Common Schedule M-1 Adjustments

Headnote

ACCOUNTING METHODS & PERIODS

Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, provides a reconciliation between book income and taxable income on corporate and partnership returns. New practitioners may find it difficult to understand Schedule M-1; by learning a few concepts, it may cease to seem like a mystery.

Overview

Schedule M-1 adjustments are based on the taxpayer's method of accounting. Generally, Sec. 446 requires taxable income to be computed under the same method of accounting as the taxpayer uses for its books. For cash-method taxpayers, income is included in gross income when payment is actually or constructively received; deductions are allowable when payment is made. Under sec. 461(h)(1) and (4), accrual-method taxpayers record revenue and expenses when all three of the following have occurred: (1) all events have occurred that establish the fact of the transaction; (2) the amount of the transaction can be determined with reasonable accuracy; and (3) economic performance has occurred.

Sec. 461(h) (3) provides a recurring-item exception for the economic performance test. An item is treated as incurred during the tax year if all events with respect to the item have been met; economic performance occurs within the shorter of (1) a reasonable period or (2) 8 ½ months after the close of the tax year; the item is recurring in nature; and it is either not a material item or the accrual in the tax year provides a better matching of income and expenses.

It is important to understand how book income was determined before adjusting it to arrive at taxable income. The following list describes and illustrates common Schedule M-1 adjustments.

Accrued Compensation and Benefits

When an accrual-method taxpayer accrues expenses related to a plan, method or arrangement (i.e., salary, vacation, commissions and management fees), these amounts will ordinarily not be deductible for income tax purposes and must be added back to arrive at taxable income on Schedule M-1. However, Temp. Regs. sec. 1.404(b)-1T, Q&A-2, provides an exception if these amounts are paid to employees within 2 ½ months of the end of the tax year.

Example 1: X Corp. accrued $20,000 of bonus compensation earned by employees for the tax year ended Dec. 31, 2004. By March 15, 2005, X paid...