Schedule M Guidance

Schedule M Guidance

Caution: While every effort is made to ensure that this document contains the most current and accurate information available, the user is advised that items contained herein may be outdated. The user continues to be personally responsible for meeting all applicable professional standards (including those applicable standards set forth in the Tax Practice Manual), including the obligations to: ensure the current accuracy and applicability of the document; collaborate with colleagues who possess the relevant skills and knowledge pertinent to the area of inquiry; and obtain all required approvals.

FOR INTERNAL USE ONLY Updated: November 14, 2011

Schedule M Guidance

Table of Contents Overview .................................................................................................................................... 1 Introduction to Schedule M......................................................................................................... 1 LD100A – Master Trial Balance ................................................................................................. 3 LD100C – Amount Subject to Book Reclass Summary .............................................................. 3 LD400 – Book to Tax Reconciliation .......................................................................................... 3 LD450 – Schedule K Workpaper ................................................................................................ 4 LD500 – Equity Rollforward........................................................................................................ 4 LD600– Sec. 444 Election of Taxable Year other than Required Taxable Year .......................... 4 Sch E – Officers Compensation ................................................................................................. 4 Schedule Ms .............................................................................................................................. 5 MP100A – Federal Income Tax* ......................................................................................................... 5 MP100B – State and City Income Taxes* ........................................................................................... 6 MP100C – Foreign Income Taxes ...................................................................................................... 7 MP100D – Foreign Withholding Tax ................................................................................................... 8 MP200 – Club Dues ............................................................................................................................ 9 MP210A – Other Interest Expense ................................................................................................... 10 MP201B – Other Interest Income...................................................................................................... 11 MP220 – Lobbying Expense ............................................................................................................. 12 MP230 – Meals and Entertainment* ................................................................................................. 13 MP230A – Skybox Rental Expense .................................................................................................. 15 MP240 – Business Gifts .................................................................................................................... 16 MP250 – “Key Man” Life Insurance................................................................................................... 17 MP260 – Fines and Penalties* .......................................................................................................... 18 MP270 – Punitive Damages .............................................................................................................. 19 MP300 - Tax Exempt Interest* .......................................................................................................... 20 MP300A – Tax Exempt Dividends .................................................................................................... 21 MP300B – Other Tax-Exempt Interest Income ................................................................................. 22 MP310 – Section 965(F) DRD .......................................................................................................... 23 MP400 – Outstanding Stock-Issuance, Repurchase and Refinancing Redemption ........................ 24 MP410 – Stock Options .................................................................................................................... 25 MP420 – Nondeductible Compensation ........................................................................................... 26 MP430 – Parachute Payments ......................................................................................................... 27 MP500 – Goodwill Amortization*....................................................................................................... 28 MP510 – Exchange Gain/Loss.......................................................................................................... 29 MP520 – Leased Inclusion Costs* .................................................................................................... 30 MP600 - Credit Expense Addback .................................................................................................... 31 MP610 – Domestic Production Activity Deduction ............................................................................ 32 MP700 – Environmental Remediation Costs .................................................................................... 33 MP800 or MT110 – Acquisition/Reorganization Costs ..................................................................... 34 MPB25A – Bank Life Insurance ........................................................................................................ 35 MPB25B – Bank-Owned Life Insurance Income............................................................................... 36 MPB30A – Sec 291 Interest Expense Disallowance ........................................................................ 37 MPB30B – Sec 265 Interest Expense Disallowance ........................................................................ 38 MPX100 – Deemed Inclusions .......................................................................................................... 39 MPX200 – Distribution of PTI ............................................................................................................ 40 MPX210 – PTI Exchange Gain/Loss................................................................................................. 41 MPX300 - Branch Remittance Gain/Loss ......................................................................................... 42 MPX400 – Section 78 Gross-Up ....................................................................................................... 43

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MPX500 – Reverse Section 901 Taxes ............................................................................................ 44 MPX600 – FSC Commission ............................................................................................................ 45 MPX700 – Section 965 DASTM Gain/Loss ...................................................................................... 46 MPX800 – Gross Foreign Dividend Not Previously Taxed ............................................................... 47 MPX900 – Excess Distribution 2 ....................................................................................................... 48 MTA10A – Accrued Bonus* .............................................................................................................. 49 MTA10B – Accrued Payroll ............................................................................................................... 51 MTA10C – Accrued Deferred Compensation ................................................................................... 52 MTA10D – Accrued Rabbi Trust ....................................................................................................... 53 MTA10E – Accrued Benefits ............................................................................................................. 54 MTA10F – Accrued Vacation* ........................................................................................................... 55 MTA10G – Accrued ASC 715 (formerly FASB 106) ......................................................................... 56 MTA10H – Accrued Severance......................................................................................................... 57 MTA10I – Accrued Commissions ...................................................................................................... 58 MTA10J or MT120 - Accrued Professional Fees* ............................................................................. 59 MTA10K – Accrued Directors Fees................................................................................................... 61 MTA10L – Accrued Related Party Compensation ............................................................................ 62 MTA10M – Accrued Retirement ........................................................................................................ 63 MTA10Q – Accrued Related Party Bonus ........................................................................................ 64 MTA10R – Accrued Related Party Vacation ..................................................................................... 65 MTA10S – Accrued Pension/Profit-Sharing ...................................................................................... 66 MTA10T – Accrued 401(k) ................................................................................................................ 67 MTA20A – Accrued Workers Compensation .................................................................................... 68 MTA20B – Accrued Charitable Contribution ..................................................................................... 69 MTA20C – Accrued Coupons ........................................................................................................... 70 MTA20D – Accrued Discounts .......................................................................................................... 71 MTA20E – Accrued Environmental Clean-Up ................................................................................... 72 MTA20F – Accrued Promotions ........................................................................................................ 73 MTA20G – Accrued Rebates ............................................................................................................ 74 MTA20H – Accrued Insurance .......................................................................................................... 75 MTA20I – Accrued Self-Insurance .................................................................................................... 76 MTA20J – Accrued Advertising ......................................................................................................... 77 MTA20K – Co-Op Advertising ........................................................................................................... 78 MTA20L - Accrued Interest ............................................................................................................... 79 MTA20M – Accrued Management Fees ........................................................................................... 80 MTA20N – Accrued Personal Property Taxes .................................................................................. 81 MTA20O – Accrued Payroll Taxes .................................................................................................... 82 MTA20P – Accrued Royalties ........................................................................................................... 83 MTA20Q – Related Party Accrued Interest ....................................................................................... 84 MTA20R – Accrued Development Costs .......................................................................................... 85 MTA20S – Accrued Sales Tax .......................................................................................................... 86 MTA300 – Accrued Real Property .................................................................................................... 87 MTB10A – FHLB Stock Dividend ...................................................................................................... 88 MTB10B – FHLB Stock Redemption Gain Of Sale ........................................................................... 89 MTB200 – Non-Accrual Interest ........................................................................................................ 90 MTB30A – Bad Debt Provision ......................................................................................................... 91 MTB30B – Tax Loan Loss – Reserve Method .................................................................................. 92 MTB30C – Tax Loan Loss – Spec Charge Off ................................................................................. 93 MTB30D - Tax Reserve Recap – 481(A) .......................................................................................... 94 MTB400 - Accrued SIP Adjustment .................................................................................................. 95 MTB450 – SERP Expense ................................................................................................................ 96 MTB500 – Loan Costs ...................................................................................................................... 97 MTB510 – Tax Loan Fees ................................................................................................................. 98 MTD10A – Deferred Rent Expense .................................................................................................. 99 MTD20A – Deferred Revenue......................................................................................................... 100 MTD20B – Unearned Rent Income* ............................................................................................... 101

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MTD20C – Unearned License Fee ................................................................................................. 102 MTD20D – Unearned Income ......................................................................................................... 103 MTD20E – Unearned Interest ......................................................................................................... 104 MTD300 – Deferred Intercompany Profit ........................................................................................ 105 MTD400 or MT280 – Unrealized Book Gain(Loss) ......................................................................... 106 MTF100 – Amortization* ................................................................................................................. 107 MTF110 – Intangible Assets Roll-Forward ...................................................................................... 109 MTF200 – Intangible Basis Difference ............................................................................................ 110 MTF30A – Book Depreciation* ........................................................................................................ 111 MTF30B_4562 – Tax Depreciation* ................................................................................................ 112 MTF30B_4626 – Alternative Minimum Tax and ACE Data Entry ................................................... 115 MTF310 – Fixed Assets Roll-Forward............................................................................................. 116 MTF35A – Book Depletion .............................................................................................................. 117 MTF35B – Tax Depletion ................................................................................................................ 118 MTF400 - Fixed Asset Basis Difference ......................................................................................... 119 MTF410 – Imp of Long Lived Assets – ASC 360 (formerly FAS 144) ............................................ 120 MTF420 - Other Impairment of Assets ............................................................................................ 121 MTF50A – Book Gain/(Loss) on Sale of Fixed Assets* .................................................................. 122 MTF50B_4684 – Casualties and Thefts ......................................................................................... 123 MTF50B_4797 – Tax Gain/(Loss) on Sale of Fixed Assets* .......................................................... 124 MTF60A – Book Gain/(Loss) on Sale of Capital Assets ................................................................. 125 MTF60B_Sch D – Tax Gain/(Loss) on Sale of Capital Assets ....................................................... 126 MTI100 – LIFO ................................................................................................................................ 127 MTI200 – 263A UNICAP Adjustment* ............................................................................................ 128 MTI300 – Capitalized Interest ......................................................................................................... 130 MTI400 – Lower of Cost/Market Write-Downs ................................................................................ 131 MTM100 – IRC Section 481(a) Adjustment* ................................................................................... 132 MTM20D – Income/Loss from Domestic Schedules K-1 ................................................................ 133 MTM20F – Income/Loss from Foreign Schedule K-1 ..................................................................... 134 MTM20Z – Income/Loss from Other Schedules K-1....................................................................... 135 MTM300 – Installment Sales* ......................................................................................................... 136 MTM400 – Equity Earnings of Subsidiary ....................................................................................... 137 MTM500 – Minority Interest ............................................................................................................ 138 MTM600 – Hedging Transactions ................................................................................................... 139 MTM610 - OID & Other Imputed Interest ........................................................................................ 140 MTM620 - Mark to Marked Income/(Loss) ...................................................................................... 141 MTM700 – Inc Recognition from LT Contracts ............................................................................... 142 MTM71A – Sale versus Lease ........................................................................................................ 143 MTM71B – Purchase versus Lease ................................................................................................ 144 MTM800 – Accrual to Cash Adjustment ......................................................................................... 145 MTP10A – Prepaid Advertising*...................................................................................................... 146 MTP10B - Prepaid Insurance* ........................................................................................................ 148 MTP10C – Prepaid Supplies ........................................................................................................... 149 MTP10D – Prepaid Rent Expense .................................................................................................. 150 MTP10E – Prepaid Legal Fees*...................................................................................................... 151 MTP10F – Prepaid VEBA ............................................................................................................... 152 MTR10A – Bad Debt Reserve* ....................................................................................................... 153 MTR10B – Inventory Reserve ......................................................................................................... 155 MTR10C – Obsolescence Reserve................................................................................................. 156 MTR10D – Sales Returns & Allowance Reserve ............................................................................ 157 MTR10E – Warranty Reserve* ........................................................................................................ 158 MTR10F – Contingency Reserve* .................................................................................................. 160 MTR10G - Restructuring Reserve* ................................................................................................. 161 MTR10H – Litigation Reserve* ........................................................................................................ 162 MTS100 – Stock Options ................................................................................................................ 163 MTT100 – State Taxes* .................................................................................................................. 164

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Schedule M Guidance

MTT200 – Capitalized Real Estate Taxes ...................................................................................... 165 OT100 – Federal Tax Payments ..................................................................................................... 166

Additional Hedge Fund Partnership Schedule Ms .................................................................... 167 MP100 – Federal Tax Exempt Interest and Income ....................................................................... 167 MP110 – Syndication Fees ............................................................................................................. 168

Additional Partnership Schedule Ms ......................................................................................... 169 Sch B – Other Partnership Information ........................................................................................... 169 KP100 – Partner Information........................................................................................................... 170 KP200 – Partner Contributions ....................................................................................................... 171 KP300 – Partner Distributions ......................................................................................................... 172 KP400 – Transfer of Interest ........................................................................................................... 173 KP500 – Partnership Liabilities ....................................................................................................... 174 KP600 – Guaranteed Payments Detail ........................................................................................... 175 KP700 – Foreign Partner Withholding ............................................................................................ 176 MP440 or MP120 – Guaranteed Payments .................................................................................... 177 MP450 – Syndication Costs ............................................................................................................ 178

Additional S Corporation Schedule Ms ..................................................................................... 179 LD550 – AAA Reconciliation (S Corporation) ................................................................................. 179 Sch B – Other S Corporation Information ....................................................................................... 180 KS100 – Shareholder Information ................................................................................................... 181 KS200 – Shareholder Contributions................................................................................................ 182 KS300 – Shareholder Distributions ................................................................................................. 183 KS350 – Taxability of Distributions to Shareholders ....................................................................... 184 KS400 – Ownership and Transfers ................................................................................................. 185 KS500 – Schedule K Allocations..................................................................................................... 186 KS600 – Shareholder Foreign Withholding ..................................................................................... 187 MP450 – Shareholder Fringe Benefits ............................................................................................ 188 OT200 – Composite Tax Payments ................................................................................................ 189

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Schedule M Guidance

Overview This document was compiled from two legacy data sources: o

The Hows and Whys of Calculating Some Common Schedule M Adjustments

o

The DCW Tax Law

This document does not cover every situation, but is a tool for gaining a general understanding of Schedule Ms that are often encountered in business compliance. Specialists should always be consulted when appropriate. The rules discussed in the document are generally applicable, but are not intended to cover all exceptions.

Introduction to Schedule M Form 1120 Schedule M-3 Schedule M-3 reconciles financial statement net income (loss) for the consolidated financial group to taxable income on Form 1120, page 1, line 28. Corporations with consolidated assets that equal or exceed $10 million are required to file Schedule M-3. Partnerships with assets that equal or exceed $10 million, adjusted total assets that equal or exceed $10 million, or have gross revenues equal or greater to $35 million are required to file Schedule M-3. All other corporations and partnerships must still use Schedule M-1. Schedule M-3 requires the reporting of much more detail about book-tax differences than Schedule M-1. The current Schedule M-1 has remained virtually unchanged for decades. In that time, large and midsize corporations have made dramatic changes in the ways they are structured and conduct business, and in their corresponding financial and tax accounting. Schedule M-1 and the related instructions do not provide a uniform reporting requirement for “net income per books” on line 1 of Schedule M-1. As a result, taxpayers may provide information for (i) the worldwide group, (ii) the U.S. consolidated tax group, or (iii) something in between. Similarly, Schedule M-1 and the related instructions do not provide uniform disclosure requirements for reporting differences between financial accounting net income and taxable income. The lack of requirements prevents efficient comparisons being made among taxpayers and prevents comparisons from year-to-year for the same taxpayer, thus making it more difficult to assess the risk of noncompliance associated with an issue or a taxpayer.

Objectives of Schedule M-3 According to the IRS, Schedule M-3: •

Increases transparency while minimizing overall taxpayer burden;

•

Reduces the time required to examine tax returns and ensure IRS is in a position to examine the most recent tax returns filed;

•

Provides consistent reporting among taxpayers and, from year-to-year, for each taxpayer;

•

Provides a method of presentation to obtain more useful, descriptive information at the time the federal income tax return is filed to assist the IRS in the identification of tax returns that should or should not be selected for audit, identification of issues that should or should not be audited, and identification of trends and areas of greater compliance risk;

•

Will be modified periodically to highlight emerging issues, identify trends, and adapt to future changes encountered by large and midsize corporations;

•

Facilitates tax return selection and issue identification through electronic filing;

•

Facilitates the use of Limited Issue Focused Examination (LIFE) audits through greater transparency.

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Schedule M Guidance

Illustration: Excerpt from 2010 Corporate Form Schedule M-3

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Schedule M Guidance

What Is a Schedule M-1 Adjustment? Schedule M-1 is located on page 4 of Form 1120 Corporate and Form 1065 Partnership Federal Tax Return. M-1 adjustments arise when the GAAP (a.k.a., the book/financial statement) rules for certain income or expense items differ from the tax treatment as promulgated by the Internal Revenue Code. Illustration: Page 4 of the 1120 and 1120S – Schedule M-1 Book Income per Financial Statements (GAAP)

LD100A – Master Trial Balance

Taxable Income per IRC

Potentially Applicable TCC Sections • • • • • • • • • • • •

1.05 2.01 2.02 2.03 2.05 2.06 2.07 2.93 2.96 4.26 14.00 25.06

Trial Balance Review Accounting Methods Accounting Method Changes Book Accounting Changes Adopting an Accounting Method Initial Tax Year Change of Tax Year Determination of Accounting Method Following a Transaction Accounting for Investments Financial Accounting Controlled Groups and Consolidated Returns Debt Considered a Second Class of Stock

LD100C – Amount Subject to Book Reclass Summary Potentially Applicable TCC Sections • • •

1.03 2.03 14.00

Recordkeeping Book Accounting Changes Controlled Groups and Consolidated Returns

LD400 – Book to Tax Reconciliation Potentially Applicable TCC Sections • •

1.02 1.03

Impact of Prior Year Events Recordkeeping

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Schedule M Guidance

• • • • • • • • • • • • • •

1.05 1.07 1.08 1.09 2.00 2.01 2.02 2.04 2.05 2.06 2.07 2.93 2.94 2.96

Trial Balance Review Schedule M-3/M-1 and M-2 Reconciliation Provision to Return Reconciliation Schedules M-3/M-1 and M-2 Analysis Accounting Periods and Methods Accounting Methods Accounting Method Changes Effecting a Method Change by Amending an NOL Adopting an Accounting Method Initial Tax Year Change of Tax Year Determination of Accounting Method Following a Transaction Net Operating Loss Carryback Accounting for Investments

LD450 – Schedule K Workpaper Potentially Applicable TCC Sections • • • • • • •

26.01 26.02 26.03 26.04 26.05 27.02 27.03

Items that Pass Through to Shareholders Separately Stated Income and Gains(Losses) Separately Stated Deductions Other Separately Stated Items Separately Stated AMT Items Income and Credits of Partner Partnership Computations (IRC § 703)

LD500 – Equity Rollforward Potentially Applicable TCC Sections • • • •

1.02 1.03 1.08 1.09

Impact of Prior Year Events Recordkeeping Provision to Return Reconciliation Schedules M-3/M-1 and M-2 Analysis

LD600– Sec. 444 Election of Taxable Year other than Required Taxable Year Potentially Applicable TCC Sections • •

26.52 26.53

Calendar Year-End Year-End Other Than Calendar Year

Sch E – Officers Compensation Potentially Applicable TCC Sections •

6.18

Compensation Paid to Top Executives

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Schedule M Guidance

Schedule Ms MP100A – Federal Income Tax* GAAP (Financial Statement) Treatment Book net income or loss is presented net of income tax expense or benefit. ASC 740, Income Taxes, addresses financial accounting and reporting for the effects of all income taxes that result from an enterprise’s activities during the current year and preceding years.

