 or $167/month per employee
45 employees x $167 = $7,500 tax per month
Annual excise tax of $90,000
18
Mandatory Health Care Coverage
Penalty
if Employer offers Health Care coverage but
does not meet certain criteria
 Failure to offer all FTE’s the opportunity to enroll in minimum essential
coverage under an eligible employer sponsored plan; and
 At least 1 FTE has been certified as having enrolled in a state exchange plan
and has received a premium tax credit

For example, minimum essential coverage is not met if at least one FTE receives a credit or
cost sharing reduction in a state exchange plan because the employer’s premium under the
health care plan exceeds 9.5% of that employee’s household income or the employer-offered
plan pays for less than 60% of covered health care expenses
 For each month the employee is not covered, the tax is computed as follows:


1/12 x $3,000 or $250/month per employee
Penalty is capped at the penalty the employer would have owed had no
health care plan been provided
19
Individual Mandate
 Effective
January 1, 2014, all U.S. residents are required
to maintain minimum essential coverage unless they meet
one of the following exceptions:
 Incarcerated individuals
 Undocumented aliens
 Individuals who meet certain hardship conditions and are
unable to afford coverage
 Individuals below the tax filing threshold
 Members of Indian tribes
20
Individual Mandate
 Annual
penalty for not having minimum essential
coverage will be the greater of
 A flat dollar amount or

$95 in 2014, $325 in 2015, and $695 in 2016
 A percentage of the individual’s taxable income over a
certain threshold

Phased in at 1% in 2015, 2% in 2015, and 2.5% in 2016
21
Other Provisions in the Act
 Small
Business Health Care Credit (2010-2013)
 Credit is available up to 35% of health insurance premiums
 Maximum eligibility for the credit is for employers with 10
or fewer workers with average wages of $25,000 or less
22
Election Year Proposals
 President
Obama’s Tax Proposals
 Set long term capital gains rate to 20% (Increases to 23.8% with the
Medicare tax on investment income under the Affordable Care Act)
 Reinstate the top two pre-2001 individual income tax rates
(36% and 39.6%), but maintain Bush era tax rates for lower
income taxpayers
 Tax dividends at ordinary income tax rates
23
Election Year Proposals
 Establish limitations on the benefits of itemized deductions
for higher income earners
 Supports Federal Estate Tax of 45% with an exemption of
$3.5 million
 Repeal the Alternative Minimum Tax; Replace the AMT
with the “Buffett Rule” which would institute a minimum
30% tax on taxpayers with an AGI > $1 million
 Reduce the corporate tax rate from 35% to 28% while
removing deductions/loopholes embedded in the tax code
24
Election Year Proposals
 Governor Romney’s
Tax Proposals
 Repeal the 3.8% Medicare tax on Investment income embedded in
the Affordable Care Act
 Reduce the tax rate on long term capital gains, dividend income and
interest income rate to zero for all taxpayers with AGI below
$200,000
 Maintain a 15% rate on capital gains and qualified dividends for
taxpayers with AGI > $200,000
 Permanent, across-the-board 20% tax cut on all individual income
tax rates
25
Election Year Proposals
 Governor Romney’s
Tax Proposals cont’d
 Repeal the Alternative Minimum Tax
 Eliminate the Federal Estate Tax
 Reduce the corporate tax rate from 35% to 28% while
removing deductions/loopholes embedded in the tax code
 Supports transitioning our Corporate Tax to a Territorial tax
system
26
Accounting for Income Taxes
 Definitions
 Basics
of Income Tax Expense Accrual
 Deferred
 Balance
Tax Components
Sheet Approach vs. Expense
 Footnote
Disclosure
 Valuation Allowance
27
Accounting for Income Taxes
 Definitions
 Income Tax
Expense – tax expense recorded on Income Statement

Current Tax Expense/(Benefit) – amounts owed to (or due from) federal and
state tax authorities that must be paid currently

Deferred Tax Expense/(Benefit) – amounts owed to (or due from) federal
and state authorities but not yet paid or received
 Income Tax (Payable)/Receivable – current income tax liability or
receivable recorded on balance sheet
 Deferred Tax Asset/(Liability) – an asset/liability on a company’s
balance sheet that may be used to reduce (or increase) a subsequent
period’s income tax payable
28
Accounting for Income Taxes
 Basics
of Accruing Tax Expense
 Pre-tax book income (GAAP)

Adjust for Permanent Items
 Examples of permanent tax adjustments (M-3’s)





Tax exempt interest income
Fines & Penalties
Social Club Dues
Meals & Entertainment
Federal income tax expense
 APB 11 (Income Statement) Approach

