Schedule M-3, Net Income (Loss) Reconciliation, is required for returns of corporate and partnership entities that report assets of $10 million or more on their Schedule L balance sheet, to reconcile taxable income or loss with financial statement income or loss. The IRS introduced Schedule M-3 effective for tax years beginning after Dec. 31, 2004. Since then, numerous changes to the form have expanded its reporting requirements.
The most recent change, for 2010 and following tax years, requires new disclosures of research and development (R&D) costs and Sec. 118 exclusions from income of nonshareholder contributions to capital for corporate filers including S corporations. Entities taxed as partnerships must also disclose R&D costs but have no reporting requirement for the Sec. 118 exclusion, since they are not entitled to it. In addition, certain partnerships with assets less than $10 million are required to complete Schedule M-3 if an alternative computation of gross assets meets the $10 million threshold or if a corporate partner is required to file the Schedule M-3.
The R&D reporting requirement creates a new level of transparency for such expenses. Although a supporting attachment for R&D costs will not be required for 2010 and 2011 tax years, their amount must still be reported. Furthermore, specifics of exclusion from income of nonshareholder contributions to capital must be disclosed in an attachment even if there is no book-tax difference. Since these are Tier I audit issues, taxpayers availing themselves of these tax benefits should maintain adequate documentation to defend these items’ tax treatment.
Corporate taxpayers should budget for the additional time that will likely be required to accurately compute and report the related book-tax permanent and timing differences associated with these expenditures. Mapping and classification issues may arise when attempting to obtain the required information from the company’s accounting information system. The new disclosures may have reporting implications for taxpayers that apportion R&D expenses under cost-sharing arrangements. Also, there may be an effect on the amount of expenses that qualify for the credit for increasing research activities.
Taxpayers were given little lead time to comply with the new Schedule M-3 reporting requirements for the 2010 tax year. As a result, many may be required to make accounting method changes or file amended tax returns once they discover issues related to complying with the new requirements. Recent IRS court victories on the Sec. 118 nonshareholder capital contribution issue may prompt taxpayers that have previously excluded these amounts from income to file amended returns to recast these transactions as taxable rather than excludable income.
Taken together with the new Schedule UTP reporting requirements for uncertain tax positions, the new disclosures on Schedule M-3 require greater transparency and increased information flow that the IRS said will likely lead to “speedier issue resolution and greater efficiency and certainty” during an audit. Whether taxpayers who make these disclosures will have audit issues resolved more timely and quickly remains to be seen.
For a detailed discussion of the issues in this area, see “Managing New Schedule M-3 Disclosures,” by Cherie J. Hennig, Ph.D.; Edward J. Schnee, CPA, Ph.D.; and Blaise M. Sonnier, CPA, J.D., DBA, in the December 2011 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
The Tax Adviser is the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or email firstname.lastname@example.org for a subscription to the magazine or to become a member of the Tax Section.
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