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Chapter 2B.Corp. Taxation

Reconciliation of Book and Taxable Income

Howard Godfrey, Ph.D., CPAProfessor of Accounting

Copyright © 2014Edited January 10, 2014

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Reconcile tax and book income[Page 25+]

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• Corporation governed largely by Section 162 when determining deductibility of payments to shareholders.

• Shareholders governed largely by Sections 162 and 212 when making corporate related expenditures, but are limited by Sections 262 and 263(a)(1).

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162(a) In General. There shall be allowed as a deduction all the ordinary and necessary expenses … in carrying on any trade or business, including-

(1) a reasonable allowance for salaries ..

(2) traveling expenses …

(3) rentals …

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•What is the presumption in the Code regarding the relationship of corporate activities and Section 162(a)?

•Does Section 212 apply to corporations?

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Corporation's Taxable Income.Business Expenses. Deductions are allowed for ordinary and necessary business expenses.

No deduction is allowed for:interest on amounts borrowed to purchase tax-exempt securities, illegal bribes or kickbacks, fines or penalties imposed by a government, or insurance premiums incurred to insure the lives of officers and employees when the corporation is beneficiary.

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• Note that on the next slide, the problem provides net income as a starting point.

• You remove any item of income or expense that is not part of the computation of taxable income.

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Return

Income per books-2014 $400,000 $400,000

Book Income includes:

Municipal bond Interest 8,000

Meals & entertain. Exp. 20,000

Prem. - officers' life ins. (corp. is beneficiary) 3,800 Capital losses 1,000

Fines 200

What is taxable income?

Char. Corp.-organized 1-1-2014

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Return

Income per books-2014 $400,000 $400,000

Book Income includes:

Municipal bond Interest 8,000 (8,000)

Meals & entertain. Exp. 20,000 10,000

Prem. - officers' life ins. (corp. is beneficiary) 3,800 3,800

Capital losses 1,000 1,000

Fines 200 200

What is taxable income? $407,000

Char. Corp.-organized 1-1-2014

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UNCC Corporation - 1 of 3Compute Tax. Income Debit Credits Sales $700,000 Cost of sales $400,000 Mun. bond interest 2,000 Compensation 100,000 Meals, entertain-Gross 20,000 Other Expense 140,000 Subtotal 660,000 702,000 Net Income before tax

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UNCC Corp - 2 of 3 Debit Credits Sales $700,000 Cost of sales $400,000 Municipal bond interest 2,000 Compensation 100,000 Meals, entertain. (Gross) 20,000 Other Expense 140,000 Subtotal 660,000 702,000 Net Income before tax 42,000 Add: one half of entertain.Less: Mun. bond interestTaxable incomeIncome TaxCompute E & P (Similar to Retained Earnings)

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UNCC Corp - 3 of 3 Debit Credits Sales $700,000 Cost of sales $400,000 Municipal bond interest 2,000 Compensation 100,000 Meals, entertain. (Gross) 20,000 Other Expense 140,000 Subtotal 660,000 702,000 Net Income before tax 42,000 Add: One half of entertain. 10,000 Less: Mun. bond interest (2,000)Taxable income 50,000 Income Tax 7,500 Compute E & P (Similar to Retained Earnings)

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Financial Information for X Corp. (first year)

Revenue $900,000Expenses reported under GAAP ($500,000)

GAAP net income in Year 1: $400,000

GAAP bad debts expense in Year 1: $3,000

Amount of bad debts written off: $2,000

Taxable income in the future will be $500,000

Net income before bad debts exp.

