S chedule 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 December 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. 1 Entities taxed as partnerships 2 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 Form 1065 filers 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 reporting requirement for R&D costs creates a new level of transparency for Sec. 174 research and experimental (R&E) expenses, including those claimed as qualified research expenses and basic research payments for the Sec. 41 credit for increasing research activities. Al though a supporting attachment for R&D costs will not be required for 2010 and 2011 tax years, 3 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 the Sec. 41 credit and the Sec. 118 exclusion are Tier I audit issues, taxpayers availing themselves of these tax benefits should ensure that there is adequate documentation to defend the tax treatment of these items. This article discusses the likely tax compliance and tax reporting issues that Schedule M-3 filers face when completing these new lines on their 2010 and following Schedules M-3.
R&D Expenses Reportable on Schedule M-3
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. 4 Also, there may be an effect on the amount of expenses that qualify for the credit for increasing research activities. 5
Sec. 174: R&E Expenses
Reportable R&D expenses include R&E expenses under Sec. 174 that are paid or incurred by the taxpayer in connection with the taxpayer’s trade or business that are reasonable in amount under the circumstances. 6 They include the cost of obtaining a patent, such as attorneys’ fees for making and perfecting a patent application for a discovery made by the taxpayer. Amounts the taxpayer pays or incurs for research or experimentation carried on in the taxpayer’s behalf by another person or organization also qualify as R&E expenditures. 7
The costs must be incurred in the “experimental or laboratory sense,” 8 arising from activities intended to discover information to eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer before undertaking the research does not establish either (1) the capability or method for developing or improving the product or (2) the appropriate design of the product. The nature of the activity determines whether the costs qualify, not the nature of the product or improvement or the level of technological advancement brought about by it. 9
Expenditures for the following types of activities do not qualify:
- Ordinary testing or inspection of material for quality control, management studies, advertising or promotions, consumer surveys, or efficiency surveys; 10
- Obtaining another person’s patent, model, production, or process; 11
- Research in connection with literary, historical, or similar projects; 12
- Acquiring or improving land used in connection with research and experimentation; 13
- Acquiring or improving property subject to an allowance for depreciation or depletion that is used in connection with research and experimentation; 14 and
- Ascertaining the existence, location, extent, or quality of mineral deposits, including oil and gas. 15
The Code provides three methods for deducting R&E costs. First, the taxpayer may deduct the expenses in the year paid or incurred. 16 Second, the taxpayer may elect to amortize the expenses over a period selected by the taxpayer of not less than 60 months. 17 Only expenses that would be chargeable to a capital account in the absence of Sec. 174 (except for expenditures chargeable to property that is depreciable or depletable) qualify for the 60-month amortization method. The amortization period under this method begins with the month the taxpayer first realizes benefits from the expenditures. A benefit is first realized in the first month that the process, formula, invention, or similar property is put to an income-producing use. 18 Third, the taxpayer may amortize the expenditures over a 10-year period beginning in the year they are paid or incurred. 19 R&E expenses not accounted for using one of these three methods must be capitalized. 20 The way a taxpayer treats R&E expenses for financial accounting purposes does not affect their tax treatment. 21
The future results and benefits of R&E undertaken by a taxpayer are generally uncertain. If a research project is abandoned without realizing any benefits and the taxpayer has elected to amortize the expenditures using the second or third method or capitalizes the expenses, the expenditures may be recovered in full as a loss. 22 The same rule would apply for any unrecovered cost if a project initially thought to be successful is abandoned after cost recovery has begun.
R&E expenditures are not subject to recapture as ordinary income upon the sale of the technology to which the deduction relates. Therefore, if the capital gain requirements are otherwise satisfied upon the sale of the technology, the entire gain may be treated as a capital gain despite the prior tax benefit received by offsetting R&E expenditures against ordinary income. 23
The Sec. 174 deduction for R&E expenditures must be reduced by the amount of the Sec. 41 incremental research credit for the year. 24 If the taxpayer capitalizes the research expenditures instead of immediately taking a deduction for them, the amount capitalized must also be reduced by the amount of the research credit. 25 The taxpayer can make an annual irrevocable election to take a reduced research credit instead of reducing the research expense deduction or capitalized research costs (Sec. 280C election). 26 The effect of the election is to reduce the amount of the research credit by the amount of tax saved (using the highest corporate tax rate) by not making a reduction of the Sec. 174 deduction.
