on May 28, 2007.
Joann M. Weiner is a contributing editor for Tax Notes International.
This report discusses some of the flaws Weiner sees in the old book-tax income reconciliation form, Schedule M-1, and identifies, according to Weiner, the benefits provided in the new reconciliation form, Schedule M-3. She thinks the old reconciliation form requested only minimal information from companies to explain the differences between their income reported to shareholders and their income reported to the tax authorities. By contrast, she finds Schedule M-3 requests sufficient information to make an informed reconciliation.
More importantly, in Weiner's view, although the consolidated group for book purposes would only rarely include the same entities as the consolidated group for tax purposes, Schedule M-1 failed to reconcile the composition of the consolidated group. Thus, she finds that shareholders, researchers, and the tax authorities had no way to determine whether differences in the group or differences the book and tax treatment of various income and expense items that caused the gap in income reported to shareholders and income reported to the tax authorities. Short of conducting an on-site audit of the corporation's books and records, the IRS could not tell whether it was consolidation differences, accelerated tax depreciation, stock options, or income shifting that explained the $444 billion dollar difference between book and tax net income in 2003. Using Schedule M- 1 to reconcile book and tax income was like comparing apples to oranges. The two amounts were not comparable.
As the report argues that the real problem with the book-tax income gap was not that it existed but that no one really knew why it existed and why it was growing.
Following public outcry over the perceived abuses, the IRS introduced Schedule M-3 effective for tax years ending on or after December 31, 2004. New reconciliation form Schedule M-3 provides significantly more useful information than did the old Schedule M-1, according to Weiner. These improvements begin with a reconciliation of the consolidated group. She believes advance data from the new schedule reveal how flawed the old reconciliation schedule was. Schedule M-3 also identifies which differences are temporary, and will reverse over time, and which differences are permanent, and will never reverse. Weiner thinks the IRS will allocate resources and is more likely to investigate firms with large permanent differences than firms with large temporary differences.
The report concludes that making Schedule M-3 public would better inform shareholders and analysts than they are now. The report suggests that providing these details would be a reasonable compromise between making the full tax return public and providing no information.
Since well before the accounting scandals of the early 2000s, tax researchers have recognized that the information public corporations report to their shareholders does not always reflect the information reported to the tax authorities. Following a series of accounting and related tax controversies, researchers began bringing the implications of their findings to public attention. For example, speakers at an American Tax Policy Institute conference on the "Intersection of Financial Accounting and Tax Policy" pointed out that the story a company tells to the investment community regularly deviates from the story it tells to the tax collector. And no one knows which story, if either, is true.
To illustrate the problem, George Plesko of the University of Connecticut matched tax return data with financial statement data to determine how accurately he could estimate a firm's true tax position from publicly available information.1 Given the conflicting financial and tax reporting incentives, Plesko appeared skeptical that the financial and tax figures would tell the same story.
Table 1. Reconciling Book and Tax Net Income on Schedule M-1
of Form 1120, Selected Years, 1990-2003
1990 1992 1995 1998 1999 2000 2001 2002 2003
Pretax book $292 $247 $629 $817 $854 $784 $221 $348 $899
Tax net 271 292 515 532 535 518 270 259 455
Book income 21 -45 114 284 318 266 -49 89 444
Book income 108% 85% 122% 153% 159% 151% 82% 134% 196%
Numbers may not add to total due to rounding.
All corporations (excluding S, RIC, and REIT) filing U.S. returns.
Source: Boynton, DeFilippes, and Legel (2005, 2006a).
Table 2. Items on Schedule M-1 That Help Explain the Gap Between
Book and Tax Net Income, 1999
Amounts That Amounts That
Increase Book Decrease Book
Over Tax Income From Tax Income
Income for book, $523 Income for tax, -$405
not tax not book
Tax-exempt interest 23
Other income 95
Deductions for tax, 809 Expenses for book, -733
not book not tax
Depreciation 213 Depreciation -126
Travel and -10
Net increase in book 1,332 Net decrease in book -1,138
income, not tax income, not tax
Capital loss limit -22
Amount of gap M-1 172
All corporations (excluding S, RIC, and REIT) filing U.S. returns.
