Form 1120 Schedule M3

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Form 1120Schedule M-3

• Presented by Melissa Horne
• Smith Howard, PC
• January 20, 2006

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Purpose of Schedule

• Increase transparency between financial
  accounting net income and taxable income
• Identify aggressive transactions that may have
  occurred
• Identify high-risk taxpayers to be audited by IRS
• Increase the efficiency of IRS audits

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Who Must File Schedule M-3

• Any domestic corporation or U.S. consolidated tax
  group with total assets that equal or exceed 10
  million.
• This is the same criteria used to determine
  whether a corporation is within the jurisdiction
  of the IRS Large and Mid-Size Business Division
  (LMSB).

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Basis of Accounting for Determination of Total
Assets

• Total Assets must be determined based on the
  Accrual Method unless both of the following
  apply
• The tax return or returns of all includible
  corporations in the U.S. consolidated tax group
  are prepared using an overall cash method of
  accounting, and
• No includible corporation in the U.S.
  consolidated tax group prepares or is included in
  the financial statements prepared on an accrual
  basis.

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Tax Return (Schedule L) previously reported on
Cash Basis when Accrual basis Financials prepared
under GAAP

• Beginning Balance Sheet on tax return should not
  be restated
• Any difference between beginning tax basis
  retained earnings and beginning GAAP basis
  retained earnings as reported on the Financial
  Statements should be reported on Schedule M-2 as
  a reconciling amount and an explanation provided

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What does the Schedule M-3 Look Like?
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Schedule M-3, Part I
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Part 1 Financial Information and Net Income
Reconciliation

• Source of financial information
• SEC Form 10-K
• Certified Audited Income Statement
• Corporation Prepared Income Statement
• Books and Records

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Part 1 Financial Information and Net Income
Reconciliation

• Reconciliation of financial statement net income
  per books and tax return net income per books
• Net Income/Loss from nonincludible foreign
  entities
• Net Income/Loss from nonincludible U.S. entities
• Net Income/Loss of other includible corporations
• Adjustments

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Part 1 Financial Information and Net Income
Reconciliation

• Attachments
• A schedule for entities (both foreign and
  domestic) not included in the tax return
• A schedule for entities included in the return
  but not on the financial statements
• A schedule for any other adjustments necessary to
  reconcile financial statement book income to tax
  return book income

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Schedule M-3, Parts II III
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Parts II and III Reconciliation is in a
columnar Format as Follows

• Column A Income Statement Balance
• Column B Temporary Differences
• Column C Permanent Differences
• Column D Tax Return Balance

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Parts II and III General Reporting Requirements

• The first year a corporation is required to file
  Schedule M-3, Columns A and D are optional.
• Columns A and D are optional for any year that a
  corporation elects to file Schedule M-3 in lieu
  of Schedule M-1, even though the corporation is
  not required to file the schedule M-3
• After the first required year, amounts in Columns
  A and D should reflect the book/return balance
  even if no current year difference (e.g. Meals
  Entertainment)

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Parts II and III General Reporting Requirements
cont.

• There is no dollar or ratio threshold for
  materiality - Every item of difference should be
  separately stated and adequately disclosed.
• Separately stated and adequately disclosed?
• Specific line instruction attach schedule,
  attach details
• No specific line instruction
• Do general ledger account titles constitute
  adequate disclosure?

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Parts II and III General Reporting Requirements
cont.

• Certain line items in Parts II and III may not
  correspond to similar line items elsewhere on
  Form 1120 and/or other schedules and forms
  included in the return. (i.e. Gains and Losses,
  stock option expense, etc.)

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Parts II and III General Reporting Requirements
cont.

• Adjustments must be shown as either temporary or
  permanent (Columns B and C)
• Temporary differences Items that will be
  recognized in different tax years for book and
  tax
• Permanent differences Items recognized for book
  and will NEVER be recognized for tax or vice
  versa

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Schedule M-3, Part II
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Part II Reconciliation of Income Items

• Examples of Income Reconciling Items
• Minority interest for includible corporations
• Income from equity method of Foreign and U.S.
  corporations
• Net Capital Gains/Losses from flow-through
  entities
• Disallowed Capital Losses and utilization of
  Capital Loss Carryforward
• Sale vs. Lease
• Accrual to Cash adjustments
• 481(a) Adjustments
• Inventory Valuation Adjustments (i.e. 263A, etc.)
• Other Income from flow-through entities

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Part II Reconciliation of Income Items cont.

• Flow-Through entities
• Separate lines for domestic partnerships, foreign
  partnerships and other flow-through entities
• Entity-by-entity reporting required
• ALL items (including separately stated items) of
  flow-through entities are reported on line 9, 10,
  or 11 even if
• The item is described elsewhere on the form
  (Exceptions Reportable transactions Line 12
  199 deductions Line 22) and/or
• There is no current year difference

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Part II Reconciliation of Income Items cont.

• Flow-Through entities
• Basis limitation, at-risk limitation, 469 taken
  into account in determining amount reported in
  column D
• Owner-level limitations such as capital losses
  and charitable contributions not taken into
  account in calculating the amounts on lines 9,
  10, and 11
• Attachments for each entity reported on lines 9,
  10 and 11
• Name, EIN, EOY Profit-Sharing , EOY Loss-Sharing
  , and the amounts included in columns A, B, C
  and D, as applicable

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Schedule M-3, Part III
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Part III Reconciliation of Expense Items

• Examples of Expense Reconciling Items
• Taxes Federal and State Current and Deferred
• Interest
• Stock option expense
• Meals Entertainment
• Fines Penalties
• Domestic production activities deduction
• Depreciation
• Bad Debt Expense
• Utilization of Charitable contribution
  carryforward
• Prepaid Expenses

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ConsolidatedGroups
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U.S. Consolidated Tax Group

• Total assets at the end of the tax year must be
  based on the total year-end assets of all
  includible corporations listed on Form 851, net
  of eliminations for intercompany balances between
  the includible corporations.