Tax Treatment As provided in IRC § 275, federal income tax expense is not an allowable deduction for tax purposes. These costs must be added back in order to arrive at taxable income. Note: The deduction of these expenses is never allowed for tax purposes and therefore produces permanent differences.

Where Do I Get the Information? Source documents: Tax provision workpapers, post-provision adjusted trial balance, financial statement footnote, and income statement. In taxable entities, federal income tax will be clearly identifiable in both the income statement and the expense portion of the trial balance. The account that contains federal income tax expense should be properly coded in the tax trial balance as “Federal Income Taxes.” Note, a company may have an accounting policy to include interest and/or penalties in the “Income Taxes” line in the income statement. It is important to confirm that only the amount related to federal income taxes (and not related interest and penalties) is included in this schedule M adjustment.

How Do I Calculate the Schedule M Adjustment? The entire amount of the expense is disallowed in calculating taxable income. This amount is added back to book income as an unfavorable addback on the schedule.

Potentially Applicable TCC Sections • •

2.72 2.73

Disallowed Deductions Federal Income Tax

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Schedule M Guidance

MP100B – State and City Income Taxes* GAAP (Financial Statement) Treatment Book net income or loss is presented net of income tax expense or benefit, including state income taxes. Through the process of calculating the tax provision, an estimate of the current year’s state income tax expense is included in the financial statements and deducted from book income.

Tax Treatment IRC § 164(a) provides that the following taxes shall be allowed as deductions for the taxable year within which they were paid or accrued subject to IRC § 461(h) economic performance rules: • • •

State and local, foreign, and real property taxes State and local personal property taxes State and local, foreign, income, war profits, and excess profits taxes

Note: See IRC § 461(d). For example, California accrual of state taxes not deductible until subsequent year to which franchise tax relates.

Where Do I Get the Information? Source documents: Post-provision adjusted trial balance, tax provision, financial statement footnote. The estimated amount for state income/franchise taxes can be found in both the trial balance and the income statement section of the financial statements. Note, a company may have an accounting policy to include interest and/or penalties in the “Income Taxes” line in the income statement. It is important to confirm that only the amount related to state income taxes (and not related interest and penalties) is included in this schedule M adjustment.

How Do I Calculate the Schedule M Adjustment? The Schedule M adjustment amount is the difference between the book expense and the tax expense. If the book amount is larger than the tax amount, the difference will be treated as an unfavorable adjustment and will be added back to the book income. If the tax amount is larger than the book amount, the difference will be treated as a favorable adjustment and will be subtracted from the book income in arriving at taxable income. Accrued state tax expense per books

$20,000

Accrued state tax expense per tax

25,000

Schedule M – favorable reduction

($5,000)

Potentially Applicable TCC Sections • • • • • • • • •

2.74 8.02 8.03 8.04 8.06 8.07 8.08 8.09 8.11

Deductibility of State and Local Tax Accruals Filing Obligations Nexus Issues State Filing Methods Law Changes Alternate Measures of Tax Federal-To-State Adjustments Loss Carryovers and Carrybacks Federal Consolidated Return Regulations

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Schedule M Guidance

MP100C – Foreign Income Taxes Tax Law Companies can elect to either deduct foreign income taxes, under IRC §164, or apply them as a credit against US-income tax. A book/tax difference arises with respect to foreign taxes when such taxes are deducted for book purposes but not for tax purposes. Often, companies will claim credit for foreign taxes on Form 1118 rather than claim a tax deduction.

Potentially Applicable TCC Sections • • • • •

10.21 12.22 12.42 16.07 26.60

AMT Foreign Tax Credit Information Reporting and Withholding Foreign Bank Account Reporting (FBAR) Foreign Tax Credits Foreign Subsidiaries Classified as Corporations for U.S. Tax

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Schedule M Guidance

MP100D – Foreign Withholding Tax Tax Law Companies can elect to either deduct foreign income taxes or apply them as a credit against US-income tax. A book/tax difference arises with respect to foreign taxes when such taxes are deducted for book purposes but not for tax purposes. Often, companies will claim credit for foreign taxes on Form 1118 rather than claim a tax deduction.

Potentially Applicable TCC Sections • • • •

12.22 12.42 16.14 16.17

Information Reporting and Withholding Foreign Bank Account Reporting (FBAR) U.S. Effectively Connected Income ("ECI") Withholding on Outbound Payments

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Schedule M Guidance

MP200 – Club Dues Tax Law Per IRC § 274(a), a deduction is not allowed for membership dues in any club organized for business, pleasure, recreation, or other social purpose.

Potentially Applicable TCC Sections •

2.72

Disallowed Deductions

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Schedule M Guidance

MP210A – Other Interest Expense Tax Law This adjustment only applies when the interest paid or received has not been reflected in the income statement. This adjustment is usually only necessary in unusual circumstances.

Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • •

1.06 2.31 2.40 2.80 4.02 4.03 4.04 4.05 4.06 4.07 4.08 4.09 4.10 4.11 4.12 4.13 4.14 4.15 4.18 4.21 4.22 4.23 4.24 4.25 4.27 4.28 4.29 4.30 5.06 5.08 5.17 5.22 5.32 7.05 7.06 15.16

IRS Interest Expense/Income Economic Performance [including Accrual Method Liability Quick Reference Sheet] Capitalization of Interest, Taxes Related Party Debt Acquisition Deferred Payment Obligations/Nontraded Debt Variable or Stepped Interest Payments Multiple Debt Instruments Issued in the Same Transaction Contingent Payment Debt Obligations Interest Not Due Currently (Including "Payment in Kind" Debt) Debt Issued with Warrants or Other Property Short-Term Debt Instruments Applicable High-Yield Debt Obligations (AHYDOs) Acquisition Indebtedness Debt Exchanges or Modifications Retirements or Prepayments of Debt Issuance of Convertible Debt Issuance of Debt Payable In (or Indexed to) Portfolio Stock Issuance of Convertible Debt with Contingent Interest Low Interest Loans Hedges of Issuer’s Debt Obligations: Synthetic Debt Treatment Hedges of Issuer’s Convertible Debt Obligations Equity-Linked Securities Investment Units Consisting of Debt and a Forward Contract Interest Capitalization Prepaid Interest Treatment as Debt Interest on Related Party Debt Related-Party Debt Acquisitions Market Discount Short-term Investments Hedging Ordinary Property or Liabilities Tax Straddle Transactions Repurchase Agreements Interest Income on Finance Leases Finance Lease v. Sale Contingent Stock Payments

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Schedule M Guidance

MP201B – Other Interest Income Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • •

1.06 2.31 2.40 4.18 4.30 5.01 5.02 5.03 5.05 5.06 5.07 5.08 5.17 5.32 7.05 7.07 7.06 10.12

IRS Interest Expense/Income Economic Performance [including Accrual Method Liability Quick Reference Sheet] Capitalization of Interest, Taxes Low Interest Loans Related-Party Debt Acquisitions Original Issue Discount (corporate obligations) Original Issue Discount (non-corporate obligations) Stripped Obligations Deferred Payment Sales Market Discount Bond premium Short-term Investments Hedging Ordinary Property or Liabilities Repurchase Agreements Interest Income on Finance Leases Lessee Default Finance Lease v. Sale Private Activity Bonds

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Schedule M Guidance

MP220 – Lobbying Expense Tax Law Under IRC § 162(e), deductible business expenses generally do not include amounts paid or incurred in influencing legislation. Nondeductible lobbying expenses include amounts incurred while participating in political campaigns, influencing the general public with respect to legislation, or while communicating directly with certain executive branch officials on official matters. Nondeductible lobbying also includes dues paid to exempt organizations allocable to lobbying. When payments are made to an organization that incurs lobbying expenses the entity will generally provide the payor with the percentage of total expenses that are directly attributable to the lobbying activity on an invoice or in some instances an annual statement. Traditionally lobbying expenses are recorded in various accounts. Some of these accounts could include dues and subscriptions, contribution accounts, donations, lobbying expenses, political contributions, and organization expenses. See also Treas. Reg. §§ 1.162-28 and 29.

Potentially Applicable TCC Sections • • •

2.60 2.61 2.72

Political Contributions Lobbying Costs Disallowed Deductions

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Schedule M Guidance

MP230 – Meals and Entertainment* GAAP (Financial Statement) Treatment These expenditures are expensed as incurred for GAAP purposes.

Tax Treatment IRC § 274(n) states that for certain meal and entertainment (M&E) expenses, only 50% of the total expense is allowed as a deduction. However, some M&E expenses are fully deductible for tax purposes. In general, M&E expenses related to entertaining clients (nonemployees) and travel are subject to the 50% disallowance. In particular circumstances, the following types of M&E expenses are fully deductible (not subject to the 50% limitation): •

Recreational or social employee activities. However, such activities cannot discriminate in favor of highly compensated employees (IRC § 414(q)) (e.g., a company picnic or holiday party)

•

Cost of ticket package to a sporting event if the benefit is organized to benefit a tax-exempt organization all net proceeds of the event are contributed to such origination and volunteers

•

Overtime meal allowances. Certain limitations are placed on the deductibility of such expenses due to frequency and value issues

•

An employee's meal expenses incurred while moving that are reimbursed by the employer and includable in the employee's gross income

•

Food and beverages provided to employees on certain vessels and oil or gas platforms and drilling rigs

•

Expenses incurred by an employer and reimbursed by their client (common in the services industry). Very specific document substantiation requirements must be met before reimbursed expenses may qualify for a full deduction (see IRC § 274(d) and Rev. Rul. 2008-23)

•

De minimis fringe benefits (IRC § 132). Certain prohibitions and limitations are placed on the deductibility of such expenses due to frequency, value, and accountable plan issues

•

Goods, services or facilities that are treated as compensation

•

Goods, services or facilities made available to the public or sold to customers for adequate consideration

•

Reimbursed expenses for services performed by employees but only if these expenses are not treated as wages

•

A portion of the per diem rates up to the federal M&E rate (see Rev. Proc. 2010-39)

Additionally, as part of your review of the client’s travel, meals, and entertainment accounts, particular attention should be paid to expenses that are either 50% or 100% nondeductible, that may have been inadvertently treated as fully deductible. For example, to the extent that hotel meals are charged to a hotel room invoice that was captured in a fully deductible general ledger account, such meals charges should be identified and subjected to the 50% limitation on deductibility. Further, exposure may exist if the client’s expenses include entertainment costs associated with luxury boxes that are used for entertaining. You should consult with your senior or manager to determine whether your client’s facts meet the terms and conditions listed above. There is potential for a substantial consulting opportunity in performing a study of your client’s M&E expense to review either opportunity items, exposure items, or both. See your senior, manager, or partner if you feel there is potential for such a review.

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Schedule M Guidance

Where Do I Get the Information? The nature of the M&E expense should be established before any adjustments are calculated. If you are not sure that the expenses are 100%, 50% deductible, or 100% nondeductible, you must find this out from the client or another member of the engagement team before proceeding.

How Do I Calculate the Schedule M Adjustment? The adjustment is calculated by multiplying the “50% deductible expenses” by 50%. The adjustment is then added back to book income as an unfavorable permanent Schedule M adjustment. M&E (subject to 50% disallowance)

$5,000 × 50%

Schedule M – unfavorable addback

$2,500

Practice Tips and Techniques Many companies have misclassified exempted meals and entertainment expenditures as deductions subject to the 50% limitation on deductibility. These misclassifications result in an overpayment of federal and state income tax. In addition, ordinary and necessary expenses (i.e., hotel charges, office supplies, advertising, charitable contributions, etc.) are being erroneously included in the meals and entertainment accounts. Significant tax savings and improved financial statement earnings may result from a comprehensive analysis of the general ledger accounts to which the 50% limitation is currently being applied. Misclassifications may be reversed to restore full deductibility. Because these misclassifications do not constitute a method of accounting, taxpayers may amend open years to claim tax refunds. Prospectively, we may assist clients with their general ledger classification of expenses to ensure that full deductions are obtained on expenditures that meet the various exceptions to the 50% limitation.

Potentially Applicable TCC Sections • • • • • • •

2.43 2.72 6.21 6.24 6.25 6.29 8.27

Travel, Meals, & Entertainment Costs [including M&E Quick Reference Sheet] Disallowed Deductions [including Meals & Entertainment Quick Reference Sheet] Company Cars & Aircraft Fringe Benefits Eating Facilities Travel and Entertainment Expenses Meals for Employees

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Schedule M Guidance

MP230A – Skybox Rental Expense Tax Law The cost of the skybox lease must be reduced to the cost of non-luxury box seats, per IRC § 274(I)(2), for the same number of seats in the box covered by the lease, before computing the limitation. The total cost of the non-luxury box seats must also be reduced by 50%, the general limitation for entertainment costs.

Potentially Applicable TCC Sections •

2.72

Disallowed Deductions

15

Schedule M Guidance

MP240 – Business Gifts Tax Law Generally, a company is not allowed a business deduction for gifts to an employee to the extent that the total cost of all gifts of cash, tangible personal property, and other items to the same individual during the taxable year exceed $25. A $400 limitation applies to gifts of tangible personal property awarded to an employee for length of service, safety achievement, or productivity.

Potentially Applicable TCC Sections • •

2.72 6.20

Disallowed Deductions Employee Gifts

16

Schedule M Guidance

MP250 – “Key Man” Life Insurance Tax Law Per IRC § 264, premiums paid by an employer for insurance on the life of any individual are deductible only if it can be shown that payments are 1) in the nature of additional compensation, 2) total compensation including premiums is not unreasonable, and 3) the employer is not directly or indirectly a beneficiary under the policy. Generally, premiums paid under split-dollar life insurance arrangements are not deductible. Premiums on group-term life insurance covering the lives of employees are deductible by the employer unless the employer is a direct or indirect beneficiary. The payment of such premiums may result in income to the employee if coverage exceeds $50,000 or if the plan is discriminatory in favor of key employees. In general interest on debt incurred or continued to purchase or carry a life insurance policy is not deductible. However interest on preJune 21, 1986 policies and policy loans of up to $50,000 on a limited group of key persons.

Potentially Applicable TCC Sections • • •

2.65 2.66 6.17

Life Insurance Loans Life Insurance Premiums Life Insurance

17

Schedule M Guidance

MP260 – Fines and Penalties* GAAP (Financial Statement) Treatment Generally, fines and penalties are expensed as incurred for GAAP purposes.

Tax Treatment IRC § 162(f) states that no deduction shall be allowed for a fine or similar penalty imposed by a federal, state, or local government for the violation of any law. Note: Fines and penalties imposed by vendors, such as those for airline ticket changes and hotel cancellations, are fully deductible for tax purposes.

Where Do I Get the Information? Source documents: Client’s trial balance or completed client information request. Any account that contains fines and/or penalties should be investigated to determine what kind of fines or penalties are included in that account. Check the treatment of these accounts in prior years or ask the client about the nature of the accounts if this is the first year that they are present. If the accounts are expenses due to fines and/or penalties paid to governmental organizations, they cannot be deducted for federal income tax purposes. Note, companies may have an accounting policy for financial statement purposes to report penalties in the income tax expense line.

How Do I Calculate the Schedule M Adjustment? Nondeductible fines and penalties are added back to book income as an unfavorable permanent Schedule M addback.

Practice Tips and Techniques Perform a detailed analysis of the account for the following examples of fines and penalties, which are fully deductible and do not have to be added back to book income in determining taxable income. • • • •

Hotel cancellation penalties Airline ticket change penalties Other similar vendor fines or penalties Fines or penalties that are compensatory in nature

Potentially Applicable TCC Sections • • • • •

2.59 2.68 2.72 9.09 12.32

Fines and Penalties Department of Justice Settlements Disallowed Deductions Tax Liability and Tax Payments Penalties

18

Schedule M Guidance

MP270 – Punitive Damages Tax Law Punitive damages paid under IRC § 104(a)(2) that are includible in gross income by the recipient are deductible to the payer. There are cases where punitive damages paid are excluded from gross income by the recipient if received in a civil action for wrongful death and the applicable state law, in effect on September 13, 1995, provides that only punitive damages may be awarded (IRC § 104(c)). Beginning in 2005, attorney's fees and court costs incurred in prosecuting claims based on unlawful discrimination and certain other federal claims, including but not limited to whistleblower actions, are deductible from gross income (IRC § 62(a)(20), as added by the American Jobs Creation Act of 2004. Only punitive damages paid pursuant to a wrongful death claim are excluded from the recipient's income per IRC § 104(c) and are thus not deductible to the payer corporation.

Potentially Applicable TCC Sections •

2.24

Recoveries for Damage

19

Schedule M Guidance

MP300 - Tax Exempt Interest* GAAP (Financial Statement) Treatment For GAAP purposes, there is no distinction made (as to inclusion in income) between the interest income generated by different types of debt instruments (i.e., municipal bonds vs. corporate bonds). Generally, all interest for GAAP purposes is included in income.

Tax Treatment IRC § 103(a) states that interest income derived from bonds insured by state and local governments is generally not included in gross income for federal tax purposes. However, interest derived from certain state and local private activity bonds (within the meaning of IRC § 141), arbitrage bonds (within the meaning of IRC §148), and bonds not in registered form (not meeting the requirements of IRC §149), are included in taxable income. Note: IRC § 265(a)(2) provides that no deduction shall be allowed for interest on indebtedness incurred to purchase or carry obligations, the interest of which is wholly exempt from tax. Therefore, a separate adjustment may be required to disallow interest expense attributable to the generation of the tax-exempt interest income.

Where Do I Get the Information? Source documents: Trial balance, audit workpapers, or completed client information request. In most cases, tax-exempt interest will be assigned its own trial balance account. If the description is vague, or you question the nature of the interest income, document your questions on the open items list, and follow up with the senior or manager on the engagement.

How Do I Calculate the Schedule M Adjustment? Any interest income amounts that are deemed to be tax-exempt have been included in the book income amount and need to be removed in arriving at taxable income. The total tax-exempt interest amount should be subtracted from book income as a favorable permanent adjustment. Tax-exempt interest income per books Tax-exempt interest income per tax Schedule M – favorable reduction

$2,000 0 ($2,000)

Potentially Applicable TCC Sections • •

5.24 8.08

Tax-Exempt Interest Federal-To-State Adjustments

20

Schedule M Guidance

MP300A – Tax Exempt Dividends Tax Law IRC § 103(a) provides that gross income does not generally include dividend income derived from any state or local bond. However, dividends derived from certain state and local private activity bonds (within the meaning of IRC § 141), arbitrage bonds (within the meaning of IRC §148), and bonds not in registered form (not meeting the requirements of IRC §149), are included in taxable income.