Source: Boynton, DeFilippes, and Legel (2005).
His research confirmed his skepticism.
Plesko found that reported financial information "does not allow a user to infer important information about a firm's tax attributes. Financial reports may provide accurate information about some firms' tax situation, but they do not provide statistically unbiased information about tax liabilities." Because firms have an incentive to maximize financial earnings and to minimize taxable income, many firms engage in activities designed solely to reduce their tax liabilities without leading to adverse financial reporting consequences.2
Some took the position that making tax returns public would help remedy the situation. Others, however, noted that public disclosure would be beneficial only if the tax return actually provided useful information. And, as they argued, the information firms provided on their tax returns was so inadequate that there would be little benefit to public disclosure.3
What We Knew Then
Beginning in 1964 the IRS required corporations to reconcile their book and tax income as part of their annual federal income tax return via Schedule M-1 of Form 1120. For the next 40 years, Schedule M-1 was the only place on the tax form where corporations identified transactions that created differences in book and tax net income. (IRS examiners have always been able to examine the supporting documentation for amounts listed on the M-1, but those amounts were not standardized, were not available electronically, and in many cases, were available only during on-site physical audits.)
The reconciliation was relatively simple. Corporations reported their net income or loss per books (after tax) as reported to their shareholders on line 1 of Schedule M-1. Ten lines later, the corporation reported a figure that represented its tax net income reported to the IRS on line 28 of Form 1120 (net income before net operating losses). In between, corporations identified income and expense amounts that reconciled the difference between book and tax net income.4
The difference between pretax net income per books (line 1 plus line 2 of the M-1) and tax net income (line 10) represents the pretax book-tax income gap.5 The gap itself does not necessarily reflect improper activity by firms. The treatment of many income and expense items under the accounting rules and the tax rules differ for many legitimate reasons.
Moreover, although book income is usually greater than tax net income, it is not always that way. If corporations report larger losses to shareholders than to the tax authorities, as occurred in 1992 and in 2001, taxable income will exceed book income. This situation can arise, for example, if capital losses exceed capital gains on the sale of capital assets (such as securities); for book purposes, corporations may deduct those losses in full during the year in which the loss occurs but may not deduct them for tax purposes in the current year.6
Table 1 on the previous page provides some details. For example, in 1990, U.S. corporations reported 8 percent more book income than taxable income. By 2000, corporations reported 50 percent more income on their books than on their tax returns, and in 2003, book income was nearly twice as high as tax income.
As shown in the chart on the next page, the gap has generally grown over time. For example, in 1990 the gap between book and tax income was $21 billion ($292 billion in book income versus $271 billion in tax net income). In 2003 the gap was $444 billion ($899 billion in book income versus $455 billion in tax net income).
As helpful as the M-1 was in identifying the gap, the minimal data provided on the M-1 also illustrated its deficiencies in understanding the causes of the gap. Table 2 on the previous page shows that Schedule M-1 provided few details on amounts that explained the gap between book and tax income.
The left-hand column of Table 2 on the previous page shows amounts that caused book income to be greater than tax income and the right-hand column identifies amounts that caused book income to be lower than tax income. For example, in 1999 corporations included in book income $523 billion in income, such as tax-exempt interest, that is not considered income for tax purposes. Corporations also claimed $809 billion in tax deductions that were not considered expenses for book purposes.
Likewise, the right-hand column of Table 2 shows that corporations included in tax income $405 billion that is not considered income for book purposes and $733 billion of book expenses that are not deductible for tax purposes.
On balance, corporations reported $1,332 billion in amounts that increased book income over tax income and $1,138 billon in amounts that reduced book income below tax income. On net, Schedule M-1 "explained" only $172 billion of the $318 billion difference between pretax book income and tax net income.
