To compute taxable income, most corporations begin with book (financial reporting) income and then make adjustments for book–tax differences to reconcile to the tax numbers.4
Book–Tax Differences
Many items of income and expense are accounted for differently for book and tax purposes.
The following discussion describes several common book–tax differences applicable to corporations. Each book–tax difference can be considered “unfavorable” or “favorable”
depending on its effect on taxable income relative to book income. Any book–tax difference that requires an add-back to book income to compute taxable income is an unfavorable book–tax difference because it increases taxable income (and taxes payable) relative to book income. Any book–tax difference that requires corporations to subtract the difference from book income in computing taxable income is a favorable book–tax difference because it decreases taxable income (and taxes payable) relative to book income.
LO 16-2
1See the Business Income, Deductions, and Accounting Methods chapter for a detailed discussion of determining the timing of taxable income and tax deductions under the accrual method.
2§448. Other special types of corporations such as qualified family farming corporations and qualified personal service corporations may use the cash method of accounting. A C corporation that fails the $25 million gross receipts test is precluded from using the cash method for the year in which the test is not satisfied but can resume using the cash method in future years in which the test is satisfied. The $25 million annual aver- age gross receipts test is indexed for inflation for taxable years beginning after 2018.
3See C. B. Cloyd, J. Pratt, and T. Stock, “The Use of Financial Accounting Choice to Support Aggressive Tax Positions: Public and Private Firms,” Journal of Accounting Research 34 (Spring 1996), pp. 23–43.
4This chapter generally assumes that GAAP is used to determine book income numbers.
THE KEY FACTS Computing Corporate Regular Taxable Income
• Corporations reconcile from book income to taxable income.
• Favorable (unfavorable) book–tax differences decrease (increase) taxable income relative to book income.
• Permanent book–tax differences arise in one year and never reverse.
• Temporary book–tax differences arise in one year and reverse in a subsequent year.
In addition to the favorable/unfavorable distinction, book–tax differences can be cat- egorized as permanent or temporary. Permanent book–tax differences arise from items that are income or deductions during the year for either book or tax purposes but not both.
Permanent differences do not reverse over time, so over the long-term, the total amount of income or deductions for the items is different for book and tax purposes. In contrast, temporary book–tax differences reverse over time such that, over the long-term, corpo- rations recognize the same amount of income or deductions for the items on their income statements as they recognize on their tax returns. Temporary book–tax differences arise because the income or deduction items are included in financial accounting income in one year and in taxable income in a different year. Temporary book–tax differences that are initially favorable (unfavorable) become unfavorable (favorable) in future years when they reverse.
Distinguishing between permanent and temporary book–tax differences is important for at least two reasons. First, as we discuss later in the chapter, large corporations are required to disclose their permanent and temporary book–tax differences on a schedule attached to their tax returns. Second, the distinction is useful for those responsible for computing and tracking book–tax differences. For temporary book–tax differences, it is important to understand how the items were accounted for in previous years to appropri- ately account for current year reversals. In contrast, for permanent book–tax differences, corporations need only consider current year amounts to determine book–tax differences.
Below we describe some of the most common book–tax differences.
Common Permanent Book–Tax Differences As we describe in the Business Income, Deductions, and Accounting Methods chapter, businesses, including corporations, are allowed to exclude certain income items from gross income, and they are not allowed to deduct certain expenditures for tax purposes. Because these income items are included in book income, and the expenditures are deducted for financial reporting purposes, they generate permanent book–tax differences. Exhibit 16-2 identifies several permanent book–
tax differences associated with items we discuss in the Business Income, Deductions, and Accounting Methods chapter, explains their tax treatment, and identifies whether the items create favorable or unfavorable book–tax differences.
Elise reviewed PCC’s prior-year tax return and its current-year trial balance. She discovered that PCC earned $12,000 of interest income from City of San Diego municipal bonds issued in 2016; expensed
$34,000 for premiums on key employee life insurance policies; and expensed $28,000 in business- related meal expenses for the year. What amount of permanent book–tax differences does PCC report from these transactions? Are the differences favorable or unfavorable?
Answer: See Elise’s summary of these items below:
Adjustment
(Favorable)
Item Unfavorable Notes
Interest income from City of $ (12,000) Income excluded from gross income.
San Diego municipal bonds issued in 2016
Premiums paid for key employee 34,000 Premiums paid to insure lives of
life insurance policies key company executives are not
deductible for tax purposes.
Business-related meals 14,000 $28,000 expense for book purposes, but only 50 percent deductible for tax purposes.
