A deferred tax asset valuation allowance is required under ASC 740 when it is more likely than not, meaning a likelihood of more than 50 percent, that some or all of a deferred tax asset will go unrealized. You decide by weighing all positive and negative evidence and matching the asset against four possible sources of future taxable income.
That judgment changed shape for 2025 and 2026. The One Big Beautiful Bill Act (OBBBA) restored immediate expensing of domestic research costs and loosened the business interest cap, which moves deferred tax asset balances around and changes the income available to absorb them. ASU 2023-09 also puts "changes in valuation allowances" into its own line of the rate reconciliation. This guide covers the test, the evidence, the OBBBA effects and a worked example.
A deferred tax asset is a future tax saving. It arises when book income and taxable income diverge in a way that will reduce tax later. The two usual causes are a deductible temporary difference, where an expense hits the financial statements before the tax return allows the deduction, and a carryforward, such as a net operating loss or an unused credit.
A warranty reserve is the classic case: the cost is booked now and deducted when claims are paid. The company records a deferred tax asset measured at the enacted rate expected to apply when the difference reverses. For a U.S. C corporation, the federal rate is a flat 21 percent, which is why entity type matters so much here; our C corporation tax guide covers how that rate applies.
The mirror image, where tax is owed later, is a deferred tax liability. Both sit on the balance sheet under ASC 740, and our plain-English ASC 740 guide walks through the full model for current and deferred taxes.
A deferred tax asset is only worth something if the company will have taxable income to deduct it against. The valuation allowance is a contra account that reduces the gross asset to the amount the company expects to use.
The original FASB text, carried into ASC 740-10-30-5(e), tells preparers to "[r]educe deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized" (FASB Statement No. 109). The allowance must be large enough to bring the asset down to the amount that is more likely than not to be realized.
Two points follow from that wording. The test is about realizability: the deduction is real, and the open question is whether there will be income to use it. The allowance can also cover only part of the asset, so the work is sizing the amount as well as deciding whether one is needed.
The standard asks for all available evidence, positive and negative. Each piece is weighted by how objectively it can be verified. In the words of the same FASB Statement, "The more negative evidence that exists (a) the more positive evidence is necessary and (b) the more difficult it is to support a conclusion that a valuation allowance is not needed."
The heaviest single item is cumulative losses in recent years. The standard says that forming a conclusion that no allowance is needed "is difficult when there is negative evidence such as cumulative losses in recent years." In practice, preparers and auditors measure this as a cumulative pretax book loss for the current year and the two preceding years. The three-year measure is a convention drawn from the FASB's own basis for conclusions, which discussed "a cumulative pretax loss for financial reporting for the current and two preceding years." The FASB chose not to make it a bright-line rule.
Other negative evidence listed in the standard includes:
Examples of positive evidence include existing contracts or a firm sales backlog that will produce enough taxable income, appreciated assets worth more than their tax basis, and a strong earnings history where the loss came from an unusual item. When a company is in a three-year cumulative loss, projections of future profit usually carry little weight on their own because they are hard to verify. Signed contracts and reversing deferred tax liabilities carry much more.
ASC 740-10-30-18 lists the four sources of taxable income that can support a deferred tax asset. The FASB text names them as:
If one source is enough to conclude no allowance is needed, the others need not be examined. To size a partial allowance, each source has to be considered.
Two U.S. rules shape how these sources work today. First, federal net operating losses arising after 2017 generally cannot be carried back, and under 26 U.S.C. § 172 they carry forward "to each taxable year following the taxable year of the loss," with no expiry. Our NOL carryforward rules guide covers the mechanics. Second, those post-2017 losses can offset only 80 percent of taxable income in a given year. Many preparers therefore treat a reversing taxable temporary difference as supporting only part of its amount when the asset being tested is a post-2017 NOL. The worked example below shows the effect of that approach.