Bad debts expense on tax return

Taxable income

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Financial Information for X Corp. (first year)

Revenue $900,000Expenses reported under GAAP ($500,000)

GAAP net income in Year 1: $400,000

GAAP bad debts expense in Year 1: $3,000

Amount of bad debts written off: $2,000

Taxable income in the future will be $500,000

Net income before bad debts exp. $403,000

Bad debts expense on tax return ($2,000)

Taxable income $401,000

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Financial Information for X Corp. (first year)Revenue $900,000Expenses reported under GAAP ($500,000)GAAP net income in Year 1: $400,000GAAP bad debts expense in Year 1: $3,000Amount of bad debts written off: $2,000Taxable income in the future will be $500,000Financial statements at end of first year include:a. Deferred tax asset of $340

b. Deferred tax asset of $660

c. Deferred tax liability of $340

d. Deferred tax liability of $660

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Financial Information for X Corp. (first year)Revenue $900,000Expenses reported under GAAP ($500,000)GAAP net income in Year 1: $400,000GAAP bad debts expense in Year 1: $3,000Amount of bad debts written off: $2,000Taxable income in the future will be $500,000Financial statements at end of first year include:a. Deferred tax asset of $340

b. Deferred tax asset of $660

c. Deferred tax liability of $340

d. Deferred tax liability of $660

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GAAP- 2014- Income Statement:Sales (Gross) $200,000Cost of sales 100,000

Gross Profit 100,000 Expenses 60,000

Net income before taxes $40,000

For GAAP, company charges 4% of gross sales to bad debts expense. Allow. for bad debts, 12/31/2013 $5,000Allow. for bad debts, 12/31/2014 4,000What is taxable income for 2014? a. $ 40,000 b. $42,000 c. $39,000 d. $38,000

Big Corp. Bad Debts-Sec. 166

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GAAP- 2014- Income Statement:Sales (Gross) $200,000Cost of sales 100,000

Gross Profit 100,000 Expenses 60,000

Net income before taxes $40,000

For GAAP, company charges 4% of gross sales to bad debts expense. Allow. for bad debts, 12/31/2013 $5,000Allow. for bad debts, 12/31/2014 4,000What is taxable income for 2014? a. $ 40,000 b. $42,000 c. $39,000 d. $38,000

Big Corp. Bad Debts-Sec. 166-Answer

Bad Debts. Direct write-off for Tax PurposesAmounts in$Thousands GAAP Tax GAAP Tax

Sales $800 $800 $800 $800 Cost of Sales 500 500 500 500 Gross Margin 300 300 300 300 Bad Debts Expense 80 60 50 60 Total other expenses 100 100 120 120 Net Income Before Tax $120 $140 $130 $120

Assume income tax rate is 34%Amount of the deferred tax asset at 12-31-2014?

2014 2015

Book TaxableYear Income Income

2014 $120,000 $140,0002015 130,000 120,000

Total 250,000 260,000

10,00034%

$3,400

Sales Co. [2]

DifferenceMarginal rate

Deferred Tax Asset

Sales $100Bad debts (provision) 5Other Expenses 80Total Expenses 85Net Income before Taxes $15

Beg. End.Accounts Receivable $80 $85Allow. for Bad Debts $7 $4

Amount of Acct. Rec. written off?What is taxable income?

Bad Debts Problem ($000)

Beg. Bal. XXX 80 7 1 Sales 100 2 Collection 87 87 3 Write-off 8 8 4 Other Exp. 80 5 Provision 5

Balance 85 4

1 Sales 100 4 Other Exp. 80 5 Provision 5

Bad Debts Problem

Cash AllowanceAccts. Rec.Transaction

Revenue

Revenue and Expense ($000)Bad Debts Exp.Other Exp.Transaction

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Bad Debts Problem - Solution

GAAP net income $15,000

GAAP bad debts expense $5,000

Amount of debts written off: ($8,000)

Taxable income $12,000

Book income before tax $400,000 Revenue included: Tax-exempt interest income 8,000

Expenses included:

Meal & Entertainment Exp. 22,000

Life insurance premium 3,300 Fines 200 Taxable income

Tax Rate

Income Tax Liability

Maxwell Corp. Book/Tax Differences

Book income before tax $400,000 Tax-exempt interest incomeMeal & Entertainment Exp.

(50% x $22,000)

Life insurance premiumFinesTaxable income

Tax Rate 34%Income Tax Liability

All adjustments - permanent differences.

Maxwell Corp. Book/Tax Differences

Book income before tax $400,000 Tax-exempt interest income (8,000)Meal & Entertainment Exp.