Example 16-1
EXHIBIT 16-2 Common Permanent Book–Tax Differences Associated with Items Discussed in the Business Income, Deductions, and Accounting Methods Chapter
Description Explanation Difference
Interest income from Income included in book income, excluded Favorable municipal bonds from taxable income for regular tax
purposes
Death benefit from life Income included in book income, Favorable insurance on key employees excluded from taxable income
Interest expense on loans to Deductible for books, but expenses Unfavorable acquire investments generating incurred to generate tax-exempt income
tax-exempt income are not deductible for tax
Life insurance premiums Deductible for books, but expenses Unfavorable for which corporation incurred to generate tax-exempt
is beneficiary income (life insurance death benefit) are not deductible for tax
Business-related meal Fully deductible for books but only Unfavorable
expenses 50 percent deductible for tax
Fines and penalties and Deductible for books but not for tax Unfavorable political contributions
Business-related Deductible for books, but not deductible Unfavorable entertainment expenses for tax
Federal income tax expense. Corporations deduct federal income tax expense (called a “provision for income taxes”) in determining their book income [determined under ASC (Accounting Standards Codification) 740]. However, they are not allowed to deduct federal income tax expense for tax purposes.5 The book–tax provision acts as a permanent difference if the corporation is reconciling after-tax book income with taxable income.
5§275(a)(1).
6Note that this example is presented in what-if form because this is not the income tax expense PCC will report in its financial statements. We compute PCC’s actual income tax expense in the Accounting for Income Taxes chapter.
Example 16-2
What if: Assume that PCC’s audited financial reporting income statement indicates that its federal income tax provision (expense) is $2,000,000.6 What is PCC’s book–tax difference for the year as- sociated with this expense? Is the difference favorable or unfavorable? Is it permanent or temporary?
Answer: $2,000,000 unfavorable, permanent book–tax difference because PCC is not allowed to deduct federal income tax expense for tax purposes.
Common Temporary Book–Tax Differences Corporations experience temporary book–tax differences because the accounting methods they apply to determine certain items of income and expense for financial reporting purposes differ from those they use for tax purposes. Unlike permanent book–tax differences, temporary book–tax differ- ences balance out over time, so corporations eventually recognize the same amount of income or deduction for the particular item. Exhibit 16-3 identifies common book–tax differences associated with items we discuss in other chapters. Exhibit 16-4 summarizes PCC’s temporary book–tax differences described in Exhibit 16-3.
EXHIBIT 16-3 Common Temporary Book–Tax Differences Associated with Items Discussed in Other Chapters
Initial
Description Explanation Difference*
Depreciation expense (Property Acquisition Difference between depreciation expense for tax purposes Favorable and Cost Recovery chapter) and depreciation expense for book purposes.
Gain or loss on disposition of depreciable Difference between gain or loss for tax and book purposes Unfavorable assets (Property Dispositions chapter) when corporation sells or disposes of depreciable property.
Difference generally arises because depreciation expense, and thus the adjusted basis of the asset, is different for tax and book purposes. This difference is essentially the reversal of the book–tax difference for the depreciation expense on the asset sold or disposed of.
Bad debt expense (Business Income, Direct write-off method for tax purposes; allowance method Unfavorable Deductions, and Accounting Methods chapter) for book purposes.
Unearned rent revenue (Business Income, Taxable on receipt but recognized when earned for book Unfavorable Deductions, and Accounting Methods chapter) purposes.
Deferred compensation (Business Income, Deductible when accrued for book purposes, but deductible Unfavorable Deductions, and Accounting Methods when paid for tax purposes if accrued but not paid within
chapter) 2.5 months after year-end. Also, accrued compensation to shareholders owning more than 50 percent of the corporation is not deductible until paid.
Organizational expenses and start-up costs Immediately deducted for book purposes but capitalized and Unfavorable (Property Acquisition and Cost Recovery amortized for tax purposes (limited immediate expensing
chapter) allowed for tax).
Warranty expense and other estimated Estimated expenses deducted for book purposes, but actual Unfavorable expenses (Business Income, Deductions, expenses deducted for tax purposes.
and Accounting Methods chapter)
UNICAP (§263A) (Business Income, Certain expenditures deducted for book purposes, but Unfavorable Deductions, and Accounting Methods capitalized to inventory for tax purposes. Difference reverses
chapter) when inventory is sold. There is an exception for taxpayers with an annual average of $25 million or less in gross receipts over the three prior years.
