Book Income vs. Taxable Income Reconciliation

Book Income vs. Taxable Income Overview

• Differences between net income per financial statements (GAAP) and taxable income reported on a tax return exist due to differences between GAAP and tax law.

• Financial statement income calculation: Gross income less Expense equals Net income before tax, minus Tax equals Net income.

• Tax return income calculation: Tax Return Income less Deductions, minus Charitable contributions, minus Dividends-received deduction equals Taxable income.

Temporary vs. Permanent Differences

• Temporary Differences: Recognized in one period for book but in a different period for tax, causing timing differences that result in the same total deduction or income over time (e.g., straight-line depreciation for books vs. accelerated MACRS depreciation for tax).

• Permanent Differences: Recognized for book but never recognized for tax, or vice versa, resulting in differences that never reverse (e.g., municipal bond interest income).

Schedules M-1 and M-3

• IRS requires corporations to reconcile book and tax differences on either Schedule M-1 or Schedule M-3.

• Schedule M-1: Does not distinguish between temporary and permanent differences. Reconciles book net income to taxable income before the dividends-received deduction and net operating loss (NOL) carryforward deduction.

• Schedule M-3: Required for companies with total assets of $10\text{ million}$ or greater. Breaks out book income and expense items in greater detail and distinguishes between temporary and permanent differences.

Items Treated Identically for Book and Tax

The following items are treated the same under GAAP rules and Internal Revenue Code (IRC) rules:

• Domestic research and experimental costs

• Gain/loss on treasury stock

• Losses on the abandonment of property or property casualties

• Losses on worthless securities

• Net capital gains

• State taxes paid and state tax refunds

Common Book-to-Tax Differences

• Income Items:

  • Installment sales: Recognized when performance obligations are met for books vs. when received for tax (Temporary difference).

  • Advance rents and royalties: Recognized when earned for books vs. when received for tax (Temporary difference).

  • State and municipal bond interest: Recorded as book income vs. not taxable (Permanent difference).

  • Key person life insurance proceeds: Recorded as book income vs. not taxable (Permanent difference).

• Expense Items:

  • Officers' compensation: Expensed for books vs. subject to a $\$1,000,000$ limit each for the top $5\text{ officers}$ for tax (Permanent difference).

  • Bad debt expense: Estimated via allowance method for books vs. direct write-off method for tax (Temporary difference).

  • Warranty expense: Accrued estimated liability for books vs. no deduction until paid for tax (Temporary difference).

  • Business interest expense: Expensed for books vs. subject to limitations for tax (Permanent or temporary difference).

  • Charitable contributions: Expensed for books vs. subject to a $1\%\text{ of ATI floor}$ and $10\%\text{ of ATI ceiling}$ for tax (Permanent or temporary difference).

  • Depreciation: Straight-line or other book method vs. accelerated MACRS, Bonus, or Section 179 for tax (Temporary difference).

  • Start-up/organizational expenses: Expensed for books vs. $\$5,000$ maximum deduction with excess amortized over $15\text{ years}$ for tax (Temporary difference).

  • Franchise fees: Amortized over expected life for books vs. amortized over $15\text{ years}$ for tax (Temporary difference).

  • Goodwill: Tested for impairment for books vs. amortized over $15\text{ years}$ for tax (Temporary difference).

  • Pension and profit-sharing expense: Accrued for books vs. no deduction until paid for tax (Temporary difference).

  • Meals: Expensed for books vs. generally $50\%$ deductible for tax (Permanent difference).

  • Key person life insurance premiums paid: Expensed for books vs. not deductible for tax (Permanent difference).

  • Fines and penalties: Expensed for books vs. not deductible for tax (Permanent difference).

  • Entertainment: Expensed for books vs. not deductible for tax (Permanent difference).

  • Political contributions/lobbying expenses: Expensed for books vs. not deductible for tax (Permanent difference).

  • Federal income taxes: Expensed for books vs. not deductible for tax (Permanent difference).

  • Accrued bonus/vacation: Expensed for books vs. deductible when accrued if paid within $2.5\text{ months}$ of year-end for tax (Temporary difference).

• Special Items:

  • Dividends-received deduction: No deduction for books vs. $100/65/50\%$ exclusion for tax (Permanent difference).

  • Net capital loss: Reported as a loss for books vs. not deductible with carryback $3\text{ years}$ and carryforward $5\text{ years}$ for tax (Temporary difference).

  • Net operating loss: Reported as a loss for books vs. carried over indefinitely for tax (Temporary difference).