All businesses that are required to file a tax return must maintain records. But the records they keep for tax purposes may be different than the records they need for business purposes.
If a company is required to or chooses to comply with Generally Accepted Accounting Practices (GAAP), they will typically follow an accrual-basis method for reporting revenue. Their tax records, on the other hand, must comply with the Internal Revenue Code, which recognizes Cash, Accrual or a Hybrid Accounting Method as valid methods of reporting.
If the company is not using the same accounting method for both sets of books, the income that gets reported on their financial statement may not match the income they report on their tax return.
Note: The difference between Book Income (Loss) and the Tax Income (Loss) is reported on the tax return for larger entities that meet certain revenue and asset requirements. This reconciliation is contained on Schedule M-1 on 1065, 1120 and 1120S returns.
Accrual-basis accounting
The accrual accounting method records anticipated revenue when a product or service is delivered, even if payment for said-product has not yet been received. Expenses, too, are reported in the year they are incurred, regardless of when they will be paid.
It should be noted that some expenses must be paid within a certain time to be deductible under the accrual method, such as pension contributions like 401k matching. Other expenses must meet certain reporting test to be expensed. For example, health claims and workers compensation claims are incurred but not reported (IBNR) claims
Cash-basis accounting
The cash basis method of accounting involves an immediate recognition of revenue and expenses. Revenue is reported on the income statement only when money is received, and expenses are only recorded for the tax year when they are actually paid out.
Tax accounting
Tax accounting is focused on calculating a company’s taxable assets and liabilities with the purpose of raising revenue for the U.S. government. It is regulated by the laws in the Internal Revenue Code (IRC) and accepts either cash, accrual or a hybrid as valid methods of reporting to determine how much of the company’s income is taxable.
Book income vs. tax income
Book income describes a company’s financial income before taxes. It is the amount a corporation reports to its investors or shareholders and gives an idea of how well a company performed during a certain period of time. Tax income, on the other hand, is the amount of taxable income a company reports on its return.
Temporary differences
Certain transactions will eventually be reflected in both a company’s book income and tax income; but if they are using different accounting methods for each set of records, those transactions may simply be recognized at different times.
For example, if a company receives advance payment for a service, they are required to report it as taxable income on their tax return. But for their book accounting, that advance payment will not be reported as income until the day the money is due, or “earned.” Once this occurs, the temporary difference in book and tax income that was a result of this transaction will be reversed.
One common temporary difference between book income and tax income that you may observe with your clients’ results when they take bonus depreciation and Section179. In such cases, the entity is accelerating the tax deduction before the actual expense has occurred. This overstates deductions on the tax return in the early years of the asset’s useful life and understates deductions later.
Permanent Differences
Certain differences in book and tax income will never be reversed. Some common permanent differences include:
Penalties and fines –These may be deducted from book income but are not deductible for tax purposes.
Meals and entertainment – Costs for meals and entertainment can be completely expensed for book accounting. For tax purposes, a company can only deduct 50%of meals and 0% of entertainment expenses.
Municipal bond interest – This is considered net income for book accounting, but it is not included in taxable income.
Unlike temporary differences, permanent differences only impact the specific period in which they occur, so they do not create deferred tax assets or liabilities.
Related Reading on Book and Tax Income from TaxSlayer Pro
- Form 1065 – Schedule M-1 – Reconciliation of Income(Loss) per Books With Income (Loss) per Tax Return
- Creating a Basic Form 1120 – U.S. Corporate Income Tax Return
- Creating a Basic Form 1065 – U.S. Return of Partnership Income
The information in this article is up to date through tax year 2021 (taxes filed 2022).