Potentially Applicable TCC Sections •

15.02

Distributions

21

Schedule M Guidance

MP300B – Other Tax-Exempt Interest Income Potentially Applicable TCC Sections •

5.24

Tax-Exempt Interest

22

Schedule M Guidance

MP310 – Section 965(F) DRD Potentially Applicable TCC Sections • • • • •

5.09 5.25 8.08 8.12 16.23

Dividends Dividends Received Deduction Federal-To-State Adjustments Foreign Source Dividends and IRC § 78 Gross-Up IRC § 965

23

Schedule M Guidance

MP400 – Outstanding Stock-Issuance, Repurchase and Refinancing Redemption Tax Law Pursuant to IRC § 162(k), no deduction is allowed for any amount paid or incurred by a corporation in connection with reacquisition of its stock or of the stock of any related person (as defined in IRC § 465(b)(3)(C)). Note that there are exceptions to the general rule.

Potentially Applicable TCC Sections • • • • • •

2.72 5.04 15.03 15.04 26.57 26.58

Disallowed Deductions Redemption Premiums on Preferred Stock Redemptions Related Party Stock Sales Treated as Redemptions Compensation: Employee Stock Option Plans Shareholders Receiving Little to no Compensation

•

26.59

Limit on Deductibility of Business Expenses by the Corporation

24

Schedule M Guidance

MP410 – Stock Options Tax Law In general, IRC § 421(a) prevents tax income recognition to the employee and consequently a tax deduction to the employer of the value of a qualified stock option if the stock is held for two years after the date of the grant of the option and the share of stock is not sold within one year of the option being exercised. Qualified stock options include incentive stock options (ISO) as provided in IRC § 422 and employee stock purchase plans as provided in IRC § 423. If the employee does not hold the stock for the two year holding period or the one year grant to exercise period, then IRC § 421 does not apply to the option, the employee recognizes income on the value of the stock option when the stock is sold, and the employer is allowed a deduction for the value of the option included in income of the employee.

Potentially Applicable TCC Sections • • • • • • • • •

2.63 6.01 6.13 6.14 6.15 6.18 26.57 26.58 26.59

Compensation to Executives Nonqualified and Qualified Plans Nonqualified Stock Options Incentive Stock Options Employee Stock Purchase Plans Compensation Paid to Top Executives Compensation: Employee Stock Option Plans Shareholders Receiving Little to no Compensation Limit on Deductibility of Business Expenses by the Corporation

25

Schedule M Guidance

MP420 – Nondeductible Compensation Tax Law IRC § 162(m)(1). Publicly held corporations are generally not able to deduct compensation paid to certain covered employees to the extent that such compensation exceeds $1 million per tax year. Treas. Reg. § 1.16227. The $1 million limit does not apply to certain "performance based compensation" (IRC § 162(m)(4)(C)).

Potentially Applicable TCC Sections • • • • •

2.63 6.18 26.57 26.58 26.59

Compensation to Executives Compensation Paid to Top Executives Compensation: Employee Stock Option Plans Shareholders Receiving Little to no Compensation Limit on Deductibility of Business Expenses by the Corporation

26

Schedule M Guidance

MP430 – Parachute Payments Tax Law Per IRC § 280G, a corporation that enters into a contract whereby it agrees to pay an employee amounts in excess of the employee's usual compensation in the event that control or ownership of the corporation changes is barred from taking a deduction for an 'excess parachute payment' made to a 'disqualified individual. See IRC § 280G for definitions and calculation of 'excess parachute payment.'

Potentially Applicable TCC Sections •

6.19

Golden Parachutes

27

Schedule M Guidance

MP500 – Goodwill Amortization* GAAP (Financial Statement) Treatment Goodwill is not amortized for GAAP purposes. Goodwill is tested for impairment on an annual basis and in between annual tests in certain circumstances. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill is its new accounting basis.

Tax Treatment IRC § 197 states that a taxpayer shall be entitled to an amortization deduction with respect to certain intangibles. The amount of such deduction shall be determined by amortizing the adjusted basis (for determining gain) of such intangible ratably over the 15-year period beginning with the month in which such intangible was acquired. To qualify as a § 197 intangible, the acquisition must have been made after 8-11-93 (or 7-25-91 if an election was made). The asset must be held in connection with the conduct of a trade or business or held for the production of income. (See IRC § 212 for a more complete description). Amortization of goodwill on acquisitions prior to IRC § 197 is not deductible (permanent difference).

Where Do I Get the Information? Source documents: Prior-year tax analysis and audit workpapers. Goodwill is separately stated in the financial statements and, generally, is easily identifiable in the asset section of the trial balance and/or audit workpapers. Goodwill impairment, if any, may be found in the income and expense section of the trial balance. The other number used in the calculation is the tax amortization expense amount and will be found in fixed asset system (FAS Encore, Fast-Tax, or other) which is used to calculate amortization and depreciation.

How Do I Calculate the Schedule M Adjustment? The taxpayer is allowed to deduct the amount of goodwill amortization expense that is calculated by the method prescribed above in the tax treatment section. Since goodwill is not amortized for book purposes, the difference between the book amount (generally zero unless goodwill is impaired during the year) and the tax amount gives rise to a Schedule M adjustment. Goodwill impairment per books Goodwill amortization per tax Schedule M – unfavorable addback

$10,000 4,000 $6,000

Potentially Applicable TCC Sections • •

2.35 3.11

Depreciation/Amortization Intangible Assets

28

Schedule M Guidance

MP510 – Exchange Gain/Loss Tax Law Unrealized foreign exchange gains, resulting from functional currency translation differences, are favorable M items, and should be deducted from book income. Similarly, unrealized foreign exchange losses are nondeductible and should be added back to income as an unfavorable M.

Potentially Applicable TCC Sections • •

15.12 16.01

IRC § 351 Transactions and Incorporations Foreign Currency Transactions

29

Schedule M Guidance

MP520 – Leased Inclusion Costs* GAAP (Financial Statement) Treatment Automobile expenditures are generally expensed as incurred for GAAP purposes.

Tax Treatment For tax purposes, IRC § 280F(c) and Treas. Reg. § 1.280F-7(a) require that a corporation must include a certain amount of income based on the fair value of the automobile for post-1986 leases of automobiles. To determine the income inclusion under IRC § 280F(a), consult the lease inclusion tables issued by the IRS annually in a revenue procedure (e.g., in Rev. Proc. 2009-24 for vehicles first leased in 2009). You will find tables that provide you with the IRC § 280F(c)–lease income inclusion–by year, based on the fair market value of the automobile. Separate lease inclusion tables are provided for trucks (including sports-utility vehicles) and vans that are built on a truck chassis. Leased trucks and vans with loaded gross vehicle weight over 6,000 pounds are exempt from lease income inclusion. The IRC § 280F(c)–lease income inclusion—by year amount effectively reduces the lease payment deduction on the automobile for tax purposes. Example: A car with a fair market value of $21,300 leased for 3 years beginning April 15, 2009, would have an income inclusion amount of $11 (261/365 days × $15 (from tables in Rev. Proc. 2009-24)) for 2009. This amount would be included on page 1, line 10 of the Form 1120 (“other income”). It would also be included on page 2, line 25 of Schedule M-3 (Form 1120, “Other Income (Loss) Items with Differences”).

Where Do I Get the Information? Source documents: Client information (fair market value of automobile) and the lease inclusion table (e.g., Rev. Proc. 2009-24 for 2009).

How Do I Calculate the Schedule M Adjustment? Look up the fair market value in lease inclusion table. Look across to the year in the lease. Include the amount in miscellaneous income on the return. You will need to determine the lease date and then include in income a pro-rata amount based on the number of days during the year the car was leased by the corporation. Illustration: Table from Rev. Proc. 2009-24 (2009) Fair Market Value

$21,000 – $21,500

Tax Income Inclusion Amount

1st

2nd

3rd

4th

5th and later

$15

$31

$47

$55

$64

Assumptions: Fair market value of the automobile = $21,300 Lease Date: April 15, 2009 Income inclusion under IRC Section 280F(c) = $11 ($15 × 261/365 Days) Schedule M – unfavorable addback.

Potentially Applicable TCC Sections •

7.02

Lessor as Tax Owner

30

Schedule M Guidance

MP600 - Credit Expense Addback Tax Law Pursuant to IRC § 280C, a taxpayer cannot deduct expenses for which the taxpayer is also claiming a credit; the effect of this is an unfavorable Schedule M equal to the credit amount.

Potentially Applicable TCC Sections • • • • • • • • • • • •

8.08 9.14 9.15 10.06 10.22 11.00 20.00 20.07 20.08 20.11 20.13 26.34

Federal-To-State Adjustments Nonhighway Fuel Credit Work Opportunity Credit Alcohol Fuel Credit General Business Credits Research and Experimental Deductions and Credits Federal Tax Credits IRC § 48C Advanced Energy Manufacturing Credit Section 48D Credit: Qualifying Therapeutic Discovery Project Credit IRC § 45D New Markets Tax Credit HIRE Act Credit Fuel Tax Credit

31

Schedule M Guidance

MP610 – Domestic Production Activity Deduction Potentially Applicable TCC Sections • • • •

8.08 16.22 19.00 18.32

Federal-To-State Adjustments IRC § 199 Calculations Domestic Production Activities Deduction (IRC § 199) IRC § 199 Considerations

32

Schedule M Guidance

MP700 – Environmental Remediation Costs Tax Law Under IRC § 198(a), a taxpayer may elect to treat any qualified environmental remediation expenditure which is paid or incurred by the taxpayer as an expense which is not chargeable to capital account. Any expenditure which is so treated shall be allowed as a deduction for the taxable year in which it is paid. IRC § 198 environmental remediation costs are separately stated on Form 1120, Schedule M-3, Part III, Line 29. Amounts shown on this line are generally deductible and a Schedule M adjustment should not be considered automatic.

Potentially Applicable TCC Sections • • •

2.46 2.95 9.04

Environmental Remediation Specified Liability Loss (IRC § 172(f)) Specified Liability Loss (IRC § 172(f))

33

Schedule M Guidance

MP800 or MT110 – Acquisition/Reorganization Costs Tax Law The regulations under IRC § 195 provide that a taxpayer is deemed to make an election under IRC § 195(b) to deduct start-up expenditures for the taxable year in which the active trade or business to which the expenditures relate begins. The regulations under IRC §§ 248 or 709 provide that a corporation or partnership, respectively, is deemed to make an election under IRC §§ 248(a) or 709(b) to deduct organizational expenditures for the taxable year in which the corporation or partnership begins business. Amortization of acquisition, reorganization, and start-up costs are separately stated items on Form 1120, Schedule M-3, Part III, Lines 23-25 and Line 27.

Potentially Applicable TCC Sections • • • • • •

2.49 2.50 4.10 8.18 15.00 15.18

Organization Costs Start-Up Costs Acquisition Indebtedness Mergers and Acquisitions Distributions, Mergers and Acquisitions, Reorganizations and Other Capital Transactions Other Transaction Considerations

34

Schedule M Guidance

MPB25A – Bank Life Insurance Potentially Applicable TCC Sections • • •

2.65 2.66 6.17

Life Insurance Loans Life Insurance Premiums Life Insurance

35

Schedule M Guidance

MPB25B – Bank-Owned Life Insurance Income Potentially Applicable TCC Sections •

6.17

Life Insurance

36

Schedule M Guidance

MPB30A – Sec 291 Interest Expense Disallowance Potentially Applicable TCC Sections •

10.16

Mining Exploration and Development Costs

37

Schedule M Guidance

MPB30B – Sec 265 Interest Expense Disallowance Potentially Applicable TCC Sections •

5.24

Tax-Exempt Interest

38

Schedule M Guidance

MPX100 – Deemed Inclusions Potentially Applicable TCC Sections •

16.03

Subpart F Income (IRC §§ 951 - 964)

39

Schedule M Guidance

MPX200 – Distribution of PTI •

16.01

Foreign Currency Transactions

40

Schedule M Guidance

MPX210 – PTI Exchange Gain/Loss Potentially Applicable TCC Sections •

16.01

Foreign Currency Transactions

41

Schedule M Guidance

MPX300 - Branch Remittance Gain/Loss Potentially Applicable TCC Sections • • •

16.01 16.15 16.16

Foreign Currency Transactions Branch Profits Tax Branch Level Interest Tax

42

Schedule M Guidance

MPX400 – Section 78 Gross-Up Potentially Applicable TCC Sections • •

8.08 8.12

Federal-To-State Adjustments Foreign Source Dividends and IRC § 78 Gross-Up

43

Schedule M Guidance

MPX500 – Reverse Section 901 Taxes Potentially Applicable TCC Sections •

16.07

Foreign Tax Credits

44

Schedule M Guidance

MPX600 – FSC Commission Potentially Applicable TCC Sections •

8.10

Foreign Sales Corporation ("FSC")

45

Schedule M Guidance

MPX700 – Section 965 DASTM Gain/Loss Potentially Applicable TCC Sections • •

16.01 16.24

Foreign Currency Transactions Foreign Account Tax Compliance Act (FATCA)

46

Schedule M Guidance

MPX800 – Gross Foreign Dividend Not Previously Taxed Potentially Applicable TCC Sections •

16.01

Foreign Currency Transactions

47

Schedule M Guidance

MPX900 – Excess Distribution 2 Potentially Applicable TCC Sections •

16.05

Passive Foreign Investment Company ("PFIC")

48

Schedule M Guidance

MTA10A – Accrued Bonus* GAAP (Financial Statement) Treatment ASC 710, Compensation - General, requires a liability to be accrued for employees’ compensation for future absences if all of the following conditions are met: 1. 2. 3. 4.

The employer’s obligation is attributable to employees’ services already rendered, The obligation relates to rights that vest or accumulate, Payment is probable, and The amount can be reasonable estimated.

Bonuses are accrued by a charge to income if both of the following are met: 1. 2.

The amount can be reasonably estimated, and It is probable that the liability has been incurred at the financial reporting date.

Tax Treatment A vacation, sick leave pay, or bonus (to employees with no “significant” ownership) deduction is generally limited to the amount earned or awarded during the year to the extent that: 1. 2.

The amount is paid to employees during the year, or The amount is vested as of the last day of the tax year (fixed and determinable) and is paid to employees within 2 ½ months after the end of the year. (IRC § 404(a)(5); Temp. Reg. § 1.404(b)-1T, Q & A-1 and Q & A-2(b))

IRC § 461 requires that the following conditions be met for an accrual to be deductible for tax purposes: •

The liability must be fixed and determinable at end of the tax year (versus “probable and estimable” for GAAP as discussed above)

•

“Economic performance” must have occurred (i.e., the services have been provided). In general, under IRC § 404(a)(11) and Treas. Reg. § 1.461-4(d)(2)(iii)(A), deferred compensation is generally deducted for tax purposes in the same tax year that the payment is recognized in income of the recipient. Treas. Reg. § 1.404(b)-1T allows that economic performance will be considered to have occurred if the taxpayer made payment within 2 ½ months of the end of the tax year (original due date of the return without regard to extensions) in which the services were provided.

Amounts not paid within 2 ½ months of year end are considered deferred compensation and are not deductible until the tax year paid.

Where Do I Get the Information? The trial balance will provide the amount of expense accrued at year-end, but client contact is required to determine the amount paid within 2 ½ months. Also, prior year workpapers will be required in order to find the amount paid within 2 ½ months and deducted on the prior-year tax return.

How Do I Calculate the Schedule M Adjustment? The adjustment amount is calculated in the following manner: Accrued vacation, beginning of year Amount paid within 2-1/2 months in prior year Accrued vacation, adjusted beginning of year (not deducted in prior year return) Accrued vacation, end of year

$20,000 -5,000 $15,000 30,000

49

Schedule M Guidance

Amount paid within 2-1/2 months in current year

-10,000

Accrued vacation, adjusted end of year

$ 20,000

Schedule M – unfavorable addback

$5,000

Practice Tips and Techniques Change from beginning to end of tax year

Adjustment to book income

Net Increase in Accrued Vacation per Books (GAAP) (Net of payment within 2- 1/2 months)

Addback

To increase book accrual, the journal entry on the GAAP set of books was a debit to expense and a credit to accrual liability. This is not allowed for tax purposes for the reasons mentioned above. The expense must be added back.

Net Decrease in Accrued Vacation per Books (GAAP) (Net of payment within 2-1/2 months)

Reduction

To decrease book accrual, the entry was a debit to accrued liability and a credit to cash. This now becomes deductible for the tax set of books for the reasons mentioned above.

Why?

Potentially Applicable TCC Sections •

• • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.32 Vacation Pay, Bonus Pay, and Deferred Compensation [including Accrual Method Liability Resource] 6.02 Deferred Compensation 6.03 FICA Treatment of Nonqualified Deferred Compensation, Vacation Pay and Bonuses 6.04 Application of § 409A

50

Schedule M Guidance

MTA10B – Accrued Payroll Tax Law Please see MTA10A – Accrued Bonus*

Potentially Applicable TCC Sections • • • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.32 Vacation Pay, Bonus Pay, and Deferred Compensation [including Accrual Method Liability Resource] 6.02 Deferred Compensation 6.04 Application of § 409A

51

Schedule M Guidance

MTA10C – Accrued Deferred Compensation Tax Law Please see MTA10A – Accrued Bonus*

Potentially Applicable TCC Sections • • • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.32 Vacation Pay, Bonus Pay, and Deferred Compensation [including Accrual Method Liability Resource] 6.02 Deferred Compensation 6.03 FICA Treatment of Nonqualified Deferred Compensation, Vacation Pay and Bonuses

52

Schedule M Guidance

MTA10D – Accrued Rabbi Trust Tax Law A Rabbi Trust is generally designed to provide some assurance that future benefit obligations will be satisfied. The IRS will find a valid rabbi trust exists if all three conditions are met: the trust's assets must be available to all the general creditors of the employer if the employer files for bankruptcy , there are no insolvency triggers that hasten payments to employees when the employer's net worth falls below a certain point, thereby bypassing creditors before insolvency is declared , there is a procedure to provide notice to the trustee of the bankruptcy of the employer or financial hardship of the employer. Because a rabbi trust is subject to the claims of the employer's general creditors, the employer is considered the owner of the trust and the executive is not subject to tax on the deferred amounts until payments are actually received. When payments are actually received and the executive is taxed, the employer may take a corresponding deduction.