The lack of detail on the composition of the gap was not the only problem with the old Schedule M-1. Two other fundamental problems existed. First, the schedule provided no information regarding whether the differences were permanent or temporary. Since temporary differences would eventually reverse while permanent differences would not, policymakers would be more interested in the permanent differences than in temporary differences. Schedule M-1 provided no guidance in that area.
Difference Between Pretax Book Income and Tax Net Income
Reported on Schedule M-1
Source: Boynton, DeFilippes, and Legel (2005, 2006a).
More importantly, the book-tax income reconciliation schedule did not start from the same consolidated group for tax purposes. Thus, it was impossible to identify which elements of the book-tax differences were caused by differences in the accounting and the tax rules and which elements were caused by differences in the composition of the consolidated group. Schedule M-1 was effectively trying to reconcile the differences between an apple and an orange.
What We Knew We Didn't Know
This is not the first time the book-tax income gap has taken center stage. In earlier years, however, Congress specifically designed the tax policy changes and knew that the differences in tax and accounting rules would create a book-tax gap. For example, in the early 1980s Congress introduced accelerated depreciation rules to spur additional business fixed investment during the economic slowdown. In some cases, those tax allowances were so large that many companies had negative income for tax purposes after taking depreciation and other tax preferences into account. Simultaneously, because financial reporting rules followed straight-line depreciation, book depreciation expenses were much lower than the tax deductions and those firms reported positive book income.
Although the gap had legitimate policy justifications, this situation inspired Robert McIntyre, now with Citizens for Tax Justice (CTJ), to investigate how those tax preferences affected the taxable income of major U.S. corporations. By scrutinizing the footnotes to their financial statements, he found that many corporations were entitled to, and therefore claimed, significant tax deductions that they were not required to reflect in book income. The outcry over the finding that U.S. corporations could earn billions of dollars and pay little or no federal income tax played a part in the debates preceding the Tax Reform Act of 1986 (TRA 86) that scaled back or eliminated many of the most generous corporate tax preferences.7
In the late 1990s and early 2000s, attention shifted toward other causes of the book-tax income gap. The sharp rise in the stock market, especially in the high-technology sector, led many firms to compensate their employees with stock options rather than with a traditional salary. Differences in the tax and financial treatment of stock-based executive compensation reinforced that trend. Corporations could deduct stock option compensation as an expense when employees exercised their options (individuals included those amounts as taxable income), but the accounting rules did not require corporations to treat those same amounts as expenses for book purposes. That "permanent" difference in the book and tax treatment of stock-based compensation was one cause of the growing book-tax income gap.
CTJ again provided some of the first estimates on the scale of the "problem." In October 2000 CTJ estimated that 233 of 250 firms studied received a total of $25.8 billion in stock-option-based tax benefits from 1996 to 1998. A follow-up report four years later found that 270 major companies claimed roughly $32 billion in stock option tax benefits from 2001 to 2003.8 Although the $71 billion in possible tax savings obtained from accelerated depreciation dwarfed the $32 billion in tax benefits from stock options for those three years, the stock option tax benefit appeared to explain some of the gap.9
Moreover, unlike accelerated depreciation, which Congress designed to stimulate additional business investment, the preference for stock options lacked a sound policy rationale. Congress probably had not imposed the section 162(m) cap on deductions for stock-based compensation to encourage companies to switch to stock-based compensation.
A growing public interest in understanding how corporations are legally able to report significant profits for financial purposes while reporting significantly lower income for tax purposes is one of the most important fallouts from the collapse of Enron in late 2001. For example, the Joint Committee on Taxation reported that Enron artificially created more than $12 billion in financial income.10 Most analysts would give a company with $12 billion in profits a clean bill of health.
As is now known, however, Enron was far from healthy -- it was on its deathbed. The catastrophe drew public attention that continues to extend well beyond the tax community. Writing in The New Yorker earlier this year, Malcolm Gladwell explained that if analysts had been able to examine Enron's tax accounts, they would have seen a very different picture of the firm's financial condition than what Enron presented to shareholders. While reporting sizable profits, Enron paid no tax in four of its last five years of existence because, from the IRS's point of view, the firm did not have any taxable income. However, since firms do not disclose their tax returns, only those with legal access to tax returns could see the wide differences between publicly reported book income and privately reported taxable income.
