FIN 48 and its Application to Tax-Exempt Organizations
by Elizabeth M. Mills, McDermott Will & Emery LLP, Chicago, IL
Many tax-exempt healthcare organizations have not started planning to address the sleeper issue of 2007. This issue is Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"). FIN 48 will in essence require exempt organizations, as part of the preparation of their audited financial statements, to determine whether it is "highly certain" that they are tax-exempt and that they are reporting all their material unrelated business taxable income ("UBIT").
FIN 48 has fundamentally different implications for tax-exempt organizations than it does for taxable organizations. For a taxable organization, taxes are "only money," but whether an exempt organization is in fact exempt and the extent of its UBIT have a qualitative impact on tax-exempt bond financing, employee plans, and exemption from other taxes.
FIN 48, issued in June 2006, is an accounting pronouncement intended to provide more transparency in audited financial statements of the effects of tax positions the reporting organization has taken. It is intended to disclose whether the reporting organization is entitled to the economic benefits of the open tax positions it has taken in current and past years and what the dollar effect will be on the reporting organization if these tax positions are not upheld. A "tax position" includes treating an organization as exempt from income tax, as well as treating a stream of income as subject or not subject to unrelated business income.
FIN 48 is effective for reporting years starting after December 15, 2006. Thus, organizations on a calendar fiscal year will need to take FIN 48 into account in their financial statements for CY 2007. Further, many healthcare organizations must provide quarterly financial statements in connection with their financing, so most organizations have already prepared quarterly statements for periods subject to FIN 48.
FIN 48 requires a two-step analysis for each material tax position. The first step is determining the degree of certainty of the tax position. If the tax position taken is "highly certain," then the reporting organization is entitled to the full benefit of that tax position. "Highly certain" means that there is more than a 50 percent chance that 100 percent of the benefit of the tax position will be upheld. (Each tax position is evaluated on its technical merits, presuming that it will be audited and that the taxing authority will have full knowledge of all relevant facts.) If the tax position taken does not have at least a "more likely than not" level of certainty, then the reporting organization is not entitled to any benefit of that tax position. In either case, the analysis of that position is completed.
If the tax position is at least "more likely than not" but less than "highly certain," then the reporting organization proceeds to the second step. The second step is to estimate the amount of benefit that has a greater than 50 percent likelihood of being recognized upon ultimate settlement with a taxing authority. This entails estimating the probability of settlement at various dollar amounts.
Much concern has been expressed by taxable organizations that the required financial statement disclosures will constitute a "road map" for the IRS to identify vulnerable areas. In addition, there is concern that the IRS will ask for tax accrual workpapers to zero in on vulnerable areas contrary to its current policy of restraint in seeking tax accrual workpapers and that otherwise privileged documents will be disclosed in the process of implementing FIN 48. These considerations should not be downplayed. For exempt organizations, however, the concern is more fundamental. An exempt organization likely will wish never to advance beyond the first step of the analysis or to have tax positions other than "highly certain." If an exempt organization must disclose that its tax-exempt status is less than highly certain, the specific dollar amount of tax benefit it is entitled to realize may be unimportant. The damage in the eyes of the public, bondholders, rating agencies, and local tax authorities may already be done. The IRS's draft overhauled Form 990 asks for the text of the reporting organization's FIN 48 disclosure, so the disclosed information will be readily available to the public.
In summary, implementing FIN 48 will be a herculean undertaking for many exempt hospitals and health systems and how it is done will have significant ramifications. Exempt healthcare organizations should make implementation plans with finance and tax staff, auditors, and tax advisors.