Schedule M-3 is part of the effort by the Internal Revenue Service to get a better handle on abusive tax shelters and other aggressive tax techniques by getting sufficient detail on book/tax differences that it can guide IRS auditors to transactions in need of further examination.The IRS is sufficiently confident in its ability to track book/tax differences on Schedule M-3 that earlier this year it removed book/tax differences as a criteria required for reportable transactions. While the former Schedule M-1 required only 10 lines of information, Schedule M-3 expands that to 90 lines of information, with an emphasis on making a distinction between temporary and permanent book/tax differences.
Schedule M-3 is divided into three parts. Part I attempts to determine the appropriate financial net income starting point for the reconciliation. Part II is a reconciliation of income and loss items. Part III is a reconciliation of expense and deduction items.
Schedule M-3 was required for corporations with assets equal to or greater than $10 million for the first time on 2004 returns. Those returns were required to include only the information in Columns A and D (from the income statement or from the tax return), with the information on temporary and permanent differences in Columns B and C to be required in later years.
The IRS is now well along in processing those returns and making an initial examination of the results obtained. Taking that information into account, the IRS is not only making modifications to the Schedule M-3 requirements for larger corporations for 2006, it is also rolling out Schedules M-3 for other entities that will be required to submit Schedule M-3 for the first time in 2006: partnerships, S corporations and insurance companies.
Now appears to be a good time to take stock of what has been learned from M-3 filings to this point, and what new requirements are anticipated for the coming tax filing season.
Lessons learned
The IRS has reported processing more than 10,000 Schedule M-3s from 2004. That is a small number compared to 2 million Form 1120s filed. Many business tax return preparers may have thus far escaped worrying about the Schedule M-3 requirements, with the initial focus only on large corporations. As the scope of Schedule M-3 requirements continues to expand, it will become more and more difficult for tax practitioners to avoid dealing with them.
In its examination of corporations required to file Schedule M-3, the IRS has detected a significant non-compliance problem, primarily from simply not filing a Schedule M-3 although the corporation appeared to be required to do so. The IRS has sent out 1,200 inquiries to corporations asking them to state why they did not file a Schedule M-3 for 2004.
While there is no specific penalty in the code for failure to file a Schedule M-3, the IRS is of the view that Schedule M-3 would be self-policing, with the failure to file the schedule or to file it incompletely as likely to attract an audit as the disclosure of specific information on a transaction. The IRS has indicated that banks make up a significant percentage of those corporations that failed to file a Schedule M-3.
In addition to these letters, approximately 200 of the returns that did file a Schedule M-3 have been selected for audit based on information reported on that schedule. Those returns are being selected for audit centrally and then assigned to agents for audit. The IRS believes that its filters associated with the information reported on Schedule M-3 are permitting it to target much more accurately those returns that appropriately should be the focus of further examination.
Other problems encountered with the 2004 Schedule M-3 included reporting of cost of goods sold. Difficulties in figuring how to reconcile cost of goods sold on Schedule M-3 has resulted in the IRS rolling out a new form for 2006 - Form 8916-A, Reconciliation of Cost of Goods Sold Reported on Schedule M-3.
The IRS has also indicated that it is disturbed by the relatively large amount of dollars being reported in the catch-all "Other income (loss) items with differences" on Line 26 of Part II of Schedule M-3, rather than being reported elsewhere on the schedule. Although Line 26 requires a schedule to be attached, the IRS is reported to be considering ways to get this information broken out on Schedule M-3, rather than being lumped on Line 26.
During a recent audio seminar on Schedule M-3, the authors of a new book on the subject (John O. Everett, Cherie Henning and William A. Raabe) also pointed out that there is a problem with the listing of U.S. current income tax expense and U.S. deferred income tax expense on Lines 1 and 2 of Part III of Schedule M-3.
While the two items are listed as expense/deduction items, they net to income taxes payable, a balance-sheet item, rather than income tax expense. The IRS has not yet clarified how this apparent discrepancy is to be handled.
New requirements
At the same time that the IRS is evaluating the Schedule M-3s that have now been submitted, it is rolling out additional M-3 requirements.
In June of this year, the IRS released final draft 2006 Schedules M-3 not only for Form 1120 but also for Form 1120-L (life insurance companies), 1120-PC (property casualty insurance companies), 1120S (S corps) and 1065 (partnerships). Schedule M-3 will be required for insurance companies, S corps and partnerships for the first time for 2006 tax year returns.
The scope of the Schedule M-3 requirements for these entities will be similar to the corporate requirements. In the case of partnerships, Schedule M-3 will be required if the partnership's total assets at the end of the tax year equal or exceed $10 million; if the partnership's adjusted total assets for the year equal or exceed $10 million (to prevent any benefit from temporary year-end distributions or other adjustments); if the partnership's total receipts for the year equal or exceed $35 million; or if an entity that is required to file a Schedule M-3 owns or is deemed to own, directly or indirectly, an interest of 50 percent or more in the partnership's capital, profit or loss on any day during the partnership year.
These new requirements should greatly expand the number of Schedule M-3s being filed with the IRS in 2006 as compared to 2004, and also increase the number of tax return preparers required to be familiar with Schedule M-3 requirements. The new Schedule M-3s are also likely to result in additional questions. For example, while the procedures for filing Schedule M-3s for consolidated corporate returns have been spelled out in some detail, it is unclear at this point what special Schedule M-3 requirements might be imposed on tiered partnerships.
Summary
The Schedule M-3s filed for the 2004 year are already providing the IRS with some of the additional transparency that they sought to better identify corporations that warrant additional audit resources. The lessons learned from these filings are already being translated into expanded disclosures required for the corporate Schedule M-3 for 2006, and the new Schedule M-3 filing requirements for 2006 for partnerships, S corporations and insurance companies.
A 2006 survey conducted by the Tax Council Policy Institute indicated that the vast majority of tax directors felt that they had a good handle on meeting the expanded reporting requirements of Schedule M-3. Still, the IRS reported a significant percentage of noncompliance in 2004.
As the number of entities required to file Schedule M-3 continues to expand, in-house tax departments as well as outside tax practitioners will increasingly be required to become familiar with the intricacies of these expanded disclosure requirements.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a Wolters Kluwer business.