Interest expense [§163(j)] (Business Income, The deduction for interest expense is disallowed to the Unfavorable Deductions, and Accounting Methods chapter) extent it exceeds the sum of business interest income and
30% of adjusted taxable income (ATI). There is an exception for taxpayers with an annual average of $25 million or less in gross receipts over the three prior years. Unused amounts can be carried forward indefinitely. ATI is defined as taxable income computed without regard to any business interest expense or business interest income. It also excludes depreciation and amortization.
*Note that each of the initial book–tax differences will reverse over time [the initially favorable (unfavorable) book–tax differences will reverse to become unfavorable (favorable) book–tax differences in the future].
EXHIBIT 16-4 PCC’s Temporary Book–Tax Differences Associated with Items Discussed in Other Chapters
(2) − (1)
(1) (2) Difference
Books Tax (Favorable)
Item (Dr) Cr (Dr) Cr Unfavorable
Depreciation expense $(2,400,000) $(3,100,000) $(700,000)
Gain on fixed asset disposition 54,000 70,000 16,000
Bad debt expense (165,000) (95,000) 70,000
Warranty expense (580,000) (410,000) 170,000
Deferred compensation (300,000) (450,000) (150,000)
Dividends. Corporations receiving dividends from other corporations may account for the dividends in different ways for book and tax purposes. For tax purposes, corpo- rations receiving dividends include the dividends in gross income.7 For financial reporting purposes, accounting for the dividend depends on the level of stock owner- ship in the distributing corporation. The general rules for such investments are summarized as follows:
∙ If the receiving corporation owns less than 20 percent of the stock of the distribut- ing corporation, the receiving corporation includes the dividend in income (same as tax; no book–tax difference).
∙ If the receiving corporation owns at least 20 percent but not more than 50 percent of the distributing corporation’s stock, the receiving corporation usually includes a pro rata portion of the distributing corporation’s earnings in its book income under the
“equity method of accounting” (ASC 323) and does not include the dividend in its income, resulting in a temporary favorable or unfavorable book–tax difference for the difference between the pro rata share of equity income reported on the books and the dividend amount reported on the tax return.
∙ If the receiving corporation owns more than 50 percent of the distributing corpora- tion’s stock, the receiving corporation and the distributing corporation usually con- solidate their financial reporting books (ASC 810) and the intercompany dividend is eliminated (book–tax difference beyond the scope of this text).8
Example 16-3
What if: Assume that PCC owns 30 percent of the stock of BCS, a U.S. corporation, and applies the equity method of accounting for book purposes. During 2018, BCS distributed a $40,000 dividend to PCC. BCS reported $100,000 of net income for 2018. Based on this information, what is PCC’s 2018 book–tax difference relating to the dividend and its investment in BCS (ignore the dividends received deduction)? Is the difference favorable or unfavorable?
(continued on page 16-8 )
7As we discuss later in the chapter, corporations are entitled to deduct a certain percentage of the dividends received based on the level of the receiving corporation’s ownership in the distributing corporation.
8Note that 80 percent ownership is required to file a consolidated tax return.
Goodwill acquired in an acquisition. When a corporation acquires the stock of another corporation in a cash (taxable) transaction, the tax basis of the assets of the target corporation generally carry over. As a result, the tax basis of self-created assets such as goodwill carries over unchanged (usually close to zero). The accounting rules (ASC Topic 805) require the target corporation’s identifiable assets to be reported at fair value, with any residual amount allocated to book goodwill. Such book goodwill generally is subject to impairment testing (private com panies can elect to amortize the book goodwill over 10 years). A book/tax difference does not arise until the goodwill is written off as impaired, at which time the book expense creates a (permanent) unfavorable difference.
In less frequent acquisitions, the acquiring corporation may acquire the assets of an- other business directly in a taxable transaction. When this occurs, the assets acquired will get a “new” tax basis equal to fair market value. Any residual will be allocated to tax goodwill, which is amortizable over 15 years (180 months).9 In this case, the goodwill will have both a tax and book basis, which may be the same or different because of differ- ences in the purchase price computation. As the corporation amortizes the goodwill for tax purposes, the resulting book–tax difference is treated as a favorable temporary differ- ence (if book and tax goodwill are different, the accounting becomes more complex and is beyond the scope of this book). If the corporation writes the goodwill off as impaired in a future period, the excess of book goodwill impaired over the amortized goodwill for tax purposes is treated as an unfavorable book–tax difference.10
Answer: $10,000 unfavorable book–tax difference, computed as follows:
Description Amount Explanation
(1) Dividend received in 2018 (included in 2018 $ 40,000 taxable income but not in book income)
(2) BCS 2018 net income $100,000
(3) PCC’s ownership in BCS stock 30%
(4) PCC’s book income from BCS investment $ 30,000 (2) × (3) Unfavorable book–tax difference associated with dividend $ 10,000 (1) − (4) What if: Assume the same facts as above, except that PCC owns 10 percent of BCS rather than 30 percent. What would be PCC’s 2018 book–tax difference relating to the dividend and its investment in BCS (ignore the dividends received deduction)?
