Terms: 1) Valuation Allowance 740-10-20-Glossary: y Definition: The portion of a deferred tax asset for which it is more likely than

not that a tax benefit will not be realized y A valuation allowance is a balance sheet line item that offsets all or a portion of the value of a company's deferred tax assets because the company doesn't expect it will be able to realize this value. y Sometimes, a company expects it will not be able to realize the benefits of its deferred tax assets. For example, If a company loses $10 million, it would record a deferred tax asset representing the decrease in taxes on its next $10 million in earnings. However, if the company doesn't expect profits for the next several years, and doesn't expect to earn $10 million in the seven-year time horizon before these deferred tax assets expire, it can't record them at full value - because the company won't be able to take advantage of this tax benefit. i. If a company expects there is more than 50% chance it will not be able to realize some of its deferred tax assets (because its future income won't be large enough to take full advantage of these tax breaks), it must report a valuation allowance to account for this.

Capital Gains and Losses:

If your capital losses exceed your capital gains, the amount of the excess loss that can be claimed is the lesser of $3,000, ($1,500 if you are married filing separately) or your total net loss as shown on line 16 of the Form 1040 Schedule D, Capital Gains and Losses. If your net capital loss is more than this limit, you can carry the loss forward to later years. Use the Capital Loss Carryover Worksheet in Publication 550, to figure the amount carried forward.

Deferred Tax Asset The deferred tax consequences attributable to deductible temporary differences and carryforwards. A deferred tax asset is measured using the applicable enacted tax rate and provisions of the enacted tax law. A deferred tax asset is reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized. y An asset on a company's balance sheet that may be used to reduce any subsequent period's income tax expense. Deferred tax assets can arise due to net loss carryovers, which are only recorded as assets if it is deemed more likely than not that the asset will be used in future fiscal periods. It must be determined that there is more than a 50% probability that the company will have positive accounting income in the next fiscal period before the deferred tax asset can be applied. o If, for example, a company has a deferred tax asset of $25,000 on its balance sheet, and then the company earns $75,000 in before-tax accounting income, accounting tax expense will be applied to $50,000 ($75,000 $25,000), instead of $75,000.

Establishment of a Valuation Allowance for Deferred Tax Assets

740-10-30-16 As established in paragraph 740-10-30-2(b), there is a basic requirement to reduce the measurement of deferred tax assets not expected to be realized. 740-10-30-17 All available evidence, both positive and negative, shall be considered to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed. Information about an entity's current financial position and its results of operations for the current and preceding years ordinarily is readily available. That historical information is supplemented by all currently available information about future years. Sometimes, however, historical information may not be available (for example, start-up operations) or it may not be as relevant (for example, if there has been a significant, recent change in circumstances) and special attention is required. 740-10-30-18 Future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback, carryforward period available under the tax law. The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards:
y y y y

a. Future reversals of existing taxable temporary differences b. Future taxable income exclusive of reversing temporary differences and carryforwards c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law d. Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for example:
o o

1. Accelerate taxable amounts to utilize expiring carryforwards 2. Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss 3. Switch from tax-exempt to taxable investments.

Evidence available about each of those possible sources of taxable income will vary for different tax jurisdictions and, possibly, from year to year. To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of the valuation allowance that is recognized for deferred tax assets. 740-10-30-19 In some circumstances, there are actions (including elections for tax purposes) that:
y y

a. Are prudent and feasible b. An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused c. Would result in realization of deferred tax assets.

This Subtopic refers to those actions as tax-planning strategies. An entity shall consider tax-planning strategies in determining the amount of valuation allowance required. Significant expenses to implement a tax-planning strategy or any significant losses that would be recognized if that strategy were implemented (net of any recognizable tax benefits associated with those expenses or losses) shall be included in the valuation allowance. See paragraphs 740-10-55-39 through 55-48 for additional guidance. Implementation of the tax-planning strategy shall be primarily within the control of management but need not be within the unilateral control of management. 740-10-30-20 When a tax-planning strategy is contemplated as a source of future taxable income to support the realizability of a deferred tax asset, the recognition and measurement requirements for tax positions in paragraphs 74010-25-6 through 25-7; 740-10-25-13; and 740-10-30-7 shall be applied in determining the amount of available future taxable income. 30-21 Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Other examples of negative evidence include, but are not limited to, the following:
y y y

a. A history of operating loss or tax credit carryforwards expiring unused b. Losses expected in early future years (by a presently profitable entity) c. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years d. A carryback, carryforward period that is so brief it would limit realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year or the entity operates in a traditionally cyclical business.

740-10-30-22 Examples (not prerequisites) of positive evidence that might support a conclusion that a valuation allowance is not needed when there is negative evidence include, but are not limited to, the following:
y

a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures b. An excess of appreciated asset value over the tax basis of the entity's net assets in an amount sufficient to realize the deferred tax asset c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition.

740-10-30-23 An entity shall use judgment in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence shall be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed for some portion or all of the deferred tax asset. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome. 740-10-30-24 Future realization of a tax benefit sometimes will be expected for a portion but not all of a deferred tax asset, and the dividing line between the two portions may be unclear. In those circumstances, application of judgment based on a careful assessment of all available evidence is required to determine the portion of a deferred tax asset for which it is more likely than not a tax benefit will not be realized.

740-10-30-25 See paragraphs 740-10-55-34 through 55-38 for additional guidance related to carrybacks and carryforwards.