Sec. 41: Incremental Research Credit
The Economic Recovery Tax Act of 1981 27 added a nonrefundable income tax credit for certain qualified research expenses paid or incurred in carrying on an active trade or business. The Sec. 41 credit for increasing research activities currently provides two methods for determining the amount of credit. Under the “regular” method, the credit is equal to the sum of (1) 20% of the qualified research expenditures in a tax year over a base amount, plus (2) 20% of “basic research payments” to qualified organizations over a “qualified organization base period amount,” plus (3) 20% of any amounts paid or incurred by the taxpayer to an energy consortium for energy research in connection with carrying on the taxpayer’s trade or business. 28
Qualified research expenses consist of three categories of in-house research expenses and contract research expenses paid to third parties. 29 In-house research includes (1) wages for employees engaged in the research activity, (2) cost of supplies used in the research, and (3) amounts paid or incurred to a third party for the right to use computers in conducting the research. 30 Contract research services are amounts paid by the taxpayer to a third person (other than an employee of the taxpayer) for research. 31 Only 65% of the amount paid for the contract research services is taken into account in computing the research credit. However, the amount is increased to 75% for amounts paid to a qualified research consortium for qualified research on behalf of the taxpayer and one or more unrelated taxpayers 32 and to 100% for amounts paid for qualified energy research to an eligible small business, an institution of higher education, or a federal laboratory. 33
The qualified research expense base amount is computed by multiplying the “fixed-base percentage” by the taxpayer’s average annual gross receipts for the four preceding years. 34 However, the base amount may not be less than 50% of the qualified research expenses for the year. 35 The fixed-base percentage is equal to the percentage that the aggregate qualified research expenses of the taxpayer after 1983 and before 1989 is of the aggregate gross receipts of the taxpayer for such tax years. 36 The fixed-base percentage may not exceed 16%. 37 Special computation rules are provided for companies that began having gross receipts and qualified research expenses after 1983. 38
For tax years after 2006, taxpayers may elect to compute the credit using the alternative simplified credit method. 39 The election may be revoked only with the consent of the IRS. 40 Under this method, the credit is equal to 14% of the excess of the qualified research expenses for the year over 50% of the average qualified research expenses for the three preceding tax years. 41
Under both methods, qualified research must meet the following requirements:
- The expenditures must be incurred in connection with the taxpayer’s trade or business and must be a research cost in the experimental or laboratory sense in accordance with Sec. 174;
- The research must be undertaken to discover information that is technological in nature (technological information test);
- The discovered information must be intended to be useful in the development of a new or improved business component of the taxpayer (business component test); and
- Substantially all the research activities must constitute elements of a process of experimentation for a qualified purpose (process-of-experimentation test). 42
The research credit is available only for research expenditures incurred in carrying on a trade or business 43 or for research expenses incurred in a business in which the taxpayer already is engaged. Research expenses incurred in developing a product for a new business prior to commencing the business are not eligible for the credit. 44 An exception exists for start-up businesses that have in-house research expenses, provided the taxpayer’s principal purpose is to use the results in the active conduct of a future trade or business. 45
To satisfy the technological information test, the process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science. 46 A taxpayer may use existing technologies and rely on existing principles of those disciplines.
For purposes of the business component test, a business component is any product, process, computer software, technique, formula, or invention that is to be held for sale, lease, or license or used in a trade or business of the taxpayer. 47 Expenditures for research related to a new or improved function, performance, reliability, or quality of a business component will qualify for the credit. 48 However, research related to style, taste, cosmetic, or seasonal design factors will not qualify. 49 A taxpayer must be able to tie the research for which it is claiming the credit to the relevant business component.
