December 2007
Schedule M-3 Update for 2007
By John Ledbetter and Lucinda Van Alst
John Ledbetter and Lucinda Van Alst examine Schedule M-3,
including its expanded application to other types of entities, and
provide a detailed example illustrating the use of Schedule M-3.
F
or tax years ending on or after December
31, 2004, the Schedule M-3 is a required
component of Form 1120 for those corporations with $10 million or more in total reportable
assets. The Schedule M-3 replaced the Schedule
M-1 that had not been updated in several decades
and had been found increasingly inadequate for
IRS purposes
purposses due to, among other reasons, the
growing
complexity
of business transactions. The
ow
wing
i g co
omp
ple
purpose
article is to rev
review
Schedule M-3
urp
pose
e of this art
ar
iew the Schedu
developments
expanded use
evvelop
p ents to date,
pme
e, including
di its expande
for
other
or o
othe
er types
types of entities,
en ties, and
and to provide
pro ide a detailed
de
example
mple
l with
with explanations
e pla
l
ons of
o the
he Schedule
Sc d l M-3
M for
illustration
i purposes.
Background
Initial Requirement
On January 28, 2004, the IRS issued IR-2004-14 announcing the release of a new proposed draft form,
the Schedule M-3, Net Income (Loss) Reconciliation
for Corporations with Total Assets of $10 Million or
More, for use by certain corporate taxpayers filing
the Form 1120. Affected taxpayers would complete
the new Schedule M-3 in lieu of completing the
much less detailed Schedule M-1, effective with
John Ledbetter, Ph.D., CPA, is an Assistant Professor of
Accounting at Ball State University in Muncie, Indiana.
Lucinda Van Alst, DBA, CPA, is the Chair and Associate
Professor of Accounting at Ball State University in Muncie,
Indiana.
TAXES—THE TAX MAGAZINE
©
tax years ending on or after December 31, 2004.
Smaller businesses and self-employed taxpayers,
however, would continue to use the Schedule M-1.
The news release stated that the purpose of the new
Schedule M-3 was to increase the transparency of
corporate return filings, making the differences
between financial accounting net income and taxable income more evident. IRS personnel stated
that that, in turn, would help agents to determine
which returns should be audited and to identify the
differences that would matter most for those returns
that were audited. They saw benefits accruing to
taxpayers and the IRS alike from the new Schedule’s use resulting from a reduction in unnecessary
audits
udi s and a faster
faster identifi
de ification
cation of
of the
he differences
difference
more likely
when
taxpayers
aggressive
l kel to aarise
rise w
n ta
xpayers take
ake agg
gressiv
positions or engage in aggressive transactions. IRS
Commissioner Mark W. Everson noted that the new
Schedule would let the IRS sharpen and improve
monitoring of corporate compliance while Treasury Assistant Secretary for Tax Policy Pam Olson
stated that the increased transparency would have
a deterrent effect.
Expanding Usage
The IRS increased the use of the Schedule M-3
by requiring three additional entities to file that
Schedule rather than the Schedule M-1. First
announced in News Release IR-2005-141 in December 2005, the Schedule M-3, when finalized,
became required reporting by property and casualty insurance companies filing Forms 1120-PC;
2007 J. Ledbetter and L. Van Alst
39
Schedule M-3 Update for 2007
composed of large and mid-size corporations and
life insurance companies filing Forms 1120-L; and
partnerships were growing rapidly. The multiple
S corporations filing Forms 1120S, providing the
criteria would ensure uniform tax accounting disentities had total assets of $10 million or more.
closures by entities similar to or related to LMSB
The reporting was effective for tax years ending
taxpayers.
on or after December 31, 2006. In the initial
news release, Deborah M. Nolan, IRS Large and
Form 8916
Mid-Size Business (LMSB) Division Commissioner,
reiterated the Commissioner’s earlier remarks that
In early April of 2006, the IRS issued updated drafts
the increased disclosure provided by the Schedules
of Schedules M-3 for the 2006 tax year and added
M-3 would enable the IRS to distinguish returns
a new Form 8916, Reconciliation of Schedule M-3
with potentially higher compliance risk from those
Taxable Income with Tax Return Taxable Income
with lower risk, which, in turn, would lead to refor Mixed Groups, to be filed by certain insuranceduced examination cycle
related corporations. The
times and increased curpurpose of the Form 8916
The Schedule M-3 replaced the
rency. She emphasized
is reflected in the Form
that the end result would
title and is to reconcile
Schedule M-1 that had not been
be reduced taxpayer burtaxable income reported
updated
in
several
decades
and
had
den and improved tax
on the Schedules M-3 to
been found increasingly inadequate the taxable income recompliance.