(50% x $22,000) 11,000

Life insurance premium 3,300 Fines 200 Taxable income $406,500 Tax Rate 34%Income Tax Liability $138,210

All adjustments - permanent differences?

Maxwell Corp. Book/Tax Differences

Maxwell Corp. Book/Tax

Please prepare schedule M-1.Pg. 2-36of your textbook.

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Schedule M-1 Reconciliation of Income (Loss) per Books with Income per Return

1 Net income (loss) per books......………...................... 7 Income recorded on books this year

2 Federal income tax............................. not included on this return (itemize):

3 Excess of capital losses over capital gains ……............ Tax-exempt interest.

4 Income subject to tax not recorded on

books this year (itemize):……………….……………………………… 8 Deductions on this return not charged

against book income this year (itemize):

5 Expenses recorded on books this yr, a. Depreciation

not deducted on this retum (itemize): b. Charitable Contributions

a Depreciation .….............

b Contributions …………....

c Travel and entertainment...

9 Add lines 7 and 8

6 Add lines 1 throuqh 5 10 Income (Line 28, pg 1) - ln 6 less ln 9

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Schedule M-1 Reconciliation of Income (Loss) per Books with Income per Return

1 Net income (loss) per books......………......................$400,000 7 Income recorded on books this year

2 Federal income tax............................. not included on this return (itemize):

3 Excess of capital losses over capital gains ……............ Tax-exempt interest. $8,000

4 Income subject to tax not recorded on $8,000

books this year (itemize):……………….……………………………… 8 Deductions on this return not charged

against book income this year (itemize):

5 Expenses recorded on books this yr, a. Depreciation

not deducted on this retum (itemize): b. Charitable Contributions

a Depreciation .….............

b Contributions …………....

c Travel and entertainment... $11,000

Life Ins. Prem. $3,300 Fines $200 $14,500 9 Add lines 7 and 8 $8,000

6 Add lines 1 throuqh 5 $414,500 10 Income (Line 28, pg 1) - ln 6 less ln 9 $406,500

Client recorded 2014 transactions on cash basisand prepares the tax return on the accrual basis. Collections from customers in 2014 $300,000 Cash payments for expenses 200,000 Other information

Beginning Accounts Receivable 100,000Ending Accounts Receivable 90,000Write-off of uncollectible accounts 4,000Depreciation Expense 50,000Change in accounts payable 0All sales are on creditDirect Charge-Off Method is used.

What is amount of sales (accrual)?

What is taxable income?

Client - Slide 2 of 3Cash Ac-Rec. Other Rev. Exp.

Beg. Bal.

Sales

Collection

Write-off

Deprec.

Other Exp.

Balance

Client - Slide 3 of 3Cash Ac-Rec. Other Rev. Exp.

Beg. Bal. 100Sales 294 294Collection 300 (300)Write-off (4) 4Deprec. (50) 50Other Exp. (200) 200Balance 90

Office Rental Inc. – Slide 1 of 6.Office Rental, Inc. collects rent in advance from some tenants and bills others at the end of each month for that month’s rent. The accrual basis income statement (GAAP) for Year 2 shows revenue earned of $54,700.

Rent Receivable was $3,100 at start of Year 2 and $2,500 at the end of Year 2. Unearned Revenue Account had a balance of $2,600 at start of Year 2 & $1,300 at end of Year 2. What is cash basis revenue for Year 2 (collections from tenants)?

Year 2 Year 1

Balance SheetRent receivable $2,500 $3,100Unearned revenue $1,300 $2,600

GAAP Income Statement:Rent Revenue $54,700 $49,800

Cash Collections from tenants for rent-Yr. 2?

Office Rental Inc.-Slide 2 of 6

Year 2 Year 2

Revenue Earned-Yr 2 $54,700 $54,700

Beg. Rent Receivable 3,100

End. Rent Receivable 2,500

Beg. Unearned Revenue 2,600

End. Unearned Revenue 1,300

Collected from tenants

In Year 2, you collected receivables

of $3,100 for rent in Year 1, etc.