Unfortunately, as Plesko and others have documented, the tax return did not provide much help in understanding why the aggregate book-tax income gap existed. Form 1120 and Schedule M-1 provided tax authorities few clues on why a corporation's taxable income was often so much lower than its financial income.
Thus, the real problem with the book-tax income gap was not that it existed but that no one really knew why it existed and why it was growing. Did it exist merely because of temporary divergences in the book and tax treatment of items, such as capital depreciation, and thus not pose much of a problem? Was it growing because of an increased amount of income shifting, such as through tax shelters, thus posing a real problem in terms of a permanent corporate tax base erosion?
As many tax experts began to argue, it was time for the IRS to demand greater information from U.S. corporations on their tax avoidance and potential tax shelter activities.11 To obtain greater disclosure, the IRS reworked its reconciliation schedule so that it would provide more details about the causes of the gap and whether the gap was caused by temporary or permanent differences in book and tax income.
What We Know Now: Schedule M-3
In January 2004 the IRS proposed a new reconciliation form, Schedule M-3, that for the first time allows the tax authorities to identify the causes of the book-tax-income gap.12 Advance data from Schedule M-3 presented by Charles Boynton, Portia DeFilippes, and Ellen Legel of the IRS and Treasury's Office of Tax Analysis are revealing a very interesting story.13
Table 3. Reconciling the Entities Included in the
Consolidated Book and in the Tax Group
Consolidated for generally
accepted accounting principles
(books) Consolidated for tax
Parent company Parent company
Plus 100% income earned by domestic Plus 100% income earned by domestic
subsidiaries more than 80% owned subsidiaries more than 80% owned
Plus 100% income of all other
domestic or foreign subsidiaries
more than 50% owned
Less share of income attributable
to minority interest in the
Plus share of income attributable to
equity interest in corporations owned
20% or more but 50% or less
Exclude income or loss from special Include income or loss from special
purpose entities that meet strict purposes entities structured as
ownership tests above but can be partnerships for tax purposes under
excluded under special rules the check-the-box regulations
Less income or expenses from Less income or expenses from
intercompany transactions with intercompany transactions with
entities included above entities included above
Plus pretax dividends (actual and
deemed) from entities not included
above (e.g., dividends from foreign
or less than 80% owned domestic
= Book income for entities = Book income for entities
included in the consolidated included in the consolidated
financial statements tax return
Notes: Affiliated groups may elect to file a single consolidated tax
return. Consolidation of the parent corporation and majorityowned
domestic and foreign subsidiaries is mandatory for financial purposes.
Source: Table on p. 870 of Mills and Plesko (2003).
The newborn Schedule M-3 makes several improvements over the middle-aged Schedule M-1. (For Schedule M-1, which is included in Form 1120, and Schedule M-3, see Appendix, p. 858.) Beginning with the first line in Part I and ending two pages and more than 80 lines later with line 38 in Part III, Schedule M-3 provides an unprecedented amount of information regarding the differences between a corporation's financial earnings and its taxable income. By contrast, Schedule M-1 provided only about a dozen lines of information in a two-inch box underneath Schedule L. If the IRS wished to know more about those items, it had to send auditors to the company to review the physical records or pore through potentially thousands of pages of attachments, none of which was in standardized form or available electronically.14
Schedule M-3 contains three parts:
- Part I, Financial Information and Net Income (Loss) Reconciliation;
- Part II, Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations With Taxable Income per Return; and
- Part III, Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations With Taxable Income per Return --- Expense/Deduction Items.
If the parent corporation of a U.S. consolidated tax group files Form 1120 and Schedule M-3, all members of the group must file Schedule M-3.
Comparing Apples to Apples
Table 3 above, from Mills and Plesko (2003), shows the main differences between the consolidated group for book and for tax purposes. Since the consolidated groups for tax purposes and for financial purposes are rarely identical, the corporation must adjust its income for amounts attributable to these operations. Any attempt to reconcile book and tax income that did not begin by reconciling the consolidated group would be inaccurate.