ported on the income tax
for IRS purposes due to, among
Partnerships
returns. The new drafts
other
reasons,
the
growing
provided the means for
One week after excomplexity of business transactions. consolidating and recpanding the use of the
onciling taxable income
Schedule M-3, the IRS
for both insurance comissued yet another news
panies and noninsurance companies, or for two
release,
IR-2005-146,
announcing the draft of the
ase, IR-20
different types of insurance companies. The same
Schedule
hedu
dule
l M-3
M 3 for
fo Form 1065 filers. Effective startnews release, IR-2006-51, included a draft Schedule
ing
years
December 31,
ng with
h tax
x ye
ars ending
ing on or after Decemb
M-3 for Form 1065 that added additional report2006,
a more detailed
00
06, tthe
he Schedule
S edu M-3
Sche
M- provided
vi
de
ing of net income of other includible entities and
reconciliation
between
eco
onciliattion b
etw en financial
nancial aaccounting
countin net
additional lines in Part III to report state, local and
income
and
taxable
ome
e an
d tta
abl
b income
come than
han was reported in
foreign
the past. Partnerships meeting any of four different
g taxes. The Schedule M-3 that accompanies
Forms
criteria would be required
red to
o file
e SSchedule
Sched
dule M-3.
M-3.
orms 1120S
120S and
and 1065
1065 was also changed
cha ged to include
nc ud
separate
reporting
off gas and oil and o
other
depletion.
The criteria included the
partnerhe following:
owing: tthe
he p
artne epa ate re
porting o
the de
pletion
For the first time Form 1065 filers were requested
ship has (1) $10 million or more in total assets at
to provide information in the checkboxes at the top
the end of the tax year; (2) $10 million or more
of Schedule M-3 to indicate the reason(s) they are
in “adjusted total assets” at the end of the year;
required to file the Schedule M-3.
(3) $35 million or more in total receipts; or (4) a
“reportable partner.” A “reportable partner” was
Adding Form 8916-A
defined as one that is itself required to file Schedule
M-3 on its most recent tax return and that owns,
After considering many helpful comments from
directly or indirectly, 50 percent or more interest
stakeholders, the IRS released final drafts of
in the income, loss or capital of the partnership on
Schedules M-3 and Forms 8916 for the 2006 tax
any day of the partnership tax year on or after June
year. The IRS also reported the addition of a new
30, 2006. “Adjusted total assets” means total assets
Form 8916-A which would be required for cost
at the end of the tax year before capital distribuof goods sold. The Form’s purpose is to provide
tions, losses and any other adjustments that reduce
for a uniform, consistent manner for taxpayers to
total partnership capital. The IRS LMSB Division
reconcile cost of goods sold reported in Part II of
Commissioner, Deborah M. Nolan, was quoted as
Schedule M-3. Additional lines were added to the
saying that the Schedule M-3 for partnerships was
Schedule M-3 for the reporting of inter-company
particularly important since complex enterprises
dividend adjustments, other statutory adjustment
40
December 2007
and other adjustments, and Part I was renumbered
so that all of the Schedules M-3 were consistent
with reporting worldwide consolidated financial
net income and consolidated net income for the
tax group. The new Form would accompany Forms
1065, 1120 and 1120S.
Comment Period for More Additions
IR-2007-94 was released by the IRS in May 2007
for public comment on draft versions of the revised
Form 1120-F, U.S. Income Tax Return of a Foreign
Corporation, for tax year 2007, which included the
Schedule M-3. Thus, taxpayers with $10 million or
more in total reportable assets filing Form 1120-F
will be required to file Schedule M-3, effective for
tax years ending on or after December 31, 2007. In
addition, three other schedules for Form 1120-F are
new, as follows: Schedule H, Deductions Allocated
To Effectively Connected Income Under Regulations Section 1.861-8; Schedule I, Interest Expense
Allocated Under Regulations Section 1.882-5; and
Schedule P, List of Foreign Partner Interest in Partnerships. In all instances, the schedules will provide
increased disclosure of information to the IRS and a
more consistent reporting format for the taxpayers.
Looking
o ing
ooki
gA
Ah
Ahead
When
Wh
hen the
t IRS iss
is
issued IR-200
IR-2006-71
6-71 in April 20
2006, it
stated
tated tthat
hat it soon
so
oon planned
nn to introduce
in
ce a new Form
1120-C
replace
990-C,
which
12
20-C
C to rep
lacce Form
orm 99
0-C, wh
ch is filed by
cooperative
Form 1120
1120-C
operaati
tivee associations.
ass cia
i
s Fo
C would also
be filed b
by Subchapter T cooperatives that had previously filed Form 1120. O
Once
again,
the
taxpayers
e again
n, th
e tax
xpayyers
affected would be those wit
with total
year
end
otal aassets
sets aat ye
ear en
d
of $10 million or more.
With the increased usage of the Schedule M-3,
it would seem that the IRS has gathered at least
some evidence that the Schedule is, indeed, providing more transparency and, thus, compliance
assistance. Boynton et al. (2006)1 provide statistical information about 2004 reporting on Schedule
M-3, but they do not present any conclusions
about the transparency provided by Schedule M-3.
