Business entities issuing financial statements under accounting principles generally accepted in the United States (GAAP) are subject to Accounting Standards Codification 740 (ASC 740). This guidance requires the presentation of deferred tax assets and deferred tax liabilities on the balance sheets of those businesses — reflecting future tax effects as a result of differences between GAAP and the tax basis of assets and liabilities. The computation of deferred tax assets and liabilities also takes into account the future benefits of tax attributes that have been carried forward (e.g., loss and credit carryforwards, excess business interest limitations, etc.). Businesses need to assess the realizability of the deferred tax assets carried on their balance sheets — i.e., the likelihood that the deferred tax assets will, in fact, reduce future cash income taxes. Businesses are required to record offsetting valuation allowances that reduce the carrying value of deferred tax assets when it’s not more likely than not that all or a portion of the deferred tax asset can produce future economic benefit.
GAAP requires businesses to evaluate four potential sources of future taxable income when determining the realizability of deferred tax assets:
- Income in a year to which future reversing deferred tax assets could potentially be carried back (assuming permitted by law.)
- The tax effect of reversing temporary differences (i.e., deferred tax liabilities).
- Projections of future taxable income, exclusive of the effect of reversing temporary differences.
- Tax-planning strategies (i.e., actions that are both prudent and feasible, and that a business would undertake to prevent a deferred tax asset from expiring unused.)
Income from one of these sources may only be relied upon if it’s of the same character (e.g., ordinary versus capital), in the same taxing jurisdiction, and projected to be generated in the same time period as the future benefits represented by the deferred tax assets. A valuation allowance should be recorded when there is insufficient income from one of these sources to allow the realization of the deferred tax assets.
Although every valuation allowance analysis has unique considerations, we’ve noted several common questions when discussing valuation allowances with businesses.
My business has three years of cumulative book losses. Doesn’t that mean I automatically need a “full valuation allowance?”
Three years of cumulative losses is strong negative evidence against the realizability of deferred tax assets and frequently leads to recording valuation allowances. While this can be difficult to overcome, other positive evidence may reduce or eliminate the need for a valuation allowance. All available positive and negative evidence should be considered and given appropriate weight. Examples of situations that may mitigate the impact of prior losses include:
- Events that gave rise to prior losses that are nonrecurring in nature.
- Prior losses resulting from one-time charges that involved an overall reduction to cost structure.
- Changes in business operations.
- Signed contracts with new customers representing a new source of future income.
While we typically see valuation allowances recorded when there is a cumulative history of losses, other surrounding facts may produce enough positive evidence to recognize some or all of the deferred tax assets.
My business is profitable. Why might I still need to consider a valuation allowance?
Deferred tax assets represent a future reduction in tax liability — i.e., the tax benefit from future deductions or attributes that are carried forward. To gain the full benefit of the deferred tax assets, a business needs to have sufficient taxable income of the same character as the deferred tax assets, in the same jurisdiction, and in the correct period. While, on the surface, a business may appear to have projected profitability, it may still need to record a valuation allowance against some or all of its deferred tax assets.
For example, an otherwise profitable company that has a capital loss carryforward will require future capital gains income in order to benefit from the loss carryforward. This company may still need a valuation allowance to the extent of the capital loss deferred tax asset if it can’t reliably project capital gain income before the carryforward expires. Another example is a deferred tax asset related to limited excess business interest — i.e., interest above modified taxable income thresholds, which is disallowed but carried forward to later years. If a company is projecting future taxable income but an insufficient amount to allow utilization of the interest carryforward, a valuation allowance may be required.
Jurisdictional allocation of income is particularly important when considering the realizability of deferred tax assets. If, for example, a business has a foreign subsidiary where that subsidiary’s income isn’t included on the U.S. tax return, it’s not appropriate to consider that foreign income as a potential source for recognizing a U.S. deferred tax asset — and vice versa.