There is only one case in which the two groups are identical: when a purely domestic company owns 100 percent of its U.S. subsidiaries and files a consolidated tax return. That situation describes a small fraction of the U.S. corporate community and excludes all multinational corporations.
In Part I, a corporation reconciles worldwide financial income with U.S. consolidated book income by first identifying the source of the income, for example, from Form 10-K or audited statements. It then constructs a consolidated financial group that is equivalent to the consolidated taxable group and adjusts net income for transactions between includible and nonincludible entities.
The final line in Part I shows net income for book purposes for all corporations (those listed on Form 851) and included in the consolidated U.S. federal income tax return for the tax year. That amount is the new starting point for reconciling book and tax income.
As the instructions explain, a principal purpose of Schedule M-3 is to report the financial accounting net income of only the corporations included in the consolidated U.S. federal income tax return. Schedule M-1 did not make that reconciliation between the book and taxable group.
Table 4 on the next page shows that consolidation differences explain many of the differences between book and tax income. Those figures include $204 billion in losses from nonincludible foreign entities (the net of $310 billion in losses and $106 billion in income) and $86 billion in losses from nonincludible domestic entities (the net of $132 billion in losses and $46 billion in income).
Table 4 also shows that after adjusting for the different consolidation rules for financial and tax purposes, pretax net income for financial statement (book) purposes is $707 billion compared with $575 billion in net tax income. Net tax income is 81 percent of pretax net book income, with 62 percent ($82 billion) of the difference being temporary and 38 percent ($50 billion) being permanent.
Tax Minimization and Tax Sheltering
Not only were companies' financial statements inadequate for determining the tax position, but their tax returns also failed to provide the information needed to determine why the financial and tax positions differed by such large amounts and whether those differences were important.
To make that determination, it helps to divide the differences between those that are temporary and those that are permanent. Temporary differences reflect the fact that the tax and financial reporting each recognize the same total amount, but may do so in different periods or in different amounts during the same period. Permanent differences occur when one system recognizes an item as an income or expense but the other system does not.
Table 4. Financial Information and Net Income (Loss)
Reconciliation of Consolidated Group Calculated on
Part I of Schedule M-3, Tax Year 2004
Worldwide consolidated net income (loss) $568,010
Income (loss) from nonincludible foreign entities -$204,469
Income (loss) from nonincludible U.S. entities -86,534
Income (loss) from other includible corporations 3,785
Adjust consolidation eliminations 184,101
Net adjustments due to entity differences -103,117
Adjusted entity net income 464,893
Miscellaneous adjustments 50,530
Net income per income statement of includible 515,423
Net income reported on M3, Part II, line 30(a) 515,422
Federal tax expense 191,670
Pretax book income 707,092
Temporary differences before federal tax expense -81,587
Permanent difference before federal tax expense -50,131
Net tax income from Part II, line 30, column D 575,375
Notes: These data reflect Forms 1120 corporate tax return data for Dec.
2004 through June 2005 from the 2004 Statistics of Income advance corporate
file. The authors identify 30,430 returns that pass a reconciliation test.
These values may differ from the final file and from official Statistics of
Income values reported in Publication 16.
Source: "Table 7. Aggregate Schedule M-3 Data for U.S. Corporations
With Reconcilable Data," in Boynton, DeFilippes, and Legel (2006b).
It matters to the IRS whether a difference is temporary or permanent. Temporary differences represent timing differences, for example, when companies apply accelerated depreciation rules for tax purposes and straight-line depreciation rules for financial purposes. Because those totals eventually reach the same amount, they pose a low risk for the tax authorities. By contrast, permanent differences reflect fundamental differences in how an amount of income or expense is treated and thus pose a high risk for tax authorities.
Under the temporary-permanent difference delineation, the growth in the book-tax income gap may reflect greater use of corporate tax shelters, as the Treasury Department considered in its tax shelter report.15 Even Treasury, however, did not know whether that was the case. It simply did not have the information necessary to evaluate the gap.
