Schedule M-3: closing the corporate book-tax gap.

• Author: McGowan, John R.

EXECUTIVE SUMMARY

* Schedule M-3 was developed in response to concern over differences between book and taxable income, declines in corporate tax revenues and dissatisfaction with Schedule M-1.

* The additional information requirements will increase the compliance burden for both taxpayers and practitioners.

* Filing Schedule M-3 will satisfy tax shelter disclosure requirements for transactions with a significant book-tax difference.

For tax years ending after 2004, corporations with at least $10 million in assets must file Schedule M-3. This article offers an in-depth, line-by-line look at the new form and discusses the IRS's goals and reasons behind it.

In 2004, Treasury and the IRS released the final draft of Form 1120, U.S. Corporation Income Tax Return, Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More; see the exhibit starting on p. 410. Schedule M-3 replaces Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, for taxpayers meeting the dollar threshold. Taxpayers below the cut-off will continue to file Schedule M-1.

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In general, Schedule M-3's chief goal is to increase reporting transparency, while minimizing taxpayer burden. (1) According to Robert Adams, the IRS's Senior Industry Advisor for the Large and Midsized Business Division, "it is estimated that the M-3 should reveal between 75 to 90 percent of the book-tax difference for most companies." The new form should also reduce the time the IRS spends on examining returns, and will allow it to examine the most recently filed returns. Schedule M-3 will identify book-tax differences that matter most when auditing corporate returns.

Certain taxpayers engaging in abusive transactions have benefited from the difference in the rules between financial (book) accounting and tax accounting by claiming tax benefits that have no corresponding financial cost. (2) According to Treasury's Acting Assistant Secretary for Tax Policy, Greg Jenner, "Schedule M-3 will enable the IRS to identify quickly those differences that warrant additional scrutiny."

Another goal of Schedule M-3 is consistent reporting among taxpayers from year to year. Finally, the schedule will be revised periodically to highlight emerging issues, identify trends and adapt to future changes encountered by large and mid-sized businesses.

Reasons for Schedule M-3

Schedule M-3 is replacing Schedule M-1 because of the ever-increasing expansion of the book-tax income gap, a decline in the corporate tax base, an increasing compliance burden on an already overwhelmed IRS and general dissatisfaction with Schedule M-1. (3)

Book and Tax Differences

Differences between book and tax accounting have become a major concern of the IRS. According to a recent IRS Research Bulletin, the aggregate gap between book income and taxable differences continues to generate a sizeable gap in net income per books and net taxable income. (4)

Corporate Tax Revenue

A decline in corporate tax revenue is another motive pushing Treasury and the IRS to close the tax gap. While the number of U.S. tax returns filed and total tax revenues have grown steadily over the past 30 years, corporate tax revenue has remained flat. Some of this decrease can be attributed to changes in tax rates due to the Tax Reform Act of 1986 and its influence on the proliferation of other business entities, such as limited liability companies and S corporations. However, despite these reasons, the IRS, tax policy analysts and members of Congress believe that a significant part of the decline is due to the expanding book-tax gap.

Transparency/Efficiency

A lack of technological and human resources in the IRS is another reason for introducing Schedule M-3; the form is intended to increase transparency and audit efficiency. (5)

Schedule M-1 Problems

Schedule M-1 has two major deficiencies that the IRS is hoping to overcome in the new schedule. First, it does not provide a uniform reporting requirement for net income per books (6); taxpayers could supply information for the worldwide group, the U.S. consolidated tax group or something in between. Similarly, it does not promote uniform disclosure requirements for reporting differences between financial accounting net income and taxable income. These flaws prevent efficient annual comparisons, making it difficult to assess the noncompliance risk associated with a specific issue or a particular taxpayer.

Caveat

While Schedule M-3's format is a more useful and descriptive presentation of critical information (to help the IRS identify likely audit candidates), the new information comes at a cost--the data requirements will increase the compliance burden for both taxpayers and tax advisers. Corporate tax departments will need additional resources to collect information, the time needed to file a corporate return will increase and practitioners will need to be compensated for the additional time required.

Schedule M-3 Overview

Filing Requirements

A U.S. corporation filing Form 1120 must file Schedule M-3 if it has at least $10 million of assets on Schedule L, Balance Sheets per Books. Total assets shown on Schedule L, line 15, column (d), must equal the corporation's total assets (or, for a consolidated group, all members' total assets) as of the last day of the tax year, and be the same total assets reported by the corporation (or by each member) in its financial statements.

If the corporation prepares financial statements, Schedule L must equal the sum of the financial statement total assets for each corporation listed on Form 851, Affiliation Schedules, and included in the U.S. consolidated tax return (includible corporation), net of eliminations for intercompany transactions between includible corporations. If the corporation does not prepare financial statements, Schedule L must be based on the books and records. The Schedule L balance sheet may show tax-basis balance sheet amounts if the corporation is allowed to use books and records for Schedule M-3, and the books and records reflect only tax-basis amounts.

Finally, if a consolidated group's parent files Form 1120 and any group member files Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return, or Form 1120-L, U.S. Life Insurance Company Income Tax Return, and the consolidated Schedule L in the return includes the assets of all of the insurance companies (as well as those of the non-insurance companies in the consolidated group), the total assets reported on Schedule L of the consolidated return are used to determine whether the group meets the $10 million threshold to file...