Capital Losses If your capital losses are more than your capital gains, you can claim a capital loss deduction. Report the deduction on line 13 of Form 1040, enclosed in parentheses. Limit on deduction. Your allowable capital loss deduction, figured on Schedule D, is the lesser of:
y y

$3,000 ($1,500 if you are married and file a separate return), or Your total net loss as shown on line 16 of Schedule D.

You can use your total net loss to reduce your income dollar for dollar, up to the $3,000 limit. Capital loss carryover. If you have a total net loss on line 16 of Schedule D that is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you had incurred it in that next year. If part of the loss is still unused, you can carry it over to later years until it is completely used up. When you figure the amount of any capital loss carryover to the next year, you must take the current year's allowable deduction into account, whether or not you claimed it and whether or not you filed a return for the current year.

When you carry over a loss, it remains long term or short term. A long-term capital loss you carry over to the next tax year will reduce that year's long-term capital gains before it reduces that year's short-term capital gains. Figuring your carryover. The amount of your capital loss carryover is the amount of your total net loss that is more than the lesser of: 1. Your allowable capital loss deduction for the year, or 2. Your taxable income increased by your allowable capital loss deduction for the year and your deduction for personal exemptions. If your deductions are more than your gross income for the tax year, use your negative taxable income in computing the amount in item (2). Complete Worksheet 4-1 to determine the part of your capital loss for 2010 that you can carry over to 2011. Example. Bob and Gloria sold securities in 2010. The sales resulted in a capital loss of $7,000. They had no other capital transactions. Their taxable income was $26,000. On their joint 2010 return, they can deduct $3,000. The unused part of the loss, $4,000 ($7,000 $3,000), can be carried over to 2011. If their capital loss had been $2,000, their capital loss deduction would have been $2,000. They would have no carryover.

Worksheet 4-1. Capital Loss Carryover Worksheet Use this worksheet to figure your capital loss carryovers from 2010 to 2011 if Schedule D, line 21, is a loss and (a) that loss is a smaller loss than the loss on Schedule D, line 16, or (b) Form 1040, line 41, is less than zero. Otherwise, you do not have any carryovers. 1. Enter the amount from Form 1040, line 41. If a loss, enclose the amount in parentheses 2. Enter the loss from Schedule D, line 21, as a positive amount 3. Combine lines 1 and 2. If zero or less, enter -04. Enter the smaller of line 2 or line 3 If line 7 of Schedule D is a loss, go to line 5; otherwise, enter -0- on line 5 and go to line 9. 5. Enter the loss from Schedule D, line 7, as a positive amount 6. Enter any gain from Schedule D, line 15. If a loss, enter -06. 5. 1. 2. 3. 4.

7. Add lines 4 and 6 8. Short-term capital loss carryover to 2011. Subtract line 7 from line 5. If zero or less, enter -0If line 15 of Schedule D is a loss, go to line 9; otherwise, skip lines 9 through 13. 9. Enter the loss from Schedule D, line 15, as a positive amount 10. Enter any gain from Schedule D, line 7 11. Subtract line 5 from line 4. If zero or less, enter -012. Add lines 10 and 11 13. Long-term capital loss carryover to 2011. Subtract line 12 from line 9. If zero or less, enter -010. 11.

7. 8.

9.

12. 13.

Use short-term losses first. When you figure your capital loss carryover, use your short-term capital losses first, even if you incurred them after a long-term capital loss. If you have not reached the limit on the capital loss deduction after using the short-term capital losses, use the long-term capital losses until you reach the limit.

Example 13: Valuation Allowance for Deferred Tax Assets

55-124 This Example illustrates the guidance in paragraphs 740-10-55-7 through 55-9 relating to recognition of a valuation allowance for a portion of a deferred tax asset in one year and a subsequent change in circumstances that requires adjustment of the valuation allowance at the end of the following year. This Example has the following assumptions:
y

a. At the end of the current year (Year 3), an entity's only temporary differences are deductible temporary differences in the amount of $900. b. Pretax financial income, taxable income, and taxes paid for each of Years 1-3 are all positive, but relatively negligible, amounts. c. The enacted tax rate is 40 percent for all years.

55-125 A deferred tax asset in the amount of $360 ($900 at 40 percent) is recognized at the end of Year 3. If management concludes, based on an assessment of all available evidence (see guidance in paragraphs 740-1030-17 through 30-24), that it is more likely than not that future taxable income will not be sufficient to realize a tax benefit for $400 of the $900 of deductible temporary differences at the end of the current year, a $160 valuation allowance ($400 at 40 percent) is recognized at the end of Year 3.

55-126 Assume that pretax financial income and taxable income for Year 4 turn out to be as follows.

55-127 The $50 pretax loss in Year 4 is additional negative evidence that must be weighed against available positive evidence to determine the amount of valuation allowance necessary at the end of Year 4. Deductible temporary differences and carryforwards at the end of Year 4 are as follows.

55-128 The $360 deferred tax asset recognized at the end of Year 3 is increased to $380 ($950 at 40 percent) at the end of Year 4. Based on an assessment of all evidence available at the end of Year 4, management concludes that it is more likely than not that $240 of the deferred tax asset will not be realized and, therefore, that a $240 valuation allowance is necessary. The $160 valuation allowance recognized at the end of Year 3 is increased to $240 at the end of Year 4. The $60 net effect of those 2 adjustments (the $80 increase in the valuation allowance less the $20 increase in the deferred tax asset) results in $60 of deferred tax expense that is recognized in Year 4.