Schedule M-3 largely remedies the situation with the details provided for two dozen income items and roughly three dozen expense items. Table 5 on the next page summarizes some of those items.
Stock Options: A Big Part of the Story
It should come as no surprise that stock options play a major role in this story.16
When employees exercise their stock options, corporations may deduct those amounts as stock-based compensation, but until recently, corporations did not have to expense those amounts on their financial statements. Thus, reported earnings for companies that used stock options as a form of compensation would, all else being equal, exceed their taxable income. However, no one could provide details on the size of the difference because no further details were available.
Table 5. Selected Pretax Income and Expense Items
Reported on Schedule M-3, Preliminary Data for All Corporations
(Excluding S, RIC, and REIT) Filing U.S. Returns, Tax Year 2004,
Part II. Selected Income Items
Subpart F, QEF, and similar transactions $8,550 $15,550
Section 78 gross-up 925 26,003
Items related to reportable transactions -35,650 -9,186
Interest income -3,047 -12,006
Inventory valuation adjustment 46,850 -1,239
Book disposition of assets other than inventory -47,936 -7,665
Sale versus lease (for sellers and/or lessors) 31,073 -1,750
Subtotal (includes amounts not listed above) 6,757 -52,668
Part III. Selected Expense items
Foreign current income tax expense (not 620 14,968
Nonqualified stock options -1,692 -38,738
Meals and entertainment 17 5,637
Pension and profit-sharing -16,505 -1,466
Amortization/impairment of goodwill -11,107 9,179
Depreciation -113,162 384
Subtotal (includes amounts not listed above) -80,837 186,738
Reconciliation totals (includes amounts not -74,502 134,454
Reverse federal income tax expense -7,085 -184,585
Pretax book income and M-3 differences -81,587 -50,131
Source: Boynton, DeFilippes, and Legel (2006b).
The best that research analysts could do was to examine the minimal information relating to stock options that companies reported in their publicly available financial statements.
Companies have sharply increased their use of stock options as a form of employee compensation over the past 20 years. For example, exercised stock options made up 73 percent of total compensation of a typical CEO in 2005 ($5,180,820 out of $7,127,200 total) compared with just 42 percent in 1994 ($682,580 out of $1,644,190 total).17
New Schedule M-3 provides concrete evidence that differences in the accounting and tax treatment of stock option compensation expenses explain a great deal of the differences in book and taxable income. In 2004, nonqualified stock options accounted for $40.4 billion of the total difference between financial and tax expenses. Incentive stock options accounted for another $6.3 billion, and other equity-based compensation for $2.8 billion. In total, those three forms of equity-based compensation reduced tax net income by nearly $50 billion while having minimal impact on book income. Stock options and other equity-based compensation accounted for roughly 30 percent of the permanent reduction in tax income from book income.18
Schedule M-3 also shows the sharp contrast between the book treatment and the tax treatment of stock option compensation. Companies reported just under $2 billion of temporary nonqualified stock option expenses compared with more than $38 billion in permanent deductions for stock options. Until Schedule M-3 came into effect, only the companies claiming these deductions had this information. Going forward, however, the gap will narrow significantly since the financial reporting rules now require companies to report a nonzero value for their stock-based compensation expenses.19
Do We Need to Know More?
In light of the growing book-tax gap, many analysts have suggested ways to address the book-tax income gap, either by requiring companies to base their tax on book income or by requiring companies to use taxable income as their book income. The House Ways and Means Committee examined those issues at a hearing in May 2006 at which experts testified on tax reform and the possibility of requiring book-tax conformity.20 Evidence presented at the hearing was mixed.
Recently, John McClelland of Treasury's Office of Tax Analysis and Lillian Mills of the University of Texas, a former researcher with OTA, analyzed the benefits and risks of taxing book income.21 Overall, they concluded that the costs of taxing book income outweigh its benefits. Significant changes to tax depreciation rules and to financial reporting requirements (through the Sarbanes-Oxley Act, and the Securities and Exchange Commission enforcement initiatives, new rules in FIN 48 governing accounting for uncertain tax positions, among others) and in accounting regulations that restrict managers' ability to inflate financial earnings should narrow the book-tax income gap over time.