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Consolidated GroupsWho must fill out an M-3?

• Each member of the consolidated tax group must
  fill out a Schedule M-3
• You must also attach a Schedule M-3 as follows
• A separate Consolidating Schedule M-3
• A separate Consolidated Schedule M-3

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Consolidated GroupsWho must fill out an M-3?

• Consolidating Schedule M-3
• Adjustments at the consolidated group level that
  are not attributable to any specific member (i.e.
  Disallowance of net capital losses, contribution
  deduction carryovers and limitations)
• Used to report differences in Financial Statement
  book income and Taxable Income related to
  intercompany transactions

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Consolidated GroupsWho must fill out an M-3?

• Consolidated Schedule M-3
• Includes Parts I, II and III resulting from
  consolidating the Schedules M-3 described
  previously

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Consolidated GroupsExample

• Facts A U.S. consolidated tax group consists of
  a parent and three subsidiaries.
• Answer You would expect to complete six
  Schedules M-3 to attach to the tax return of the
  group.

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Consolidated GroupsExample, cont.

• Facts One Parent and Three Subsidiaries
• Parent Company M-3 Parts I, II and III
• Part I Information for the entire consolidated
  group
• Part II and III Parents own activity
• - 4) Each of the three subsidiaries M-3 Parts
  II and III
• Part II and III Each subsidiarys own activity
• Consolidating M-3 Parts II and III
• Consolidated M-3 Parts I, II and III

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Reportable Transactions
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Reportable Transactions

• Rev. Proc. 2004-45 was issued to address
  alternate disclosure procedures for reportable
  transactions
• Generally, the filing of Schedule M-3 with the
  corporations timely-filed original tax return
  (including extensions) satisfies the disclosure
  requirements for transaction with a significant
  (10 million or more) book/tax difference

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Reportable Transactions cont.

• Under the alternate disclosure procedures
  addressed in Rev. Proc. 2004-45
• A taxpayer that is required to disclose
  transactions with significant book/tax
  differences, but is not required to file a
  Schedule M-3 is deemed to satisfy the disclosure
  requirements if the taxpayer
• Completes Schedule M-3 as if it was required to
  complete Schedule M-3 and
• Separately states and adequately discloses each
  item on the applicable line of Parts II and III

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Reportable Transactions cont.

• Amounts associated with Reportable Transactions,
  which pass through from other entities to the
  corporation filing the Schedule M-3, should be
  reported on Part II, Line 12 NOT on Line 9, 10 or
  11.

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Reportable Transactions cont.

• Details required related to reportable
  transactions
• You must either
• Sequentially number each Form 8886 and list each
  transaction by Form 8886 reference number on the
  supporting statement for Schedule M-3, Part II,
  Line 12 and list the amounts associated with
  columns A, B, C and D or
• Report on the supporting statement for Schedule
  M-3, Part II, Line 12
• A description of each transaction (as would be
  required on Form 8886)
• Information required on lines 1-5 of Form 8886
• The amounts associated with columns A, B, C and D

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Penalties
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Penalties

• Penalties related directly to the M-3
• There are currently no penalties specific to the
  Schedule M-3 however, all penalties applicable
  to Form 1120 are applicable to Schedule M-3 that
  is filed as part of Form 1120.

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Penalties, cont.

• Rev. Proc. 2005-75
• Describes what is adequate disclosure for
  purposes of the imposition of accuracy-related
  penalty on underpayments as described in 6662(d)
  and avoiding preparer penalties under 6694(a)
• Rev. Proc. 2005-75 does not apply with respect to
  any other penalty provisions, including the
  disregard provisions under 6662.

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Penalties, cont.

• Rev. Proc. 2005-75
• Items on the Schedule M-3 must be separately
  stated and adequately disclosed
• Columns B and C must be completed for all items
  that have differences
• Other Income and Expense items with differences
  on Parts II and III must include a proper
  description (i.e. Cost of non-compete agreement
  deductible not capitalizable)

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Latest Information
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Latest Information

• If a corporation is required to file Schedule M-3
  in one year and in a subsequent year its assets
  drop below the 10 million requirement, is it
  still required to file the M-3?
• No, the corporation can choose to fill our either
  the Schedule M-1 or Schedule M-3
• However, should its assets exceed 10 million in
  a later year, the M-3 must be filled out in its
  entirety (Columns A, B, C and D)

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Latest Information, cont.

• Schedule M-3 filing requirements for other
  entities
• Form 1120PC, 1120L and 1120S
• Draft issued December 13, 2005
• Expected compliance date tax years ending on or
  after December 31, 2006
• 10 million in total assets

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Latest Information, cont.

• Schedule M-3 filing requirements for other
  entities
• Form 1065
• Draft issued December 20, 2005
• Expected compliance date tax years ending on or
  after December 31, 2006
• 10 million in total assets
• 35 million or more in total receipts or,
• 50 owned by an LMSB or other taxpayer required
  to file Schedule M-3

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Need Help with Schedule M-3

• Extensive Q A on IRS website
• www.irs.gov
• Provides guidance line by line
• Form Instructions provide a great amount of
  detail