Answer: $0. PCC includes the $40,000 dividend in income for both book and tax purposes.
9§197. Self-created goodwill is not amortizable for tax purposes.
10When corporations acquire the stock of another corporation, they often recognize book goodwill but do not recognize any tax goodwill. When this book goodwill is written off as impaired, it generates a permanent unfavorable book–tax difference. Private companies can elect to amortize book goodwill over 10 years or less.
What if: Suppose that on July 1, 2018, PCC acquired the assets of another business in a taxable ac- quisition. As part of the transaction, PCC recognized $180,000 of goodwill for both financial account- ing and tax purposes. During 2018, PCC amortized $6,000 of the goodwill for tax purposes ($180,000/180 months × 6 months during year) and did not impair any of the goodwill for financial accounting purposes. What was PCC’s book–tax difference associated with this goodwill in 2018? Is it a favorable or unfavorable difference? Is the difference permanent or temporary?
Answer: $6,000 favorable, temporary book–tax difference. The amount of capitalized goodwill is the same for book and tax purposes, and PCC deducted $6,000 of the goodwill for tax purposes and none for book purposes.
Example 16-4
Corporate-Specific Deductions and Associated Book–Tax Differences
Certain deductions and corresponding limitations apply specifically to corporations. In this section, we introduce these deductions and identify book–tax differences associated with the deductions.
Stock Options Corporations often compensate executives and other employees with stock options. Stock options allow recipients to acquire stock in the corporation issuing the options at a predetermined price over a specified period of time. To acquire the stock, employees exercise the options and pay the exercise price. The exercise price is usually at or above the stock price on the day the options are issued to the employee. For exam- ple, when a corporation’s stock is trading for $10 per share, a corporation might issue (or grant) 100 stock options to an employee that allow the employee to purchase up to 100 shares of the corporation’s stock for $10 a share. In most cases, after receiving the op- tions, employees must wait a certain amount of time, the requisite service period, before they are able to exercise them (they must wait until the options vest before they can exer- cise them). If employees quit working for the corporation before the options vest, they forfeit the options.
Stock options are valuable to employees when the stock price appreciates above the exercise price because, when the options vest, employees can use them to purchase the stock at a below-market price. Stock options are a popular form of compensation because they provide incentives for employees receiving the options to work to increase the value of the corporation’s stock and thereby benefit themselves and other stockholders.
For tax purposes, the tax treatment to the corporation (and the employee11) depends on whether the options are incentive stock options (ISOs) (less common, more administrative requirements for the corporation to qualify) or nonqualified stock options (NQOs) (more common, options that don’t qualify as ISOs).12 Corpora- tions issuing ISOs generally do not deduct compensation expense associated with the options for tax purposes. In contrast, for NQOs, corporations deduct the difference
What if: Assume that at the end of 2019, PCC recorded a $30,000 goodwill impairment expense on its income statement. What is PCC’s book–tax difference associated with its goodwill during 2019? Is the difference favorable or unfavorable? Is the difference permanent or temporary?
Answer: $18,000 unfavorable, temporary book–tax difference, computed as follows:
Description Amount Explanation
(1) Goodwill initially recorded on 7/1/18 $180,000 acquisition
(2) Goodwill impairment recorded in 2019 $ 30,000 This write-down is expensed for book purposes.
(3) Months over which goodwill amortized 180 15 years × 12 months =
for tax purposes. 180 months
(4) Tax goodwill amortization expense for 2019 $ 12,000 [(1)/(3)] × 12 months Unfavorable book–tax temporary difference $ 18,000 (2) − (4) associated with goodwill in 2019
11Employees do not recognize any compensation income when they exercise incentive stock options. However, for nonqualified options, they recognize compensation (ordinary) income for the difference between the value of the stock and the exercise price on the date of exercise. This chapter emphasizes the tax treatment of the options from the corporation’s perspective.
12Requirements for options to qualify as incentive stock options are more restrictive than the requirements for nonqualified stock options. The formal requirements for incentive stock options are beyond the scope of this text.