Interestingly, they report unusually large proportions of total differences for the “other income
items with differences” category (Part II, line 25
on the 2007 form).
businesses/corporations/article/0,,id=119992,00.
html. The page contains links to a lengthy FAQ
page, a link to subscribe to a Schedule M-3 e-mail
service, and a form for submitting questions about
the schedule to the IRS. IRS also provides a listing of
draft tax forms (which can be sorted by form number
or date) at www.irs.gov/taxpros/lists/0,,id=97782,00.
html. The most recent 2007 drafts at this writing are
as shown in Table 1.
Example for Schedule M-3
(Form 1120)
As an example, consider an affiliated group which
files consolidated financial statements with the
SEC and consolidated returns with the IRS. The
affiliated companies include a publicly traded
U.S. parent corporation (“US”) and the following
additional entities:
A 90 percent owned U.S. subsidiary (“US1”)
A wholly owned foreign subsidiary (“FORN1”)
A 60 percent owned U.S. subsidiary (“US2”)
An 80 percent owned U.S. subsidiary (“US3”)
that does not meet the requirements for financial
statement consolidation
Consolidated financial statements filed with the
SEC include US, US1, FORN1 and US2, but do not
include US3. The consolidated tax return includes US,
US1 and US3, but does not include FORN1 or US2.
Exhibit 1 presents a consolidating spreadsheet for
the group. The spreadsheet initially consolidates US
and US1, the companies included in both the book
and
consolidation
eliminates
nd tax
a cconsolidations.
onso dations This
his co
nsol d tion eli
mi ate
$100,000
US1
service
revenue
from
US)
$100
,000 of US
1 se
r e re
venue ((derived
d rived fr
om U
and other expenses of US. Another entry eliminates
the $32,320 minority interest in US1’s earnings.
The spreadsheet then consolidates FORN1 and
US2 to complete the financial statement consoli-
Table 1.
Form
“As of” Release Date
Schedule M-3 (Form 1120)
July 25, 2007
Schedule M-3 (Form 1065)
July 10, 2007
Schedule M-3 (Form 1120S)
July 25, 2007
Schedule M-3 (Form 1120-F)
June 15, 2007
Schedule M-3 (Form 1120-L)
July 17, 2007
Available Resources
Schedule M-3 (Form 1120-PC)
July 17, 2007
IRS maintains a Web site dedicated to Schedule M-3;
the main page is currently located at www.irs.gov/
Form 8916
June 14, 2007
TAXES—THE TAX MAGAZINE
Form 8916-A
August 20, 2007
41
Schedule M-3 Update for 2007
Exhibit 1.
Consolidated Spreadsheet
Consolidated for Book and Tax
90%
US
Sales
5,280,000
Cost of goods sold
3,416,000
Gross profit
1,864,000
Consolidated for Book Only
US/US1 Included
US1
Elim
US Book
FORN1
US2
80%
Elim
Total Book
5,280,000 3,000,000 1,000,000
3,416,000 2,400,000
0
0 1,864,000
Service revenue
300,000
800,000 (100,000) 1,000,000
Interest income
215,000
215,000
Dividend income
220,000
Equity in earnings of
investees
Tax Only
60%
600,000
600,000
400,000
US3
Total Tax
9,280,000
5,280,000
6,416,000
3,416,000
0
2,864,000
0
1,864,000
(150,000)
850,000
40,000
1,040,000
415,000
215,000
220,000
220,000
220,000
200,000
200,000
200,000
200,000
Gain on sales of assets
225,000
225,000
225,000
225,000
Other income
400,000
400,000
400,000
400,000
3,424,000
800,000 (100,000) 4,124,000
800,000
400,000 (150,000)
135,000
125,000
140,000
Total income
Compensation
415,000
550,000
200,000
5,174,000
40,000
4,164,000
815,000
550,000
Repairs and
maintenance
60,000
60,000
60,000
60,000
Bad debts
50,000
50,000
50,000
50,000
Interest expense
40,000
40,000
40,000
40,000
Charitable contributions
20,000
20,000
20,000
20,000
Depreciation
and amortization
55,000
55,000
55,000
Pension,
on, etc.
