State income taxes, franchise taxes and PTET elections

• Determine whether a state or local tax is within the scope of ASC 740
• Compute a blended state and federal rate with apportionment and the federal deduction
• Apply ASU 2019-12 to franchise taxes partly based on income
• Evaluate how an elective pass-through entity tax is reported by the entity

Scope: taxes based on income

Statement 109 paragraph 4 applies ASC 740 to federal income taxes and to foreign, state and local (including franchise) taxes based on income. A gross receipts tax, a sales tax or a property tax is not an income tax and is accounted for as an operating expense. The test is the tax base, not the label the state gives the tax.

ASU 2019-12 addressed taxes that combine the two. Under ASC 740-10-15-4(a) as amended, if a franchise tax (or similar tax) is partially based on income, such as a tax equal to the greater of an income-based amount and a capital-based amount:

• Deferred tax assets and liabilities are recognized and measured at the applicable statutory income tax rate.
• The entity does not consider the effect of possibly paying the non-income-based tax in future years when assessing realizability.
• Current tax expense equal to the income-based amount is an income tax; any incremental amount is a non-income-based tax.

Measuring state deferred taxes

Statement 109 paragraph 17 requires deferred taxes by tax-paying component in each jurisdiction, and paragraph 18 uses the enacted rate expected to apply when the difference reverses. For states, that means:

• Each state's rate times the apportionment percentage the entity expects in the reversal years, not just this year's.
• Separate-return states and unitary combined-report states measured by the group that actually files.
• State loss carryforwards tracked by state, with each state's carryforward period and any limits.

State income taxes are deductible for federal purposes, so a state deferred tax asset or liability has a federal effect. The common shortcut is a blended rate: state rate + federal rate x (1 - state rate).

In the rate reconciliation, ASU 2023-09 requires a PBE to present state and local income tax, net of federal (national) income tax effect as one category, and to describe the states making up more than 50 percent of it. The rate reconciliation lesson has the details.

Pass-through entity taxes

Many states let a partnership or S corporation elect to pay state income tax at the entity level. IRS Notice 2020-75 announced that the Treasury and the IRS intend to issue proposed regulations clarifying that state and local income taxes imposed on and paid by a partnership or S corporation on its income are deductible by the entity in computing its non-separately stated income or loss for the year of payment. That is why owners favor the election.

For the entity's own GAAP statements, apply the scope test:

• If state law imposes the tax on the entity and the entity is the taxpayer, it is an income tax of the entity under ASC 740. Record current tax expense, and evaluate deferred taxes on the state's temporary differences for the years the entity expects to be subject to the tax.
• If the entity is paying a liability that belongs to its owners (for example, a withholding on their behalf), the payment is a distribution or a receivable from owners, not tax expense.

Because most elections are made year by year, ask management whether it expects to elect in the years temporary differences reverse, and document the basis. The PTET standard page summarizes state regimes.

Single-member and disregarded entities

ASU 2019-12 also says an entity is not required to allocate consolidated current and deferred tax expense to a legal entity that is not subject to tax in its separate statements. It may elect to do so, entity by entity, for a legal entity that is both not subject to tax and disregarded by the taxing authority.

Audit focus

Check that apportionment factors used for deferred taxes were reconsidered this year, that each state's rate is enacted, and that the federal benefit of state taxes is computed once, not twice. The nexus guide helps when the question is whether the entity files in a state at all.

Blended rate for Summit Ridge Logistics, Inc.