Potentially Applicable TCC Sections • • •

2.31 6.02 6.04

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Deferred Compensation Application of § 409A

53

Schedule M Guidance

MTA10E – Accrued Benefits Tax Law Please see MTA10A – Accrued Bonus*

Potentially Applicable TCC Sections • • • • • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.53 Incurred but not Reported Employee Medical Expense (Including IBNR in Workers' Compensation) 6.02 Deferred Compensation 6.03 FICA Treatment of Nonqualified Deferred Compensation, Vacation Pay and Bonuses 6.04 Application of § 409A 6.12 Plan Terminations and Significant Reductions in Future Benefit Accruals

54

Schedule M Guidance

MTA10F – Accrued Vacation* Tax Law Please see MTA10A – Accrued Bonus*

Potentially Applicable TCC Sections • • • • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.32 Vacation Pay, Bonus Pay, and Deferred Compensation [including Accrual Method Liability Resource] 6.02 Deferred Compensation 6.03 FICA Treatment of Nonqualified Deferred Compensation, Vacation Pay and Bonuses 6.04 Application of § 409A

55

Schedule M Guidance

MTA10G – Accrued ASC 715 (formerly FASB 106) Tax Law Generally, accruals for post-retirement benefits under ASC 715, Compensation – Retirement Benefits, (formerly FASB 106) are not deductible for tax purposes until paid. The costs accrued are any benefits which are expected to be paid by the employer not otherwise covered by another pension or qualified plan. These benefits commonly include postretirement health care and life insurance provided outside a plan. For book purposes, these costs are accrued currently in the financial accounts, but are not deductible for tax purposes until paid. The costs are generally treated the same as deferred compensation.

Potentially Applicable TCC Sections • • •

2.31 6.09 6.23

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Funding Post-Retirement Benefits

56

Schedule M Guidance

MTA10H – Accrued Severance Tax Law IRC § 461 requires that the following conditions be met for an accrual to be deductible for tax purposes: •

The liability must be fixed and determinable at end of the tax year (versus “probable and estimable” for GAAP as discussed above).

•

“Economic performance” must have occurred (i.e., the services have been provided).

Treas. Reg. § 1.404(b)-1T imposes the additional requirement that payment must be made within 2-1/2 months of the end of the tax year (original due date of the return without regard to extensions) that the services were provided. Amounts not paid within 2-1/2 months are not deductible until the tax year paid (it also generally must be includable as income by the recipient). IRC § 404(a)(11) states that “no amount is treated as paid for this purpose until it is actually received by the employee.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

57

Schedule M Guidance

MTA10I – Accrued Commissions Tax Law IRC § 461 requires that the following conditions be met for an accrual to be deductible for tax purposes: •

The liability must be fixed and determinable at end of the tax year (versus “probable and estimable” for GAAP as discussed above).

•

“Economic performance” must have occurred (i.e., the services have been provided).

Treas. Reg. § 1.404(b)-1T imposes the additional requirement that payment must be made within 2-1/2 months of the end of the tax year (original due date of the return without regard to extensions) that the services were provided. Amounts not paid within 2-1/2 months are not deductible until the tax year paid (it also generally must be includable as income by the recipient). IRC § 404(a)(11) states that “no amount is treated as paid for this purpose until it is actually received by the employee.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

58

Schedule M Guidance

MTA10J or MT120 - Accrued Professional Fees* GAAP (Financial Statement) Treatment In order to fairly represent the expenses applicable to a reporting period (i.e., the matching principle), GAAP requires an accrual for professional fees that have been incurred as of year-end but have not been paid. Expenses are generally recognized when an entity's economic benefits are consumed (i.e., actual or expected cash outflow) in revenue-earning activities or otherwise.

Tax Treatment For tax purposes, expenses are allowed as deductions only after the “all events test” is satisfied and economic performance has occurred. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year (versus probable and estimable for GAAP, as discussed above) and “economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. §1.461-4(d)(2)(i). The all events test for accrued professional fees is generally satisfied the earlier of the date that: (1) the required performance occurs, (2) payment is due, or (3) payment is made. The economic performance requirement for accrued professional fees is generally satisfied as the services are provided to the taxpayer. Note: The mere execution of an insurance or service contract (e.g., professional service contracts including those for audit and tax services) by an accrual method taxpayer does not satisfy the all events test for incurring the liability. For example, absent a prepayment, the amount of accrued professional fees deductible in the 2010 tax year would be limited to the amount of services actually performed in that tax year (2010). See Rev. Rul. 2007-3 and TCC Section 2.44 – Executory Contracts. The recurring item exception should be considered when the all events test is satisfied in the earlier year as a result of payment due or made, and the services are provided within 8 ½ months of year-end. Under Treas. Reg. § 1.461- 5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

The 3 ½ month rule should be considered. For economic performance purposes, the taxpayer can treat the services as provided/rendered at the time of payment if the services are expected to be provided within 3 ½ months of payment (Treas. Reg. § 1.461-4(d)(6)(ii)). See Tax Alert 07002 for a detailed discussion of accrued professional fees.

Where Do I Get the Information? The accrual of professional fees should be relatively easy to find on both the trial balance and the financial statements. To determine the deductible tax expense, consulting the client for additional details and facts will be necessary. In most cases, however, the entire accrual will be disallowed and added back to book income.

59

Schedule M Guidance

How Do I Calculate the Schedule M Adjustment? If the increase in the accrual is larger than the allowable tax deduction, the difference should be added back to book income as an unfavorable adjustment. In the following example accrued professional fees (estimated) for services to be provided in the following year were accrued by XYZ Corp. Beginning Balance – 12/31/0X

$20,000

Ending Balance – 12/31/0X

30,000

Schedule M – unfavorable addback

$10,000

Potentially Applicable TCC Sections • • •

2.31 2.33 2.44

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Accrued Professional Fees Executory Contracts

60

Schedule M Guidance

MTA10K – Accrued Directors Fees Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Potentially Applicable TCC Sections • • • •

2.31 6.02 6.04 6.18

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Deferred Compensation Application of § 409A Compensation Paid to Top Executives

61

Schedule M Guidance

MTA10L – Accrued Related Party Compensation Tax Law Generally, accrued related party compensation accruals are not deductible for tax purposes until the recipient recognizes the income.

Potentially Applicable TCC Sections • • • •

2.31 2.78 6.02 6.04

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Related Party Expenses Deferred Compensation Application of § 409A

62

Schedule M Guidance

MTA10M – Accrued Retirement GAAP (Financial Statement) Treatment In order to fairly represent the expenses applicable to a reporting period (i.e., the matching principle), GAAP requires an accrual for retirement costs (e.g., retirement plans, pension plans, 401(k) plans) that have been incurred as of year-end but have not been paid. Expenses are generally recognized when an entity's economic benefits are consumed (i.e., actual or expected cash outflow) in revenue-earning activities or otherwise.

Tax Treatment For tax purposes, accrued retirement/pension/401(k) expenses (deferred compensation) are allowed as deductions only after the “all events test” is satisfied, economic performance has occurred (i.e., the services have been provided), and the requirements under IRC § 404(a)(5) are met. The timing of the tax deduction will vary depending on the type of plan. A stock bonus, pension, or profitsharing plan that meets the requirements of IRC § 401(a) is a qualified plan. For qualified plans, generally the deduction is allowed as contributions to the plan are made. For nonqualified plans, generally the deduction is allowed as payments are made to the employee. Under IRC § 404(a), expenses are generally deductible in the year they are paid. However, IRC § 404(a)(6) provides a special rule for payments made by a pension trust, employees’ annuity, or stock bonus or profitsharing trust. If payment is made by one of these types of plan, the taxpayer is deemed to have made payment during the taxable year for which the return is being prepared if the accrued expenses are on account of that taxable year and payment was made no later than the time prescribed to file the return (including extensions). If payments are not made to a qualified pension trust, employee annuity, or stock bonus or profit-sharing trust, IRC § 404(a)(5) applies. Under IRC § 404(a)(5) and Treas. Reg. § 1.461-4(d)(2)(iii)(A), deferred compensation is generally deducted for tax purposes in the same tax year that the payment is recognized in income of the recipient. Under Treas. Reg. § 1.404(b)-1T A-2:(c), economic performance will be considered to have occurred as of year-end if the taxpayer makes payment within 2-1/2 months of the end of the tax year in which the services were provided, to the extent accrued as of the end of such year. Amounts not paid within 2-1/2 months are not deductible until the tax year paid.

Potentially Applicable TCC Sections • • •

2.31 6.01 6.02

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Nonqualified and Qualified Plans Deferred Compensation

63

Schedule M Guidance

MTA10Q – Accrued Related Party Bonus Tax Law Generally, accrued related party bonus accruals are not deductible for tax purposes until the recipient recognizes the income.

Potentially Applicable TCC Sections • • • • •

2.31 2.78 6.02 6.03 6.04

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Related Party Expenses Deferred Compensation FICA Treatment of Nonqualified Deferred Compensation, Vacation Pay and Bonuses Application of § 409A

64

Schedule M Guidance

MTA10R – Accrued Related Party Vacation Tax Law Generally, accrued related party vacation accruals are not deductible for tax purposes until the recipient recognizes the income.

Potentially Applicable TCC Sections • • • • • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.32 Vacation Pay, Bonus Pay, and Deferred Compensation [including Accrual Method Liability Resource] 2.78 Related Party Expenses 6.02 Deferred Compensation 6.03 FICA Treatment of Nonqualified Deferred Compensation, Vacation Pay and Bonuses 6.04 Application of § 409A

65

Schedule M Guidance

MTA10S – Accrued Pension/Profit-Sharing Tax Law Please see MTA10M – Accrued Retirement

Potentially Applicable TCC Sections • • • • • •

2.31 6.01 6.12 6.15 6.02 6.08

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Nonqualified and Qualified Plans Plan Terminations and Significant Reductions in Future Benefit Accruals Employee Stock Purchase Plans Deferred Compensation Plan Contributions

66

Schedule M Guidance

MTA10T – Accrued 401(k) Tax Law Please see MTA10M – Accrued Retirement

Potentially Applicable TCC Sections • • • • •

2.31 6.01 6.02 6.08 6.12

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Nonqualified and Qualified Plans Deferred Compensation Plan Contributions Plan Terminations and Significant Reductions in Future Benefit Accruals

67

Schedule M Guidance

MTA20A – Accrued Workers Compensation Tax Law Generally, workers compensation accruals are not deductible for tax purposes until paid. Pursuant to Treas. Reg. § 1.461-5(c), the "recurring item" exception does not apply to any liability related to Worker's Compensation.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

68

Schedule M Guidance

MTA20B – Accrued Charitable Contribution Tax Law Under IRC § 170(a) and Treas. Reg. § 1.170A-1, only charitable contributions paid during the tax year are allowable as a deduction. Under IRC § 170(a)(2) and Treas. Reg. § 1.170A-11(b), taxpayer may elect to recognize charitable contributions made after year end in the prior taxable year if 1) the taxpayer's board or directors authorizes the charitable contribution in the taxable year for which the return is being prepared and 2) payment of the charitable contribution was made before the 15th day of the 3rd month after the end of the taxable year. Charitable contributions are subject to limitations contained in IRC § 170(b)(2) and Treas. Reg. § 1.170A-8 or 1.170A-11. Note that special rules exist for charitable contribution of inventory

Potentially Applicable TCC Sections • • • • •

2.31 2.54 2.55 2.56 2.57

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Post-Year-End Charitable Contributions Property Contributions Property Sales to Charity Charitable Contribution Limitation

69

Schedule M Guidance

MTA20C – Accrued Coupons Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461- 4(d)(2)(i). In general a liability for a coupon redemption is not fixed until the coupon has been tendered. Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

70

Schedule M Guidance

MTA20D – Accrued Discounts Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461- 4(d)(2)(i). Generally, a liability for a discount is not fixed until the discount is earned. For example, a trade discount is earned when the requisite amount of goods have been purchased to earn the trade discount. Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Potentially Applicable TCC Sections • •

2.31 2.90

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Trade & Cash Discounts

71

Schedule M Guidance

MTA20E – Accrued Environmental Clean-Up Tax Law Environmental cleanup (remediation) costs incurred by the taxpayer (as the contaminating party) may be deductible as a current business expense under IRC § 162 if certain requirements are met (Rev. Rul. 94-38); however, costs may be required to be capitalized to inventory if requirements of IRC § 263A are met (Rev. Rul. 2004-18). Environmental liabilities are capitalizable when assumed in an acquisition or are otherwise paid by a non-contaminating party.

Potentially Applicable TCC Sections • •

2.31 2.46

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Environmental Remediation

72

Schedule M Guidance

MTA20F – Accrued Promotions Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Generally, a liability for promotional expenses is fixed upon performance of the promotion. Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

73

Schedule M Guidance

MTA20G – Accrued Rebates Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Generally a liability for rebates is fixed when the rebate is earned. Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

5.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs. Rebates are a payment liability and the recurring item exception applies.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

74

Schedule M Guidance

MTA20H – Accrued Insurance Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Note: The all events test for accrued insurance is generally satisfied the earlier of the date that: (1) the required performance occurs, (2) payment is due, or (3) payment is made. Insurance is often prepaid which would meet the requirement of fixed and determinable. The mere execution of an insurance or service contract by an accrual method taxpayer does not satisfy the all events test for incurring the liability. See Rev. Rul. 2007-3 and TCC Section 2.44 – Executory Contracts. Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Insurance is a payment liability, thus if prepaid, all three prongs of the all events test are met upon payment. You should also consider the capitalization rules if the contracts are over 1 year.

Potentially Applicable TCC Sections • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.53 Incurred but not Reported Employee Medical Expense (Including IBNR in Workers' Compensation)

75

Schedule M Guidance

MTA20I – Accrued Self-Insurance Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Generally, self-insurance costs (i.e., for employee medical, retiree medical, or workers compensation) are deductible in the year the medical services are provided including incurred but not reported (IBNR) amounts. In other words, taxpayers may be able to deduct these costs in the year that the medical services are provided to the employee rather than in the subsequent year when the claims are submitted for reimbursement.

Potentially Applicable TCC Sections • •

2.31 2.53

Economic Performance [including Accrual Method Liability Quick Reference Sheet] IBNR Employee Medical Expense (Including IBNR in Workers' Compensation)

76

Schedule M Guidance

MTA20J – Accrued Advertising Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Generally, a liability for advertising costs is fixed when the advertising services are rendered or upon payment, if earlier. For economic performance purposes, the taxpayer can treat the services as provided/rendered at the time of payment if the services are expected to be provided within 3 ½ months of payment (Treas. Reg. § 1.461-4(d)(6)(ii)). Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Note: In most cases, advertising is deductible as the advertising services are rendered, unless provided within 3 ½ months of the year in which the amounts were fixed.

Potentially Applicable TCC Sections • •

2.31 2.67

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Prepaid Expenses [including Accelerating Deduction of Prepaid Expense Resource Page]

77

Schedule M Guidance

MTA20K – Co-Op Advertising Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual of advertising for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. These differences require that an M adjustment be calculated. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year (versus probable and estimable for GAAP, as discussed above) and “Economic performance” must have occurred (i.e., the services have been provided) per Treas. Reg. § 1.461-4(d)(2)(i). If the all events test (fixed and determinable) is met by year-end for the liability, Reg. § 1.461-5 provides that the recurring item exception shall be deemed to apply for co-op advertising if economic performance occurs by the earlier of: 1) the filing date of the timely-filed return (including extensions) or 2) 8-1/2 months.. In Rev. Rul. 98-39, co-op advertising is fixed at the time advertising services are rendered. Because this is a service liability, all three prongs of all events test are met at the time the services are rendered.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

78

Schedule M Guidance

MTA20L - Accrued Interest Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Generally, for interest, economic performance occurs as the interest cost economically accrues (Treas. Reg. § 1.461-4(e)).

Potentially Applicable TCC Sections • •

2.31 2.40

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Capitalization of Interest, Taxes

79

Schedule M Guidance

MTA20M – Accrued Management Fees Tax Law In general, accrued management fees that are incurred by an accrual basis company may be accrued in the current year and paid in the following year. The company enters an accrued liability in the current year and also deducts the expense on its books in the current year. A company may generally deduct payments made for services rendered prior to the end of year. In some cases, if prepayment is made, services expected to be rendered within 3 ½ months of prepayment may be deducted in the earlier year. However, the purpose of a management fee may affect its deductibility. For example, under Rev. Rul. 81-150, management fees that compensate for services performed to acquire a capital asset may be considered capital expenditures that are required to be capitalized under IRC § 263(a). Additionally, management fees that compensate for services performed before a taxpayer begins a trade or business may also be required to be capitalized under IRC § 263(a) and may be amortized as start-up expenditures under IRC § 195 once the trade or business begins. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the management services have been provided) prior to year end per Reg. § 1.461-4. The all events test for accrued management fees is generally satisfied the earlier of the date that: (1) the required performance occurs, (2) payment is due, or (3) payment is made. The economic performance requirement for accrued management fees is generally satisfied as the services are provided to the taxpayer. Note: The mere execution of an insurance or service contract by an accrual method taxpayer does not satisfy the all events test for incurring the liability. See Rev. Rul. 2007-3 and TCC Section 2.44 – Executory Contracts. Note: If prepaid, taxpayer may be able to deduct 3 1/2 months of fees, if expects to have those services rendered within 3 ½ months of year end. Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2. 3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a) date on which taxpayer timely files the return or b) within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Potentially Applicable TCC Sections • •

2.31 2.44

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Executory Contracts

80

Schedule M Guidance

MTA20N – Accrued Personal Property Taxes Tax Law Generally, accrued state and local personal property taxes are deductible in the tax year in which all the events have occurred which determine the fact of liability, the amount thereof can be determined with reasonable accuracy, and economic performance has occurred. Under Treas. Reg. § 1.461-4(g)(6), taxes are considered payment liabilities for which economic performance occurs in the tax year in which the taxes are paid.

Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

81

Schedule M Guidance

MTA20O – Accrued Payroll Taxes Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461- 4(d)(2)(i). Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Rev. Proc. 2008-25 provides under a special safe harbor method of accounting that solely for purposes of the recurring item exception in Treas. Reg. § 1.461-5, a taxpayer will be treated as satisfying the requirement for the recurring item exception in Treas. Reg. § 1.461-5(b)(1)(i) for its payroll tax liability in the same tax year in which all events have occurred that establish the fact of the related compensation liability and the amount of the related compensation liability can be determined with reasonable accuracy. Rev. Proc. 2008-25 doesn't apply to an employee's portion of FICA tax imposed under IRC § 3101 and deducted by the employer from wages paid to the employee.

Potentially Applicable TCC Sections • •

2.31 Economic Performance [including Accrual Method Liability Quick Reference Sheet] 2.32 Vacation Pay, Bonus Pay, and Deferred Compensation [including Accrual Method Liability Resource]

82

Schedule M Guidance

MTA20P – Accrued Royalties Tax Law For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. Royalties are fixed and determinable depending upon when owed under the contract. Typically economic performance occurs as property is used. Caution: There are proposed regulations that provide rules for sales-based royalties. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Potentially Applicable TCC Sections • • • •

2.20 2.25 2.26 2.31

Upfront Fees, Milestone Payments, and Royalties Receipts for Royalties Receipts for Intellectual Property Economic Performance [including Accrual Method Liability Quick Reference Sheet]

83

Schedule M Guidance

MTA20Q – Related Party Accrued Interest Tax Law Generally, accrued related party interest accruals are not deductible for tax purposes until the recipient recognizes the income.

