Book Income vs. Taxable Income and Reconciliations
Book Income vs. Taxable Income
Differences between net income per GAAP financial statements (book income) and taxable income reported on a tax return exist due to differences between GAAP rules and tax law.
Temporary vs. Permanent Differences
Temporary Differences: Recognized in one period for book purposes and a different period for tax purposes. These cause timing differences that reverse over time, resulting in no long-run difference between book and tax income (e.g., straight-line book depreciation vs. accelerated MACRS tax depreciation).
Permanent Differences: Recognized for book purposes but never for tax, or vice versa. These differences never reverse (e.g., municipal bond interest income).
Schedules M-1 and M-3
Schedule M-1: Used to reconcile book and tax differences but does not distinguish between temporary and permanent differences.
Schedule M-3: Mandatory for companies with total assets of or greater. It breaks out items in greater detail and explicitly distinguishes between temporary and permanent differences.
Items Treated Identically Under GAAP and Tax Law
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; recognized when received for tax (Temporary).
Advance rents and royalties: Recognized when earned for books; recognized when received for tax (Temporary).
State and municipal bond interest: Included in book income; non-taxable (Permanent).
Key person life insurance proceeds: Included in book income; non-taxable (Permanent).
Expense Items:
Officers' compensation: Limited to each for top 5 officers for tax (Permanent).
Bad debt expense: Estimated via allowance for books; direct write-off method for tax (Temporary).
Warranty expense: Accrued estimated liability for books; no deduction until paid for tax (Temporary).
Business interest expense: Expensed for books; subject to 1% ATI floor and 10% ATI ceiling for tax (Permanent or Temporary).
Charitable contributions: Expensed for books; subject to tax limitations (Permanent or Temporary).
Depreciation: Straight-line or other method for books; accelerated MACRS/Bonus/Sec. 179 for tax (Temporary).
Start-up/organizational expenses: Expensed for books; maximum deduction with excess amortized over 15 years for tax (Temporary).
Franchise fees: Amortized over expected life for books; amortized over 15 years for tax (Temporary).
Goodwill: Tested for impairment for books; amortized over 15 years for tax (Temporary).
Pension and profit-sharing expense: Accrued for books; no deduction until paid for tax (Temporary).
Meals: Generally 50% deductible for tax (Permanent).
Key person life insurance premiums paid: Expensed for books; not deductible for tax (Permanent).
Fines and penalties: Expensed for books; not deductible for tax (Permanent).
Entertainment: Expensed for books; not deductible for tax (Permanent).
Political contributions/lobbying expenses: Expensed for books; not deductible for tax (Permanent).
Federal income taxes: Expensed for books; not deductible for tax (Permanent).
Accrued bonus/vacation: Expensed for books; deductible when accrued if paid within 2.5 months of year-end for tax (Temporary).
Special Items:
Dividends-received deduction: No deduction for books; 100%, 65%, or 50% exclusion for tax (Permanent).
Net capital loss: Reported as a loss for books; not deductible for tax, carried back 3 years and forward 5 years (Temporary).
Net operating loss: Reported as a loss for books; carried over indefinitely for tax (Temporary).