Permanent and Temporary Differences between Book Income and Taxable Income for Partnerships and Corporations
The rules governing tax accounting are much the same as cash accounting, in that income becomes recognized as taxable when it is received and expenses do not become deductible until they are actually paid. Furthermore, there are some types of income that are not recognized for tax purposes, such as the interest earned from municipal bonds or the dividends received by corporations. Moreover, some items are not deductible at all, such as fines or political lobbying. Nonetheless, to represent the true financial status of the company, a business must record all forms of income whether recognized as taxable or not and it must deduct all expenses, whether they are deductible or not.
Because of the differences between financial accounting and tax accounting, differences arise between booking income and taxable income. Some of these differences are permanent while others are temporary. Permanent differences occur only for the tax year in which they occur. Temporary differences occur over several years, ending when the differences reverse. Forms of income that lead to permanent differences include:
- interest earned from tax-exempt bonds;
- nontaxable life insurance proceeds on key employees;
- dividends received from other corporations that qualify for the dividends received deduction.
Nondeductible items that lead to permanent differences between book and taxable income include:
- 50% of business meals and entertainment;
- expenses related to tax exempt income;
- bribes, kickbacks, and other illegal payments;
- lobbying and other political expenses;
- premiums paid on life insurance policies for key people.
So if a corporation pays a $10,000 fine, then that must be recorded as an expense since it must be paid, but it is never deductible, so it leads to a permanent difference between book and taxable income.
A common temporary difference occurs for nonqualified deferred compensation for key employees. Some businesses set aside some compensation in a retirement plan for key employees that does not satisfy ERISA requirements. This compensation must be treated as an expense because the business is legally obligated to pay it, but IRC §§ 83(h) and 404(a)(5) only allow a deduction when the employee receives the compensation, which may be many years later.
Temporary differences also arise because, in financial accounting, income is not recognized until it is earned, whereas for taxes, income is recognized when it is received. So if a business receives $20,000 for an office rental from July 1, 2018 to June 30, 2019, then the business would record $10,000 of that income for 2018 and the remaining $10,000 for 2019. However, the business must include the entire $20,000 in its taxable income for 2018. Hence, taxable income would be $10,000 greater than book income in 2018. However, in 2019, the difference reverses, because book income will be $10,000 greater than taxable income since the taxes due on the $10,000 recorded for 2019 have already been paid.
Accrued liabilities are one of the main reasons why book income and taxable income often differ. According to the rules of Generally Accepted Accounting Principles (GAAP), an expense must be recorded at the earliest time possible when the liability for the expense is incurred and when the dollar amount can be reasonably ascertained. However, for tax purposes, an expense is not deductible until the 3 requirements of what is known as the all-events test are satisfied:
- the events that establish the liability must have occurred;
- the amount of the expense can be ascertained with reasonable accuracy; and
- economic performance associated with the liability has been completed.
Economic performance refers to either so-called payment liabilities, where the economic performance is the actual payment for the liability, or the fulfillment of a contractual obligation to provide services or property to another party. So if a business runs a contest in which there is a guaranteed winner of $100,000, then the business must set aside $100,000 as an expense item when it becomes fully committed to running the contest, but the expense is not deductible until the award is paid.
However, there is an exception provided for businesses where the accrual of liabilities occurs routinely. IRC §461(h)(3) allows a business to deduct the expense of the accrued liability if the 1st 2 requirements of the all-events test are satisfied and economic performance occurs within 8½ months after the end of the tax year. In such a case, the business can deduct the accrued liability in the tax year in which it is recorded.
Other differences between financial and tax accounting result because of different rules affecting the capitalization of certain business expenditures, such as start up costs and inventory costs. Other differences arise because of different rates of depreciation, amortization, or depletion for some assets. For instance, if a business uses §179 expensing, then it can deduct the whole cost of an asset when it is acquired. However, because it's actual useful life is longer than 1 year, financial accounting would depreciate the item according to its expected useful life. For many businesses that carry an inventory, a recurring source of differences results from uniform capitalization rules, which require that many expenses that are incurred to produce or acquire property for resale must be capitalized rather than expensed, such as the administrative costs allocable to the production or acquisition of inventory.
Schedule M-1 Reconciliation
The differences between book and taxable income are reconciled in Schedule M-1 of Form 1120, U.S. Corporation Income Tax Return, 1120S, U.S. Income Tax Return for an S Corporation, and 1065, U.S. Return of Partnership Income. Unfavorable M-1 adjustments increase taxable income, whereas favorable M-1 adjustments decrease taxable income from book income.
Financial Accounting for Income Taxes
Because financial accounting represents the true financial picture of the business, there must be some way of recognizing tax benefits and liabilities that will occur in a future year because of accounting entries in the present tax year, because benefits must be recorded when the right to the benefit occurs even if it is not received and expenses must be recorded when the liability arises even if the expense is paid in a later year. Temporary differences between book and taxable income give rise to accrued tax benefits and liabilities. Because permanent differences only affect the current tax year, tax assets or liabilities arising from permanent differences do not accrue. The deferred tax asset account and the deferred tax liability account are the accounts used in financial accounting to record accrued tax assets or liabilities.
A deferred tax asset is the payment of tax on taxable income that exceeds book income because of temporary differences for the tax year. So if temporary differences cause taxable income to be $10,000 greater than book income for a given tax year, then the business will be able to deduct that $10,000 in a later tax year, since the tax has already been paid on the amount. Thus, a deferred tax asset is much like the overpayment of tax that the business will recoup in a later year. A deferred tax liability arises when book income exceeds taxable income because of temporary differences, in which case the business must pay tax on the difference in incomes in a later tax year. Hence, a deferred tax liability is much like an underpayment of tax that will payable in a future year. Increases in deferred tax assets decrease the corporation's future tax liability, whereas deferred tax liabilities increases it.