The process-of-experimentation test requires that substantially all the activities of the research constitute elements of a process of experimentation. 50 The “substantially all” requirement is satisfied only if 80% or more of the research activities constitute elements of a process of experimentation. 51 A process of experimentation is designed to evaluate one or more alternatives to achieve a result where the capability of achieving that result, or the appropriate design of that result, is uncertain at the beginning of the taxpayer’s research activities. 52 A process may involve modeling, simulation, or a systematic trial and error process. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component or the appropriate design of the business component.
To satisfy the experimentation requirement of Sec. 41, the taxpayer must:
- Identify the uncertainty regarding the development or improvement of a business component that is the object of the taxpayer’s research activities;
- Identify one or more alternatives intended to eliminate the uncertainty; and
- Identify and conduct a process of evaluating the alternatives.
In addition to the six items discussed above that are not deductible under Sec. 174, the following cannot be included as qualified research expenses for the Sec. 41 research credit:
- Research done outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States; 53
- Research in the social sciences, arts, or humanities; 54
- Research funded by another person, or any governmental entity, by means of a grant or contract; 55
- Research conducted after commercial production of the business component; 56
- Research for the adaptation of existing business components; 57
- Research for the duplication of existing business components; 58 and
- Except to the extent permitted by the Treasury regulations, research with respect to internal-use software (other than for use in qualified research or a related production process). 59
IRS Challenges to Sec. 41 Credits
The Tax Court discussed the requirements for properly substantiating the incremental research credit in Eustace. 60 In that case, the taxpayer filed an amended return claiming the credit based on employee interviews conducted by the company’s newly hired tax manager. At trial, the taxpayer offered the testimony of six employees regarding the nature of their activities in the years in question. Their testimony was based solely on their recollection of events that occurred years earlier, and no documentation existed to corroborate their testimony. The company had five departments and 450 employees. The Tax Court found the taxpayer’s reconstruction of qualifying expenses to be “unreliable, inaccurate, incomplete, and wholly insufficient.” The court found the pro-forma list of salaries, supplemented by testimony, insufficient for the taxpayer to meet its burden of proof that the salaries were paid for qualified research activities.
In 2007, the IRS designated claims for tax refunds based on the Sec. 41 incremental research credit as a Tier I audit issue. 61 In announcing the designation, the IRS noted that the number of such refund claims had continued to rise and that a growing number of the claims were based on “marketed tax products supported by studies prepared by the major accounting and boutique firms.” The IRS further noted that “these studies are marketed on a contingent fee basis and exhibit one or more of the following characteristics: high-level estimates, biased judgment samples, lack of nexus between the business component and qualified research expenses (QREs), and inadequate contemporaneous documentation.” One of the items that IRS auditors examining a Sec. 41 research credit claim must request is a description “by dollar amount where these additional QREs were deducted on your original return, i.e., cost of goods sold, capitalized as part of plant or equipment, overhead accounts or claimed and deducted as research expenses.”
Schedule M-3: Line 35, R&E Costs
Taxpayers are now required to report on Part III, line 35, of Schedule M-3:
- Column (a): The amount of expenses included in net income on a taxpayer’s financial statements that are Sec. 174 R&E costs;
- Columns (b) and (c): Any difference in timing recognition for financial and tax purposes and whether the difference is temporary or permanent.
- Column (c): Adjustments for any amounts treated for U.S. income tax purposes as R&E expenditures that are treated as some other type of expense for financial accounting purposes (i.e., salaries, supplies, contract services, etc.); and
- Column (d): The amount of Sec. 174 R&E expenses deducted on the taxpayer’s tax return.
For tax years after 2011, the Schedule M-3 instructions also require an attachment that separately states and adequately discloses R&D transactions. The description should clearly identify (1) the account name under which the Sec. 174 R&E expenses were recorded in the financial statements or books of the taxpayer and (2) the amount of the temporary and permanent differences.
The instructions to the revised Schedule M-3 provide the following examples when disclosing R&D expenses on line 35, Research and development costs.
Example 1: X incurs $100,000 of R&D costs that it recognizes as an expense in its financial statements. X also incurs $20,000 in attorney fees to obtain a patent that it capitalizes and amortizes at $2,000 per year in its financial statements. X deducts $120,000 as Sec. 174 expenditures on its tax return.
