0:20
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 adjustment 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 a 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 from 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 different year.
Temporary book tax differences that are initially favorable or
subsequently become unfavorable in future years when they reverse and vice versa.
2:08
Let's now examine some of the many possible book tax differences
beginning with those 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 a prior financial reporting course.
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 interests 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% of qualified meals and entertainment expenses are deductible,
thus the other 50% represents an unfavorable difference that will never be
deducted for tax purposes, but is deducted for book purposes.
Similarly, because no expense is incurred for violations of public
policy are deductible for tax purposes, they too are unfavorable permanent
differences that must be added back to book income to determine taxable income.
3:34
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 to know is that these items help determine taxable income.
As a result, schedule M1 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 complete schedule M3 which
is a far more expansive book tax reconciliation than schedule M1.
Instead of 10 lines the schedule M3 includes 80 items over 3 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 Illini Inc 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, entertainment and regulatory fines.
Also assume that the depreciation expense was $55,000 for book purposes and
$60,000 for tax purposes.
To determine taxable income, Illini Inc 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 expense is non deductible, thus it is added back.
Only 50% 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, the 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
