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 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 where non-taxable income is reported, which, incidentally, has arrived in droves due to the plethora of PPP loan forgiveness programs available to small business owners.

For the following 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 temporary and permanent differences between book and taxable income is challenging but not necessarily daunting. It most certainly separates the tax pros from transactional tax form processors and makes those of us armed with this knowledge a hit at the #nerdfests.

The Internal Revenue Code determines taxable income, whereas book income is determined by applying generally accepted accounting principles (GAAP). This causes 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 I see a lot of is using different accounting methods for book and tax purposes.  Whereas a cash-basis taxpayer recognizes expenses 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 often required to complete Schedule M-2, Analysis of Unappropriated Retained Earnings per Books. Schedule M-2 reconciles the corporation’s unappropriated retained earnings account as found on the beginning-of-the-year and 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 book (after-tax income)
• Other increases (e.g., prior-period adjustments or a change in accounting)

To reconcile the beginning unappropriated retained earnings balance to the ending balance, the following items are subtracted:

• Dividends
• Net loss
• Other decreases (e.g., certain treasury stock transactions, prior period adjustments, or a change in accounting)

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

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

Two conditions must be met for tax purposes 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, to track the future tax effects of events that have already been recognized on the financial statements, we recognize the following:

• 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. It clarifies that a tax position must be more likely than not to be 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 is 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 liability account.
• The differences necessitate recording 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 increases in taxes payable in future years because of temporary taxable differences. Future taxable amounts will increase taxable income in coming years and, consequently, raise 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 recording deferred tax assets in the years they originate.
• Deferred tax assets are the increases in taxes that are refundable (or saved) in future years because of temporary deductible differences.
• Future deductible amounts will decrease taxable income in future years and decrease taxes payable in coming years.

Deductible Amounts in Future Years

Deductible Amounts in Future Years are expenses and losses deducted for tax after the 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 only recognized as income once the rent is earned.

For book income purposes, warranty costs are recognized in the period incurred (matched with the sales revenue) but only deducted once paid for tax purposes.

Permanent Differences between Book and Taxable Income

Specific differences between taxable and book income are permanent. Unlike temporary differences, permanent differences do not result in future taxable or deductible amounts. They 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 a violation of the 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 more than 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 principles:

• 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-reorganization procedure allows a company with a deficit (debit balance in retained earnings) to eliminate the deficit and have 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 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.

Dividends

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
• Stock
• Property
• Scrip
• Liquidating

Cash dividends: Cash dividends are the most common form of dividend. They are a distribution of assets in 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 the issuance of additional shares of the corporation’s own stock proportionate 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 scrip, representing a particular type of note payable to the stockholders. A scrip dividend may be declared when sufficient unappropriated retained earnings but insufficient cash to pay the dividend. The scrip payable may be a current or noncurrent liability or 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, which is reduced instead of unappropriated retained earnings. This type of dividend represents a return on 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 the corporation needs these assets 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 the 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 the 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 the 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), the cost exceeds the original issuance price; the excess is charged to unappropriated retained earnings (after exhausting the balance in paid-in capital from treasury stock).

Convertible preferred stock: The book value method records the conversion of convertible preferred stock into common stock. When the par value of the common stock issued at conversion exceeds the preferred stock’s book value (carrying value), 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 records the 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 are 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

Canceling the appropriated retained earnings for the cost of treasury stock will increase 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 decrease or increase unappropriated retained earnings. Since the error two years ago caused too much expense, this prior-period adjustment ($$) must be added 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 it. As a result, when the treasury stock is sold below market value, the difference must be recorded as a decrease in unappropriated retained earnings. This is accomplished by subtracting from the 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, unappropriated retained earnings are not adjusted on Schedule M-2. This revision is reflected in the current and future years’ financial statements.

Thank you for reading my musings if you’ve made it this far. Please feel free to reach out to me for a deeper dive into Understanding Schedule M-2 on IRS Forms 1120 and 1120-S.