Schedule M-1, Reconciliation of Income (Loss) per Books With Income
per Return, provides a reconciliation between book income and taxable
income on corporate and partnership returns. New practitioners may find
it difficult to understand Schedule M-1; by learning a few concepts, it
may cease to seem like a mystery.
Schedule M-1 adjustments are based on the taxpayer’s method of
accounting. Generally, Sec. 446 requires taxable income to be computed
under the same method of accounting as the taxpayer uses for its books.
For cash-method taxpayers, income is included in gross income when
payment is actually or constructively received; deductions are allowable
when payment is made. Under Sec. 461(h)(1) and (4), accrual-method
taxpayers record revenue and expenses when all three of the following
have occurred: (1) all events have occurred that establish the fact of
the transaction; (2) the amount of the transaction can be determined
with reasonable accuracy; and (3) economic performance has occurred.
Sec. 461(h)(3) provides a recurring-item exception for the economic
performance test. An item is treated as incurred during the tax year if
all events with respect to the item have been met; economic performance
occurs within the shorter of(1) a reasonable period or (2) 8 1/2 months
after the close of the tax year; the item is recurring in nature; and it
is either not a material item or the accrual in the tax year provides a
better matching of income and expenses.
It is important to understand how book income was determined before
adjusting it to arrive at taxable income. The following list describes
and illustrates common Schedule M-1 adjustments.
Accrued Compensation and Benefits
When an accrual-method taxpayer accrues expenses related to a plan,
method or arrangement (i.e., salary, vacation, commissions and
management fees), these amounts will ordinarily not be deductible for
income tax purposes and must be added back to arrive at taxable income
on Schedule M-1. However, Temp. Regs. Sec. 1.404(b)-1T, Q&A-2,
provides an exception if these amounts are paid to employees within 2
1/2 months of the end of the tax year.
Example 1: X Corp. accrued $20,000 of bonus compensation earned by
employees for the tax year ended Dec. 31, 2004. By March 15, 2005, X
paid $12,000 of these bonuses. Because $12,000 was paid out during the 2
1/2 months following the end of X’s tax year, it is deductible on
X’s 2004 return; the $8,000 not paid must be added back in
computing taxable income and will be deductible in the year paid.
In general, Sec. 461(h)(4) disallows a deduction for a reserve
account, because the liability cannot be determined with reasonable
accuracy, nor have all the events occurred to establish the liability.
For example, bad debt expense can be deducted from taxable income only
if a debt becomes worthless in whole or in part during the tax year, the
amount of the loss can be determined with reasonable accuracy and the
debt has been written off or down for book purposes in an amount at
least equal to the deduction claimed. Noncorporate taxpayers cannot
deduct a partially worthless nonbusiness bad debt.
Example 2: Q Corp.’s Dec. 31, 2004 income statement reflected
a $13,000 bad debt expense. Its balance sheet for that date reported a
$10,000 net increase in allowance for doubtful accounts. Q also wrote
off a $3,000 worthless receivable from a previous year. The $10,000 bad
debt expense relating to the increase in allowance for doubtful accounts
is not deductible and must be added back to book income on Schedule M-1.
However, the $3,000 writeoff for the worthless receivable is deductible.
Thus, although book income reflects bad debt expense of $13,000, taxable
income will be reduced only by $3,000, resulting in a $10,000 Schedule
Generally under Sec. 461, an accrual-method taxpayer cannot deduct
taxes until economic performance has occurred (i.e., until the taxpayer
has paid the taxes). However, there are a few exceptions. Under Kegs.
Sec. 1.461-1(c), an accrual-basis taxpayer may elect to ratably accrue any real property tax related to a definite period. The election must be
made on the return for the first tax year in which the taxpayer incurs
the taxes. Also, the recurring-item exception may apply to allow a
taxpayer to deduct taxes even when the economic performance test has not
been met. If this exception applies, a taxpayer can deduct a tax when
all the events have occurred that fix the amount and the liability to
pay, even if payment may not be due until a later date; see Kegs. Sec.
Example 3: During 2004, B Corp. made $10,000 in state estimated tax payments and booked them as state tax expense. While it generally
“trues up” its prior-year state tax expense by adjusting it
for the current year, this was not required for 2003 taxes. After
B’s 2004 financial statements were issued, its CPA prepared its
2004 state returns and determined that B’s actual state tax was
$25,000, leaving B with a $15,000 balance due. Because state tax is a
recurring item, it may be accrued and deducted if paid within 8 1/2
months of the year-end. Thus, B may deduct an additional $15,000 from
book income on Schedule M-1 for the 2004 tax year (even though state tax
expense for books is only $10,000), as long as it paid all state tax due
by Sept. 15, 2005.
Under Sec. 1211 (a), a C corporation may only use its capital
losses to offset capital gains. The excess capital losses may be carried
back or forward to a year in which the company has excess capital gain.
All excess capital losses in excess of capital gains in the tax year
must be added back to arrive at taxable income on Schedule M-1.