Now that federal net operating loss (NOL) carryforwards don’t expire, why would I ever need a valuation allowance?
If a business has nonexpiring NOLs, the timing of future projected taxable income may not be as critical; however, it’s still necessary to project future taxable income in order to demonstrate that the NOLs will be utilized at some point in the future. A current return to profitability may be sufficient evidence to recognize deferred tax assets, even without a specific amount of projected income in each successive year. However, continuing to generate taxable losses (i.e., adding to NOLs rather than utilizing them) would represent strong negative evidence that may be difficult to overcome. In addition, while new (post-2017) federal NOLs are no longer subject to expiration, many businesses have loss carryforwards that originated in years before the current law or are in jurisdictions that still have expirations. In those situations, the timing of projected taxable income is extremely important as it needs to be generated during a period that allows the deferred tax asset to produce a benefit.
I have a large pool of deferred tax liabilities to offset the majority of my deferred tax assets. I’m not able to project any future income. Don’t I just need a valuation allowance against the remaining net deferred tax asset?
Valuation allowances are recorded against deferred tax assets only, not against deferred tax liabilities. Generally, it’s not appropriate to net only deferred tax assets and deferred tax liabilities when determining the amount of a valuation allowance, but the existence of deferred tax liabilities is an important factor to consider. One source of income that should be considered when evaluating the realizability of a deferred tax asset is reversing temporary differences (i.e., deferred tax liabilities) as they represent future increases in taxable income as compared to book income.
As noted earlier, for future taxable income to be used as a source for recognizing a deferred tax asset, it must be of the right character, in the correct period, and in the same taxing jurisdiction. As such, it’s important to schedule the expected reversal of deferred tax liabilities and analyze how that reversal matches against deferred tax asset utilization. A common situation where deferred tax liabilities can’t be used as a source of income is when the deferred tax liability results from the book versus tax basis difference on indefinite-lived intangibles, i.e., those that aren’t amortized for book purposes but are subject to periodic impairment testing. In these situations, the only way the deferred tax liability will reverse is a future impairment of an asset. As the timing of such impairments can’t be projected until they actually occur, a business may still need a valuation allowance against its deferred tax assets, even if the deferred tax liability is of a sufficiently large magnitude.
What if I have a deferred tax asset for NOLs that don’t expire and a deferred tax liability for an indefinite lived intangible? Can’t I “net” them since they will both be available at the same time?
Deferred tax liabilities related to indefinite lived assets represent future book expenses that aren’t deductible for income tax purposes, thereby increasing future taxable income. These deferred tax liabilities will reverse when the underlying intangibles are impaired, creating a decrease in book income without a corresponding tax deduction, which makes taxable income higher. They may be considered as a source of income against indefinite-lived deferred tax assets such as nonexpiring NOL carryforwards. Even if the indefinite-lived deferred tax asset and deferred tax liability are both on the books at the point the company winds down, at the moment the intangible is impaired in that last moment of business operations, the deferred tax asset would still be available to absorb the effect of the unfavorable book-tax difference that would be recorded, assuming the deferred tax asset hasn’t been utilized earlier.
However, take care when using such deferred tax liabilities as a source of income. Although federal NOLs generated after 2017 no longer expire, they may only be used to offset a maximum of 80% taxable income in a given year. For example, if a company has $1 million of NOLs that don’t expire and $1 million of book basis in an indefinite-lived intangible (with no tax basis) in the same taxing jurisdiction, the magnitude of the deferred tax assets and deferred tax liabilities would be the same. However, the NOLs could only offset $800,000 of the resulting income (i.e., 80% of the total). As such, a valuation allowance may be required for the deferred tax asset representing the remaining $200,000 of NOLs, unless there is another source of income anticipated in future years.
The decision to record, or not record, a valuation allowance against a business’s deferred tax assets requires application of considerable judgment, and necessitates an understanding of past history, projected future performance, and the nature of how deferred tax assets and deferred tax liabilities will reverse.
