20 Feb Understanding Schedule M-2 on IRS Forms 1120 and 1120-S
Understanding Schedule M-2 on IRS Forms 1120 and 1120-S is being brought to you from the rear passenger seat of my Toyota Sienna while commuting back to Fort Collins Colorado where my eldest is navigating CSU’s new Agricultural Biology program.
To assuage pending separation anxiety, jotting notes on the Schedule M-2 seemed better than barraging the lad with copious and purportedly repeated questions. After all the M-2 is getting more attention these days as one of the places non-taxable income is reported, which incidentally due to the plethora of PPP loan forgiveness programs available to small business owners, has ‘arrived’ in droves.
For the next 6000 words or so this post addresses accounting for income taxes and Schedule M-2 of Form 1120-S for S-Corp shareholders including LLC members electing to be treated as S-corporations, including:
- Issues concerning temporary and permanent differences between book income and taxable income.
- Types of transactions that result in future taxable differences.
- Types of transactions that result in future deductible differences, originating and reversing differences
- An analysis of the year’s change in unappropriated retained earnings.
Learning about various types of temporary and permanent differences between book income and taxable income is challenging but not necessarily daunting. It most certainly separates the tax pros out from transactional tax form processors and makes those of us armed with this knowledge a hit at the #nerdfests.
Taxable income is determined by the Internal Revenue Code, whereas book income is determined by applying generally accepted accounting principles (GAAP), causing differences, sometimes significant, between taxable income for IRS (& state) purposes and book income (aka pretax financial income for shareholder purposes) due to MANY underlying differences in the rules for determining these amounts.
The big one that I see a LOT is using different accounting methods for book and tax purposes. Whereas a cash-basis taxpayer recognizes expense on the tax return when paid, an accrual-basis taxpayer deducts expenses when incurred. There can be a big difference in income for reporting purposes based on when an expenditure is recognized as a deductible expense for income tax purposes.
In addition to reconciling financial net income to taxable income on Schedule M-1, the corporation is required to complete Schedule M-2, Analysis of Unappropriated Retained Earnings per Books. The purpose of Schedule M-2 is to reconcile the corporation’s unappropriated retained earnings account as found on the beginning of the year and the end of the year balance sheets, both of which are listed on Schedule L. An analysis of unappropriated retained earnings may be presented as a statement of retained earnings for financial reporting purposes.
Reconciling Beginning and Ending Unappropriated Retained Earnings
To analyze the changes in unappropriated retained earnings during the year, the following items are added to the beginning of the year balance of unappropriated retained earnings:
- Net income per books (after-tax income)
- Other increases (e.g., prior-period adjustments or a change in accounting principle)
To reconcile the beginning unappropriated retained earnings balance to the ending balance, the following items are subtracted:
- Net loss
- Other decreases (e.g., certain treasury stock transactions, prior period adjustments, or a change in accounting principle)
Other Increases in Unappropriated Retained Earnings
The following are examples of items other than net income that are added to the beginning unappropriated retained earnings balance on Schedule M-2:
- Prior-period adjustments
- Change in accounting principle
- Adjustments due to a quasi-reorganization
- Cancellation during the period of appropriated retained earnings
Prior-period adjustments are included in the items that affect retained earnings (unappropriated) per books, are primarily corrections of errors in the financial statements of prior periods, and may either increase or decrease retained earnings in the year of the adjustment. They are reported as direct adjustments of the beginning balance of retained earnings and are shown net of tax effect.
Tax Deductible Expenses
For tax purposes, two conditions must be met before an expense can be deducted.
- An “all-events test” reasonably determines the amount of a liability to be accrued and deducted.
- “Economic performance” usually has occurred. The taxpayer has:
- Received goods or services.
- Provided goods or services required under a pre-arranged obligation to a third party (e.g., product warranty repairs), and
- Paid or committed to pay for the expenses.
For book purposes, under GAAP so as to track the future tax effects of events that have already been recognized on the financial statements, we recognize:
- Income taxes that are payable or refundable
- Income tax expenses for the current year
- Deferred tax liabilities
- Assets with accompanying current and deferred tax expense
Accounting Standards Codification (ASC) 740
ASC 740 specifies a single model to address accounting for uncertainty in tax positions by clarifying that a tax position must be more likely than not of being sustained before recognition in the financial statements; for further details, see ASC 740-10-25.
Temporary Differences between Taxable Income and Book Income
- One result of temporary differences between taxable income and book income for any tax year are differences between the basis of assets and liabilities for tax purposes and their book values for financial reporting purposes.
- Temporary differences arise because tax laws and generally accepted accounting principles differ in their recognition and measurement of assets, liabilities, equity, revenues, gains, expenses, and losses.