80,000
80,000
80,000
80,000
725,000
410,000
Other
theer expenses
exp
pensees
350,000
160,000 (100,000)
410,000
32,320
32,320
Minority
interest
Min
ority intere
est
in
income
n in
ncomee
400,000
65,000 (150,000)
100,000
49,920
82,240
Total
expenses
ota
al expe
ensess
1,070,000
70,
295,000
95,
(67,680)
1,297,320
67
1
525,000
205,000 (100,080)
1,927,240
100,000
Income
ome b
before
f e
income
taxes
e ta
axes
2,354,000
505,000
(32,320) 2,826,680
275,000
195,000
3,246,760
(60,000)
847,440
181,800
81,80
1,029,240
,
96,250
96,25
0
70,200
,
1,506,560
560
323,200
3,200
(32,320)
(32,
2 ) 1,797,440
,797,4 0
178,750
78,750
124,800
12
4,800
Income tax expense
Net income
dation. Here, one entry eliminates $150,000 of
US1 service revenue (derived from FORN1) and
other expenses of FORN1. This consolidation also
eliminates the $49,920 minority interest in US2’s
earnings. After consolidating FORN1 and US2,
the spreadsheet reports $2,051,070 of net income.
This equals the net income reported by the group
in Form 10-K.
The spreadsheet shows a loss of $60,000 for US3.
US3 is not included in the financial statement consolidation, so the spreadsheet shows no eliminating
entries related to US3.
The final column of Exhibit 1 reports the book income for entities included in the consolidated U.S.
income tax return. This column combines the consolidated amounts for US and US1 plus the amounts for
42
(49,920)
32,320
1,195,690
,
,
(49,920)
(49
92
2,051,070
2,0
1,070
155,000
1,397,320
2,766,680
1,029,240
((60,000)
0,000)
1,737,440
1,737,44
US3. For example, consolidated net income for the
entities included in the tax return is $1,737,440; this
is the sum of consolidated net income for US and US1
($1,797,440) and the net loss for US3 ($60,000).
Schedule M-3, Part I
Exhibit 2 illustrates the completion of Schedule M-3,
Part I for the group. Since US files Form 10-K with
the SEC, Line 4 reports that consolidated net income
($2,051,070). Line 5a subtracts the net income of
FORN1 ($178,750) since it is a foreign corporation
not includible in the consolidated U.S. tax return.
Line 6a subtracts the net income of US2 ($124,800)
because US does not own the 80 percent of US2’s
stock required for U.S. tax consolidation. Line 8 adds
back the net income effect of eliminating entries to
December 2007
Schedule M-3, Part II
Exhibit 2.
2007 Form 1120—Schedule M-3, Part I
Net Income Reconciliation
Line Description
1
Questions to identify source income
statement
2
Income statement period
and restatement questions
3
Publicly traded common stock symbol
& CUSIP
4
Net income from line 1 source income
statement
5a
Net income from nonincludible foreign
entities
Sch
2,051,070
yes
5b
Net loss from nonincludible foreign entities yes
6a
Net income from nonincludible U.S. entities yes
(178,750)
(124,800)
6b
Net loss from nonincludible U.S. entities
yes
7a
Net income (loss) of other includible
disregarded entities
yes
7b
Net income (loss) of other includible
corporations
yes
(60,000)
8
Adjustment to eliminations
yes
49,920
9
Adjustment to reconcile to tax year
yes
10 a Intercompany dividend adjustments
yes
10 b Other statutory accounting adjustments
yes
10 c Other adjustments
yes
11
Net income per income statement (add 4-10)
1,737,440
consolidate
on
nsolidatee FO
FORN1
ORN and
nd US2 ($49,920).
$49,920). The n
net loss
(60,000),
tax purof US3
U (60
,000
0), which
ch is consolidated
ns
ed for ta
poses
appears
7.. Boynt
Boynton
Wilson
oses only,
o
app
pears on
n line 7
on and W
(2006)
00
06)2 suggest
sugggestt that
t att IRS may
ma be
b particularly
partic
l interested
i t
in the income and expenses of these loss entities, since
their losses are included for tax
purposes,
forr
x purpo
oses, but not fo
financial statement purposes.
11,, ne
nett iincome
ose Line
ne 1
nco
ome fforr
entities included in the tax return, is consistent with
Exhibit 1 ($1,737,440).
Exhibit 2 and the following exhibits include a “Sch”
column. Each line with “yes” in the Sch column requires the taxpayer to attach a supporting schedule
for that item. This example does not provide these
details, but provides this column to identify items
which will require additional reporting.
The group files only one consolidated Schedule
M-3, Part I. However, the group files five Schedules
M-3, Parts II and III and Forms 8916-A: one for each
included corporation (US, US1 and US3), one for
eliminating entries, and one for the consolidated
group. The remainder of the example illustrates the
reporting for the parent corporation; the group’s
actual tax return would also contain the other four
sets of this information.
TAXES—THE TAX MAGAZINE
Exhibit 3 illustrates Schedule M-3, Part II, Income
(Loss) Items for US, the parent corporation. Item 6(a)
reports $200,000 book income from equity method
U.S. corporations, which represents US’s $209,000
share of taxable income less its $9,000 share of
nondeductible fines. US reports a $9,000 positive
difference in column (c) and a $209,000 negative
difference in column (b).
