What Is the Schedule M-1 Book-to-Tax Reconciliation?

Schedule M-1 is a reconciliation schedule attached to business tax returns, including Form 1120 for C corporations, Form 1120-S for S corporations, and Form 1065 for partnerships. Its purpose is to reconcile the net income or loss on a company’s books with the taxable income or loss reported to the Internal Revenue Service (IRS). This reconciliation is necessary because financial accounting rules differ from tax laws.

A company’s financial statements inform investors about its financial health, while a tax return calculates tax liability according to federal law. Schedule M-1 provides transparency to the IRS by detailing these adjustments. A business must file Schedule M-1 if its total receipts or total assets are $250,000 or more for the tax year. Corporations and partnerships with total assets of $10 million or more file the more detailed Schedule M-3 instead.

The Foundation of Schedule M-1 Book-to-Tax Differences

The need for a book-to-tax reconciliation arises from differences between financial accounting principles, like Generally Accepted Accounting Principles (GAAP), and the Internal Revenue Code (IRC). GAAP prioritizes accurately reflecting a company’s economic reality for investors, whereas the IRC is designed to raise revenue and implement fiscal policy. These differing objectives lead to two categories of book-to-tax differences: permanent and temporary.

Permanent differences are items of income or expense that are recognized for either book or tax purposes, but not both, and they will never reverse in a future period. Temporary differences occur when an item of income or expense is recognized in one period for book purposes and a different period for tax purposes. These timing differences will eventually reverse over subsequent years, meaning the total amount of income or expense recognized will ultimately be the same.

Common Reconciling Items on Schedule M-1

Items Increasing Taxable Income (Add-Backs)

Certain expenses recorded on a company’s books are not fully deductible on its tax return, requiring an adjustment that increases taxable income. One common add-back is the federal income tax expense itself, which is recorded for book purposes but is never deductible when calculating federal taxable income. Business meal expenses are another frequent adjustment, as tax law allows only 50% of the cost to be deducted, so the non-deductible 50% must be added back.

Other add-backs include expenses disallowed as tax deductions, such as entertainment costs, fines, penalties, and political contributions. Depreciation can also lead to an add-back adjustment when the depreciation expense on the books is greater than the tax deduction allowed for that year. Additionally, premiums paid on key-person life insurance policies where the company is the beneficiary are not tax-deductible and must be added back.

Items Decreasing Taxable Income (Subtractions)

Some items of income recorded on the books are not taxable, or certain deductions are allowed for tax purposes that were not expensed on the books. A primary example is tax-exempt interest from sources like municipal bonds, which is included in book income but subtracted for tax purposes. Another example is income from key-person life insurance proceeds, which is recorded on the books but is not subject to federal income tax.

Depreciation differences can also result in a subtraction. When the tax depreciation deduction, often accelerated under MACRS, is greater than the straight-line depreciation recorded on the books, the excess amount is subtracted from book income. This is a common scenario in the early years of an asset’s life.

Information Required to Prepare Schedule M-1

To accurately complete Schedule M-1, several financial documents and detailed records must be gathered. These documents are used to identify and quantify the reconciling items.

• The full-year Income Statement, or Profit and Loss (P&L) statement, which provides the starting net income figure.
• Comparative Balance Sheets for the beginning and end of the tax year.
• Detailed reports from the general ledger for accounts where book-to-tax differences occur, such as meals, entertainment, insurance, interest income, taxes, and penalties.
• The prior year’s tax return, which helps in identifying carryover items or temporary differences that might be reversing in the current tax year.
• A detailed fixed asset schedule to calculate the current year’s tax depreciation deduction, showing all asset additions and disposals during the year.

Step-by-Step Guide to Completing Schedule M-1

The process of completing Schedule M-1 is a methodical reconciliation. On Line 1, you enter the net income (or loss) per books, which should match the figure on the company’s income statement.

Next, you add back items that were expensed on the books but are not deductible for tax purposes. Line 2 is for the federal income tax expense recorded on the books. Line 3 is used to add back the excess of capital losses over capital gains, as the deductibility of capital losses is limited. Line 4 is for income subject to tax but not recorded on the books in the current year, such as certain installment sale income.

Line 5 is a total of other expenses recorded on the books that are not allowed on the tax return. This requires an attached statement that itemizes each adjustment, such as the 50% non-deductible portion of meals, entertainment expenses, and any fines or penalties. The sum of lines 1 through 5 is entered on Line 6.

The next section subtracts items from book income. Line 7 is for income recorded on the books that is not included on the tax return, which also requires an attached statement listing items like tax-exempt interest. Line 8 is for deductions claimed on the tax return that were not expensed on the books, with the most common example being the excess of tax depreciation over book depreciation.

Line 9 is the sum of the subtractions from lines 7 and 8. The final step is to subtract Line 9 from Line 6, with the result entered on Line 10. This final figure represents the taxable income before the net operating loss and special deductions and should match the corresponding taxable income line on the main tax form, such as Line 28 of Form 1120.