Potentially Applicable TCC Sections • • • • •

2.31 2.78 2.80 4.29 8.08

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Related Party Expenses Related Party Debt Acquisition Interest on Related Party Debt Federal-To-State Adjustments

84

Schedule M Guidance

MTA20R – Accrued Development Costs Tax Law Accrued development costs can include a number of different items which can invoke a number of different tax account rules. Some accrued development costs may include research and development, software development (see MTF100 – Amortization*), and other tangible and intangible development. For tax purposes, expenses are usually allowed as deductions only after they meet both the “all events” test and economic performance has been met. This requires that the expenses be both fixed and determinable and that the services are performed. Since the accrual for book purposes does not require that the deduction amount be fixed and determinable, differences arise between book and tax. IRC § 461 requires that an accrual meet the following criteria to be deductible: The liability must be fixed and determinable at the end of the tax year and “Economic performance” must have occurred (i.e., the services have been provided) prior to year end under Treas. Reg. § 1.461-4(d)(2)(i). Under Treas. Reg. § 1.461-5, taxpayer using an accrual method may adopt the recurring item exception for recurring items incurred by the taxpayer. Under the recurring item exception, a liability is treated as incurred for a taxable year if: 1. 2.

3. 4.

as of the end of that taxable year, all events have occurred to establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; economic performance with respect to the liability occurs before the earlier of a. date on which taxpayer timely files the return or b. within 8 1/2 months of tax year end; liability is recurring in nature and either the amount of the liability is not material or the deduction of the liability in that taxable year results in better matching of the deduction with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

Potentially Applicable TCC Sections • • • •

2.31 2.36 11.03 2.37

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Software Development Costs [including Software Development Costs Resource Page] Method of Identifying Research Costs Research & Development Expenses

85

Schedule M Guidance

MTA20S – Accrued Sales Tax Tax Law Generally, accrued sales taxes are deductible in the tax year in which all the events have occurred which determine the fact of liability, the amount thereof can be determined with reasonable accuracy, and economic performance has occurred. Under Treas. Reg. § 1.461-4(g)(6), taxes are considered payment liabilities for which economic performance occurs in the tax year in which the taxes are paid.

Potentially Applicable TCC Sections • • • • • • • •

2.31 8.03 8.19 8.20 8.21 8.23 8.24 8.28

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Nexus Issues Sales and Use Taxes and Other Transfer Taxes Obligation to Collect Exemption Certificates Sales Between Affiliated Groups Hosted Software/Digital Goods Sales/Use Tax on Purchases

86

Schedule M Guidance

MTA300 – Accrued Real Property Tax Law Generally, accrued taxes are deductible in the tax year in which all the events have occurred which determine the fact of liability, the amount thereof can be determined with reasonable accuracy, and economic performance has occurred. For real property taxes, the lien date fixes the liability. Under Treas. Reg. § 1.4614(g)(6), taxes are considered payment liabilities for which economic performance occurs in the tax year in which the taxes are paid (modified lien date method). However, under the alternative ratable accrual method, and a taxpayer has made a valid election under IRC § 461(c), any real property tax shall accrue ratably for tax purposes in accordance with IRC § 461(c). For a taxpayer using the modified lien date method, property taxes are deductible in the current tax year if property tax payments are made within 8.5 months of the end of the tax year that includes the lien date.

Potentially Applicable TCC Sections • •

2.31 2.41

Economic Performance [including Accrual Method Liability Quick Reference Sheet] Real Property Tax

87

Schedule M Guidance

MTB10A – FHLB Stock Dividend Potentially Applicable TCC Sections • •

15.02 14.10

Distributions Intercompany Transactions

88

Schedule M Guidance

MTB10B – FHLB Stock Redemption Gain Of Sale Potentially Applicable TCC Sections • •

15.03 15.04

Redemption Related Party Stock Sales Treated as Redemptions

89

Schedule M Guidance

MTB200 – Non-Accrual Interest Potentially Applicable TCC Sections • • •

2.34 5.13 10.11

Bad Debt & Disputed Sales Bad Debts Bad Debts of Financial Institutions

90

Schedule M Guidance

MTB30A – Bad Debt Provision Potentially Applicable TCC Sections • • •

2.34 5.13 10.11

Bad Debt & Disputed Sales Bad Debts Bad Debts of Financial Institutions

91

Schedule M Guidance

MTB30B – Tax Loan Loss – Reserve Method Potentially Applicable TCC Sections • • • •

2.34 2.47 5.13 10.11

Bad Debt & Disputed Sales Reserves Bad Debts Bad Debts of Financial Institutions

92

Schedule M Guidance

MTB30C – Tax Loan Loss – Spec Charge Off Potentially Applicable TCC Sections • • •

2.34 5.13 10.11

Bad Debt & Disputed Sales Bad Debts Bad Debts of Financial Institutions

93

Schedule M Guidance

MTB30D - Tax Reserve Recap – 481(A) Potentially Applicable TCC Sections •

2.02

Accounting Method Changes

94

Schedule M Guidance

MTB400 - Accrued SIP Adjustment Potentially Applicable TCC Sections •

2.31

Economic Performance [including Accrual Method Liability Quick Reference Sheet]

95

Schedule M Guidance

MTB450 – SERP Expense Potentially Applicable TCC Sections •

6.04

Application of § 409A

96

Schedule M Guidance

MTB500 – Loan Costs Potentially Applicable TCC Sections • •

2.71 4.19

Loan Origination Costs/Debt Issuance Costs Stock and Debt Issuance Costs

97

Schedule M Guidance

MTB510 – Tax Loan Fees Potentially Applicable TCC Sections •

2.71

Loan Origination Costs/Debt Issuance Costs

98

Schedule M Guidance

MTD10A – Deferred Rent Expense Tax Law Generally, deferred rent expenditures are deductible for tax purposes over the period to which they relate (ratable accrual).

Potentially Applicable TCC Sections • •

2.29 2.51

Deferred Rental Income Deferred Rental Expense

99

Schedule M Guidance

MTD20A – Deferred Revenue Tax Law Under Rev. Proc. 2004-34 (2004-22 I.R.B. 991), there are two permissible methods of accounting for the advance payment: •

The "full inclusion method" is simply the method under which a taxpayer includes the full amount of advance payments in gross income in the taxable year of receipt.

•

Under the "deferral method," on the other hand, a qualifying taxpayer only includes an advance payment in gross income for the taxable year of receipt to the extent that the taxpayer recognizes the payment in revenues in its "applicable financial statement" for the taxable year of receipt. The taxpayer includes the remaining amount of the advance payment in gross income for the next succeeding taxable year.

An election to use the "deferral method" must be made in the first year such payments are received; otherwise, taxpayers must apply for a change in accounting method. Note that the methods provided for in Rev. Proc. 2004-34 may not apply to all types of advanced payments. Advanced payments not covered by Rev. Proc. 2004-34 should instead be accounted for under Treas. Reg. § 1.451-5 which required advanced payments to be recognized in the taxable year of receipt. Also see Treas. Reg. § 1.451-1 for special rules for deferring advanced payments received for inventoriable goods.

Potentially Applicable TCC Sections • • • • •

2.10 2.15 2.17 2.18 2.21

Prepaid Subscription Income Prepaid Income and Advance Payments Gift Card Income Government Contract Accounting Deposits

100

Schedule M Guidance

MTD20B – Unearned Rent Income* GAAP (Financial Statement) Treatment GAAP rules dictate that unearned rental revenue should not be recognized until the income has been earned. This means that any rents received before the period to which they apply will not be taken into income until the applicable period begins. They are recorded by crediting a liability account called “unearned rent” and debiting the cash account.

Tax Treatment Except as provided in IRC § 467 and the regulations there under, Treas. Reg. § 1.61-8(b) state that gross income includes advance rentals, which must be included in income the year of receipt regardless of the period covered or the method of accounting employed by the taxpayer. IRC § 467(d) and Treas. Reg. § 1.467-1(c)(1) define a IRC § 467 rental agreement to include any rental agreement for the use of tangible property under which there is prepaid or deferred rent under the agreement. IRC § 467(d)(2) provides that IRC § 467 only applies to agreements involving rental payments of more than $250,000. IRC § 467(a) requires the lessor and lessee of a IRC § 467 rental agreement to take into account for any taxable year the sum of (1) the amount of rent that accrues during the taxable year determined under IRC § 467(b) and (2) interest for the year on the amounts that were taken into account for prior taxable years and that are unpaid.

Where Do I Get the Information? Source documents: Properly classified trial balance, audit workpapers, or completed client information request. An understanding of the current tax method for recognizing advance rentals and a review of the rental agreements may be required.

How Do I Calculate the Schedule M Adjustment? Unearned rent revenue, beginning of year

$6,000

Unearned rent revenue, end of year

8,000

Schedule M – unfavorable addback

$2,000

Practice Tips and Techniques Rev. Proc. 2004-34 may provide some deferral if the advance rental is for: • • •

The use of intellectual property (as defined in the Rev. Proc.) The occupancy of use of property, if the occupancy or use is ancillary to the provision of services The sale, lease, or license of computer software.

Potentially Applicable TCC Sections • •

2.29 7.08

Deferred Rental Income Advance Rents/Bonuses to Lessor

101

Schedule M Guidance

MTD20C – Unearned License Fee Tax Law Under Rev. Proc. 2004-34 (2004-22 I.R.B. 991), there are two permissible methods of accounting for the advance payment: The "full inclusion method" is simply the method under which a taxpayer includes the full amount of advance payments in gross income in the taxable year of receipt. Under the "deferral method," on the other hand, a qualifying taxpayer only includes an advance payment in gross income for the taxable year of receipt to the extent that the taxpayer recognizes the payment in revenues in its "applicable financial statement" for the taxable year of receipt. The taxpayer includes the remaining amount of the advance payment in gross income for the next succeeding taxable year. An election to use the "deferral method" must be made in the first year such payments are received; otherwise, taxpayers must apply for a change in accounting method.

Potentially Applicable TCC Sections •

2.15

Prepaid Income and Advance Payments

102

Schedule M Guidance

MTD20D – Unearned Income Tax Law Under Rev. Proc. 2004-34 (2004-22 I.R.B. 991), there are two permissible methods of accounting for the advance payment: • •

The "full inclusion method" is simply the method under which a taxpayer includes the full amount of advance payments in gross income in the taxable year of receipt. Under the "deferral method," on the other hand, a qualifying taxpayer only includes an advance payment in gross income for the taxable year of receipt to the extent that the taxpayer recognizes the payment in revenues in its "applicable financial statement" for the taxable year of receipt. The taxpayer includes the remaining amount of the advance payment in gross income for the next succeeding taxable year.

An election to use the "deferral method" must be made in the first year such payments are received; otherwise, taxpayers must apply for a change in accounting method.

Potentially Applicable TCC Sections • • • • •

2.10 2.15 2.17 2.18 2.21

Prepaid Subscription Income Prepaid Income and Advance Payments Gift Card Income Government Contract Accounting Deposits

103

Schedule M Guidance

MTD20E – Unearned Interest Tax Law General Rule: Treas. Reg. §1.61-8(b) states that gross income includes payments received in advance, and must be included as income in the year of receipt regardless of the period covered or the method of accounting employed by the taxpayer. There are exceptions to the general rule, please consult the applicable regulation sections.

Potentially Applicable TCC Sections •

2.15

Prepaid Income and Advance Payments

104

Schedule M Guidance

MTD300 – Deferred Intercompany Profit Tax Law General Rule: Treas. Reg. § 1.61-8(b) state that gross income includes payments received in advance, and must be included as income in the year of receipt regardless of the period covered or the method of accounting employed by the taxpayer. There are exceptions to the general rule, please consult the applicable regulation sections.

Potentially Applicable TCC Sections • •

10.27 14.10

Deferred Intercompany Transactions Intercompany Transactions

105

Schedule M Guidance

MTD400 or MT280 – Unrealized Book Gain(Loss) Tax Law In general, unrecognized gain/loss represents income recorded on the books that is not included on the tax return. However, if the taxpayer has elected mark-to-market for tax purposes, the gain/loss will be recognized for tax purposes.

Potentially Applicable TCC Sections • • •

3.05 10.29 14.00

Abandonment of Business Property Gain on Disposition Controlled Groups and Consolidated Returns

106

Schedule M Guidance

MTF100 – Amortization* GAAP (Financial Statement) Treatment An intangible asset with a finite life is amortized over its estimated useful life. An indefinite-lived intangible asset is accounted for in the same manner as goodwill.

Tax Treatment The Internal Revenue Code has established its own amortizable lives for intangible assets. Some intangible assets that are amortizable for book purposes cannot be amortized for tax purposes. For more information regarding amortization expense, see the following sections of the IRC: Goodwill and other intangibles

§ 197

Start up costs**

§ 195

Bond discount or premium

§ 171

Lease acquisition costs

§ 178

Organizational expenditures**

§ 248

Partnership organization fees**

§ 709(b)

Research expenditure

§ 174(b)

**See standard common election templates in AS/2 Tax Pack. Note: Under IRC § 197, a taxpayer may amortize the cost of goodwill and most other intangible assets acquired after August 10, 1993 over a period of 15 years. No tax deduction is allowed for acquisitions prior to this date. Depreciable computer software generally acquired after August 10, 1993, that is not an amortizable IRC § 197 intangible may be depreciated using the straight-line method over a three-year period (IRC § 167(f)(1), (as added by the Revenue Reconciliation Act of 1993 (P.L. 103-66))). Software amortization should be on Form 4562 as depreciation -- not amortization. This workpaper includes amortization adjustments related to other intangible assets which do not fall under IRC § 197 (IRC §§ 248, 195, etc.). See MTF30B_4562 – Tax Depreciation* for information regarding software development costs.

Where Do I Get the Information? The financial statements should provide the necessary detail for intangible assets. The trial balance will also contain accounts detailing book amortization expense for the current year. Tax amortization will be taken from either FAS Encore or GoSystem, depending on which software is used to determine tax depreciation and amortization.

How Do I Calculate the Schedule M Adjustment? If the tax amortization expense is greater than the book amortization amount, then the difference should be subtracted from book income as a favorable adjustment. If book amortization exceeds tax amortization, the difference is added back as an unfavorable adjustment to book income. Amortization expense per books Amortization expense per tax Schedule M – favorable reduction

$100,000 160,000 ($60,000)

Potentially Applicable TCC Sections • •

2.35 2.36

Depreciation/Amortization Software Development Costs [including Software Development Costs Resource Page]

107

Schedule M Guidance

• • • • • • • • • • •

2.37 2.49 2.50 2.69 3.06 3.11 5.07 15.06 15.07 15.09 27.16

Research & Development Expenses Organization Costs Start-Up Costs Settlement Fees Amortization of Pollution Control Facilities Intangible Assets Bond Premium Asset Acquisitions or Sales Stock Acquisitions Treated as Asset Acquisitions Reorganizations - Acquisitive Asset Reorganizations Treatment of Organization and Syndication Fees

108

Schedule M Guidance

MTF110 – Intangible Assets Roll-Forward Potentially Applicable TCC Sections •

3.11

Intangible Assets

109

Schedule M Guidance

MTF200 – Intangible Basis Difference Potentially Applicable TCC Sections • • • •

3.11 15.06 15.07 15.09

Intangible Assets Asset Acquisitions or Sales Stock Acquisitions Treated as Asset Acquisitions Reorganizations - Acquisitive Asset Reorganizations

110

Schedule M Guidance

MTF30A – Book Depreciation* Please see MTF30B_4562 – Tax Depreciation*

Potentially Applicable TCC Sections •

2.35

Depreciation/Amortization

111

Schedule M Guidance

MTF30B_4562 – Tax Depreciation* Please see below for Software Development Costs*

GAAP (Financial Statement) Treatment For GAAP purposes depreciation is the method of allocating the cost of a tangible capital asset over the estimated useful life of the asset in a systematic and rational manner (generally straight-line).

Tax Treatment For regular tax purposes, depreciation expense is calculated by using the Modified Accelerated Cost Recovery System (MACRS). (For more information on calculating tax depreciation expense, see the CCH U.S. Master Depreciation Guide.) Usually the tax depreciation expense for a specific asset will be greater than the book depreciation expense in the early years of its depreciable life, and the difference will reverse in later years.

Where Do I Get the Information? The book depreciation amount should be easily accessible in both the financial statements and the trial balance. The tax depreciation amount will be provided by either FAS Encore, GoSystem or other system, depending on which software is used to calculate tax depreciation expense.

How Do I Calculate the Schedule M Adjustment? If the book amount is greater than tax amount, add the difference back to book income as an unfavorable adjustment. If tax depreciation exceeds book depreciation, subtract the amount from book income as a favorable adjustment. Both of these adjustments are temporary in nature and at some point will reverse. G&A expense

Depreciation expense per books Depreciation expense per tax Schedule M – favorable reduction

Inventory Schedule A

$100,000

$150,000

160,000

200,000

($60,000)

($50,000)

Software Development Costs* GAAP (Financial Statement) Treatment For GAAP purposes, costs incurred during implementation of an internal-use software application (e.g., an Enterprise Resource Planning “ERP” package) costs are often capitalized.

Tax Treatment Significant portions of internal-use software development are currently deductible for tax purposes as “akin” to IRC § 174 expenditures under Rev. Proc. 2000-50 (see also PLR 200236028). In certain circumstances (e.g., taxpayer has established a method of accounting to capitalize these costs for tax purposes), in order to deduct these costs for tax purposes, a taxpayer may be required to file a request to change a method of accounting (Form 3115). Capitalizable Implementation Costs: •

Costs paid to a third party to purchase or license/lease the standard software system (purchased software) – Amortization over 36 months beginning when the software system is placed in service

112

Schedule M Guidance

•

Direct costs incurred in-house or amounts paid to a third party to configure the purchased software system without writing new software code, for example by activating embedded templates or switches (installation) – Does not include indirect in-house expenses, such as overhead

•

Amounts paid to a third party to design and write additional software code (“add on”) but as to which the taxpayer does not bear the risk (purchased software) – Third-party has the right to receive and/or retain payment only if its work product meet performance criteria guaranteeing that the underlying development work was successfully completed

Deductible Implementation Costs: •

Amounts incurred in-house or paid to a third party to design and write additional software code (“add on”) where the taxpayer bears the risk (development) – Activity is conducted in-house or payment to the third party is not contingent on the success or failure of the underlying R&D work

•

Indirect costs (e.g., overhead) incurred in-house which otherwise are allocable to merely configuring a purchased software system – Such costs fall outside the scope of IRC § 263A

•

Other amounts incurred in-house or paid to a third party in connection with a broader implementation project which may be characterized as ‘business process re-engineering costs” under Example 5 of Treas. Reg. § 1.263(a)-4(l) – Do not create a separate and distinct intangible asset

•

Training costs incurred in-house or paid to a third party to teach employees how to operate a new software system – Deductible under IRC § 162

•

Costs incurred in-house or paid to a third party to input new data or transfer data from the “old” software system to the “new” system – Deductible under IRC § 162

Where Do I Get the Information? The financial statements may include the information you need to establish capitalized book amounts. The trial balance will also contain accounts detailing book amortization expense for the current year. Additional client inquires may be required to gather the necessary information. Tax amortization will be taken from either FAS Encore or GoSystem, depending on which software is used to determine tax amortization.