The One Big Beautiful Bill Act, Public Law 119-21, was enacted on July 4, 2025. Two of its business provisions bear directly on the valuation allowance analysis. Because the law was enacted in 2025, ASC 740 required the effects to be reflected in the period that includes the enactment date.
From 2022 through 2024, companies had to capitalize domestic research and experimental expenditures and amortize them over five years, which created large deferred tax assets for research-heavy businesses. OBBBA added section 174A, which allows domestic research costs to be deducted for tax years beginning after December 31, 2024. Foreign research remains on a 15-year amortization schedule.
Revenue Procedure 2025-28 explains the transition rules. A taxpayer "may elect to amortize any remaining unamortized amount with respect to such expenditures in full in the first taxable year beginning after December 31, 2024, or alternatively, amortize such remaining unamortized amount with respect to such expenditures ratably over the 2-taxable year period" (IRS Rev. Proc. 2025-28). Small businesses that met the section 448(c) gross receipts test had a separate election to apply the new rules back to 2022, which had to be made by July 6, 2026.
For the valuation allowance, the effect is a reshuffle. Accelerating the remaining deduction removes the research deferred tax asset and, for a loss company, turns it into a larger NOL. That NOL carries forward indefinitely, but it is subject to the 80 percent limit, and it sits on top of current expensing that keeps future taxable income lower. Our Section 174 guide covers the tax mechanics, and the book side of research costs is in our ASC 730 guide.
Section 163(j) caps the deduction for business interest at 30 percent of adjusted taxable income (ATI), and disallowed interest carries forward indefinitely. For 2022 through 2024, ATI was computed after depreciation and amortization, which shrank the cap. OBBBA changed the rule to "add back deductions for depreciation, amortization, or depletion to taxable income when calculating ATI," effective for tax years beginning after December 31, 2024 (IRS questions and answers on the business interest limitation).
A higher cap means more interest is deductible each year, and some companies will be able to absorb part of their disallowed interest carryforward sooner. That can reduce the allowance on a section 163(j) deferred tax asset. The analysis is still separate from the NOL analysis, because carryforward interest is usable only within the annual 30 percent limit. Our business interest expense limitation guide explains the later changes that apply from 2026.
A calendar-year C corporation is closing its 2025 books. It has a cumulative pretax book loss for 2023 through 2025, so management gives no weight to its profit forecast and relies only on reversing taxable temporary differences. It elected to deduct its remaining capitalized domestic research costs in full on the 2025 return, and that deduction is already inside the NOL below. The example uses only the 21 percent federal rate and ignores state tax. The facts and the judgment calls in it are illustrative assumptions: giving no weight to the forecast, scheduling the accrual deduction first, applying the 80 percent cap to reversal income, and reserving the full section 163(j) asset. A real analysis depends on the company's facts and its auditor's view.
| Item | Gross amount | Deferred tax at 21% |
|---|---|---|
| Post-2017 NOL carryforward | $20,000,000 | $4,200,000 asset |
| Section 163(j) disallowed interest carryforward | $5,000,000 | $1,050,000 asset |
| Accrued liabilities (deductible next year) | $2,000,000 | $420,000 asset |
| Total gross deferred tax assets | $27,000,000 | $5,670,000 |
| Fixed assets (book basis over tax basis) | $9,000,000 | $1,890,000 liability |
Step 1: Schedule the reversing income. The $9,000,000 fixed asset difference will reverse into taxable income. The $2,000,000 accrual deduction absorbs the first $2,000,000, leaving $7,000,000.
Step 2: Apply the 80 percent cap (illustrative approach). The NOL can offset 80 percent of the remaining $7,000,000, which is $5,600,000. The other $1,400,000 stays taxable.
Step 3: Find the supported amount. Supported deductions are $2,000,000 of accruals plus $5,600,000 of NOL, or $7,600,000. At 21 percent, the supported deferred tax asset is $1,596,000.