US reported $220,000 of dividend income from
cost-method investments in its income statement,
and reports this amount on line 7(a). Of this amount,
$10,000 was not received by the end of the year, and
will be reported in taxable income next year. Accordingly, US reports a ($10,000) temporary difference
in item 7(b) and income per tax return in item 7(d)
of $210,000.
Interest income includes $5,000 of exempt interest on state bonds. US reports $215,000 on line
13(a) of Schedule M-3, Part II; line 13(c) reports a
($5,000) permanent difference, and line 13(d) reports $210,000 interest income per tax return. Form
8916-A, Part II (Exhibit 4) reports (line 1) that the
$5,000 difference is in tax-exempt interest income;
lines 2 through 5 provide opportunities to report other
book/tax differences in interest income.
Other income of $400,000 includes $60,000 of
gains from hedging transactions; these gains were
reported in the previous year for tax purposes. Accordingly, line 15 of Schedule M-3, Part II reports
$60,000 income in column (a) and an offsetting
temporary difference in column (b).
Cost
Co
s of ggoods sold
so d appears
pears in
in item
item 17
7 of SchedSched
M-3,
Column
book
cost
of
ule MM
3, Part
art III.. C
o
n ((a)
a) rreports
epor s bo
ook co
st o
goods sold of $3,416,000. Temporary differences of
$120,000 and permanent differences of ($20,000)
create a tax cost of goods sold of $3,516,000. Form
8916-A, Part I (Exhibit 5) provides details of the
book/tax differences in cost of goods sold. Line 1
of Form 8916-A, Part I shows that differences in
LIFO pooling produce a temporary difference of
$85,000 in cost of goods sold related to cost flow
assumptions. Line 2c shows a ($20,000) permanent
difference for nondeductible meals and entertainment flowing through cost of goods sold. Line 4
shows $140,000 of book cost of goods sold for
excess inventory and obsolescence reserves in
column (a); column (d) reports $175,000 of deductions for excess and obsolete inventory disposed
of during the year, creating a $35,000 temporary
book/tax difference.
43
Schedule M-3 Update for 2007
Exhibit 3.
2007 Form 1120—Schedule M-3, Part II
Income (Loss) Items
Line
Description
Sch
1
2
3
4
5
6
7
8
9
Income (loss) from equity method foreign corporations
Gross foreign dividends not previously taxed
Supbart F, QEF, and similar income inclusions
Section 78 gross-up
Gross foreign distributions previously taxed
Income (loss) from equity method U.S. corporations
U.S. dividends not eliminated in tax consolidation
Minority interest for includible corporations
Income (loss) from U.S. partnerships
yes
yes
yes
yes
yes
yes
yes
yes
yes
10
11
12
13
14
15
16
17
18
19
0
20
21
22
yes
yes
yes
23 g
24
25
26
27
28
29 a
29 b
Income (loss) from foreign partnerships
Income (loss) fom other pass-through entities
Items relating to reportable transactions
Interest income (from 8916-A)
Total accrual to cash adjustment
Hedging transactions
Mark-to-market income (loss)
Cost of Goods Sold (from 8916-A)
Sale versus lease (for sellers and/or lessors)
SSection
Sectio
on 4
481(a) adjustments
U
Unea
arned/
d//d
Unearned/deferred
revenue
IIncome
Incom
me re
cogg
from lon
-term co
tra
recognition
long-term
contracts
O
Origi
nal is
ssue discount
ou and oth
ed interes
Original
issue
other imputed
interest
IIncome
Incom
me sta
ate
gain
n ssale, exchange,
ha
statement
gain/loss on
aabandonment,
aband
donm
me t,, w
hlessness or other disposition
isposition of
worthlessness,
aassets
ssetss othe
h inventory and pass-through entities
other than
Gross capital gains from Schedule D, excluding amount
ties
from pass-through entities
om SSchedule
dule D
ng amo
un s
Gross capital losses from
D, exclud
excluding
amounts
d
d
from pass-through entities, abandonment
losses, and
worthless stock losses
Net gain/loss reported on Form 4797, line 17, excluding
amounts from pass-through entities, abandonment losses,
and worthless stock losses
Abandonment losses
Worthless stock losses
Other gain/loss on disposition of assets other
than inventory
Capital loss limitation and carryforward used
Other income (loss) items with differences
Total income (loss) items (combine lines 1-25)
Total expense/deduction items (Part III, line 36)
Other items with no differences
Sum lines 26 - 28 (mixed groups, see instructions)
PC insurance subgroup reconciliation totals
29 c
30
Life insurance subgroup reconciliation totas
Reconciliation totals (combine lines 29a - 29c)
23 a
23 b
23 c
23 d
23 e
23 f
44
(a)
(b)
(c)
(d)
Income (Loss)
per Income
Statement
Temporary
Difference
Permanent
Difference
Income
(Loss) per
Tax Return
200,000
220,000
(209,000)
(10,000)
9,000
215,000
0
(5,000)
60,000
(60,000)
(3,416,000)
(120,000)
210,000
0
20,000
235,000
225,000
210,000
(3,516,000)
235,000
(225,000)
305,000
305,000
yes
yes
(2,496,000)
(972,440)
4,975,000
1,506,560
(84,000)
9,540
24,000
519,740
(74,460)
543,740
(2,556,000)
(443,160)
4,975,000
1,975,840
1,506,560
(74,460)
543,740
1,975,840
December 2007
assets sold was $80,000 higher for tax purposes than
for book purposes. Schedule M-3, Part II reports the
book gains in item 23a(a), with an offsetting amount
in item 23a(b). Assuming that all the gain is ordinary,
US reports $305,000 on line 23d as a temporary
difference in column (b) and as income per the tax
return in column (d).