Others have suggested that making tax returns public could solve the "problem" of the book-tax income gap. Although there are arguments in favor of making tax returns public, a full disclosure does not appear to be necessary. The public can understand a company's true financial position if companies disclose certain information from their tax returns. In fact, improving the transparency and information provided to the public is an important purpose of the revised Schedule M-3 reconciliation form.
The Story Continues
It is widely known that financial statements do not always reflect a company's true financial position. As long as companies can legitimately report one figure for financial purposes and another figure for tax purposes and keep the reasons for the differences secret, companies will have an incentive to maintain artificially high financial earnings and artificially low taxable income.
Many of the differences between book and taxable income have legitimate purposes. Congress, for example, often chooses to encourage additional investment by providing tax incentives to capital spending. The interest earned on state and local bonds is tax-exempt at the federal level.
However, some of the differences between book and tax practices do not appear to be as justified. The treatment of nonqualified stock options provides a good example. Until recently, companies could issue stock options as a form of compensation and take a tax deduction for that compensation but report nothing in compensation expense on financial statements.
The SEC dealt with the financial earnings issue by significantly reducing the amount of time granted to companies to report stock option grants. The committee that sets the financial rules also now requires corporations to account specifically for the value of stock option compensation in their earnings.
The IRS dealt with the taxable income issue by modifying the schedule on which companies reconcile the differences between their book and taxable income. With the new schedule, the IRS is now able to determine why book income differs from taxable income and to explore reasons for those differences, as necessary.
Schedule M-3 requires corporations to identify whether the difference in financial and tax reporting is temporary or permanent. Since permanent differences may reflect tax sheltering activities, that data will help the IRS enforce the tax laws while continuing to allow corporations to benefit from tax incentives provided through the tax code.
Another useful step would be to allow private researchers access to Schedule M-3 data. There is no need to disclose a company's entire tax return, but most tax and financial analysts would welcome access to the reconciliation data presented on Schedule M-3. Making Schedule M-3 public seems a reasonable compromise between continuing the current situation, in which only selected analysts have access to a corporation's true tax position, and the situation in which a corporation's competitors have full access to its tax position.
1 George A. Plesko, "Estimates of the Magnitude of Financial and Tax Reporting Conflicts," paper presented to the American Tax Policy Institute (ATPI) conference on "The Intersection of Financial Accounting and Tax Policy," Washington, Dec. 6, 2006.
2 See Gil B. Manzon and George A. Plesko, "The Relation Between Financial and Tax Reporting Measures of Income," 55 Tax Law Review 175-214 (2002).
3 For example, John Graham and Lillian Mills indicate that "one potential deficiency of almost all tax rates used by researchers to date is that they are calculated using data from financial statements." See "Using Tax Return Data to Simulate Corporate Marginal Tax Rates," Nov. 17, 2006, paper presented at the ATPI conference on Dec. 6, 2006. See also Michelle Hanlon, "What Can We Infer About a Firm's Taxable Income From Its Financial Statements?" 56(4) National Tax Journal 831-863 (Dec. 2003).
4 See Charles Boynton, Portia DeFilippes, and Ellen Legel, "Prelude to Schedule M-3: Schedule M-1 Corporate Book-Tax Difference Data 1990-2003," Tax Notes, Dec. 19, 2005, p. 1579; and Charles Boynton, Portia DeFilippes, and Ellen Legel, "Distribution of Schedule M-1 Corporate Book-Tax Difference Data 1990-2003 for Three Large-Size and Three Industry Groups," Tax Notes, Apr. 10, 2006, p. 177 (2006a). These are the most recent years for which data are available. Tax data are obtained from Schedule M-1 of Form 1120. These data are not available to the public and may be revised before final publication.
5 Line 10 of Schedule M-1 equals taxable income before net operating loss deductions and special deductions reported on line 28 of Form 1120, "U.S. Corporate Income Tax Return."