On its Schedule M-3, X reports $100,000 as its R&D expenses for financial statement purposes (column (a)) and $120,000 of Sec. 174 expenses for tax purposes (column (d)). The $20,000 for the patent acquisition costs being amortized for financial statement purposes is reported as a temporary difference (column (b)). In addition, on line 28, Other amortization or impairment write-offs, X reports $2,000 as amortization expenses for financial statement purposes (column (a)) and a temporary difference of ($2,000) (column (b)), with a deduction for income tax purposes of zero (column (d)).
Example 2: The facts are the same as in Example 1, except that X makes a Sec. 59(e) election to amortize $80,000 of the $120,000 of Sec. 174 expenses over 10 years. The remaining $40,000 is expensed in the current year for tax purposes. On its Schedule M-3, X reports $100,000 as its R&D expenses for financial statement purposes (column (a)) and $48,000 [$40,000 + ($80,000 ÷ 10 years)] for tax purposes (column (d)).
The temporary difference of $52,000, which equals $20,000 for the patent acquisition costs capitalized for financial accounting purposes, less $72,000 of unamortized Sec. 174 expenses ($80,000 ÷10 years × 9 years), is reported as a temporary difference (column (b)). X would report these on line 35. X would report the $2,000 temporary difference relating to amortization expenses as in the preceding example.
Example 3: X incurs $50,000 of R&D costs that it recognizes as an expense in its financial statements. X tries to develop a new machine for its business that costs $30,000. The $30,000 is composed of $10,000 of actual costs of material, labor, and components to construct the machine and $20,000 of research costs not attributable to the machine itself. For financial accounting purposes, X capitalizes all $30,000 and recognizes $6,000 of depreciation. X ’s basis in the machine for tax purposes is $10,000, and the tax depreciation is $2,000.
On its Schedule M-3, X would report $50,000 as its R&D expenses for financial statement purposes (column (a)) and $70,000 of Sec. 174 expenses for tax purposes (column (d)). X would report the $20,000 of research costs not attributable to the machine itself deducted as Sec. 174 R&E expenditures for tax purposes as a temporary difference (column (b)). In addition, on line 31, Depreciation, of Part III of Schedule M-3, X would report $6,000 of depreciation for financial statement purposes (column (a)) and $2,000 for tax purposes (column (d)). The difference of $4,000 would be reported as a temporary difference (column (b)).
Example 4: X incurs $10,000 of R&D costs related to social sciences that it recognizes as an expense in its financial statements. Such costs are not allowable Sec. 174 costs. On its Schedule M-3, X would report the $10,000 as its R&D costs for financial statement purposes (column (a)) and zero for tax purposes (column (d)). The $10,000 permanent difference would also be reported (column (c)).
If the costs are otherwise deductible, X would include the $10,000 in column (d) on line 37, Other expense/deduction items with differences, and zero in column (a) of the same line. X would include the $10,000 permanent difference in column (c).
Example 5: X incurs $100,000 of R&D costs that it recognizes as an expense for both financial and tax purposes. X claims a research credit of $1,000 and does not make the reduced credit election under Sec. 280C.
X would report $100,000 of R&D expenses for financial accounting purposes in column (a). As discussed above, the research credit reduces the Sec. 174 tax deduction available to X dollar for dollar. Therefore, X would report $99,000 in column (d) and report the $1,000 difference as a book-tax difference. The instructions to Schedule M-3 provide that the taxpayer should report the difference as a temporary difference in column (b). Since this is not a timing difference, it may be more appropriate to report the difference in column (c) (permanent difference).
Sec. 118 Receipts Reportable on Schedule M-3
Rationale for Exclusion
The origin of Sec. 118’s exclusion of nonshareholder contributions from corporate income can be found in Edwards v. Cuba Railroad Co. 62 In this case, the Cuban government gave cash and property to a corporation to build a railroad. The U.S. Supreme Court decided that the funds did not meet the definition of income and therefore were nontaxable. However, in Texas & Pacific Railway Co., 63 the Supreme Court ruled that the funds the corporation received from the federal government were taxable because they were to replace lost income rather than to be used for capital expenditures. Only actual contributions to a corporation’s capital are not included in income.