How Do I Calculate the Schedule M Adjustment? Book expenses and tax deductions are calculated independently. The difference between the two calculations represents the Schedule M adjustment amount. If the deductible implementation costs (for tax purposes) and/or tax amortization is larger than the book amortization for the year, then the difference is subtracted from book income as a favorable reduction. Conversely, if the book amortization is greater than the deductible implementation costs (for tax purposes) and/or tax amortization for the year, the adjustment is an unfavorable addback. Amortization expense per books

$30,000

Deductible software implementation costs (deductible for tax purposes)

100,000

113

Schedule M Guidance

Schedule M – favorable reduction

($70,000)

Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • •

2.35 2.36 2.37 2.39 2.40 2.45 2.49 2.50 2.64 2.69 2.71 2.75 2.76 2.91 2.92 3.00 3.01 3.02 3.03 3.04 3.06 3.08 3.09 3.11 3.12 3.14 3.16 7.02 7.03 7.04 7.10 8.08 11.02 11.03 11.04 11.14 18.13 27.16

Depreciation/Amortization Software Development Costs [including Software Development Costs Resource Page] Research & Development Expenses Construction Period Interest, Taxes Capitalization of Interest, Taxes Like-Kind Exchanges (IRC § 1031) Organization Costs Start-Up Costs Purchase of Franchise, Trademark, or Trade Name Settlement Fees Loan Origination Costs/Debt Issuance Costs Sales of Property or Patents Repair Costs (Capitalization to Expense) Package Design Costs Contributions to the Capital of a Corporation (IRC § 118) Fixed Assets and Intangibles Modified Accelerated Cost Recovery System (MACRS) Accelerated Cost Recovery System (ACRS) Pre-1981 Property: Switch to Straight-Line Bonus Depreciation Amortization of Pollution Control Facilities Incorrect MACRS Recovery Period Like-Kind Exchanges (IRC § 1031) Intangible Assets Rehabilitations Depreciation and Amortization Related Method Change Considerations Election to Expense Eligible Property (IRC § 179 DEDUCTION) Lessor as Tax Owner Leases to Tax-Exempt Entities Lessor of Foreign-Used Property Cancellations/Terminations of Leases Federal-To-State Adjustments Deduction or Capitalization of Research Expenses Method of Identifying Research Costs Research Conducted on Taxpayer's Behalf Election to Monetize Research and AMT Credits in Lieu of Bonus Depreciation Oil & Gas Tangible Property Treatment of Organization and Syndication Fees

114

Schedule M Guidance

MTF30B_4626 – Alternative Minimum Tax and ACE Data Entry Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • • • • • • • • •

9.03 9.10 10.01 10.02 10.03 10.04 10.05 10.06 10.07 10.08 10.09 10.10 10.12 10.13 10.14 10.16 10.17 10.18 10.19 10.20 10.21 10.26 10.27 10.28 10.29

Five-Year Net Operating Loss Carryback Accumulated Earnings Tax Alternative Minimum Tax (AMT) Depreciation Adjustment AMT Depreciation Preference Property Dispositions Expensing Under IRC § 179 Pollution Control Facility Alcohol Fuel Credit Long-Term Contracts Non-Dealer Installment Sales Dealer Installment Sales Passive Activities Private Activity Bonds Depletion Intangible Drilling Costs Mining Exploration and Development Costs Contributions of Property Adjusted Current Earnings (ACE) Adjusted Current Earnings (ACE) - More Considerations NOL Carryovers AMT Foreign Tax Credit SRLY Limitations Deferred Intercompany Transactions Member Leaving Group Gain on Disposition

115

Schedule M Guidance

MTF310 – Fixed Assets Roll-Forward Potentially Applicable TCC Sections •

3.00

Fixed Assets and Intangibles

116

Schedule M Guidance

MTF35A – Book Depletion Potentially Applicable TCC Sections • • •

10.13 18.15 18.23

Depletion Depletion in General Percentage Depletion Preference for AMT

117

Schedule M Guidance

MTF35B – Tax Depletion Potentially Applicable TCC Sections • • •

10.13 18.15 18.23

Depletion Depletion in General Percentage Depletion Preference for AMT

118

Schedule M Guidance

MTF400 - Fixed Asset Basis Difference Potentially Applicable TCC Sections •

3.00

Fixed Assets and Intangibles

119

Schedule M Guidance

MTF410 – Imp of Long Lived Assets – ASC 360 (formerly FAS 144) Potentially Applicable TCC Sections •

3.11

Intangible Assets

120

Schedule M Guidance

MTF420 - Other Impairment of Assets Potentially Applicable TCC Sections •

3.11

Intangible Assets

121

Schedule M Guidance

MTF50A – Book Gain/(Loss) on Sale of Fixed Assets* Please see MTF50B_4797 – Tax Gain/(Loss) on Sale of Fixed Assets*

Potentially Applicable TCC Sections • • •

2.75 3.05 3.13

Sales of Property or Patents Abandonment of Business Property Dispositions

122

Schedule M Guidance

MTF50B_4684 – Casualties and Thefts Potentially Applicable TCC Sections • • •

2.52 2.70 3.10

Federal Disaster Losses Casualty Losses (IRC § 165) [including Casualty Loss Practice Aid and Guide] Involuntary Conversions

123

Schedule M Guidance

MTF50B_4797 – Tax Gain/(Loss) on Sale of Fixed Assets* GAAP (Financial Statement) Treatment Gain or loss on the sale of fixed assets for GAAP purposes is calculated by using book basis amounts, which are based on book accumulated depreciation figures.

Tax Treatment For tax gain or loss on the sale of fixed assets, tax accumulated depreciation amounts are used in calculating basis.

Where Do I Get the Information? The financial statements and trial balance may include the information you need to establish book amounts for basis in the assets and proceeds from the sale. Additional client inquires may be required to gather the necessary information such as proceeds by asset. Tax amounts for accumulated depreciation and basis will be taken from fixed asset software (BNA, FAS Encore, or another system) used in calculating the client’s tax depreciation.

How Do I Calculate the Schedule M Adjustment? Book gain/loss and tax gain/loss are calculated independently. The difference between the two calculations represents the Schedule M adjustment amount. • •

If the book gain is larger than the tax gain, or the tax loss is greater than the book loss, then the difference is subtracted from book income as a favorable reduction. Conversely, if the tax gain is greater than the book gain, or the book loss is greater than the tax loss, the adjustment is an unfavorable addback.

Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • •

2.13 2.16 2.45 2.48 2.70 2.75 2.79 2.97 3.05 3.09 3.10 3.13 3.16 8.25 10.29 18.18 18.21 18.22

Foreign Expropriations Mark to Market Method Like-Kind Exchanges (IRC § 1031) Abandonment Losses Casualty Losses (IRC § 165) [including Casualty Loss Practice Aid and Guide] Sales of Property or Patents Related Party Losses Rescinded Transactions Abandonment of Business Property Like Kind Exchange (IRC § 1031) Involuntary Conversions Dispositions Election to Expense Eligible Property (IRC § 179 Deduction) Sales of Business Operating Assets Gain on Disposition Abandonment Losses Sale or Exchange Recapture of IDC, Mining Costs, and Depletion

124

Schedule M Guidance

MTF60A – Book Gain/(Loss) on Sale of Capital Assets Potentially Applicable TCC Sections • • • • • • • • • • • • • • • •

2.16 Mark to Market Method 3.13 Dispositions 4.20 Hedges of Issuer's Debt Obligations 5.06 Market Discount 5.12 Worthless Securities 5.16 Small Business Investment Company Stock 5.18 Swaps and Derivatives 5.20 Security Sales 5.21 IRC § 1256 Contracts 5.23 Conversion Transactions 5.26 Financial Instrument Dispositions 5.27 Short Sales 5.28 Constructive Sales 5.29 Constructive Ownership Positions 5.31 Securities Lending Transaction14.08 Disposition of a Subsidiary - Recapture and Recognition of Gain or Loss 15.13 Corporate Liquidations

125

Schedule M Guidance

MTF60B_Sch D – Tax Gain/(Loss) on Sale of Capital Assets Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • •

2.16 3.13 4.20 5.06 5.12 5.16 5.18 5.20 5.21 5.23 5.26 5.27 5.28 5.29 5.31 8.08 14.08 15.13

Mark to Market Method Dispositions Hedges of Issuer's Debt Obligations Market Discount Worthless Securities Small Business Investment Company Stock Swaps and Derivatives Security Sales IRC § 1256 Contracts Conversion Transactions Financial Instrument Dispositions Short Sales Constructive Sales Constructive Ownership Positions Securities Lending Transaction Federal-To-State Adjustments Disposition of a Subsidiary - Recapture and Recognition of Gain or Loss Corporate Liquidations

126

Schedule M Guidance

MTI100 – LIFO Tax Law Under IRC § 472(c), taxpayers may not use the LIFO method for tax purposes unless they are also using the LIFO method for financial reporting purposes. Under Treas. Reg. § 1.472-2, however, taxpayers are permitted to use different methods of computing the LIFO value of inventory for book and tax purposes. This may create differences between the amount of the book LIFO reserve and the tax LIFO reserve, which should be captured via a Schedule M adjustment on the return each year. Please also note the following special rules that apply in the last taxable year of a C corporation immediately prior to its first taxable year electing S corporation status. LIFO recapture - IRC § 1363(d) generally provides that if a C corporation uses the LIFO method for its last taxable year prior to electing S corporation status, taxpayer must include in gross income (line 10 - other income) the "LIFO recapture amount" in its last C corporation taxable year. The LIFO recapture amount is the amount by which the C corporation's inventory value under first-in, first-out (FIFO) lower of cost or market method (determined under the rules of IRC § 471 and Treas. Reg. § 1.471-2) exceeds the inventory value under the LIFO method. This provision generally applies in the case of S elections made after 12/17/1987. The LIFO recapture tax is equal to the difference between (1) calculating the tax due with the LIFO recapture amount included as income and (2) the tax due calculated without including the LIFO recapture amount in income. The additional tax resulting from the LIFO recapture must be paid in four equal installments. The first installment must be paid on or before the original due date (excluding extensions) of the return for the electing corporation's last tax year as a C corporation. The remaining three deferral installments must be paid by the due dates of the S corporation’s returns of the three succeeding taxable years (excluding extensions). The deferred portion of the tax (3 installments) is shown on Schedule J as follows: "Sec. 10227 deferred $(amount). Note that the recapture of the LIFO reserve does not terminate the taxpayer's LIFO election and they must still value inventory using LIFO as an S corporation unless an accounting method change is requested.

Potentially Applicable TCC Sections • • • • • • •

2.82 2.84 2.87 2.89 25.11 25.37 25.38

Inventory Identification and Valuation Methods Consistency of Inventory Method Last-In, First-Out (LIFO) Method Supplies Inventories and Rotable Spare Parts Inventory Value at Date of Election Use of Last-in, First-Out (LIFO) Method Recapture of Last-in, First-Out (LIFO) Benefits

127

Schedule M Guidance

MTI200 – 263A UNICAP Adjustment* GAAP (Financial Statement) Treatment A company will generally include in inventory on the balance sheet the price paid or consideration given to acquire the asset, as well as any applicable expenditure (direct and indirect) incurred to bring an article to its existing condition (raw material, work-in-process, finished good) and location (often referred to as “full absorption costing”). The determination of the costs to include in inventory on the balance sheet for GAAP purposes often involves many considerations.

Tax Treatment IRC § 263A (Uniform Capitalization, a.k.a. “UNICAP”) requires additional indirect and mixed service costs to be capitalized into inventory and not deducted in the year that the costs were incurred. These costs are often over and above the expenditures capitalized to inventory on the balance sheet (UNICAP is sometimes referred to as “super full absorption costing”). The logic behind this cost capitalization is that certain expenses incurred in the current year are actually associated with inventory goods produced or purchased that may still be in inventory, assuming that all of the inventory was not sold in the current year. These costs should not be deducted until the inventory is sold. If the goods are still in inventory, a portion of the expenses related to the production, purchase, storing, etc., of the goods should be capitalized to inventory and not currently deducted. Note: UNICAP does not apply to retailers with less than $10 million in average gross receipts (IRC § 263A(b)(2)(B)) for the three years prior to the current tax year. The UNICAP rules and regulations are quite complex and differ according to whether the taxpayer is a producer/manufacturer or a wholesaler/retailer and differentiate further into simplified and non-simplified methods. See Treas. Reg. § 1.263A-1, -2, and -3 for further guidance.

Where Do I Get the Information? The calculation of the uniform capitalization or IRC § 263A adjustment is an extremely involved process that requires quite a bit of company input and information. You will need to gather several estimates from the company concerning allocation percentages and other relevant information. A good place to start gathering the necessary information is the prior year’s workpaper file. Chances are that if the client requires an IRC § 263A calculation in the current year, they probably were required to perform a similar calculation last year. Beyond looking at a prior year’s tax workpapers, consulting the tax senior or manager on the engagement team may be a good idea. Note: Please be aware that there are several methods for computing the UNICAP balance at the end of the year.

How Do I Calculate the Schedule M Adjustment? The Schedule M results from the difference between costs required to be capitalized under IRC § 263A for inventory and the costs required to be capitalized for book purposes for inventory. Differences between the costs capitalized to capital accounts or basis are captured as part of the Schedule Ms related to differences in book and tax cost recovery methods. The calculation for the uniform capitalization balance at year-end will vary depending on the method of calculating the IRC § 263A adjustment your client has elected to use. Once you arrive at the UNICAP balance at year-end, the Schedule M analysis is very similar to most Schedule M discussed in other segments of this guide. See the following illustration: UNICAP, beginning of year UNICAP, end of year Schedule M – unfavorable addback

$4,000 6,000 $2,000

Potentially Applicable TCC Sections •

2.88

Uniform Capitalization (UNICAP)

128

Schedule M Guidance

• • • •

18.31 25.11 25.37 25.38

IRC § 263A Uniform Cost Capitalization Inventory Value at Date of Election Use of Last-in, First-Out (LIFO) Method Recapture of Last-in, First-Out (LIFO) Benefits

129

Schedule M Guidance

MTI300 – Capitalized Interest Tax Law Pursuant to IRC § 263A(f), interest incurred for production of real or tangible property must be capitalized and depreciated over the life of the related asset. The UNICAP rules and regulations for the capitalization of interest are quite complex. The return preparer should consult with the engagement manager to insure that the Schedule M has been calculated properly.

Potentially Applicable TCC Sections • • •

2.39 2.40 4.25

Construction Period Interest and Taxes Capitalization of Interest, Taxes Interest Capitalization

130

Schedule M Guidance

MTI400 – Lower of Cost/Market Write-Downs Tax Law Under Treas. Reg. § 1.471-2(c), the bases of valuation most commonly used by taxpayers that meet the requirements of IRC § 471 are cost and lower of cost or market. Typically, inventory reserves recorded to value inventory at LCM for book purposes will in general not meet the tax requirements contained in Treas. Reg. § 1.471-2 and a tax specific analysis should be performed to quantify the amount of the LCM reserve that should be recognized on the tax return. LCM taxpayers should also recognize a Schedule M adjustment each year for the full change in the book inventory reserve as the tax amount of the LCM reserve will be separately calculated and recorded here. Note that for any taxpayers using LIFO to value inventory, lower of cost or market is not a permitted method (IRC § 472(b) and Rev. Proc. 79-23).

Potentially Applicable TCC Sections • • • •

2.82 2.83 2.85 2.84

Inventory Identification and Valuation Methods Non-Saleable Items Lower of Cost or Market (LCM) Reserves Consistency of Inventory Method

131

Schedule M Guidance

MTM100 – IRC Section 481(a) Adjustment* Overview IRC § 481(a) adjustments can be negative or positive and are the result of an approved change in the accounting method that was properly filed on Form 3115.

GAAP (Financial Statement) Treatment Since this concept does not exist for GAAP purposes, there will never be account balances for IRC § 481(a) in the trial balance or on the income statement.

Tax Treatment After filing Form 3115, Application for Change in Accounting Method, there may be an IRC § 481 adjustment amount that will be taken into income over a certain number of years (under Rev. Proc. 2011-14—Automatic Changes and Rev. Proc. 97- 27—Non-Automatic Changes1). This adjustment will produce a difference between book and tax income. It is likely that positive adjustments will be included in income over four years and negative adjustments will be included in income in one year. 1

If the IRC § 481 adjustment is $25,000 or less, the de minimis rule under Rev. Proc. 2011-14 allows the adjustment to be taken all in the year of change.

Where Do I Get the Information? Some record that a Form 3115 has been filed should be present in the tax workpapers for either the current year or prior years. In the section of workpapers detailing the computation of the adjustment, you will find the total adjustment amount and the number of years that the adjustment will be taken into income.

How Do I Calculate the Schedule M Adjustment? Source documents: Approved Form 3115 and related workpapers. When the Form 3115 is prepared, all of the necessary computations are made. There will be a total IRC § 481(a) adjustment amount listed, as well as the applicable number of years that the adjustment is to be taken into income. Therefore, all of the calculations have been done for you. The IRC § 481(a) amount applicable to your return year should be added to or subtracted from book income, depending on the nature of the adjustment.

Potentially Applicable TCC Sections •

2.02

Accounting Method Changes

132

Schedule M Guidance

MTM20D – Income/Loss from Domestic Schedules K-1 Tax Law Corporate taxpayers are generally not concerned with some of the tax attributes that are provided in partnership Schedule K-1. For instance, qualified dividends' lower tax rates do not apply to corporate tax payers. When preparing a corporate tax return, the preparer will want to sum the dividend amounts show on lines, 6a and 6b in order to input the total dividend income for the corporation being passed through from the partnership K-1. The preparer will also want to note such items as foreign tax information which is reported on Line 16, foreign transactions. These amounts will need to be imported into corporate return by some means other than the MTM20D, F or Z workpapers. The purpose of this workpaper is to input the income(loss) items coming from the K-1 into the corporate return. However, due to the complexity of partnership tax law, the preparer will need to exercise diligence in order to make sure that the income (loss) effect has been accurately reported.

Potentially Applicable TCC Sections •

2.22

Passthrough Entity Income

133

Schedule M Guidance

MTM20F – Income/Loss from Foreign Schedule K-1 Tax Law Corporate taxpayers are generally not concerned with some of the tax attributes that are provided in partnership Schedules K-1. For instance, qualified dividends' lower tax rates do not apply to corporate tax payers. When preparing a corporate tax return, the preparer will want to sum the dividend amounts show on lines, 6a and 6b in order to input the total dividend income for the corporation being passed through from the partnership K-1. The preparer will also want to note such items as foreign tax information which is reported on Line 16, foreign transactions. These amounts will need to be imported into corporate return by some means other than the MTM20D, F or Z workpapers. The purpose of this workpaper is to input the income(loss) items coming from the K-1 into the corporate return. However, due to the complexity of partnership tax law, the preparer will need to exercise diligence in order to make sure that the income (loss) effect has been accurately reported.

