Small Business Taxes & Management^TM--Copyright 2013, A/N Group, Inc.

Introduction

One of the complexities of doing income taxes for a business is that fact that there are really two legal sets of books for most businesses. Financial accounting rules dictate one way of recording some items; tax accounting rules another. You could even have additional sets of books for state rules. Most small businesses that only need financial statements for internal purposes may have a minimum amount of differences between tax and financial accounting, but there are almost sure to be differences. For example, meals and entertainment expenses are generally only 50% deductible for tax purposes, but must be fully deducted on financial statements. Depreciation is another frequently encountered difference. Less frequently encountered differences can include when you record income and when you can deduct certain items. Some items are timing differences, such as depreciation. Some items are permanent differences, such as the 50% for meals and fines and penalties.

If you're reporting your business income and expenses on Schedule C of your Form 1040, you just report the tax income and expenses. But if you're an S corporation or a partnership, and you're required to complete Schedule M-1 (not required for certain small entities), you've got to reconcile your book income to your tax income. (That's also true for C corporations, but the approach is different.) That means you'll have to detail the differences on Schedule M-1. To be more accurate, you're not reconciling your book income to your taxable income but to the amount shown on the last line of Schedule K of your S corporation or partnership return. That's because the net income shown on the front page of the return doesn't include separately stated items such as interest income, Section 179 deduction, etc. Schedule K starts out with the ordinary business income (or loss) from the first page of Form 1120S (or 1065). To that amount you add back the separately stated items.

In the discussion below, we'll use an S corporation as the model. While the details are slightly different for a partnership return, the concept and most of the items are the same.

Note. If you're using software to prepare your return, some of the items such as the nondeductible 50% of travel and entertainment, may be entered automatically by the software. Usually, most items have to be entered manually.

M-1 Income Reconciliation

As we said, you start off with the net income (or loss) per books. There are four categories of reconciling items. Some, the most common ones, such as depreciation, travel and entertainment, etc. are listed on the schedule. The trick is coming up with the ones that aren't listed there. We'll detail those below.

Line 2: Income Included on Schedule K Not on Books This Year. This one isn't that common, but a good example would be income from an installment sale of property. You may have recorded the sale of a used truck on the installment basis for tax purposes, but reported the full amount of the gain on your books in an earlier year. Items in this category include:

• Auto inclusion (if you took the full deduction for auto lease payments but had to add back an amount because of the luxury car rules).
  
• Gain on the sale of assets where your tax gain exceeds your book gain. (This can result for depreciation differences for book and tax.)
  
• Unearned revenue (income that's not reportable for book purposes, but taxable for tax.)
  
• Installment sale income.

Line 3: Expenses Recorded on Books This Year Not Included on Schedule K. It's almost certain you'll encounter a couple of items on this line. There are two most likely have their own separate lines--depreciation and travel and entertainment. We discussed travel and entertainment above. Meals and entertain are generally only 50% deductible. Depreciation is a timing item. Chances are you're using straight line depreciation for books, but either expensing the asset under Section 179 or using accelerated depreciation for tax purposes. There may also be different lives for book and tax purposes. Over the life of the asset the total depreciation should be the same (assuming you fully depreciated it). But in the early years, tax depreciation will be higher than book. At some point this reverses and, in the later years, book depreciation will exceed tax. On Schedule M-1 there are two places to account for this. On this line you'd enter the amount of depreciation for book purposes that's in excess of tax.

Here are other items you might have to separately schedule on this line:

• Fines and penalties.
  
• Allowance for bad debts (not deductible for tax).
  
• Officer's life insurance premiums.
  
• Prepaid expenses.
  
• Reserves (there are any number of reserves that may be set up for accounting purposes that aren't deductible for tax purposes.)
  
• Accrued vacation pay and bonuses.
  
• Other disallowed accruals.
  
• Sale of an asset where the book loss exceeds the tax loss.
  
• Amortization expense.
  
• State income or franchise taxes.

Line 5: Income Recorded on Books This Year Not Included on Schedule K. Not too many items in this category. Tax law generally requires a business to recognize income for tax purposes earlier than for book purposes. There's a line on the schedule for tax-exempt interest. Here are some other possible items:

• Sale of an asset where the book gain exceeds the tax gain.
  
• Installment sale (where the sale was not made on the installment basis for tax purposes.
  
• Officer's life insurance proceeds.
  
• Unearned revenue. (Where the revenue was originally deferred for book purposes but recognized for tax purposes.)

Line 6: Deductions Included on Schedule K Not Charged Against Book Income This Year. Many of the items here are just a reverse of those on Line 3. For example, this is where you'd enter the excess of tax depreciation over book depreciation. The accrued vacation pay that wasn't allowed in the prior year was deductible for book and not tax and reported on Line 3. The amount is deductible this year when paid and is now deductible for tax and not for book. Here's the list of items you could encounter (depreciation has its own line item):

• Bad debts (debts actually written off for tax not book; reserved earlier for book).
  
• Amortization for tax not book (item may have been expenses for books).
  
• Sale of asset where tax loss exceeds book loss.
  
• Prepaid expenses (deducted for book in prior year, now deductible for tax).
  
• Reserves (deducted for book in prior year, now deductible for tax).
  
• Accrued vacation and bonus pay.
  
• State income and franchise taxes.

Some items can be more challenging to unearth than others. One item we didn't mention involves credits. You may be able to take a credit for an expenditure. For example, the Work Opportunity Tax Credit allows business taxpayers a credit equal to 40% of qualified wages up to $6,000. If a business takes the credit, they can't claim a deduction for the same wages. That is, if Madison claims $2,400 in tax credits on Form 5884, it must reduce its wage expense by that amount on its tax return.

--Last Update 03/12/13