Uncertain Tax Positions ASC 740-10 (FIN 48): Two-Step Process and Disclosures

ASC 740-10, which carries forward FASB Interpretation No. 48 (FIN 48), governs how an entity accounts for the uncertainty in its income tax positions. A tax position is a position taken or expected to be taken in a return that affects the amount of tax paid or deferred. The rules apply to taxable entities, and to not-for-profit entities and pass-through entities for positions such as tax-exempt status, unrelated business income, and entity-level taxes. The tax position is judged before the benefit goes into the financial statements. This page explains the two steps, how the answer flows to the balance sheet, and what must be disclosed. For the larger provision, see ASC 740 for private companies.

What is the two-step process?

Step 1: recognition. The entity recognizes the tax effect of a position only if it is more likely than not that the position will be sustained on its technical merits (ASC 740-10-25-6). More likely than not means a likelihood above 50 percent. Two assumptions are built into the test. The taxing authority will examine the position, so the chance that the return is never audited does not count. And the authority has full knowledge of all relevant information. The test looks at sustainability if the entity takes any dispute to the court of last resort, but the possibility of negotiating a compromise is not considered at this step.

Step 2: measurement. A position that meets the threshold is measured as the largest amount of benefit that is greater than 50 percent likely of being realized on settlement with the taxing authority (ASC 740-10-30-7). Measurement considers the probabilities of possible settlement outcomes, including expected negotiations, and again assumes full knowledge. A position that fails recognition is measured at zero, even if part of the benefit is more likely than not to be realized.

The difference between the benefit the entity claimed or expects to claim in the return and the benefit recognized under these steps is the unrecognized tax benefit (UTB).

What is the unit of account?

The entity first decides what a "position" is. The unit of account is a matter of judgment, based on how the entity prepares and supports the return and how the authority is expected to approach an examination. Factors include the nature of the benefit, its size relative to the return as a whole, and how closely it is tied to other positions. Apply the same unit of account to similar positions from period to period unless facts change. A deduction that has several separate components may need more than one conclusion.

When does a position change?

A previously unrecognized benefit can be recognized later only when one of these happens (ASC 740-10-25-8):

• changing facts and circumstances mean the position now meets the more-likely-than-not threshold
• the matter is effectively settled through examination, negotiation or litigation
• the statute of limitations expires

The change in judgment must come from new information rather than a new reading of facts that were available before. A recognized benefit is derecognized in the first period in which the position no longer meets the threshold.

Worked illustration

Illustrative numbers. A company deducts $100,000 for a cost it believes qualifies as a current expense. At a 25 percent rate, the tax benefit is $25,000. Management and its tax advisor conclude the position is more likely than not to be sustained, so step 1 is met. Step 2 considers possible settlement outcomes:

Cumulative probabilities run from the largest benefit down. The largest amount with a cumulative probability above 50 percent is $20,000, so the company recognizes $20,000 and records a UTB of $25,000 - $20,000 = $5,000. The $30,000 and $55,000 results are not averaged. Management's conclusions should be backed by a memo that cites the authority and the settlement history relied on.

Interest and penalties

The entity accrues interest on an underpayment of tax when the full benefit of a position is not recognized and tax law would charge interest on the underpayment (ASC 740-10-25-56). Penalties are accrued when the position would not meet the minimum statutory threshold to avoid penalties. All entities disclose their policy for classifying interest and penalties, either in income tax expense or in another line such as interest expense or other expense, and the amounts of interest and penalties recognized in the income statement and on the balance sheet.

How is a UTB presented?

A UTB is presented as an increase in income taxes payable, or as a reduction of a deferred tax asset for a net operating loss carryforward or similar tax loss or credit carryforward where the criteria in ASC 740-10-45-10A are met. The liability is classified as current to the extent the entity expects to pay cash within twelve months, and the remainder is noncurrent. A valuation allowance cannot be used to derecognize a tax position. A valuation allowance addresses whether deferred tax assets will be realized, and a UTB addresses whether the position itself meets recognition and measurement.