Potentially Applicable TCC Sections •

2.22

Passthrough Entity Income

134

Schedule M Guidance

MTM20Z – Income/Loss from Other Schedules K-1 Tax Law Corporate taxpayers are generally not concerned with some of the tax attributes that are provided in partnership K-1's. For instance, qualified dividends' lower tax rates do not apply to corporate tax payers. When preparing a corporate tax return, the preparer will want to sum the dividend amounts show on lines, 6a and 6b in order to input the total dividend income for the corporation being passed through from the partnership K-1. The preparer will also want to note such items as foreign tax information which is reported on Line 16, foreign transactions. These amounts will need to be imported into corporate return by some means other than the MTM20D, F or Z workpapers. The purpose of this workpaper is to input the income(loss) items coming from the K-1 into the corporate return. However, due to the complexity of partnership tax law, the preparer will need to exercise diligence in order to make sure that the income (loss) effect has been accurately reported.

Potentially Applicable TCC Sections •

2.22

Passthrough Entity Income

135

Schedule M Guidance

MTM300 – Installment Sales* GAAP (Financial Statement) Treatment Revenues and costs of sales are recognized at the time of sale; however, the related gross profit is deferred and recognized in the periods in which the cash is actually collected. To the extent there is an excess of total proceeds over cost, each installment is deemed to bear the same proportion of profit.

Tax Treatment IRC § 453(b) states that the term “installment sale” means a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs. Subsection (c) states that the term “installment method” means a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized when payment is completed) bears to the total contract price (i.e., the income recognized in a year under the installment method is equal to the payments received during the year multiplied by the gross profit percentage from the sale). IRC § 453(e)(1) dictates that if property is disposed of to a related party and is subsequently redisposed of before the person making the first disposition receives all payments with respect to such disposition, then the amount realized with respect to the second disposition shall be treated as received at the time of the second disposition by the person making the first disposition. Generally, interest must be paid on the deferred tax related to any obligation that arises during a tax year from the disposition of property under the installment method if: a) the property had a sales price over $150,000 and b) the aggregate balance of all nondealer installment obligations arising during, and outstanding at the close of, the tax year is more than $5 million. See IRC § 453A to figure the interest.

Where Do I Get the Information? The book gain/loss amount will be shown in both the financial statements and the trial balance, and you must complete Form 6252. Information that is required for this form includes the sales price, the basis of the asset sold, and the amount of proceeds received in the current year. If the sale occurred in a prior year, then the book gain for the current year, if any, will be reflected in the trial balance. Conveniently, most of the required tax information will be found on Form 6252. The only additional information you will need is the amount of proceeds received in the current year. However, Form 6252 must still be completed.

How Do I Calculate the Schedule M Adjustment? Generally, there will be both a book gain/loss and a tax gain/loss. The difference between these two amounts will be the Schedule M adjustment. If the amount the tax gain is greater than the book gain, the difference is an unfavorable adjustment. If the tax gain is less than the book gain, the difference is a favorable adjustment. These adjustments will reverse themselves in time, and the net effect, after all proceeds have been received, will be zero.

Potentially Applicable TCC Sections • • • •

2.08 10.08 10.09 23.09

Installment Sales Non-Dealer Installment Sales Dealer Installment Sales Gains or Losses from Sales of Stocks, Securities and Other Capital Assets

136

Schedule M Guidance

MTM400 – Equity Earnings of Subsidiary Potentially Applicable TCC Sections • •

2.22 2.96

Passthrough Entity Income Accounting for Investments

137

Schedule M Guidance

MTM500 – Minority Interest Tax Law The minority interest is the income (loss) included in the income statement (loss) on Schedule M-3, Part I, Line 11, for any member of the U.S. consolidated tax group that is less than 100% owned is included on Schedule M-3, Part II, Line 8. This entry is usually made on the eliminations entity.

138

Schedule M Guidance

MTM600 – Hedging Transactions Potentially Applicable TCC Sections • • • •

4.20 4.21 4.22 5.17

Hedges of Issuer's Debt Obligations Hedges of Issuer's Debt Obligations: Synthetic Debt Treatment Hedges of Issuer's Convertible Debt Obligations Hedging Ordinary Property or Liabilities

139

Schedule M Guidance

MTM610 - OID & Other Imputed Interest Potentially Applicable TCC Sections • •

5.01 5.02

Original Issue Discount (Corporate Obligations) Original Issue Discount (Non-Corporate Obligations)

140

Schedule M Guidance

MTM620 - Mark to Marked Income/(Loss) Potentially Applicable TCC Sections • • •

2.16 5.06 5.30

Mark to Market Method Market Discount Dealers/Traders

141

Schedule M Guidance

MTM700 – Inc Recognition from LT Contracts Potentially Applicable TCC Sections • • •

2.09 2.15 10.07

Long-Term Contracts Prepaid Income and Advance Payments Long-Term Contracts

142

Schedule M Guidance

MTM71A – Sale versus Lease Potentially Applicable TCC Sections •

7.06

Finance Lease v. Sale

143

Schedule M Guidance

MTM71B – Purchase versus Lease Potentially Applicable TCC Sections •

7.06

Finance Lease v. Sale

144

Schedule M Guidance

MTM800 – Accrual to Cash Adjustment Potentially Applicable TCC Sections • •

2.01 2.02

Accounting Methods Accounting Method Changes [including Accounting Method Change Guidance]

145

Schedule M Guidance

MTP10A – Prepaid Advertising* GAAP (Financial Statement) Treatment A prepaid expense is an asset that is recognized into expense in the period, or over the period, in which the benefit is realized.

Tax Treatment Treas. Reg. § 1.461-1(a)(1) and (2) require that both cash and accrual method taxpayers capitalize expenditures under IRC §§ 263(a) or 263A, as appropriate, if the expenditure results in the creation of an asset having a useful life extending substantially beyond the close of the tax year. In general, taxpayers are required to capitalize prepaid expenses. See Treas. Reg. § 1.263(a)-4(d)(3). An exception to the general rule is the “12-month rule” set forth in Treas. Reg. § 1.263(a)-4(f). Taxpayers that meet the 12-month rule may deduct amounts paid to create any right or benefit for the taxpayer that does not (i) extend beyond the earlier of 12 months after the first date on which the taxpayer realizes the right or benefit; or (ii) the end of the taxable year following the taxable year in which the payment is made. Although the 12-month rule provides an exception to the capitalization requirement, it does not determine the timing of the deduction, which is governed by IRC § 461 and the regulations there under. Under IRC § 461, an item may not be deducted for tax purposes until all events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Economic performance generally occurs when the subject matter that gives rise to the liability (such as services, property or use of property) is provided to the taxpayer. For payment liabilities (such as insurance, warranty, service contracts, and taxes) economic performance occurs as payment is made to the person to which the liability is owed. A special rule allows a taxpayer to treat services or property as provided to the taxpayer as the taxpayer makes payment to the person providing the services or property if the taxpayer can reasonably expect the person to provide the services or property within 3 ½ months after the date of payment. This rule is commonly referred to as the “3 ½ month rule.” See Treas. Reg. § 1.461-4(d)(6)(ii). Certain liabilities may qualify for treatment under the recurring item exception. Under the recurring item exception, a liability is treated as incurred for a taxable year if: (i) as of the end of the taxable year all of the events have occurred which establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy; (ii) economic performance with respect to the liability occurs on or before the earlier of the date the taxpayer files a timely return; or the 15th day of the ninth month after the close of the taxable year; and (iii) either the liability is immaterial or the deduction of the liability for the taxable year results in better matching. If the prepaid expense meets the 12-month rule, the all-events test, and the economic performance requirements, then the increase in the prepaid is currently deductible for tax purposes. The following prepaid items that are capitalized for financial statement purposes may be deductible for tax purposes, provided they meet the tests discussed above. • • • • • • • •

Prepaid service contracts Prepaid advertising Prepaid insurance Prepaid postage Prepaid travel costs Prepaid subscription costs Other “recurring” prepaid expenses (see Treas. Reg. §1-461-5) Prepaid professional fees

The list above is by no means all-encompassing, but rather provides an example of common prepaid expense items. Review the client’s detailed trial balance for other prepaid items.

146

Schedule M Guidance

Where Do I Get the Information? Source documents: Adjusted trial balance, audit workpapers, or tax leadsheet.

How Do I Calculate the Schedule M Adjustment? Prepaid insurance per books, beginning of year

$100,000

Prepaid insurance per books, end of year

160,000

Schedule M – favorable reduction

($60,000)

Practice Tips and Techniques Change from the beginning to end of tax year

Adjustment to book income

Why?

Increase in prepaid balance per books (GAAP)

Reduction

To increase prepaid expenses per the GAAP books, the entry debits prepaid expense (asset account) and credits cash. This may be allowed as a tax deduction for tax purposes.

Decrease in prepaid balance per books (GAAP)

Addback

To decrease prepaid expense on the books, the entry was a debit to the appropriate expense account and a credit to prepaid expense (asset account).

Potentially Applicable TCC Sections • •

2.44 2.67

Executory Contracts Prepaid Expenses [including Accelerating Deduction of Prepaid Expense Resource Page]

147

Schedule M Guidance

MTP10B - Prepaid Insurance* Tax Law Please see MTP10A – Prepaid Advertising*

Potentially Applicable TCC Sections • •

2.44 2.67

Executory Contracts Prepaid Expenses [including Accelerating Deduction of Prepaid Expense Resource Page]

148

Schedule M Guidance

MTP10C – Prepaid Supplies Tax Law If supplies are used in the manufacture of inventory or held for sale in the ordinary course of business, they should be accounted for under IRC §§ 471 and 263A. Otherwise, supplies should be deducted in accordance with Treas. Reg. § 1.162-3. Under Treas. Reg. § 1.162-3, taxpayers may deduct supplies but only the amount that was actually consumed and used in operation during the taxable year. If the taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or of which physical inventories at the beginning and end of the year are not taken, the taxpayer may take a deduction for the total cost of such supplies and materials as were purchased during the year.

Potentially Applicable TCC Sections • •

2.67 2.89

Prepaid Expenses [including Accelerating Deduction of Prepaid Expense Resource Page] Supplies Inventories and Rotable Spare Parts

149

Schedule M Guidance

MTP10D – Prepaid Rent Expense Tax Law For Tax in general, an item (either normally deductible or capitalizable on the books) may not be deducted for tax purposes until both the "all events test” and economic performance requirements are met. The all events test is satisfied when the liability is: fixed (payment is unconditionally due or required performance occurs), and determinable with reasonable accuracy. As a general rule, economic performance occurs when the subject matter that gives rise to the expense (such as services, property or use of property) is provided to the taxpayer. However, for prepayment of goods or services provided to the taxpayer, if service and/or property related to the expenditure is received within 3-1/2 months after payment is made, this amount may be deducted in the year paid (the “3-1/2 month rule”). For prepayments for use of property, the prepaid expense is recognized ratably over the period of time the taxpayer is entitled to use the property (Treas. Reg. § 1.461-4(d)(3)(i)). Treas. Reg. § 1.461- 1(a)(1) and (2) require that both cash and accrual method taxpayers capitalize expenditures under IRC §§ 263(a) or 263A, as appropriate, if the expenditure results in the creation of an asset having a useful life extending substantially beyond the close of the tax year. If your case meets the all events test and economic performance requirements (or the 3-1/2 month rule) and these expenditures do not result in the creation of an asset having a useful life extending beyond one year, then the increase in the prepaid is currently deductible for tax purposes.

Potentially Applicable TCC Sections • • • • •

2.30 2.51 2.67 7.08 7.09

Construction Allowances Deferred Rental Expense Prepaid Expenses [including Accelerating Deduction of Prepaid Expense Resource Page] Advance Rents/Bonuses to Lessor Related Party Leasing Transactions

150

Schedule M Guidance

MTP10E – Prepaid Legal Fees* Tax Law Please see MTP10A – Prepaid Advertising*

Potentially Applicable TCC Sections • •

2.44 2.67

Executory Contracts Prepaid Expenses [including Accelerating Deduction of Prepaid Expense Resource Page]

151

Schedule M Guidance

MTP10F – Prepaid VEBA Tax Law For Tax in general, an item (either normally deductible or capitalizable on the books) may not be deducted for tax purposes until both the "all events test” and economic performance requirements are met. The all events test is satisfied when the liability is: fixed (payment is unconditionally due or required performance occurs), and determinable with reasonable accuracy. As a general rule, economic performance occurs when the subject matter that gives rise to the expense (such as services, property or use of property) is provided to the taxpayer. However, for prepayment of goods or services provided to the taxpayer, if service and/or property related to the expenditure is received within 3-1/2 months after payment is made, this amount may be deducted in the year paid (the “3-1/2 month rule”). For prepayments for use of property, the prepaid expense is Recognized ratably over the period of time the taxpayer is entitled to use the property (Treas. Reg. § 1.461-4(d)(3)(i)). Treas. Reg. § 1.461-1(a)(1) and (2) require that both cash and accrual method taxpayers capitalize expenditures under IRC §§ 263(a) or 263A, as appropriate, if the expenditure results in the creation of an asset having a useful life extending substantially beyond the close of the tax year. If your case meets the all events test and economic performance requirements (or the 3-1/2 month rule) and these expenditures do not result in the creation of an asset having a useful life extending beyond one year, then the increase in the prepaid is currently deductible for tax purposes.

Potentially Applicable TCC Sections •

2.67

Prepaid Expenses [including Accelerating Deduction of Prepaid Expense Resource Page]

152

Schedule M Guidance

MTR10A – Bad Debt Reserve* GAAP (Financial Statement) Treatment Losses for uncollectible receivables are accrued when it is probable that a loss as been incurred and the amount can be reasonably estimated.

Tax Treatment For tax purposes, IRC § 166 states that there shall be allowed as a deduction any debt which becomes worthless within the taxable year. Also, when satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part specifically charged off within the taxable year, as a deduction. This is referred to as the “specific charge-off method”. In regards to IRC § 166, the basis for determining the amount of the deduction for any bad debt shall be the adjusted basis provided in IRC § 1011 for determining the loss from the sale or other disposition of property.

Where Do I Get the Information? The change in the allowance account should be easily accessible in the trial balance and financial statements. Getting the amount of actual write-offs will usually require speaking to the client. Once you have both of these amounts, you are ready to calculate the adjustment.

How Do I Calculate the Schedule M Adjustment? Any increase in the allowance account must be disallowed by adding the amount back into book income. If the allowance account decreased in the current year from the prior year amount, then the difference is subtracted from book income in arriving at taxable income. These adjustments reflect temporary or timing differences and will reverse at a later point in time. Therefore, an increase in the allowance that is disallowed in the current year may be deductible next year if the receivable is actually written off.

Practice Tips and Techniques Change from beginning to end of tax year

Adjustment to book income

Increase in Allowance for Doubtful Accounts per books (GAAP)

Addback

To increase book accrual, the journal entry on the GAAP books was a debit to expense and a credit to allowance of doubtful accounts. This is not allowed for tax purposes for the reasons mentioned above.

Decrease in Allowance for Doubtful Accounts per books (GAAP)

Reduction

To decrease book accrual, the entry was a debit to allowance for doubtful accounts and a credit to account receivable. This now becomes deductible for the tax set of books for the reasons mentioned above.

Why?

Note: For certain types of companies (such as some smaller financial institutions), the calculation of bad debt expense is very different than the one described above. You should always be sure which method is being used when determining bad debt for a particular company.

Potentially Applicable TCC Sections • •

2.34 2.47

Bad Debt & Disputed Sales Reserves

153

Schedule M Guidance

• •

5.13 10.11

Bad Debts Bad Debts of Financial Institutions

154

Schedule M Guidance

MTR10B – Inventory Reserve Tax Law Under Treas. Reg. § 1.471-2(c), the bases of valuation most commonly used by taxpayers that meet the requirements of section 471 are cost and lower of cost or market. Any taxpayers following a method of using cost for tax purposes should not be recognizing for tax purposes any book inventory reserves that make adjustments to the cost of inventory in ending inventory. Taxpayer valuing inventory at cost should recognize a Schedule M adjustment each year for the full change in the book inventory reserves. Treas. Reg. § 1.471-2 provides specific rules and guidance that must be followed for tax purposes for taxpayers using lower of cost or market. Typically, inventory reserves recorded to value inventory at LCM for book purposes will in general not meet the tax requirements contained in Treas. Reg. § 1.471-2 and a tax specific analysis should be performed to quantify the amount of the LCM reserve that should be recognized on the tax return. See workpaper MTI400 for computation of the LCM deduction for these taxpayers. LCM taxpayers should also recognize a Schedule M adjustment each year for the full change in the book inventory reserve as the tax amount of the LCM reserve will be separately calculated and recorded at MTI400. Note that for any taxpayers using LIFO to value inventory, lower of cost or market is not a permitted method (IRC § 472(b) and Rev. Proc. 79-23). LIFO taxpayers should also recognize a Schedule M adjustment each year for the full change in the book inventory reserve in order to avoid creating a LIFO termination event.

Potentially Applicable TCC Sections • • •

2.47 2.85 2.86

Reserves Lower of Cost or Market (LCM) Reserves Inventory Shrinkage

155

Schedule M Guidance

MTR10C – Obsolescence Reserve Tax Law Under Treas. Reg. § 1.471-2(c), the bases of valuation most commonly used by taxpayers that meet the requirements of section 471 are cost and lower of cost or market. Any taxpayers following a method of using cost for tax purposes should not be recognizing for tax purposes any book inventory reserves that make adjustments to the cost of inventory in ending inventory. Taxpayer valuing inventory at cost should recognize a Schedule M adjustment each year for the full change in the book inventory reserves. Treas. Reg. § 1.471-2 provides specific rules and guidance that must be followed for tax purposes for taxpayers using lower of cost or market. Typically, inventory reserves recorded to value inventory at LCM for book purposes will in general not meet the tax requirements contained in Treas. Reg. § 1.471-2 and a tax specific analysis should be performed to quantify the amount of the LCM reserve that should be recognized on the tax return. See workpaper MTI400 for computation of the LCM deduction for these taxpayers. LCM taxpayers should also recognize a Schedule M adjustment each year for the full change in the book inventory reserve as the tax amount of the LCM reserve will be separately calculated and recorded at MTI400. Note that for any taxpayers using LIFO to value inventory, lower of cost or market is not a permitted method (IRC § 472(b) and Rev. Proc. 79-23). LIFO taxpayers should also recognize a Schedule M adjustment each year for the full change in the book inventory reserve in order to avoid creating a LIFO termination event.

