by Gail Perry
In January, the Internal Revenue Service announced plans for a new schedule to accompany the Form 1120, U.S. Corporation Income Tax Return. Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, will replace the Schedule M-1 for taxpayers who surpass the $10 million asset threshold.
The M-3 is effective for taxpayers filing 2004 corporation income tax returns.
Spearheaded by Deborah M. Nolan, commissioner of the IRS’s Large and Mid-Size Business Division, the function of the M-3 will be to make the differences between financial accounting net income and taxable income more transparent, so that returns that need to be audited will be more easily identifiable.
“We see benefits to taxpayers and the IRS from the new schedule: a reduction in unnecessary audits and a swifter focus on those differences that are more likely to arise when taxpayers take aggressive positions or engage in aggressive transactions,” said Pam Olson, former Treasury Department assistant secretary for tax policy in a statement earlier this year.
The old Schedule M-1, a 10-line section at the bottom of the 1120’s page four, was required of all corporations with assets of $250,000 or more. The corporation uses the 10 lines to provide a brief description of the differences between book and tax net income.
Needless to say, very little detail is allowed on the M-1. No one will say that about the M-3.
The new M-3, in its latest draft form, provides an overwhelming 75 lines on two full pages for detailing the differences between book and tax income. Each line is spread over four columns, where the taxpayer will show the book amount, the tax amount, the amount that is a permanent difference, and the amount that is a timing difference.
In addition, an entire page of the M-3 is devoted to zeroing in on what constitutes book income for the corporation.
Beyond the lines on the form, the taxpayer is expected to attach schedules that provide additional breakdown and description of the amounts listed on the M-3. Furthermore, each member of a consolidated tax group must report its own activity on separate M-3 forms. There is no dollar or ratio threshold for materiality. “Every item of difference must be separately stated and adequately disclosed on Schedule M-3,” according to a list of answers to frequently asked questions published by the Treasury Department.
“You could spend hours just working through the details on the seven pages of Q&A that they put out,” said Mel Schwartz, senior manager with Grant Thornton’s national tax office in Washington.
Grant Thornton has been the torch carrier for the midsized companies that it feels are going to be overburdened by the requirements of the M-3. When the IRS asked for comments on an early draft of the M-3, Grant Thornton responded with requests that the IRS raise the M-3 asset threshold from $10 million to $250 million, wait a year to make the M-3 effective, allow taxpayers to net book/tax differences in the same way as they do on their financial statements instead of providing detail of every difference, and eliminate the requirement for characterizing the amounts as permanent versus temporary differences.
“The Schedule M-3, in its proposed form, would place an inappropriate burden on midsized companies,” Grant Thornton said in its letter.
The firm also asked that the IRS not expect firms to duplicate Form 8886, Reportable Transaction Disclosure Statement, on the M-3. This request has been honored in the final version of the M-3.
“Even the most diligent taxpayer is going to have to scramble to come up with the figures for the form,” said a source at the American Institute of CPAs. The AICPA’s Proposed Schedule M-3 Task Force also responded to the IRS’s request for comments with a letter that asked for similar considerations as those in the Grant Thornton letter. The AICPA asked that the asset threshold be raised to $250 million, at least for the first year.
“Increasing the threshold to taxpayers with $250 million of assets would provide that approximately 10,000 taxpayers would utilize the Schedule M-3 in its initial year,” said the institute. “This would allow the IRS and Treasury to review the Schedules M-3 filed by these taxpayers, better understand the impact of the Schedule M-3, and adjust the form or procedure as necessary before requiring more taxpayers to utilize the Schedule M-3.”
The AICPA also suggested that the effective date for use of the M-3 be moved to the 2005 or even the 2006 tax year. The organization pointed out a concern that while software vendors have indicated they will probably be able to incorporate the M-3 into their 2004 products, “the more significant burden is the change required to the internal information gathering systems and internal accounting processes of corporate tax departments.”
Again, the requests fell on deaf ears at the IRS.
Vendors rise to the occasion
Meanwhile, as suggested by the AICPA, software vendors are confident that they’ll have the software ready to be able to add the Schedule M-3 to 2004 tax returns.
Brian Hasz, tax manager and 1120 developer for Lacerte Software, indicated that, “It’s probably a matter of three weeks,” to have the M-3 addition to their 1120 program up and running. “We’ve held discussions with the IRS, with other developers involved, and we’re working through the issues,” Hasz said.
The main hang-up for software companies will be if the IRS makes additional changes before the end of the year to the draft version of the form that was released in July.
Kathy Hashimoto, manager of development and support for CCH’s ProSystem fx Tax, said, “A lot is going to be dependent upon how drastically they change the forms. As a general rule, we like to be able to have final forms available on our first release.”
“If we’re lucky, if what we see on the final version is what we see on the preliminary drafts, they will be available on the first release,” she said.
Tax preparers using the corporate tax products can expect to enter the information for the M-3 separately, as opposed to entering book/tax differences throughout the return preparation process. “It would be a separate set of entries that they would make,” said Hasz. “And a portion of [the M-3] would be able to be automatically computed.”
What the future holds
The IRS’s new Schedule M-3 for corporations may be a reality, but will businesses and accounting firms be ready to deal with the new requirements it imposes?
“There’s going to have to be a significant education process, not only for the clients, but for the people in the accounting firms to prepare and review the returns,” said Schwartz.
The M-3 is a 2004 requirement only for Form 1120. The IRS is expected to incorporate similar requirements into the tax returns for pass-through entities next year, so those who prepare the 1120S for S corporations and the 1065 for partnerships can anticipate the same type of burden in future years.
Schwartz envisions a future with M-3 specialists. “Professionals are going to have to be directed to focusing on this area,” he said.
