New Schedule M-3 Expands Reporting for Large Corporations

By Walter G. Antognini

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Readers of The CPA Journal can access a Microsoft Excel spreadsheet containing the new Schedule M-3 at www.cpajournal.com/down.htm (Exhibit 1, Exhibit 2, and Exhibit 3 also show what the spreadsheet looks like.) This spreadsheet includes the details of the line items and associated calculations required by the new schedule. This article will discuss the requirements for filing the schedule, the broad details of the line items, the Treasury and IRS comments on the details of the schedule, and the ways that users can use the downloadable spreadsheet.

Filing Requirements

The new Schedule M-3 replaces Schedule M-1 only for domestic corporations whose total assets equal or exceed $10 million on the last day of the taxable year. A consolidated group with total assets of $10 million or more must likewise file the new schedule. In calculating its total assets, the taxpayer must generally use the accrual method of accounting (an exception exists for taxpayers using the cash method for tax purposes, provided no includable corporation is included in financial statements that use the accrual method). Taxpayers eligible to use Schedule M-3 will no longer file Schedule M-1.

While the new Schedule M-3 is currently required only for taxpayers filing Form 1120, the IRS and the Treasury Department anticipate analyzing and developing comparable schedules for Form 1065 (partnership returns), and Form 1120S (subchapter S corporation returns), as well as Forms 1120PC and 1120L (involving insurance companies).

The new filing requirement is effective for any taxable year ending on or after December 31, 2004. For a taxpayer’s first year of filing, however, it need not complete certain portions of the new schedule. This limited-time exception gives taxpayers a short transition into compliance. Schedule M-3 requires a reconciliation between the financial income statement and the tax return for various items, including whether such differences are temporary or permanent. In the first Schedule M-3 completed by a taxpayer, the taxpayer need not indicate the income statement amount or the tax return amount for each item, only the difference between the amounts and an indication whether this difference is temporary or permanent.

Contents of Schedule M-3

Aside from the normal identifying information (corporate name and employer identification number), the schedule consists of 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.”

Part I has essentially two sections. First, the taxpayer must supply information concerning financial reporting. The initial queries identify the level of rigor of the financial reporting. The schedule establishes four levels of rigor of financial reporting—

• SEC Form 10-K;
• certified audited financial statements;
• a prepared income statement; and
• books and records.

The initial queries determine the highest level of rigor of financial recording in order to require the taxpayer to use the data from that particular financial statement. Thus, if a corporation files SEC Form 10-K, the remainder of the schedule will use the data from the Form 10-K as the base for reporting financial statement amounts. If the corporation prepares financial statements that are audited by an independent CPA but does not file SEC Form 10-K, these certified audited financial statements are the base for financial statement amounts. And so on, down to the taxpayer’s books and records.

Part I also requires data and calculations, with the ultimate purpose of identifying the net income (or loss) per income statement of includable corporations on line 11. As previously indicated, the schedule is filed for a consolidated tax group if one exists, otherwise for a single corporation. The includable corporations would be those that are part of the consolidated tax group, if any. The corporations included in the required tax reporting unit may differ from the corporations included in the required financial accounting unit. The second portion of Part I reconciles these discrepancies. Net income (or loss) from nonincludable foreign or domestic entities—that is, entities not included in the return—is backed out from financial statement income. In addition, the taxpayer adds net income or loss from other includable entities—that is, those not included in the financial statement income but included in the tax return. Finally, the taxpayer makes the adjustments needed to reconcile between financial statement net income and net income of includable corporations. The taxpayer must also attach schedules to specify the composition of the entries on the form.

The amount arrived at on line 11 of Part I serves a critical role in the tax return: the taxpayer must reconcile the taxable income in the return (Form 1120, page 1, line 28) to the line 11 amount of financial statement income. The taxpayer is not required to do this reconciliation for the first year but is thereafter. The amount from Part I, line 11, must also be used as the net income amount on Schedule M-2, line 2, when reconciling unappropriated retained earnings.

For essentially all of Parts II and III, entries are made into a four-column grid as follows: (a) amount per income statement, (b) temporary difference, (c) permanent difference, and (d) amount per tax return. Except for the first year of implementation, the taxpayer is required to reconcile between columns (a) and (d)—between financial statement income and taxable income—for each particular line item through the either temporary or permanent differences indicated in columns (b) and (c), respectively. In the first year, the taxpayer need indicate only the timing or permanent difference. If the taxpayer prepares its financial statements in accordance with GAAP, then this is used to determine whether a difference is temporary or permanent. Otherwise, a difference is considered temporary if it will reverse in a future year (or is a reversal of a prior year’s difference); if not, permanent. If the taxpayer does not use GAAP and cannot determine whether the item will reverse, the taxpayer should report the item as permanent.