Pre-tax income + Perm M-3s x blended rate = tax expense
29
Accounting for Income Taxes
Using a Blended Tax Rate:
34% + 6% x (1-.34) = 37.96% for GA corporations
Federal Rate
.34
State Rate
.06
Benefit of Federal
deduction of state tax
(6% x 34% = 2%)
(.02)
Net State Tax
.0396
Blended Rate
.0396
.3796
30
Accounting for Income Taxes
 In
a multi-state environment the blended rate can get much
more complicated
 When state apportionment formulas are computed each year,
the rate can fluctuate based on the individual state activity
 Calculating state tax expense under APB 11:
 NC: 70% apportionment x 6.9% tax rate = .0483
 GA: 30% apportionment x 6.0% tax rate = .018
 .018 + .0483 = 6.63% blended APB 11 state tax rate
 Blended rate = .34 + 6.63% x (1- .34) = 38.45
31
Accounting for Income Taxes
 Effective Tax






Rate (ETR)
Expected ETR = tax expense / pre-tax book income
What is the impact of an increase in tax-exempt income?
What is the impact of an increase in social club dues?
ETR may fluctuate even if Permanent M-3s are consistent
Timing differences do NOT impact the ETR
Differs from Statutory tax rate (34%)
32
Accounting for Income Taxes
 How
to reflect on books
 Tax is similar to other accrued expenses


Debit expense, credit tax reserve account
Payments exceeding accrual create prepaid
 Monitor the balance in the reserve account by tracking
current tax position (accruals vs. estimated payments) as
well as deferred tax balances (supported by components of
deferred tax)
33
Accounting for Income Taxes
Making
Tax Payments
 Estimated Payments

Due 4 times each year
 Final Extension payment for prior year

Due March 15
 Payment with return

If necessary
 Refunds and Overpayments

Represent receivable on balance sheet
34
Accounting for Income Taxes
 Payment
v. Accrual
 Why are they different?

Examples of Temporary Items of Tax Adjustment (M-3’s)
 Bad Debt Reserve
 Fixed Asset Depreciation
 Accruals for Deferred Compensation
 Accruals for Contingencies
 Why
are they Temporary?
 Each item of income or expense is the same for book & tax
over time
35
ASC 740 Deferred Taxes
 ASC
740 Balance Sheet Approach to Taxes
 Timing differences between book basis and tax basis
 Does not impact total tax expense or ETR
 Recognizing deferred tax assets and liabilities
 Taxable Temporary
Differences
 Deferred Tax Liability (DTL)
 Book Basis > Tax Basis; Future Taxable income
 Deductible Temporary
Differences
 Deferred Tax Asset (DTA)
 Book Basis < Tax Basis; Future Taxable Expense
36
Deferred Tax Liability Example
 Fixed
asset depreciation
 Furniture costs $20,000
 Book depreciates over 10 yrs straight line - $2,000
 Tax depreciates over 7 yrs w/50% bonus – $11,429
 Favorable Tax

adjustment = $9,429
Reduces taxable income in current period
 Book
basis = $18,000 Tax basis = $8,571
 Deferred component = ($9,429)
 Book Basis > Tax Basis = Deferred Tax Liability
 Future taxable income upon reversal
37
Deferred Tax Asset Example
 Bad
Debt Reserve
 Initial reserve for books is $2,000,000
 Allowed reserve for tax is $150,000
 Unfavorable Tax