- There are generally two types of Temporary Differences:
- Originating difference:This is the initial difference (the difference in the current period) between the book basis and the tax basis of an asset or liability, regardless of whether the tax basis of the asset or liability exceeds the book basis or vice versa.
- Reversing difference:This difference occurs when a temporary difference that originated in prior periods is eliminated, and the related tax effect is removed from the deferred tax asset or deferred tax liability account.
- The differences necessitate the recording of deferred tax liabilities on the books in the years they originate.
- They will also cause future taxable amounts in the years that the related book assets are recovered or disposed of.
Deferred tax liabilities are the increases in taxes payable in future years because of the presence of temporary taxable differences. Future taxable amounts will increase taxable income in future years and, consequentially, will increase taxes payable in future years.
Deductible Temporary Differences
- Temporary differences between taxable and book income result in future deductible amounts in the years the related book liabilities are settled.
- Deductible temporary differences necessitate the recording of deferred tax assets in the years they originate.
- Deferred tax assets are the increases in taxes refundable (or saved) in future years because of the presence of temporary deductible differences.
- Future deductible amounts will decrease taxable income in future years and, as a consequence, will decrease taxes payable in future years.
Deductible Amounts in Future Years
Deductible Amounts in Future Years are expenses and losses deducted for tax after year recognized in book income.
Revenues and gains taxed before year-end are recognized in book income.
Rent collected in advance is generally recognized as taxable income when received. For book purposes, though, the payment is not recognized as income until the rent is earned.
For book income purposes, warranty costs are recognized in the period incurred (matched with the sales revenue) but not deducted until paid for tax purposes.
Permanent Differences between Book and Taxable Income
Certain differences between taxable and book income are permanent. Unlike temporary differences, these differences do not result in future taxable or deductible amounts. Permanent differences affect only the year in which they occur.
These differences have no deferred tax effects. Permanent differences result from revenues and expenses that enter into book income but never into taxable income or that enter into taxable income but never into book income.
The following are examples of revenues and expenses included in book income but never included in taxable income:
- Interest received on tax-exempt state and municipal debt obligations
- Entertainment expenditures
- Fines or penalties resulting from violation of law
- Key-employee life insurance policy premiums paid by the company named as the beneficiary
The following are examples of revenues and expenses included in taxable income but never included in book income:
- Percentage depletion expense related to natural resources in excess of cost
- Dividends-received deduction for domestic corporations
- Non-shareholder contributions (e.g., municipal grants to attract new businesses)
Change in Accounting Principle
A change in accounting principle recorded on the books affects unappropriated retained earnings as a retrospective adjustment. The following are examples of a change in accounting principle:
- A change in inventory valuation method (for example, a change from average cost to FIFO)
- A change in the method of accounting for long-term construction-type contracts
- A change to or from the “full” cost method of accounting in the extractive industries
- A professional pronouncement recommending that a change in accounting principle be treated retrospectively
Quasi-Reorganization Adjustments and Cancellation of Appropriated Retained Earnings
- Both a quasi-reorganization and a cancellation of appropriated retained earnings are situations that increase unappropriated retained earnings.
- A quasi-reorganizationis a procedure that allows a company with a deficit (debit balance in retained earnings) to eliminate the deficit so that the company has a “fresh start” with a zero balance in retained earnings.
Cancellation of appropriated retained earnings
When an appropriated retained earnings amount is no longer needed, the balance in appropriated retained earnings is returned to unappropriated retained earnings. For example, a $1 million balance in retained earnings appropriated for plant expansion can now be transferred back to unappropriated retained earnings because the addition to the building has been constructed.
For all types of dividends, unappropriated retained earnings are decreased on the date of declaration by the corporation’s board of directors. The board has sole discretion for the authorization of dividend payments. A corporation is not legally required to pay a dividend each year. Thus, before a dividend is declared, the board must consider the availability of funds and a positive retained earnings balance.
The following are types of dividends that can be paid, distributed, or issued:
Cash dividends: A cash dividend is the most common form of dividend. It is a distribution of assets in the form of cash. At the time of declaration, unappropriated retained earnings are reduced and the dividend becomes a current liability of the corporation.
Stock dividends: This type of dividend involves issuance of additional shares of the corporation’s own stock on a proportionate basis to the stockholders’ holdings. Unlike cash dividends, no assets are distributed. It represents a “capitalization” of unappropriated retained earnings (i.e., the market value [for small stock dividends—up to 20% to 25% of the shares outstanding] of the stock issued is transferred from unappropriated retained earnings to capital stock and additional paid-in capital).