Office Rental Inc.-Slide 3 of 6

Year 2 Year 2

Revenue Earned-Yr 2 $54,700 $54,700

Beg. Rent Receivable 3,100 3,100

End. Rent Receivable 2,500 (2,500)

Beg. Unearned Revenue 2,600 (2,600)

End. Unearned Revenue 1,300 1,300

Collected from tenants $54,000

In Year 2, you collected receivables

of $3,100 for rent in Year 1, etc.

Office Rental Inc.-Slide 4 of 6

Revenue-accrual basis-Year 2 tax return? GAAP Revenue for Year 2 54,700 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue End. Unearned Revenue Revenue on Tax ReturnTax law follows GAAP for accruing receivables, but not for reportingrent income received in advance.

Office Rental Inc.-Slide 5 of 6

Revenue-accrual basis-Year 2 tax return? GAAP Revenue - Year 2 54,700 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue (2,600) End. Unearned Revenue 1,300 Revenue on Tax Return $53,400Tax law follows GAAP for accruing receivables, but not for reportingrent income received in advance.

Office Rental Inc.-Slide 6 of 6

Realty Corp. Rental Income Realty Co. was organized on Jan-1, year 1. Realty bought a building on that date for $400,000, having an estimated 40‑year life with no salvage. The S/L depreciation method is used for tax & GAAP. Depreciation is $10,000 per year on the tax return and in the GAAP statements.Realty rented the building to IBM for 2 years at $20,000 per year. Rent of $40,000 was received on Jan-1, year 1. Realty’s income tax rate is 40%. Yr. 1 operations are described on next slide.

GAAP TaxRent Revenue $20,000Cash Expenses (5,000)Depreciation Exp. (10,000)NIBT/Taxable Income 5,000Income Tax Rate 40%Income Tax ExpenseIncome Tax PaidNet Income

asset or liability at end of Yr 1?

Realty Corporation - Slide 2.

What is the amount of the deferred tax

GAAP TaxRent Revenue $20,000 $40,000Cash Expenses (5,000) (5,000)Depreciation Exp. (10,000) (10,000)NIBT/Taxable Income 5,000 25,000Income Tax Rate 40% 40%Income Tax Expense 2,000Income Tax Paid 10,000Net Income 3,000

asset or liability at end of Yr 1?

Realty Corporation - Slide 3.

What is amount of deferred tax

GAAP TaxRent Revenue $20,000 $40,000Cash Expenses (5,000) (5,000)Depreciation Exp. (10,000) (10,000)NIBT/Taxable Income 5,000 25,000Income Tax Rate 40% 40%Income Tax Expense 2,000Income Tax Paid 10,000Net Income 3,000

asset or liability at end of Yr 1? 8,000

Realty Corporation - Slide 4.

What is amount of deferred tax

Gross sales in year 1 $500,000Cost of sales in year 1 250,000Other Expenses in year 1 100,000Net Income Before Taxes- Yr 1$150,000Year 1 sales collected in:

Year 1 $300,000Year 2 $200,000

Income Tax Rate 40%Method used for GAAP: AccrualMethod used for Tax: Inst. SalesAmount of deferred tax asset

or liability at end of Year 1?Is it a Def. Asset or Liability?

Income Tax Accounting

Gross sales in year 1 $500,000Cost of sales in year 1 250,000Other Expenses in year 1 100,000Net Income Before Taxes- Yr 1$150,000Year 1 sales collected in:

Year 1 $300,000Year 2 $200,000

Income Tax Rate 40%Method used for GAAP: AccrualMethod used for Tax: Inst. SalesAmount of deferred tax asset

or liability at end of Year 1? $80,000Is it a Def. Asset or Liability? Liability

Income Tax Accounting

Note, the installment sales method is generally prohibited for dealers in inventory. However it is allowed in limited circumstances. The problem on the preceding slide is included to help illustrate the differences between accrual accounting and other revenue recognition methods – and the impact on deferred taxes.

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The

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