Even in cases in which the transfer was nontaxable, the results were not certain because of the basis issue. 64 Since the original basis rules did not distinguish shareholder from nonshareholder contributions, the corporations argued that they were entitled to carryover basis for the property transferred as capital contributions. The courts ruled in the taxpayers’ favor. Therefore, these transactions were truly nontaxable rather than tax deferred.
Subsequently, in Glenshaw Glass, 65 the Supreme Court adopted a definition of income that includes all increases or accretions in wealth. Given this broad definition, it is questionable whether contributions such as the ones in Cuba Railroad would be ruled nontaxable today. More important, Sec. 118(a) provides that corporations do not recognize income on the receipt of a contribution to capital. The contribution can be from a shareholder or nonshareholder. Permissible nonshareholders include government units and civic groups. 66
Contributions to capital do not include payments for goods or services, or payments to induce the taxpayer to limit production. They also do not include contributions in aid of construction or any other contributions made by a current or potential customer. 67 However, certain contributions in aid of construction of regulated public utilities that provide water or sewerage disposal services are considered contributions to capital. 68
Distinguishing nontaxable contributions from taxable payments for goods and services can be difficult. To make a capital contribution, the transferor must have intended the transfer to be a contribution. 69 For contributions from government agencies, intent may be determined from the laws and regulations that authorized the transfer. For other transfers, a facts-and-circumstances test is used. In Chicago, Burlington & Quincy Railroad , 70 the Supreme Court identified the five characteristics of a nontaxable contribution:
- It must be a permanent part of the corporation’s working capital structure;
- It must not be compensation for services;
- It must be bargained for;
- The benefit to the corporation must be commensurate with the value of the property contributed; and
- The asset contributed ordinarily will be used in or contribute to the production of additional income.
At the same time it enacted Sec. 118, Congress enacted Sec. 362(c), which requires that for a cash contribution to capital, the basis of property acquired with the cash within 12 months of the contribution must be reduced by the amount of cash contributed. If the corporation does not use the cash to acquire property within 12 months, it must reduce the basis of other property it owns by the amount contributed. These rules turn the originally tax-free transaction into a tax-deferred transaction. The corporation will recognize additional income as the result of either reduced depreciation or gain on the disposition of the contributed property.
IRS Challenges to Sec. 118 Exclusions
Sec. 118 was designated a Tier I audit issue in part because noncorporate entities such as partnerships were excluding nonowners’ contributions from income. Sec. 118 specifically applies to corporations, and there is no comparable provision in subchapter K. Therefore, it is the government’s position that noncorporate entities cannot benefit from Sec. 118 and that all contributions to noncorporate entities must be included in income. 71 Although the government does not cite the case, this conclusion is based on the expanded definition of income contained in Glenshaw Glass.
Probably the most important reason that Sec. 118 became a Tier I audit issue was that certain corporations were attempting to exclude payment for services or future services from income. For example, in LMSB-04-0307-026, 72 the government directed field examiners to challenge any telecommunications corporations that were excluding receipts from the universal service fund (USF) from income. This fund reimburses a telecommunications corporation for extending services to customers that are difficult to reach or are not profitable at traditional fees. Since these payments are meant to encourage the corporation to provide services, they are considered income and not a contribution to capital.