Deferred tax balances for temporary differences are computed on the basis that results from this process, which is the more-likely-than-not tax basis, and not the basis in the filed return.

What must be disclosed?

Disclosure splits by entity type.

• All entities disclose the policy for classifying interest and penalties, the amounts of interest and penalties in the income statement and balance sheet, and a description of the open tax years by major jurisdiction. The open-years disclosure applies whether or not the entity has UTBs, and a broad label such as "federal and state" generally does not satisfy it.
• Public entities, and public business entities after ASU 2023-09, present an annual tabular rollforward of the beginning and ending UTB, with at a minimum the gross increases and decreases from prior-period positions, gross increases from current-period positions, decreases from settlements, and reductions from lapse of the statute of limitations (ASC 740-10-50-15A). They also disclose the amount of UTBs that, if recognized, would affect the effective tax rate.
• ASU 2023-09 removed the requirement to disclose, for positions where a significant change is reasonably possible within twelve months, the nature of the uncertainty, the event, and an estimate of the range. See ASU 2023-09.

Private companies are not required to give the tabular rollforward, but the auditor needs the same schedule to test the liability. The uncertain tax positions rollforward template fits that purpose.

What do auditors do with a UTB conclusion?

The question for the audit is whether management applied both steps consistently, supported them and recorded the result. Typical work:

• obtain the position inventory and ask how management identified positions, including state nexus, entity classification and pass-through elections
• read the technical memo or advisor's letter and test the facts it relies on
• test the probability table for step 2 and the settlement history behind it
• recompute interest, and check the statute of limitations dates used for releases
• confirm release of any UTB is backed by effective settlement or lapse, not by a change of mind
• consider whether a tax specialist is needed under AU-C 620
• compare to the written representation on tax positions in the management representation letter

Common problems

Practice observations, not requirements:

• State income tax exposure ignored after remote sales or employee activity, so no UTB is considered for states the entity has not filed in.
• The tax advisor's "should" or "will" opinion treated as the entity's conclusion, without testing the underlying facts.
• A reserve released because the examination went quiet, though no settlement or lapse occurred.
• Rollforward totals that omit positions offset by deferred tax balances. The rollforward should include all UTBs, including those with offsetting deferred taxes.
• Interest accrual stopped before the statute expired.

FAQ

Does ASC 740-10 apply to a company that pays no income tax, such as an S corporation?

It applies to the entity's own tax positions, which may be few. A pass-through entity's status as such is a tax position, and entity-level taxes in some states can be positions too. A not-for-profit has positions on tax-exempt status and unrelated business income.

What is the difference between recognition and measurement?

Recognition asks whether the position is more likely than not to be sustained on its technical merits. Measurement, applied only to positions that pass recognition, sets the amount at the largest benefit with a cumulative probability above 50 percent.

How often is a tax position reassessed?

At each reporting date, including interim dates if the entity reports on an interim basis. Only information available at the reporting date is used, and a change in facts after that date but before issuance is recognized in the period the change occurs.

Does a valuation allowance cover an uncertain position?

No. ASC 740-10-40-2 and 45-11 do not allow a valuation allowance to derecognize a position.

Sources

• FASB Accounting Standards Codification Subtopic 740-10, Income Taxes, Overall (paragraphs 25-6 to 25-8, 25-56, 30-7, 40-2, 45-10A to 45-11, 50-15 to 50-19): https://asc.fasb.org
• KPMG, Handbook: Accounting for Income Taxes (2025), chapters 3 and 9 (recognition, measurement, subsequent recognition, presentation and disclosure)
• FASB, ASU 2023-09, Improvements to Income Tax Disclosures (removal of the twelve-month disclosure): https://www.fasb.org

Related

• ASC 740 income taxes for private companies
• ASU 2023-09 income tax disclosures
• Uncertain tax positions rollforward template
• Income tax provision workbook
• Audit program for income taxes
• Rate reconciliation template

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error