Potentially Applicable TCC Sections • • •

2.47 2.85 2.86

Reserves Lower of Cost or Market (LCM) Reserves Inventory Shrinkage

156

Schedule M Guidance

MTR10D – Sales Returns & Allowance Reserve Tax Law IRC § 461 requires that expenses meet the "all events test" before they are allowable as deductions for taxable income purposes. The all events test requires that the costs be both fixed and determinable. Additionally, economic performance must have taken place. This may lead to a difference in the expenses deducted for books and tax with regard to these items. Many taxpayers reserve for estimated future customer returns that might relate to the current year sales. However, this liability may not be accrued for tax purposes until the all events test has been met and economic performance has occurred. For liabilities for goods and services provided by the taxpayer actually receives returns goods from a customer and issues a refund in the form of cash or replacement good to the taxpayer, economic performance occurs as the taxpayer incurs costs in connections with the satisfaction of the liability (in this case, when the customer). See Treas. Reg. § 1.4614(d)(4)(i)

Potentially Applicable TCC Sections • • •

2.47 2.85 2.86

Reserves Lower of Cost or Market (LCM) Reserves Inventory Shrinkage

157

Schedule M Guidance

MTR10E – Warranty Reserve* GAAP (Financial Statement) Treatment ASC 450, Contingencies, requires that a reserve be accrued (and expensed) if information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. The following are examples of common reserves you will probably see on many of your client engagements: • • • • • •

Litigation reserves Warranty reserves Real estate-owned (REO) reserves (financial institutions) Contingency reserves Self-Insurance Medical Reserves (a.k.a., IBNR) Other reserves

Note: ASC 450, Contingencies, defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty that will ultimately be resolved when future events occur or fail to occur. Not all uncertainties that evolve in the accounting process represent contingencies as defined in ASC 450. Often estimates are required in the financial statements to measure the financial effects of past transactions in addition to being used to measure future events, as is the case for contingencies.

Tax Treatment IRC § 461 requires that expenses meet the “all events test” before they are allowable as deductions for taxable income purposes. The all events test requires that the costs be both fixed and determinable. Additionally, economic performance must have taken place. This may lead to a difference in the expenses deducted for books and tax with regard to these items. Many taxpayers deduct the reserve on a cash basis when the payment occurs. However, not all reserves are contingent upon payment for economic performance. The Code has identified only certain specific reserve (liabilities) that are deemed “payment liabilities” and therefore the deduction is allowed generally when payment occurs. The following are examples of GAAP accruals called “payment liabilities” (as defined by Treas. Reg. § 1.461-4(g)). In general, these liabilities must be paid in order for the economic performance test to be met: • • • • • • • •

Liabilities arising out of the Workers Compensation Act, tort liabilities, breach of contract, or violation of law Rebates or refunds Awards, prizes, or jackpots Taxes Insurance Warranties Licensing fees For all reserves not classified as “payment liabilities,” economic performance is deemed to have occurred when the services, property, or use of property has been provided.

Summary of the issues IRC § 461 requires that the taxpayer meet the all events test, which is: • •

The liability is fixed and determinable (versus. estimable for GAAP as discussed above) “Economic performance” has occurred by year-end

Generally, economic performance occurs when the subject matter that comprises the expense (such as services, property, or use of property) is provided to the taxpayer.

158

Schedule M Guidance

Where Do I Get the Information? Source documents: Client’s trial balance, audit workpapers, or completed information request.

How Do I Calculate the Schedule M Adjustment? XYZ Corp. has a pending lawsuit that the law firm of F. Lee Fasby estimates will settle for $400,000. This settlement is probable to occur. What is the Schedule M for the current year’s tax return? (Note: The pending litigation balance was $300,000 at the beginning of the year.) Pending litigation reserve, beginning of year Pending litigation reserve, end of year

$300,000 400,000

Schedule M – unfavorable addback

$100,000

Practice Tips and Techniques Change from the beginning to end of tax year

Adjustment’s effect on book income

Increase in reserve per books (GAAP)

Unfavorable addback

To increase the reserve accrual, the journal entry on the GAAP books was a debit to the expense and a credit to the reserve account. This is not allowed for tax purposes for the reasons mentioned above.

Decrease in reserve per books (GAAP)

Favorable reduction

To decrease reserve accrual, the entry is generally a debit to reserve and a credit to cash. This now becomes deductible for the tax books for the reasons mentioned above. Note: Changes in reserve accounts do not always require Schedule M-1 adjustments due to items such as reclasses and other book adjustments. You may need to evaluate the detail general ledger for a transactional history.

Why?

Potentially Applicable TCC Sections •

2.47

Reserves

159

Schedule M Guidance

MTR10F – Contingency Reserve* Tax Law Please see MTR10E – Warranty Reserve*

Potentially Applicable TCC Sections •

2.47

Reserves

160

Schedule M Guidance

MTR10G - Restructuring Reserve* Tax Law Please see MTR10E – Warranty Reserve*

Potentially Applicable TCC Sections •

2.47

Reserves

161

Schedule M Guidance

MTR10H – Litigation Reserve* Tax Law Please see MTR10E – Warranty Reserve*

Potentially Applicable TCC Sections • •

2.42 2.47

Contested Liabilities Reserves

162

Schedule M Guidance

MTS100 – Stock Options Tax Law In general, Treas. Reg. § 1.83-7(a) allows an employer to deduct the value of a nonqualified stock option (NSO), without a readily ascertainable value, in the tax year that the employee includes the amount into income, which is the tax year the NSO is exercised. If the NSO has a readily ascertainable value, then the employee includes the NSO into income when the NSO is granted and the employer is allowed a deduction in the same year.

Potentially Applicable TCC Sections • • • • • •

2.63 6.01 6.13 6.14 6.15 6.18

Compensation to Executives Nonqualified and Qualified Plans Nonqualified Stock Options Incentive Stock Options Employee Stock Purchase Plans Compensation Paid to Top Executives

163

Schedule M Guidance

MTT100 – State Taxes* Tax Law Please see MP100B – State & City Income Taxes*

Potentially Applicable TCC Sections • • • • • • • • • • •

2.74 8.02 8.03 8.04 8.06 8.07 8.08 8.09 8.11 26.73 26.76

Deductibility of State and Local Tax Accruals Filing Obligations Nexus Issues State Filing Methods Law Changes Alternate Measures of Tax Federal-To-State Adjustments Loss Carryovers and Carrybacks Federal Consolidated Return Regulations State Entity-Level Taxes Other State Tax Issues

164

Schedule M Guidance

MTT200 – Capitalized Real Estate Taxes Potentially Applicable TCC Sections • • • • •

2.39 2.41 2.74 8.29 8.30

Construction Period Interest and Taxes Real Property Tax Deductibility of State and Local Tax Accruals Sales, Use, and Transfer Tax Considerations in the Merger and Acquisition Context Transfer Taxes Imposed on Real Property Deed Transfers

165

Schedule M Guidance

OT100 – Federal Tax Payments Tax Law Per IRC § 6655, four installment payments are generally required for corporations to avoid underpayment penalties. Enter the Federal Tax payments made by quarter. The amounts entered here will assist in the calculation of Form 2220, Underpayment of Estimated Tax by Corporations.

Potentially Applicable TCC Sections • • • •

2.98 9.06 9.08 9.09

Estimated Tax Payments Estimated Taxes Underpayment of Estimated Taxes Tax Liability and Tax Payments

166

Schedule M Guidance

Additional Hedge Fund Partnership Schedule Ms MP100 – Federal Tax Exempt Interest and Income Tax Law Tax Exempt Income includes interest from State & Local government obligations. Includes District of Columbia and US possessions, and tax exempt "dividend" income from Mutual Funds Exclusions: • • •

Any private activity bond which is not a qualified bond. See IRC § 141 Any arbitrage bonds within the meaning of IRC § 148 Bonds not in registered form. See IRC § 149

Expenses incurred to produce tax exempt income are non-deductible. Interest Expense paid to borrow funds to purchase tax exempt securities is non-deductible. No deduction is permitted for amortized premium on a tax-exempt bond. The amortized premium for the tax year is instead an adjustment to the basis of the bond. IRC § 103(a), IRC § 265, related regulations, Rev-Proc 72-18, Rev-Proc 74-8

167

Schedule M Guidance

MP110 – Syndication Fees Tax Law “Syndication expenses” are defined to include all expenses of issuing and marketing partnership interests, including brokerage fees, registration fees, legal fees of the underwriter and the issuer (the general partner or the partnership) for securities advice and advice relating to the adequacy of tax disclosures in the offering documents, accounting fees relating to representations included in the offering materials, and printing costs of all offering materials. IRC § 709 and related regulations Note - Syndication Fees are NOT line 18C Non-Deductible Expenses

168

Schedule M Guidance

Additional Partnership Schedule Ms Sch B – Other Partnership Information Potentially Applicable TCC Sections • • • • • • • • • • • • • • •

2.28 2.45 3.09 4.11 4.12 5.15 12.22 12.31 12.42 16.17 18.08 18.25 27.11 27.22 27.33

Cancellation of Debt Income Like-Kind Exchanges (IRC § 1031) Like Kind Exchange (IRC § 1031) Debt Exchanges or Modifications Retirements or Prepayments of Debt Debt Exchanges or Modifications Information Reporting and Withholding TEFRA Audits Foreign Bank Account Reporting (FBAR) Withholding on Outbound Payments Partnership Profits Interest Passive Activity Limitations Transactions Between Partner and a Partnership Basis Adjustments International Considerations

169

Schedule M Guidance

KP100 – Partner Information Potentially Applicable TCC Sections • • • • •

23.13 27.04 27.05 27.09 27.10

Passthroughs Partner's Distributive Share Substantial Economic Effect Acquisition of a Partnership Interest (IRC §§ 722 and 742) Taxable Years of Partner and Partnership

170

Schedule M Guidance

KP200 – Partner Contributions Potentially Applicable TCC Sections • • • • • • • • •

27.06 Nonrecourse Deductions and Minimum Gain 27.07 Contributed Property (IRC § 704(c)) 27.08 Adjustments to Basis (IRC §§ 705 and 733) 27.09 Acquisition of a Partnership Interest (IRC §§ 722 and 742) 27.11 Transactions Between Partner and a Partnership 27.14 Disguised Sales 27.17 Nonrecognition of Gain or Loss on Contribution27.18 Basis of Property Contributed to Partnership 27.19 Character of Gain or Loss on Contributed Unrealized Receivables, Inventory, and Capital Loss Property 27.22 Basis Adjustments

171

Schedule M Guidance

KP300 – Partner Distributions Potentially Applicable TCC Sections • • • • • • • • • • •

27.07 27.08 27.11 27.14 27.20 27.21 27.22 27.23 27.24 27.25 27.27

Contributed Property (IRC § 704(c)) Adjustments to Basis (IRC §§ 705 and 733) Transactions Between Partner and a Partnership Disguised Sales Extent of Recognition of Gain or Loss on Distribution Basis of Distributed Property Other than Money Basis Adjustments Character of Gain or Loss on Disposition of Distributed Property Payments to a Retiring Partner or Deceased Partner's Successor in Interest Recognition of Precontribution Gain in Case of Certain Distributions to a Contributing Partner Unrealized Receivables and Inventory Items

172

Schedule M Guidance

KP400 – Transfer of Interest Potentially Applicable TCC Sections • • • • • • • •

27.07 27.08 27.09 27.15 27.22 27.26 27.27 27.28

Contributed Property (IRC § 704(c)) Adjustments to Basis (IRC §§ 705 and 733) Acquisition of a Partnership Interest (IRC §§ 722 and 742) Continuation of Partnership Basis Adjustments Recognition and Character of Gain or Loss on Sale or Exchange Unrealized Receivables and Inventory Items Treatment of Certain Liabilities

173

Schedule M Guidance

KP500 – Partnership Liabilities Potentially Applicable TCC Sections • • • • •

27.04 27.06 27.07 27.08 27.28

Partner's Distributive Share Nonrecourse Deductions and Minimum Gain Contributed Property (IRC § 704(c)) Adjustments to Basis (IRC §§ 705 and 733) Treatment of Certain Liabilities

174

Schedule M Guidance

KP600 – Guaranteed Payments Detail Potentially Applicable TCC Sections • • • •

27.11 27.12 27.13 27.24

Transactions Between Partner and a Partnership Payments Not in Capacity as a Partner Guaranteed Payments Payments to a Retiring Partner or Deceased Partner's Successor in Interest

175

Schedule M Guidance

KP700 – Foreign Partner Withholding Potentially Applicable TCC Sections • • •

12.22 16.17 27.33

Information Reporting and Withholding Withholding on Outbound Payments International Considerations

176

Schedule M Guidance

MP440 or MP120 – Guaranteed Payments Tax Law IRC § 707(c) provides that a partnership that makes a guaranteed payment to a partner is entitled to deduct the payment at the time and to the extent that a payment under the same circumstances to an unrelated party would be deductible. IRC § 707(c) also provides that the partner receiving the guaranteed payment must include the payment as ordinary income within or with which ends the partnership taxable year in which the partnership paid or accrued the payment under its method of accounting. The partnership must report this income to the partners on Schedule K1. As such, the total amount of guaranteed payments deducted by the partnership is added back as ordinary income and then reported out to the partners on Schedule K1.

Potentially Applicable TCC Sections • • • •

27.11 27.12 27.13 27.24

Transactions Between Partner and a Partnership Payments Not in Capacity as a Partner Guaranteed Payments Payments to a Retiring Partner or Deceased Partner's Successor in Interest

177

Schedule M Guidance

MP450 – Syndication Costs Tax Law IRC § 709(a) provides that amounts paid to sell, or promote the sale of, an interest in a partnership are not deductible except as provided in IRC § 709(b). However, unlike organization costs, syndication costs are not eligible for the IRC § 709(b) amortization election, and thus not deductible by the partnership in any event. In addition, unlike the deduction available under IRC § 165 for the unamortized amount of the capitalized organization expense, when a partnership is liquidated, there is no partnership-level deduction for the capitalized syndication costs that the partnership caries on its books as an intangible asset.

Potentially Applicable TCC Sections •

27.16

Treatment of Organization and Syndication Fees

178

Schedule M Guidance

Additional S Corporation Schedule Ms LD550 – AAA Reconciliation (S Corporation) Potentially Applicable TCC Sections • •

26.28 26.29

Accumulated Adjustments Account (AAA) Other Adjustments Account (OAA)

179

Schedule M Guidance

Sch B – Other S Corporation Information Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • • • • • •

5.01 12.39 25.01 25.02 25.03 25.04 25.12 25.13 25.14 25.15 25.16 25.17 25.18 25.34 25.35 26.31 26.39 26.40 26.41 26.42 26.43 26.44

Original Issue Discount (corporate obligations) Reportable Transactions Analysis Eligibility to Elect New S Corporation Status Eligibility of a Currently Electing S Corporation General Requirements Entity Requirements Corporations with C Corporation E&P at Date of Election Corporations with Wholly Owned Subsidiaries Qualified Subchapter S Subsidiary (Qsub) Election Insolvent Wholly Owned Subsidiaries Wholly Owned Subsidiaries with Appreciated Property Wholly Owned Subsidiaries with C Corporation E&P Wholly Owned Subsidiaries with Inventory Termination of QSub Election Former C Corporation Earnings and Profits Applicability of the Built-In Gains Tax Recognized Built-In Gains Unexpired NOL or Capital Loss Carryovers Recognized Built-In Gains in Excess of NOL Carryovers Excess General Business Tax Credit Carryovers Transferred Basis Property

180

Schedule M Guidance

KS100 – Shareholder Information Potentially Applicable TCC Sections • • • • • • • •

23.13 25.01 25.02 25.03 25.05 25.09 25.19 25.20

Passthroughs Eligibility to Elect New S Corporation Status Eligibility of a Currently Electing S Corporation General Requirements Trusts as Shareholders Shareholder Consent Shareholder that is a QSST Shareholder that is a ESBT

181

Schedule M Guidance

KS200 – Shareholder Contributions Potentially Applicable TCC Sections • • • • •

26.08 26.09 26.10 26.11 26.13

Shareholder Basis Adjustments to basis Basis in Stock Loans from the S Corporation Restoration of Basis

182

Schedule M Guidance

KS300 – Shareholder Distributions Potentially Applicable TCC Sections • • • • • • • • • • • •

25.26 26.20 26.21 26.22 26.23 26.24 26.25 26.26 26.27 26.28 26.29 26.32

Distributions of Appreciated Property Cash or Noncash Distributions Corporations with E&P Multiple Distributions During the Year Election to Treat Distributions as Dividends Filing Requirements for Distributions Taxed as Dividends Debt-Financed Distributions Distributions of Appreciated Property Post Termination Distributions Accumulated Adjustments Account (AAA) Other Adjustments Account (OAA) Distributions in a Post-Termination Transition Period

183

Schedule M Guidance

KS350 – Taxability of Distributions to Shareholders Potentially Applicable TCC Sections • • • • • • • • • • •

26.20 26.21 26.22 26.23 26.24 26.25 26.26 26.27 26.28 26.29 26.32

Cash or Noncash Distributions Corporations with E&P Multiple Distributions During the Year Election to Treat Distributions as Dividends Filing Requirements for Distributions Taxed as Dividends Debt-Financed Distributions Distributions of Appreciated Property Post Termination Distributions Accumulated Adjustments Account (AAA) Other Adjustments Account (OAA) Distributions in a Post-Termination Transition Period

184

Schedule M Guidance

KS400 – Ownership and Transfers Potentially Applicable TCC Sections • • • •

26.48 26.49 26.50 26.51

Transfers of Stock Election 20 Percent or More Change in Stock Ownership Sale of 80 Percent or More of S Corporation Stock

185

Schedule M Guidance

KS500 – Schedule K Allocations Potentially Applicable TCC Sections • • • • • • • • • • • • • • • • • • • • •

23.13 26.01 26.02 26.03 26.04 26.05 26.06 26.07 26.14 26.15 26.16 26.18 26.19 26.30 26.33 26.34 26.37 26.38 26.67 26.78 26.79

Passthroughs Items that Pass Through to Shareholders Separately Stated Income and Gains(Losses) Separately Stated Deductions Other Separately Stated Items Separately Stated AMT Items Offsets to Shareholders' Share of Income Payment to Shareholders' Family Members Losses in Excess of Basis Limitation on Deductibility of Losses Loss Carryovers Material Participation Passive Activities Carryovers Investment Credit Recapture Fuel Tax Credit Non-U.S. Sourced Income Recapture of Overall Foreign Loss Individual Shareholders State Credits and Incentives State Treatment of Certain Items

186

Schedule M Guidance

KS600 – Shareholder Foreign Withholding Potentially Applicable TCC Sections • • • • •

12.22 16.17 26.62 26.63 26.67

Information Reporting and Withholding Withholding on Outbound Payments Intercompany Transactions Between S Corporation and its Foreign Affiliates Payments Received From 3rd Parties in Foreign Jurisdictions Individual Shareholders

187

Schedule M Guidance

MP450 – Shareholder Fringe Benefits Potentially Applicable TCC Sections • •

26.35 26.36

Benefits Provided to More-Than-2 Percent Shareholders Self-Insured Medical Plans

188

Schedule M Guidance

OT200 – Composite Tax Payments Potentially Applicable TCC Sections • • • • •

8.16 23.13 26.73 26.75 26.77

Special Entities Passthroughs State Entity-Level Taxes State Composite Returns State Withholding

*Previously included in The Hows and Whys of Calculating Some Common Schedule M Adjustments

189