6 For a discussion of these data, see George Plesko and Nina Shumofsky, "Reconciling Corporation Book and Tax Net Income, Tax Years 1995-2001," SOI Bulletin, Winter 2004-2005.
7 For a lively analysis of the events leading up to TRA 86 and its eventual passage, see Jeffrey H. Birnbaum and Alan S. Murray, Showdown at Gucci Gulch (Random House 1987). The authors credit McIntyre with igniting a firestorm over corporate taxes when he identified 128 profitable companies that paid no federal income taxes at some time from 1981 to 1983 (see pp. 11-13).
8 See Robert S. McIntyre and T.D. Coo Nguyen, "Corporate Income Taxes in the Bush Years," Citizens for Tax Justice and Institute on Taxation and Economic Policy, Sept. 2004.
9 It is important to note, however, that those figures do not represent actual tax savings. Corporations were required to include half of the difference between the book-tax income as a preference item for the corporate AMT. Moreover, the estimated tax benefits reported by CTJ are based on assumptions regarding the value of stock options that may not have been realized.
10 Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Mar. 2003.
11 See the papers presented at the 2002 IRS Research Conference and the papers published in the Dec. 2003 issue of the National Tax Journal.
12 The form is required for tax years ending on or after Dec. 31, 2004, for corporations with more than $10 million in total assets. Charles Boynton and Lillian Mills describe the development of Schedule M-3 in "The Evolving Schedule M-3: A New Era of Corporate Show and Tell?" National Tax Journal, Sept. 2004. See also Lillian Mills and George A. Plesko, "Bridging the Gap: A Proposal for More Informative Reconciling of Book and Tax Income," 56(4) National Tax Journal 865-893 (Dec. 2003), for the proposed redesign of Schedule M-1.
13 See Charles Boynton, Portia DeFilippes, and Ellen Legel, "A First Look at 2004 Schedule M-3 Reporting by Large Corporations," Tax Notes, Sept. 11, 2006, p. 943 (2006b). Those tax return data are from the advance corporate file, include data from tax years ending between July 2004 and June 2005, and are available to the Office of Tax Analysis and the JCT. Data in the study cover 30,430 tax returns that have reconcilable Schedule M-3 data. Companies were not required to provide details on temporary and permanent differences, and 38 percent of companies chose not to provide those details.
14 The IRS expects Schedule M-3 to reduce by 20 percent the amount of time it spends on onsite audits and reduce to two years the nearly six-year lag between when it receives a tax return and when it performs an audit.
15 See Department of the Treasury, "The Problem of Corporate Tax Shelters: Discussion, Analysis and Legislative Proposals," July 1999, and subsequent testimony by Assistant Secretary for Tax Policy Jonathan Talisman, "Penalty and Interest Provisions, Corporate Tax Shelters," before the Senate Finance Committee, Mar. 8, 2000, Tax Notes Today.
16 For a discussion, see Joann M. Weiner, "Taxing Stock Options Is an Option," Tax Notes, Apr. 2, 2007, p. 53.
17 See testimony of Steven Balsam, professor of accounting, Temple University, Fox School of Business, before the Senate Finance Committee, Sept. 6, 2006.
18 See Table 7 of Boynton, DeFilippes, and Legel (2006b).
19 Hanlon and Shevlin noted that if the accounting rules required expensing of options, which they now do, "what has been an unbooked book-tax difference ('permanent difference') becomes a run-of-the-mill temporary difference subject to SFAS 109's deferred tax treatment." See Michelle Hanlon and Terry Shevlin, "Accounting for Tax Benefits of Employee Stock Options and Implications for Research," Accounting Horizons, Mar. 2002, pp. 1-16.
20 See "A Tune-Up on Corporate Tax Issues: What Is Going on Under the Hood?" Senate Finance Committee, June 13, 2006, and House Ways and Means Committee, May 9, 2006.
21 See John McClelland and Lillian Mills, "Weighing Benefits and Risks of Taxing Book Income," Tax Notes, Feb. 19, 2007, p. 779.
END OF FOOTNOTES
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