The entries required in Parts II and III include all items included in financial statement income or taxable income, not just those items that have differences. Taxpayers will therefore have to pull apart their computations of financial statement income and taxable income in order to reconstitute those numbers into the appropriate lines of Parts II and III. This requirement is significant for several reasons. Taxpayers with any level of complications (a likely scenario, given that Schedule M-3 is required only of large corporations) may find it necessary to modify their accounting systems software in order to track the new requirements. A simple revision of the software may not suffice. Corporations may find themselves retraining employees on the reporting of certain transactions to the corporation. In addition, taxpayers will quickly notice that pulling apart their financial statements and taxable income numbers is more than just an administrative nightmare; it will also provide far greater exposure to what these taxpayers are reporting to the IRS. Taxpayers will no longer enjoy as much flexibility in simply lumping items together under generic titles such as “marketing expenses.” This point becomes increasingly apparent as one reads through the exacting requirements in the form’s instructions.

In a sense, Part II serves two functions. Overall, Part II reconciles taxable income with financial statement income. Only lines 27 through 30 actually serve this overall function. Line 27 represents the sum of lines 1 through 26, which is the second function served by Part II, discussed below. Line 28 includes the total expense/deduction items of the companies included in the return; these amounts are derived from Part III, line 36, discussed below (positive amounts from Part III, line 36, are entered as negative amounts on Part II, line 28, and vice versa). Line 29 includes other items of income or loss, expense or deduction, that don’t have differences. Line 30 is the reconciliation total, which must equal the totals of lines 27 through 29 for each of columns (a) through (d). Also, line 30 column (a) must equal Part I, line 11, “Net income (loss) per income statement of includable corporations,” discussed above, while line 30 column (d) must equal taxable income (before special deductions), as indicated on Form 1120, page 1, line 28.

Most of Part II (lines 1 through 26) requires the taxpayer to enter the particular items of income or loss as well as any differences between taxable and financial accounting income. The required line items encompass a wide variety of income (loss) items, including Subpart F income, income from foreign partnerships, hedging transactions, mark-to-market income, and gains on abandonment or disposition of assets. The taxpayer must, after the first-year transition period, indicate the financial income amount for each item, the temporary and permanent differences for that item, if any, and the reconciling taxable amount for that item.

Part III requires the disclosure of 35 categories of expense or deduction items, which are summed in line 36, which total also appears on Part II, line 28, as discussed above. Instead of the current eight lines in Schedule M-1 to indicate differences (six lines for specific items and two for other items), the taxpayer must specify which of 35 lines the expense or deduction item falls into. Similar to Part II, the taxpayer must, after the first-year transition period, indicate the financial income amount for that item, the temporary and permanent differences for that item, if any, and the reconciling taxable amount for that item.

Thus, for example, while the present Schedule M-1 requires reconciling amounts simply for “charitable contributions,” Schedule M-3 provides for four possible types of entries: line 19, “charitable contribution of cash and tangible property”; line 20, “charitable contribution of intangible property”; line 21, “charitable contribution limitation”; and line 22, “charitable contribution carryforward used.” Not only must the taxpayer differentiate charitable contribution items into these further categories, the taxpayer must also reconcile between financial and taxable income through temporary and permanent differences (subject to the first-year exemption discussed above and noting that no entry would be made for the financial statement amounts for lines 21 and 22 because these involve tax concepts).

IRS Guidance

The government has provided some further guidance, in the form of “Frequently Asked Questions, and Instructions to Schedule M-3,” as well as several revenue procedures. This guidance addresses many issues, some of which are discussed below.

One aspect of the new schedule beneficial to taxpayers involves Treasury Regulations section 1.6011-4, which requires a taxpayer who participates in a reportable transaction to disclose the transaction in order to avoid associated penalties. One such reportable transaction, described in Treasury Regulations section 1.6011-4(b)(6), occurs where a transaction gives rise to a significant book-tax difference. A transaction with a significant book-tax difference will be deemed adequately disclosed for these purposes if the corporation completes and files a required Schedule M-3. This deemed adequacy of disclosure extends only to regulation section 1.6011-4(b)(6); if a transaction is a reportable transaction both because it gives rise to a significant book-tax difference and because it is covered by another category under the regulations, the Schedule M-3 will not by itself prove sufficient disclosure. For such transactions, the taxpayer must complete Form 8886, Reportable Transaction Disclosure Statement, which should be referenced in the supporting statement attached to Schedule M-3. Furthermore, these otherwise reportable transactions must be entered on Part II, line 12, along with a supporting statement detailing each difference. Note that taxpayers not required to file a Schedule M-3 may nonetheless voluntarily file the schedule, an action that may be appropriate for taxpayers seeking the benefit of disclosure described above.