The government recently prevailed on the USF issue in Sprint Nextel Corp. 73 The district court concluded that a consolidated group of telecommunications companies was not entitled to a refund of taxes paid on amounts received from the Federal Communications Commission for providing reasonably priced telephone service to consumers in high-cost areas. The court rejected the argument that the payments were nonshareholder contributions to capital and concluded that they were intended to supplement income. 74
The government has identified three other specific abuses in Tier I directives. One is the exclusion of environmental remediation payments related to underground storage tanks from state and local entities. 75 The corporation deducts the cost of the remediation, excludes the reimbursement, and reduces the basis in an underground storage tank. It is the government’s position that the reimbursement is either a reduction in deductible expenses or included in income without an offsetting basis reduction in the new storage tank. Another issue relates to state and local tax incentives. Many states offer a reduction in taxes due, to encourage businesses to relocate to their state or to expand existing businesses. According to the government, a marketed corporate tax strategy entails deducting the full amount of state and local taxes, excluding these incentives from income under Sec. 118, and reducing the basis in a depreciable asset. The proper treatment, according to the government, is for these incentives to reduce the tax expense under Sec. 164. 76 The third issue relates to bioenergy program payments from state and local governments. The IRS takes the position that these payments are not compensation for capital asset acquisition. Rather, the payer intends them to compensate the taxpayer for operating costs incurred as a result of purchases of commodities in the taxpayer’s bioenergy production process. Thus, they do not qualify as a contribution of capital and should be included in income. 77
The Sec. 118 issue is slightly more complex where a taxpayer receives a reduction in taxes or similar incentive instead of a payment from the payer. In the case of an expense reduction, taxpayers can treat the incentive in two basic ways. The first way is to treat the expense reduction as income that is excludible under Sec. 118 and to take a corresponding reduction in the basis of one or more assets. The taxpayer also takes a deduction for the amount of taxes it would have owed absent the incentive. The second alternative is to simply net the tax reduction against a current or future tax expense (the equivalent of including the amount of the incentive in income) and not reduce the basis of any property. The following example illustrates the difference in results:
Example 6: A Corp. is promised a real estate tax holiday from paying $100,000 in property taxes over the next five years if the company relocates its business to community X. Should A (1) exclude the $100,000 from income under Sec. 118 and reduce its basis in the building that it will construct in X, or (2) reduce its total property tax expense over the next five years by the amount of taxes it doesn’t have to pay?
In scenario 1, A will have a reduced depreciation expense of $100,000, but this reduction will be spread over the depreciation period of the property with the basis reduction. It will have a property tax deduction of $100,000 over the next five years. In scenario 2, A will not have a reduced depreciation expense and will not have a tax deduction for the $100,000 in property taxes.
Given the time value of money, scenario 1 is preferable. However, the IRS has taken the position that the property tax abatement does not meet the definition of a Sec. 118 contribution that a taxpayer can exclude with a corresponding basis reduction. Presumably, the IRS plans to use the new Sec. 118 disclosures to gain a better understanding of the extent to which taxpayers are abusing the Sec. 118 exclusion.
In an audit, the IRS identifies improper Sec. 118 claims by examining the difference in the income reported for financial and tax purposes. If a corporation does not clearly label the items related to a Sec. 118 claim, discovery is difficult. Another way to identify this issue on audit is by examining the depreciation deduction. Because contributed property has a reduced tax basis under Sec. 362(c), there likely is a difference in the amount of depreciation claimed for book and tax purposes. Since there are numerous reasons that the amounts of depreciation differ, discovering a basis reduction that is due to a Sec. 118 claim by examining the depreciation deductions is also extremely difficult. Requiring corporations to identify Sec. 118 contributions will enable the IRS to more easily identify corporations receiving these transfers.
Schedule M-3: Line 36, Sec. 118 Exclusion
Since 2008, Schedule M-3 corporate filers have been required to disclose whether a position was taken on the return characterizing any amount as a contribution to capital by checking a box on line 10 of Form 1120, Schedule B, Additional Information for Schedule M-3 Filers. Apparently the IRS felt the need to expand this reporting requirement with a detailed explanation by adding line 36 to Part III of Schedule M-3.
Unfortunately, the instructions for reporting Sec. 118 exclusions are minimal, saying only that any inducements received in the current year and treated as contributions to the capital of a corporation by a nonshareholder must be reported on this line. The corporation meets the reporting requirement by attaching a schedule that separately states, adequately discloses, and identifies the fair market value of land or other property, including cash, received from any nonshareholder, including a government unit or civic group. The schedule should also list inducements to locate or expand existing operating facilities in a particular state, municipality, community, or locality and inducements that include refundable or transferable tax credits, including transferable credits that the corporation sold. The corporation must attach an explanation even if it reports no dollar amount. It is important to show receipts as negative numbers because the Sec. 118 exclusions are reported in Part III, which is a reconciliation of expenses and deductions rather than income items.
The following examples illustrate these reporting requirements.
