What Is a Tax Basis Balance Sheet for Tax Reporting?

A tax basis balance sheet is a financial statement that lists a company’s assets, liabilities, and equity based on tax regulations rather than standard accounting principles. Unlike a balance sheet prepared under Generally Accepted Accounting Principles (GAAP) for investors, a tax basis balance sheet is structured to comply with the Internal Revenue Code. It is a foundational document for preparing annual business tax returns.

The Role of the Tax Basis Balance Sheet in Tax Reporting

The Internal Revenue Service (IRS) requires certain businesses to report their financial standing on a tax basis. This applies to pass-through entities like partnerships filing Form 1065, U.S. Return of Partnership Income, and S corporations filing Form 1120-S, U.S. Income Tax Return for an S Corporation. For these entities, the tax basis balance sheet is reported on Schedule L of their tax forms. Businesses with total receipts or total assets of $250,000 or more must complete Schedule L.

The purpose of this reporting is to establish a starting point for calculating each owner’s basis, which is their investment in the entity for tax purposes. This figure is tracked annually, and information from the tax basis balance sheet helps determine each owner’s share of the company’s financial items.

This owner-level basis calculation determines the tax consequences of several events, including the taxability of distributions and the amount of business losses an owner can deduct. This individualized information, derived from the company-wide balance sheet, is reported to each owner on their Schedule K-1.

Determining Tax Basis for Balance Sheet Accounts

Calculating values for a tax basis balance sheet requires using tax rules, which differ from book accounting rules. This process involves adjusting account balances from their book values to their tax values, with differences most pronounced in asset and equity accounts.

Assets

While asset accounts like cash are the same for both book and tax purposes, many are not. Accounts receivable, for instance, will have a different basis depending on the accounting method. For a business using the accrual method for book purposes but cash method for tax, accounts receivable has a book value but a zero tax basis because income is not recognized until cash is received.

Inventory valuation also creates differences. A company might use the First-In, First-Out (FIFO) method for its books but the Last-In, First-Out (LIFO) method for tax purposes. During periods of rising costs, LIFO results in a higher cost of goods sold and a lower tax basis for the remaining inventory compared to FIFO.

Fixed assets are a common source of book-to-tax differences due to depreciation. For financial reporting, companies may use the straight-line method, which spreads the expense evenly over an asset’s life. For tax purposes, they use the Modified Accelerated Cost Recovery System (MACRS), which allows for larger, accelerated depreciation deductions in the early years of an asset’s life. This creates a significant difference in the asset’s basis on the balance sheet.

Liabilities

Many liabilities, like loans payable, are reported at the same value for both book and tax purposes. However, differences can arise. For example, an accrual-basis company may record a liability for employee bonuses at year-end for its books, but under tax law, the liability is not recognized for tax basis until the bonuses are paid.

Equity

Instead of retained earnings, an S corporation reports an Accumulated Adjustments Account (AAA). The AAA tracks the cumulative taxable income passed through to shareholders but not yet distributed. It starts at zero when the S corporation election is made and is increased by income and gains and decreased by losses and distributions.

For partnerships, the equity section is composed of the partners’ tax capital accounts, which the IRS requires to be reported on a tax basis. A partner’s tax capital account is calculated by their initial cash and tax basis of contributed property, plus their share of income, minus their share of losses and distributions. This figure is a component in determining a partner’s overall tax basis.

Reconciling Book Data to Tax Data

The company’s book records must be reconciled to the figures reported on the tax return. This is accomplished through two schedules on the tax return: Schedule M-1 and Schedule M-2, which explain the differences between financial and tax accounting.

Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, starts with the net income from the company’s financial statements. It then lists adjustments to arrive at the taxable income, reflecting the annual impact of book-tax differences. Common M-1 adjustments include differences in depreciation, non-deductible meal expenses, tax-exempt interest, and penalties.

The reconciled taxable income from Schedule M-1 flows to Schedule M-2, which analyzes changes in the company’s tax-basis equity accounts. For an S corporation, this is the Analysis of Accumulated Adjustments Account, and for a partnership, it is the Analysis of Partners’ Capital Accounts. The schedule starts with the beginning equity balance, adds tax-basis net income, and subtracts distributions. The result is the end-of-year tax basis equity, which must match the total equity on the Schedule L balance sheet.