The guidance also addresses the reporting requirements within Schedule M-3 itself. Each difference reported in Parts II and III must be separately stated and adequately disclosed. In general, adequate disclosure requires that the difference be labeled in a manner that clearly identifies the item or transaction from which the difference occurs. As a general rule, differences from the same item should be netted together, while differences from separate items should not. The instructions provide an example where a taxpayer establishes three different reserve accounts: an allowance for accounts receivable; an estimated settlement attributable to pending litigation; and an estimate of warranty expenses. All of these reserves are expenses on the corporation’s financial statements but they do not reduce taxable income, thus giving rise to temporary differences. Each of these three differences must be separately stated and adequately disclosed and not netted together.

At present, the guidance clearly states that differences must be stated and disclosed regardless of dollar amount. The government has not provided any concept of materiality to the reporting of these differences. Taken and applied literally, the guidance would require that a difference of $1 be reported, even for a billion-dollar company.

The government has provided some guidance on reporting requirements when entities are consolidated for financial or taxable income purposes. Corporations filing a consolidated tax return must provide many Schedule M-3s. The group completes Part I on a consolidated basis.Each company separately completes Parts II and III for its own items. The group must also complete a consolidating Schedule M-3. The instructions for the Schedule M-3 provide an example where a consolidated group has a parent and three subsidiaries. In this example, six Schedule M-3s must be completed: the parent will complete a Schedule M-3, Parts II and III, that includes items just from the parent’s own activity; each subsidiary will prepare a separate Schedule M-3, Parts II and III, which reflect the activity for that subsidiary; the group will prepare a consolidating Schedule M-3, Parts II and III, to account for items such as intercompany transactions and adjustments made at the consolidated group level; and the group would complete a consolidated Schedule M-3 reflecting a consolidated Part I, and the Parts II and III that result from the five other Schedule M-3s. Note that the downloadable spreadsheet does not reflect these consolidating requirements. Also note that consolidated groups that include insurance companies may report differently than outlined above.

Instructions for Using the Spreadsheet

Readers of this article are invited to download a Microsoft Excel spreadsheet containing the new Schedule M-3 from www.cpajournal.com (The spreadsheet is also depicted in Exhibits 1, 2, and 3). Naturally, software vendors that prepare Form 1120 for large corporations will also have programmed Schedule M-3. This spreadsheet may be helpful in analyzing Schedule M-3 without the need for the complete entries such return preparation software might require. The spreadsheet is mostly self-explanatory, although users are of course advised to read the Schedule M-3 instructions in understanding the meaning of the line items.

There are a few points to note with regard to using the spreadsheet itself. While every effort has been made to ensure the accuracy of the spreadsheet relative to the actual Schedule M-3, no warranty, express or implied, is made as to the accuracy of the spreadsheet. Users must provide their own judgment as to whether the calculations are accurate.

Some lines occupy more than one row in the spreadsheet (e.g., line 23c of Part II occupies three rows). Entries should be made only in the last (bottom) row for such a line. The gray boxes on the spreadsheet are consistent with the underlying Schedule M-3 presentation. Accordingly, no amounts should be entered in them.

The rightmost column of Parts II and III of the spreadsheet, which is gray, is not present in Schedule M-3. This column is purely for reconciliation purposes. These cells contain formulas that add the financial statement amount for each item, the temporary and permanent differences, and then subtract the taxable income amount. If the amounts are properly reconciled, the result from this formula should always be zero. If not, this column will reflect the error in reconciliation. Note that the spreadsheet does not reconcile Part II, Line 30, with either Part I, Line 11 (which should equal Part II, Line 30, column a), or Form 1120, page 1, Line 28 (which should equal Part II, Line 30, column d)—the reader must manually perform this comparison.

The final result of Part III, represented by line 36, is automatically carried forward, and the sign of the amount is reversed (negative to positive and vice versa), by the spreadsheet to Part II, line 28. Accordingly, users should not enter or change amounts on Part II, line 28, or Part III, line 36.

Expanded Recordkeeping Responsibilities

The new Schedule M-3 significantly ratchets up the effort required to complete a large corporation’s tax return. This effort is best expended throughout the year, identifying transactions that give rise to book-tax differences as they occur, regardless of whether the amounts involved might be considered material for financial accounting purposes. In the “Paperwork Reduction Act Notice” accompanying Schedule M-3, the IRS estimated that the average taxpayer would expend approximately 76 hours in recordkeeping required for the new schedule, four hours to learn about the schedule, and five hours to prepare the schedule. The experience of tax directors at large corporations may prove these estimates to be amusing in their understatement.