Example 7: Q Corp. receives $200,000 in payments from the USF to provide telecommunications service to schools and libraries, which pay a discounted rate that does not cover Q’s cost of providing the service. Payments are treated as income for financial accounting purposes and as a contribution to capital by a nonshareholder with a corresponding reduction in the basis of the assets for tax purposes. Q reports the Sec. 118 income on Part III, line 36a, as a negative number and then excludes the amount from income on line 36b. The tax depreciation expense will be reduced by $200,000 over the useful life of the telecommunication equipment. The corporation may be required to report this position on Schedule UTP, Uncertain Tax Positions Statement, since the IRS has taken the position that these payments are not eligible for the Sec. 118 exclusion.
Example 8: The state orders A Corp., a petroleum distributor, to remove and replace a leaking underground storage tank. A incurs removal costs for the old tank of $250,000 and installs a new tank costing $300,000. A receives a $100,000 cash payment from the EPA’s Leaking Underground Storage Tank Trust Fund. A deducts $150,000 for removal costs on its financial statements but deducts $250,000 for removal costs on its tax return and reduces its basis in the new tank by $100,000 under Sec. 118. The $150,000 deduction is shown on line 36a, and the $100,000 is reported on line 36b. The tax depreciation expense will be reduced by $100,000 over the useful life of the storage tank. As in Example 7, the corporation may be required to disclose the item on Schedule UTP.
Example 9: W Corp. received title to five acres of land from municipality V on the condition that W build and operate a megastore on the land for a period of not less than 10 years. The fair market value of the land is $500,000 and is recorded for both financial accounting and tax accounting as a nonshareholder contribution to capital. The land has a $500,000 basis for financial accounting and a zero tax basis. Since land is not depreciable, there is no book-tax adjustment to report on Schedule M-3. However, the instructions indicate that W should attach a schedule to line 36 describing the asset received, its fair market value, and the government unit making the contribution.
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 taxpayers may be required to make accounting method changes or file amended tax returns once they discover issues related to complying with the new Sec. 174 and Sec. 118 disclosure 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 excludible income.
Taken together with the new Schedule UTP reporting requirements for uncertain tax positions, 78 the new disclosures on the Schedule M-3 require greater transparency and increased information flow that the IRS says will likely lead to “speedier issue resolution and greater efficiency and certainty” 79 during an audit. Whether taxpayers who make these disclosures will have audit issues resolved more timely and quickly remains to be seen.
1 Filers of Forms 1120, U.S. Corporation Income Tax Return; 1120-L, U.S. Life Insurance Company Income Tax Return; 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return; and 1120-S, U.S. Income Tax Return for an S Corporation.
2 Filers of Form 1065, U.S. Return of Partnership Income.
4 Regs. Sec. 1.861-17.
5 Sec. 41. See also Form 6765, Credit for Increasing Research Activities.
6 Sec. 174(e) and Regs. Sec. 1.174-2(a)(6).
7 Regs. Sec. 1.174-2(a)(8).
8 Regs. Sec. 1.174-2(a)(1).
10 Regs. Sec. 1.174-2(a)(3).
11 Regs. Sec. 1.174-2(a)(3)(vi).
12 Regs. Sec. 1.174-2(a)(3)(vii).
13 Sec. 174(c) and Regs. Sec. 1.174-2(b).
14 Id. However, allowances for depreciation or depletion of property in connection with R&E may be considered R&E expenditures.