The bottom section of Schedule M-3, Part II
summarizes the amounts reported for US on this
US entered into a three-year lease on an unused
building in December. The lease period begins January, 2008. US received advance rental payments of
$235,000 at the signing of the lease, none of which
is included in 2007 book income. US reports this
item on Schedule M-3, Part II line 20 with $235,000
in columns (b) and (d).
Book income for US includes a $225,000 gain from
the sales of assets. Accumulated depreciation on the
Exhibit 4.
Line Description
1
2
3
4a
4b
5
6
2007 Form 1120—Form 8916-A, Part II
Interest Income
(a)
(b)
Income (Loss)
per Income
Temporary
Sch
Statement
Difference
Tax-exempt interest income
Interest income from hybrid securities
Sale/lease interest income
Intercompany interest income—from outside tax
affiliated group
Intercompany interest income—from tax affiliated group
Other interest income
Total interest income
5,000
210,000
215,000
(c)
(d)
Permanent
Difference
Income (Loss)
per Tax Return
(5,000)
0
(5,000)
210,000
210,000
Exhibit 5.
Line
Description
nee De
escription
p n
2007 Form 1120—Form 8916-A, Part I
Cost of Goods Sold
(a)
(b)
Income (Loss)
per Income
Temporary
Sch
Statement
Difference
1
2
2a
Amounts
Am
moun
nts aattributable to cost flow assumptions
Amounts attributable to:
Stock option expense
2b
2c
2d
2e
2f
2g
2h
2i
2j
2k
2l
2m
2n
3
4
5
6
7
8
Other equity based compensation
Meals and entertainment
Parachute payments
Compensation with section 162(m) limitation
Pension and profit sharing
Other post-retirement benefits
Deferred compensation
Section 198 environmental remediation costs
Amortization
Depletion
Depreciation
Corporate owned life insurance premiums
Other section 263A costs
Inventory shrinkage accruals
Excess inventory and obsolescence reserves
Lower of cost or market write-downs
Other items with differences
Other items with no differences
Total cost of goods sold
TAXES—THE TAX MAGAZINE
2,800,000
(c)
(d)
Permanent
Difference
Income (Loss)
per Tax Return
85,000
40,000
2,885,000
(20,000)
140,000
35,000
436,000
3,416,000
120,000
20,000
175,000
yes
(20,000)
436,000
3,516,000
45
Schedule M-3 Update for 2007
and other forms. First, line 26 totals the items
presented in Part II. Line 27 subtracts the total
expense/deduction items reported in Schedule
M-3, Part III. Line 28 reports the $4,975,000
net income or loss from items with no book/tax
differences. Finally, lines 29a and 30 report the
sum of lines 26 through 28. Column (a) of lines
29a and 30 reports book net income for US of
$1,506,560 (consistent with the consolidating
worksheet). Column (d) reports the taxable income
of $1,975,840 for US.
Two features of this section are noteworthy. First,
line 26 reports negative totals for income (loss) items,
although the firm has over $3 million of total income
on the consolidating worksheet. The negative total
occurs because line 17 reports total cost of goods
sold (if book/tax differences exist therein), while sales
are not separately reported in Part II unless book/tax
Exhibit 6.