adjustment = $1,850,000
disallowed deduction (or additional income)
 Deferred
component = $1,850,000
 Book Reserve > Tax Reserve = Deferred Tax Asset
38
Deferred Tax Inventory
 Fixed Assets
 Bad
Debt Reserve
 Total Timing Differences
 Tax rate
 Deferred Tax Asset
(rounded)
(9,429)
1,850,000
1,840,571
37.96%
700,000
 Reported
on the footnote of the company’s audited
financial statements
39
Example – Accruing Tax Expense
APB 11 Tax Accrual
Timing Differences
Tax Return
Pre tax book income:
$1,000,000
$1,840,571
$2,840,571
Tax Exempt Interest:
($75,000)
Tax Exempt Interest:
($75,000)
Permanent Taxable
Income:
$925,000
Taxable Income on Tax Return:
$2,765,571
37.96%
37.96%
$351,000 (Rounded)
Current Tax Payable:
$1,051,000 (Rounded)
Payment > Accrual
$700,000
40
Accruing Tax Expense Under APB 11
Debit
351,000
AJE # 1 Income Tax Expense
(351,000)
Income Tax Payable
351,000
700,000
AJE # 2 Income Tax Payable
Deferred Tax Asset
Cash
Dr / (Cr)
Income Tax Expense
351,000
351,000
(Credit)
(1,051,000)
Income Tax Payable
Deferred Tax Asset
(351,000) 700,000
351,000
0
700,000
41
Accruing Tax Expense under ASC 740
Debit
(Credit)
1,051,000
AJE # 1 Income Tax Expense
(1,051,000)
Income Tax Payable
1,051,000
AJE # 2 Income Tax Payable
(1,051,000)
Cash
700,000
AJE #3 Deferred Tax Asset
Income Tax Expense
Dr / (Cr)
Income Tax Expense
1,051,000
(700,000)
351,000
(700,000)
Income Tax Payable
Deferred Tax Asset
(1,051,000) 700,000
1,051,000
0
700,000
42
Footnote Disclosures
 Components
of ASC 740 current year tax expense
 Current & Deferred (current / non-current)
 Federal & State
 Rate
Reconciliation (a recon between the statutory rate
and the effective tax rate)
 Remember: Perm Differences only!
 Deferred
tax inventory
 Tax effected {37.96%}
43
Disclosure: ASC 740 Components of expense
Components of total ASC 740
income tax expense:
Current tax expense (tax return)
1,051,000
Deferred tax benefit(current year)
(700,000)
TOTAL TAX EXPENSE
351,000
44
Current Income Tax Expense
Book Income
Income tax expense
$1,000,000
($925,000 x 37.96%)
(351,000)
Net Income after tax
649,000
Income Tax Expense
351,000
Tax Exempt Interest
(75,000)
Temporary adjustments
1,840,571
Taxable income
2,765,571
Tax due with return
At 37.96%
$1,051,000
Equals current
component of income
tax expense
45
Disclosure: Rate Reconciliation
Pre-tax income at statutory rate
Tax exempt interest income
State income tax,
net of federal benefit
$1,000,000 x 34%
340,000
75,000 x 34%
(25,500)
$925,000 x 6% x (1-.34)
TOTAL INCOME TAX EXPENSE
Effective Tax Rate:
Blended Tax Rate:
36,500
351,000
351,000 / 1,000,000
35.1%
37.96%
46
Disclosure: Deferred Tax Inventory
In tax $$
Bad Debt Reserve
703,580
Premises & Equipment
(3,580)
Net Deferred Income Tax Asset
700,000
47
Cushion or Excess Reserves
 A cumulative
over or (under) accrual of income tax
expense
 Unallocated tax liability on the balance sheet
 Additional tax expense to cover exposure or risky tax positions
 ASC
740 does NOT provide for any excess tax reserve
that cannot be supported by a book/tax basis difference
 Materiality
(audit standards)
48
Valuation Allowance – GAAP
 Should
a valuation allowance against the corporation’s
deferred tax asset be booked for GAAP?
 Is it “More likely than Not” (greater than 50%), after
evaluating all available evidence, that the deferred tax
asset will not be realized?
 Requires significant judgment in evaluating negative and
positive evidence
49
Valuation Allowance – GAAP
 Negative
Evidence - objective and verifiable
 Cumulative losses over past 3 yrs – very difficult to conclude a
valuation allowance is not needed
 Large net operating loss carry forward amounts

Tax is 20 yrs; GAAP looks at a much shorter timeframe
 No carry-back capacity
 Expiring credits
 Capital losses with no capital gains
 Future income in jeopardy
 Going Concern opinion in the audited financial statements.
50
Valuation Allowance – GAAP
 Positive
Evidence that an allowance is not warranted
 Strong earnings history, exclusive of the unusual or
extraordinary item generating losses
 Strong income projections – prove that the Corporation
will quickly return to profitability!

Immediate future, not 20 yrs!
 Taxable Income Planning strategies
51
Valuation Allowance – Financial Reporting
 Tax
planning strategies are actions that are “prudent and feasible”
that an enterprise might not ordinarily take, but would take to
prevent an operating loss or credit carry forward from expiring
 Future
taxable income is the weakest form of evidence!
 Less objective, less verifiable
 Compare projections to actual over last 3 yrs
 Debit
to Expense; negatively impacts equity and capital
 Effective tax rate of 0% going forward
52
Valuation Allowance – Testing Deferred Tax Asset
 Determine
what financial statement income is projected
 Utilize consistent income projections
 Adjust
for permanent and temporary tax differences
 Consider reversal of taxable temporary differences
 Tax planning strategies
 Consider use of NOL C/fwd and credits to offset taxable
income and tax
 Quickly returning to profitability!
53
Valuation Allowance
 If
credits are likely to expire before they can be used, an
allowance is necessary
 Georgia Retraining credits – 3 yr carry-forward period
 Georgia Low Income Housing Credits – 3 yr carry-forward
period
 If
capital loss carry forwards will expire before capital
gains are generated, an allowance is necessary
 If
taxable income cannot be reliably projected in the near
future, an allowance may be necessary
54
Reversing the Valuation Allowance
 When
actual circumstances improve and some of the deferred
tax attributes are able to be used, the valuation allowance is
reversed in the period of the change
 Continued, sustained earnings over multiple quarters
 Significant judgment
 Credit to income tax expense
 For
example, if a capital gain is generated in 2011, the deferred
tax asset related to the capital loss carry forward can offset the
tax on the gain
55
Tax Rate environment
 What
if income tax rates go down?
 The impact of any tax rate changes should be reflected as of
the date of the change
 For a corporation with a significant amount of deferred tax
asset, an income tax rate change will generate a charge to
current earnings


Debit income tax expense
Credit deferred tax asset
56
Questions?
57
Contact Information
Robert Schwarzmann
Adam Polakov
404-420-5795
rschwarzmann@pkm.com
404-420-5974
apolakov@pkm.com
58