Similarly, capital losses carryovers used in the current year are a
Schedule M-1 item.
Sec. 274(n)(1) limits the deduction for meals and entertainment
(M&E) to 50% of the amount normally deductible. However, M&E
expenses are not limited if they are treated as employee compensation
and included on employees’ Forms W-2, in reimbursed expenses or are
incurred for firm recreational or social activities (i.e., holiday
Example 4: VCorp. recorded $10,000 in M&E expenses during 2004,
consisting of $5,000 for business lunches with clients and $5,000 for
the annual holiday party. The latter is fully deductible, but the
business lunch deduction is limited to $5,000 ($10,000 x 0.50),
requiring $2,500 to be added back to book income on Schedule M-1 to
arrive at taxable income.
Sec. 274(a)(3) disallows a deduction for amounts paid for
membership in any club organized for business, pleasure, recreation or
other social purpose. All amounts spent on these items should be added
back to arrive at taxable income on Schedule M-1.
Sec. 274(m)(3) bars a deduction for travel expenses of a spouse,
dependent or other individual accompanying the taxpayer, unless the
individual is an employee of the taxpayer’s business. All amounts
spent on these items should be added back to arrive at taxable income on
Sec. 7872(c)(3) states that compensation-related and
corporation-shareholder loans not exceeding $10,000 can carry a
below-market interest rate (unless tax avoidance is a principal
purpose). However, employee loans exceeding $10,000 must accrue interest
at the market rate. Interest-free loans are very common between S
corporations and their shareholders. If the loan balance exceeds
$10,000, a market interest rate must be accrued on the loan’s
Example 5: At the beginning of 2005, S corporation D has a $9,000
interest-free note due from shareholder A. During 2005, A borrows an
additional $5,000, bringing the total loan balance to $14,000 at
yearend. Because the balance exceeds the $10,000 de minimis exception, a
market rate of interest must be accrued on the note’s average
balance. The accrued interest computation is as follows, assuming the
applicable Federal rate at the end of 2005 is 6%:
Beginning balance $9,000
Ending balance $14,000
Accrued interest $690
Thus, D must add $690 interest income to its book income on
Schedule M-1 to arrive at taxable income. If the situation had been
reversed and A had loaned the money to D, A would be required to report
$690 interest income on his individual return; D would deduct $690
interest expense from book income in determining its taxable income on
Sec. 162(f) disallows a deduction for any fine or similar penalty
paid to a government for the violation of any law. All amounts spent on
these items should be added back to arrive at taxable income on Schedule
M-1. Similar treatment is required for bribes and other illegal payments
made to the extent deducted in arriving at book income for the year.
Regs. Sec. 1.461-4(d)(6)(ii) allows a taxpayer to deduct prepayment for services or property if the taxpayer can reasonably expect to
receive the services or property within 3 1/2 months after the payment
Example 6: On Dec. 31, 2004, Z Corp. prepaid its lawn maintenance
company for three months of service and booked the related asset. If Z
expects its lawn maintenance to be performed on its usual monthly
schedule, this amount may be deducted as an expense, even though the
service has not been provided as of the date accrued.
Life Insurance Premiums
Sec. 264(a)(1) allows a deduction for the premiums paid on
group-term life insurance covering employees, if the employer is not
directly or indirectly a beneficiary under the policy or contract.
Example 7: Y Corp. paid $25,000 in life insurance premiums for tax
year 2004, $20,000 of which were for policies under which Y is not the
beneficiary. However, $5,000 of premiums were paid for life insurance
policies covering Y’s officers, for which Y is the beneficiary.
Thus, $5,000 must be added back to book income on Schedule M-1.
Although these are just a few of the many Schedule M-1 adjustments,
they should illustrate the underlying concept. After identifying the
taxpayer’s method of accounting, the all-events test should be
applied to the year’s transactions and adjustments should be made
to transform book income into taxable income.
Some taxpayers engaging in abusive transactions have benefited from
the different rules for book and tax accounting, by claiming tax
benefits that have no corresponding financial cost. To combat this, the
IRS created Schedule M-3, Net Income (Loss) Reconciliation for
Corporations With Total Assets of $10 Million or More, which requires
certain C corporations to disclose detailed information about book-tax
differences as part of their returns for 2004 and later years. All
domestic corporations (including consolidated entities) with total
consolidated assets reported on Schedule L, Balance Sheets per Books, at
the end of the year of at least $10 million are required to complete
Schedule M-3 in lieu of Schedule M-1. These corporations will be treated
as satisfying the disclosure requirements under the return disclosure
regulations by completing Schedule M-3.
In addition, taxpayers not required to file the new schedule may
meet their disclosure obligations by using the standardized reporting
format contained in Schedule M-3 or by following the return disclosure
regulations. (For more information, see McGowan and Killion,
“Schedule M-3: Closing the Corporate Book-Tax Gap” TTA, July
2005, p. 408.)
FROM RACHAEL HINKLEY, MST, AIDMAN, PISER & COMPANY, P.A.,