2007 Form 1120—Schedule M-3, Part III
Expense/Deduction Items
Line Description
1
2
3
4
5
6
7
8
9
10
11
1
12
2
13
3
14
4
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
46
U.S. current income tax expense
U.S. deferred income tax expense
State and local current income tax expense
State and local deferred income tax expense
Foreign current income tax expense
(other than foreign withholding taxes)
Foreign deferred income tax expense
Foreign withholding taxes
Interest expense (from 8916-A)
Stock
expense
Sto
ock option
opt
o
Other
compensation
Otther equity-based
e
equity
yMeals
Me
eals and
a entertainment
eente
nt
Fines
Fin
nes and
an
nd penalties
peena
Judgments,
awards,
and similar costs
Jud
dgme
ents damages,
ents,
dam
d
aw
Parachute
Parachu
ute payments
p
pa
aymen
Compensation
with Code Sec. 162(m) limitation
Co
ompe
ensat
Pension and profit-sharing
Other post-retirement benefi
enefits
Deferred compensation
Charitable contribution of cash and tanible property
Charitable contribution of intangible property
Charitable contribution limitation/carryforward
Domestic production activities deduction
Current year acquisition or reorganization investment banking fees
Current year acquisition or reorganization legal and accounting fees
Current year acquisition/reorganization other costs
Amortization/impairment of goodwill
Amortization of acquisition, reorganization, and start-up costs
Other amortization or impairment write-offs
Code Sec. 198 environmental remediation costs
Depletion
Depreciation
Bad debt expense
Corporate owned life insurance premiums
Purchase vs. lease (for purchases and/or lessees)
Other expense/deduction items with differences
Total expense/deduction items (combine lines 1-35)
(a)
(b)
(c)
(d)
Income (Loss)
Income
per Income Temporary Permanent (Loss) per
Sch Statement
Difference Difference Tax Return
588,500
141,240
94,160
23,540
(588,500)
(141,240)
(6,000)
(23,540)
40,000
0
30,000
88,160
25,000
65,000
(15,000)
15,000
200,000
200,000
15,000
5,000
20,000
40,000
15,000
55,000
972,440
(9,540)
yes
(519,740)
443,160
December 2007
Exhibit 7.
2007 Form 1120—Form 8916-A, Part III
Interest Expense
(a)
Expense
per Income
Line Description
Sch Statement
1
Interest expense from hybrid securities
2
Lease/purchase interest expense
3 a Intercompany interest expense—paid to outside tax affiliated group
3 b Intercompany interest expense—paid to tax affiliated group
4
Other interest expense
40,000
5
Total interest expense
40,000
differences exist. In circumstances where significant
income items are the same for book and tax, negative
totals on line 26 will be common.
Second, the “no difference” total reported on line
28 likely combines a host of income and deduction
items. The firm may wish to prepare and retain a
worksheet which proves this “no difference” total.
Exhibit 8 provides such an example.
Schedule M-3, Part III
Exhibit 6 continues the example to Schedule M-3, Part
III, Expense/Deduction Items for US. Income tax expense
off $84
$847,440
se o
47,4 comprises U.S current income tax of
$588,500,
deferred income tax of $141,240, state
58
88 50
88,50
00 U.S.
00,
US d
and
local
nd
d loca
al current
cu
urren
nt income
i me tax of
o $94,160,
$94,16 , and state
sta and
local
deferred
income
M-3, Part
oca
al de
eferreed in
co tax
ax of $23,540.
,5 Schedule
edule M
IIII re
reports
eporrts these
theese amounts
aam
mou s in column
column (a) of
o lines 1 through
t
4. The
T U.S.
Th
U.S.
S income
iinco e tax
t items
ems appear
a ear as permanent differences iin column (c). State and local current income
tax of $6,000 is not deductible
year,
ucti e until next
n
year and
and is
is
reported in column (b) of line 3; the remainder
remainder appears
aappeea s
in column (d). The state and local deferred income tax
is reversed as a temporary difference in column (b).
Book interest expense of $40,000 does not include
$25,000 of tax interest deductions on hybrid securities.
Schedule M-3, Part III line 8 reports $40,000 in column
(a), a $25,000 permanent difference in column (c), and
$65,000 total deductions in column (d). Form 8916-A,
Part III (Exhibit 7) reveals on line 1 that the $25,000
book/tax difference relates to interest on hybrid securities; lines 2 through 4 provide other explanations for
book/tax differences in interest expense.
Book other expenses includes $30,000 of meal
and entertainment expenses which are 50 percent
deductible. Schedule M-3, Part III reports $30,000
book expense in column (a) of line 11, a negative
permanent difference of $15,000 in column (c), and
a deduction of $15,000 in column (d).
TAXES—THE TAX MAGAZINE
(b)
(c)
Temporary
Difference
0
(d)
Deduction
Permanent
per Tax
Difference
Return
25,000
25,000
0
0
0
40,000
25,000
65,000
Exhibit 8.
Proof of “No Difference” Total
Book
Income
Sales
Cost of goods sold
Gross profit
Service revenue
Interest income
Dividend income
Equity in earnings
of investees
Gain on sales
of assets
Other income
Total income
Compensation
Repairs and
maintenance
Bad debts
Interest
expense
nter st ex
pense
Charitable
Char
table
contributions
b
Depreciation
and amortization
Pension, etc.