Property dividends: A property dividend or “dividend in kind” is a distribution of nonmonetary (noncash) assets of the corporation, which may be merchandise, real estate, or securities investments held by the corporation. The unappropriated retained earnings are decreased by the FMV of the nonmonetary assets transferred, and a gain or loss is recognized by the corporation on the disposition of these assets.
Scrip dividends: This is a dividend payable in the form of scrip, which represents a special type of note payable to the stockholders. A scrip dividend may be declared when there is sufficient unappropriated retained earnings but not enough cash to pay the dividend. The scrip payable may be a current or noncurrent liability and may be interest- or noninterest-bearing.
Dividends not affecting unappropriated retained earnings are classified as liquidating dividends.
Liquidating dividends: This dividend is a return of contributed capital. Contributed capital is reduced instead of unappropriated retained earnings. This type of dividend represents a return of the stockholder’s investment in the corporation instead of profits. Consequently, a liquidating dividend would not be entered on Schedule M-2.
Other Decreases of Unappropriated Retained Earnings
Unappropriated retained earnings are decreased in several situations under the following categories:
- Appropriations of retained earnings for specific purposes
- Certain treasury stock transactions
- Conversion of convertible securities into common stock
- Prior-period adjustments
- Change in accounting principle
An appropriation of unappropriated retained earnings involves a transfer of a part of unappropriated retained earnings to an appropriated retained earnings account. An appropriated retained earnings amount consists of a portion of unappropriated retained earnings that is restricted and made unavailable for distribution of assets as a dividend because these assets are needed by the corporation for a specific purpose. Some possible reasons for creating appropriated retained earnings accounts follow:
- Contractual requirements (e.g., appropriation of retained earnings to satisfy requirements of bonded indebtedness)
- Legal restrictions (e.g., retained earnings appropriated for cost of treasury stock held by the corporation)
- Protection of working capital
- Possible or expected loss (e.g., retained earnings appropriated for estimated loss due to a pending lawsuit)
Sale of treasury stock: When treasury stock is sold below its cost, the excess of the cost over selling price is usually first charged against paid-in capital from treasury stock until its balance is exhausted. Then any additional excess of cost over selling price (after exhausting the balance in paid-in capital from treasury stock) is charged to unappropriated retained earnings.
Retirement of treasury stock: When treasury stock is permanently retired (canceled) and the cost of the treasury stock exceeds the original issuance price of the stock, the excess of the cost of the treasury stock over the original issuance price is charged to unappropriated retained earnings (after exhausting the balance in paid-in capital from treasury stock).
Convertible preferred stock: To record the conversion of convertible preferred stock into common stock, the book value method is used. When the par value of the common stock issued at conversion exceeds the book value (carrying value) of the preferred stock, the difference is charged to unappropriated retained earnings. Under the book value method, no gain or loss is recognized upon conversion.
Convertible bonds: The book value method is used to record conversion of convertible bonds into common stock. If the par value of the common stock issued exceeds the book value of the bonds at the time of the conversion, unappropriated retained earnings is charged for the difference. The book value of the common stock is merely substituted for the carrying value of the bonds. No gain or loss is recognized.
Form 1120 Schedule M-2: Increases and Decreases
The cancellation of the appropriated retained earnings for cost of treasury stock will result in an increase in unappropriated retained earnings. To reflect this increase, the $$ is added to the beginning unappropriated retained earnings balance on line 3, Schedule M-2.
The error discovered this year, related to the land purchased two years ago, is a prior-period adjustment. Prior-period adjustments result in a decrease or increase in unappropriated retained earnings. Since there was too much expense because of the error two years ago, it is necessary to add this prior-period adjustment ($$) to the beginning unappropriated retained earnings balance on line 3, Schedule M-2.
The declaration of dividends during the year causes a decrease in unappropriated retained earnings. Therefore, the cash dividends declared must be subtracted from beginning unappropriated retained earnings on line 5a, Schedule M-2.
If the corporation did not previously sell treasury stock, there is no paid-in capital from treasury stock. As a result, when the treasury stock is sold below market value the difference must be recorded as a decrease of unappropriated retained earnings. This is accomplished by subtracting from beginning unappropriated retained earnings on line 6, Schedule M-2.
One Item Not Requiring an Adjustment
IF a corporation revisits its annual depreciation expense because of a change in the estimated remaining life of a production machine, this is not a prior-period adjustment. Thus, there is no adjustment of unappropriated retained earnings on Schedule M-2. This revision is reflected in the current and future years’ financial statements.
If you’ve made it this far – thank you for reading my musings. Please feel welcome to contact me for a deeper dive.