Thus far, we have taken taxable income as given in
order to focus on tax liability computations.
However, to determine taxable income,
many corporations begin with income
computed under Generally Accepted Accounting Principles,
that is financial reporting or book purposes,
and then make adjustments for book-tax reporting differences.
There are many items that are accounted for differently for book and tax,
largely because the two reporting systems serve diverse objectives.
Financial reporting focuses on informing stakeholders,
while tax reporting aims to raise revenue for the government.
In this lesson, you will learn about
several common book-tax differences applicable to corporations.
Before examining some book-tax difference items,
it is important to understand that
each book-tax difference can be unfavorable or favorable,
from the taxpayers perspective depending on the effect it has on taxable income,
relative to book income.
Any book-tax difference requiring an increase to book income to determine taxable income,
is unfavorable in the eyes of the taxpayer because it increases taxable income,
and thus tax liability relative to book income.
The opposite is true for favorable book-tax differences that
decrease book income relative to taxable income.
Book-tax differences are also categorized as permanent or temporary.
Permanent book-tax differences arise from items or deductions
for either book or tax purposes, but not both.
These items do not reverse over time,
thus the total amount of income or deductions for
such items is different for book and tax purposes.
Temporary differences are those that reverse over time,
such that corporations record the same amount of income and
deductions for the items on their financial reports,
as they record on their tax returns.
These differences arise when
income or deduction items are included in book income in one year,
and in taxable income in a different year.
Temporary book-tax differences that are initially favorable will
subsequently become unfavorable in future years when they reverse, and vice versa.
Let's now examine some of the many possible book-tax differences,
beginning with those that are permanent in nature.
First, federal income tax expense is deducted in the determination of book income.
You likely learned a lot about accounting for
income taxes in prior financial reporting courses.
However, Code Section 275 A1
disallows a deduction for federal income taxes for tax purposes.
As a result, federal income tax expense constitutes
a permanent and unfavorable book-tax difference that
must be added back to book income to determine taxable income.
Another very common permanent book-tax difference,
is the interest income from municipal bonds.
Municipal bond interest is included in book income as it is a source of realized income.
However, to incentivize investment in municipal bonds
which typically offer lower rates of return than other types of bonds,
Congress excludes municipal bond interest from taxable income.
This book-tax difference is favorable,
and that it is deducted from book income to determine taxable income.
Two other permanent differences include,
one-half of meals and entertainment expenses,
and any fines and penalties paid during the year.
Only 50 percent of qualified meals and entertainment expenses are deductible.
Thus, the other 50 percent represents
an unfavorable difference that will never be deducted for tax purposes,
but is deducted for book purposes.
Similarly, because expenses incurred for violations of
public policy are not generally deductible for tax purposes,
they too are unfavorable permanent differences that
must be added back to book income to determine taxable income.
In terms of temporary book-tax differences,
depreciation expense is a prime example.
For tax purposes, taxpayers use
the Modified Accelerated Cost Recovery System
to depreciate fixed assets in a standardized manner.
Different methods or assumptions such as the useful life of an asset,
are often made for financial reporting purposes.
Thus, in a given year,
the book and tax depreciation expense can differ.
But over the life of the asset,
these methods often catch up with one another by eventually depreciating
the asset in full making any annual differences temporary in nature.
As mentioned, there are many more examples of book-tax differences.
The key point is to know that these items help determine taxable income.
As a result, Schedule M-1 on the corporate tax return,
which is required for corporations with less than $10 million of assets,
reconciles net income for books with taxable income on the tax return.
The IRS uses this information for a variety of tax enforcement purposes.
Corporations with more than $10 million in assets compute Schedule M-3,
which is a far more expansive book-tax reconciliation than Schedule M-1.
Instead of 10 lines,
the M-3 includes 80 items over three pages.
It also requires taxpayers to allocate
book-tax differences into their permanent and temporary components.
To wrap up this discussion,
consider a simple example.
Assume that [inaudible] reports income for financial reporting purposes of $275,000.
Included in this amount, however,
are municipal bond interest income as well as
expenses incurred for federal income tax expense,
meals and entertainment, and regulatory fines.
Also assume that depreciation expense was $55,000
for book purposes and $60,000 for tax purposes.
To determine taxable income,
[inaudible] begins with book income,
and then makes adjustments for book-tax differences.
The municipal bond interest income that is included in book income is- let me start over.
To determine taxable income,
[inaudible] begins with book income,
and then makes adjustments for book-tax differences.
The municipal bond interest income that is included in book income,
is subtracted because it is not subject to taxation.
Federal tax expenses are non-deductible,
thus it is added back.
Only 50 percent of business meals are deductible,
therefore the other half is added back.
No fines or penalties are deductible,
thus they too are added back.
Finally, depreciation expense for tax purposes was
$5,000 higher than it was for book purposes,
this difference is subtracted from book income to arrive at taxable income of $322,000.
Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