Other expenses
Minority interest
in income
Total expenses
Income before
income taxes
Income tax expense
Net income
5,280,000
3,416,000
1,864,000
300,000
215,000
220,000
M-3
Sep line
M-3
Sep amt
Other
II 17
3,416,000
(3,416,000)
II 13
II 7
215,000
220,000
5,280,000
0
5,280,000
300,000
0
0
200,000
II 6
200,000
0
225,000
400,000
3,424,000
415,000
II 23
II 15
60,000
50,000
40,000
40,0
0
IIII 8
225,000
0
60,000 340,000
(2,496,000) 5,920,000
415,000
40,000
40,0
0
20,000
55,000
80,000
350,000
20,000
III 26,
31
55,000
III 11
30,000
0
80,000
320,000
125,000
945,000
1,070,000
2,354,000
847,440
1,506,560
60,000
50,000
0
III 1-4
(2,621,000) 4,975,000
847,440
0
(3,468,440) 4,975,000
US claims a $200,000 domestic production activities
deduction for tax purposes. Schedule M-3, Part III reports this amount on line 22 as a permanent difference
in column (c) and the deduction in column (d).
Book expenses include $15,000 impairment of
goodwill and $40,000 depreciation. Tax amor-
47
Schedule M-3 Update for 2007
tization of goodwill over 15 years is $20,000,
producing a $5,000 temporary difference for goodwill on Schedule M-3, Part III, line 26. Similarly,
tax depreciation of $55,000 produces a $15,000
temporary difference on line 31.
Comparison of Schedule M-3
for Other Entities
The general information required by Schedule M-3,
Part I for Forms 1065 and 1120S is quite similar to the
Form 1120 version, but there are two notable differences. First, the top of Schedule M-3 for Form 1065
requires the partnership to identify which filing criterion (see “Partnerships, too” earlier) led to completion
of the schedule. Second, the Form 1120S version omits
Form 10-K from the hierarchy for determining which
income statement to use as book income.
The detail of reconciling items required by Schedules M-3, Parts II and III for Forms 1120S and 1065
is quite similar to that of the schedule for Form
1120, but some differences exist. The flow-through
versions do not include the items not calculable at
the flow-through level; examples include capital
loss limitations, charitable contributions limitations,
and the dom
domestic
mes production activities deduction. In
addition,
the
ow-through versions do not include
dd
di i n, th
dition
h flow
he
items
tem
em
ms unique
u
uniqu
ue to
t C corporations.
orporations. Also,
Also, the taxable
ta
income
reconciled
and
corporanco
omee rec
conc
cile by
y partnerships
rs
nd S co
tions
on
ns includes
in
nclud
des separately
se
epa
p tely stated
stated items,
items, in addition
ad
to ordin
ordinary
income
page one of th
the ttax return.
dinary iinco
me from
m pag
Schedule
l M-3
M for partnerships reconciles to the net
income (loss) reported in “Analysis
An ysis of Net Income”
ncome on
n
page four of Form 1065; the schedule
hedu e for
fo S corporaco
orpor tions reconciles to the “Income/Loss Reconciliation”
amount on line 18 of Form 1120S, Schedule K. The
insurance company versions contain items unique
to the insurance industry; a complete discussion of
these items is beyond the scope of this article.
Schedule M-3 for Form 1120-F is quite different
from the other versions. First, the 1120-F version
is the only Schedule M-3 to list gross receipts as a
separate item on Part II, Income (Loss) Items. Also,
the 1120-F version does not require completion of
Form 8916-A for cost of goods sold, interest income,
and interest expense, but requires a schedule to be
attached for cost of goods sold. This version also
decomposes mark-to-market income into four components (Part II, line 14) and decomposes interest
expense into four components (Part II, line 26).
Conclusion
The ongoing expansion of the use of the Schedule
M-3 and related Forms 8916 and 8916-A supports
the IRS’s desire for increased transparency of return
filings so differences between financial accounting net
income and taxable income are more readily evident.
According to the IRS, the additional information, in
fact, provides about 20 percent of the on-site audit
work the IRS would otherwise have to perform, reducing the on-site audit time by as much as 20 percent.
The reduction supports the IRS’s goal of reducing the
time required to examine tax returns and being in a
position to examine the most recent tax returns.
As was the case with the initial Schedule M-3, tax
advisors will need to familiarize themselves with the
additional disclosures required as the IRS expands the
requirement for preparing the Schedule and its related
forms and the information requested. They will also
have to be prepared to advise client firms about effective
ecti e means to gather
ga he the
he required
equired
d information.
nformation.
ENDNOTES
DNOTES
1
2
Boynton, DeFilippes and Legel, A First Look at 2004 Schedule M-3
Reporting by Large Corporations, 112 TAX NOTES 11 (Sept. 11, 2006),
at 943–81.
Boynton and Wilson, A Review of Schedule M-3, the Internal Revenue
Service’s New Book-Tax Reconciliation Tool, 25 PETROLEUM ACCOUNTING
AND FINANCIAL MANAGEMENT J. 1 (Spring 2006), at 1–16.
This article is reprinted with the publisher’s permission from the
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48