Step 4: Size the allowance. The valuation allowance is $5,670,000 minus $1,596,000, or $4,074,000. That equals the unsupported NOL of $14,400,000 at 21 percent ($3,024,000) plus the full section 163(j) asset ($1,050,000), which, as an illustrative judgment, management treats as unsupported because using it would depend on future ATI it cannot verify.
The balance sheet then shows a net deferred tax liability of $294,000 ($1,596,000 of net assets against $1,890,000 of liabilities). Without the 80 percent cap, the allowance would have been $3,780,000. The $294,000 difference is exactly the 21 percent tax on the $1,400,000 of reversal income the NOL cannot shelter.
If the company had no allowance at the start of the year, the full $4,074,000 runs through income tax expense. On a 2025 pretax loss of $8,000,000, the expected statutory benefit is $1,680,000, so the allowance charge equals 242.5 percent of that amount and dominates the effective rate.
The allowance is reassessed every period, and a return to sustained profits can support a release.
The offset to a new or larger allowance is deferred tax expense in continuing operations, which lowers net income. A release does the reverse. Purchase accounting adds another layer, since acquired deferred tax assets and their allowances are set up at the acquisition date; our ASC 805 business combinations guide covers that.
ASU 2023-09 rewrote the income tax disclosures. Public business entities must now show a tabular rate reconciliation in both percentages and dollar amounts with eight fixed categories, one of which is "Changes in valuation allowances." Items within certain categories that equal or exceed 5 percent of pretax income multiplied by the statutory rate need further breakdown (FASB ASU 2023-09).
The effective dates are:
Entities other than public business entities do not present a numerical reconciliation. They must "qualitatively disclose the nature and effect of specific categories of significant reconciling items," which still covers a significant valuation allowance change. All entities also disclose income taxes paid by federal, state and foreign jurisdiction. In the worked example above, the $4,074,000 charge would appear in the valuation allowance category for a public company. Our ASU 2023-09 guide covers the full disclosure set.
What is a deferred tax asset valuation allowance? It is a contra account that reduces a deferred tax asset to the amount that is more likely than not to be realized. If a company probably will not have enough future taxable income of the right character, the allowance writes the asset down.
Does a three-year cumulative loss automatically require a valuation allowance? No. ASC 740 treats cumulative losses in recent years as significant negative evidence that is difficult to overcome, and the three-year measure is the common way to test for it. A company can still avoid an allowance if objectively verifiable positive evidence, such as reversing deferred tax liabilities or firm contracts, supports realization.
How does OBBBA section 174A expensing affect deferred tax assets? Domestic research costs are deductible for tax years beginning after December 31, 2024, and companies can elect to deduct their remaining capitalized amounts over one or two years. For a loss company, that converts the research deferred tax asset into a larger NOL, which is limited to 80 percent of taxable income each year and may need its own allowance analysis.
Can deferred tax liabilities support a deferred tax asset? Yes. Future reversals of taxable temporary differences are the first of the four sources of taxable income. When the asset is a post-2017 NOL, only 80 percent of the reversing income can be offset, so the support is partial.
When do ASU 2023-09 disclosures apply to private companies? For entities other than public business entities, ASU 2023-09 applies to annual periods beginning after December 15, 2025. They give a qualitative description of significant reconciling items, including valuation allowance changes, instead of a numerical reconciliation.
Madras Accountancy supports U.S. CPA firms and their clients with income tax provision work, including deferred tax schedules and the evidence documentation behind a valuation allowance conclusion. This article is general information; confirm the treatment for any client with their tax adviser and auditor. To discuss a provision engagement, contact our team.
The section 4960 excise tax is 21% of nonprofit pay over $1M. From 2026 it covers all employees. See the medical carve-outs, Form 4720 and a worked example.
The paid family and medical leave tax credit is permanent from 2026. See the 12.5% to 25% rates, the premium option, the 6-month rule and how Form 8994 works.
Opportunity zones become permanent in 2027 under the One Big Beautiful Bill. See the new deferral, rural bonus, and the 2026 handoff.