15 Sec. 174(d) and Regs. Sec. 1.174-2(c).
16 Sec. 174(a).
17 Sec. 174(b).
18 Regs. Sec. 1.174-4(a)(3).
19 Secs. 59(e)(2) and 174(f)(2).
20 Regs. Sec. 1.174-1.
21 Rev. Rul. 58-78, 1958-1 C.B. 148.
22 Sec. 165; Regs. Sec. 1.174-4(a)(3).
23 Rev. Rul. 85-186, 1985-2 C.B. 84.
24 Sec. 280C(c)(1).
25 Sec. 280C(c)(2).
26 Sec. 280C(c)(3).
27 Economic Recovery Tax Act of 1981, P.L. 97-34.
28 Sec. 41(a).
29 Sec. 41(b).
30 Sec. 41(b)(2)(A).
31 Sec. 41(b)(3)(A).
32 Sec. 41(b)(3)(C).
33 Sec. 41(b)(3)(D).
34 Sec. 41(c)(1).
35 Sec. 41(c)(2).
36 Sec. 41(c)(3).
37 Sec. 41(c)(3)(C).
38 Sec. 41(c)(3)(B).
39 Sec. 41(c)(5), added by the Tax Relief and Health Care Act of 2006, P.L. 109-432.
40 Sec. 41(c)(5)(C).
41 Sec. 41(c)(5).
42 Sec. 41(d)(1).
43 Secs. 41(a)(1) and (b)(1).
44 Regs. Sec. 1.41-2(a)(2).
45 Sec. 41(b)(4).
46 Regs. Sec. 1.41-4(a)(4).
47 Sec. 41(d)(2)(B).
48 Sec. 41(d)(3)(A).
49 Sec. 41(d)(3)(B).
50 Sec. 41(d)(1)(C).
51 Regs. Sec. 1.41-4(a)(6).
52 Regs. Sec. 1.41-4(a)(5)(i).
53 Sec. 41(d)(4)(F) and Regs. Sec. 1.41-4(c)(7).
54 Sec. 41(d)(4)(G) and Regs. Sec. 1.41-4(c)(8).
55 Sec. 41(d)(4)(H) and Regs. Sec. 1.41-4(c)(9).
56 Sec. 41(d)(4)(A) and Regs. Sec. 1.41-4(c)(2).
57 Sec. 41(d)(4)(B) and Regs. Sec. 1.41-4(c)(3).
58 Sec. 41(d)(4)(C) and Regs. Sec. 1.41-4(c)(4).
59 Sec. 41(d)(4)(E).
60 Eustace, T.C. Memo. 2001-66, aff’d, 312 F.3d 905 (7th Cir. 2002).
61 LMSB-04-0307-025 (4/4/07).
62 Edwards v. Cuba R.R. Co., 268 U.S. 628 (1925).
63 Texas & Pacific Railway Co., 286 U.S. 285 (1932).
64 See, e.g., Detroit Edison Co., 319 U.S. 98 (1943).
65 Glenshaw Glass Co., 348 U.S. 426 (1955).
66 Regs. Sec. 1.118-1.
67 Sec. 118(b).
68 Regs. Sec. 1.118-2(b).
69 AT&T, Inc., 629 F.3d 505 (5th Cir. 2011), cert. denied, Sup. Ct. Dkt. No. 10-1204 (10/3/11).
70 Chicago, Burlington & Quincy R.R. Co. , 412 U.S. 401 (1973).
71 See LMSB-04-1106-016 (12/28/06). See also LMSB-04-1007-069 (10/19/07), which states there is no common law exclusion for contributions to noncorporations. However, it has been reported that the government might reconsider permitting the exclusion for government incentive grants (see Elliott, “Treasury Might Consider Exclusion for Government Grants to Partnerships,” 2011 TNT 8-2 (January 12, 2011). The issue is also before the Tax Court.
72 LMSB-04-0307-026 Tier I Issue: Sec. 118 Abuse Directive No. 2 (4/2/07).
73 Sprint Nextel Corp., No. 09-2325-KHV/JPO (D. Kan. 3/4/11).
74 See also AT&T, n. 69 above.
75 See, e.g., LMSB-4-0710-020 (7/9/10).
76 See LMSB-4-0608-034 (8/1/08).
77 LMSB 4-0808-041 (9/15/08).
78 See Hennig and Sonnier, “Schedule UTP: IRS Mandates Disclosure of Uncertain Tax Positions,” 42 The Tax Adviser 334 (May 2011).
79 IR-2010-107, Remarks by IRS Commissioner Douglas Shulman at the AICPA Fall Tax Division Meeting (October 26, 2010, Washington, DC).
|Cherie Hennig is a professor at the University of North Carolina–Wilmington in Wilmington, NC. Edward Schnee is the Hugh Culverhouse Professor of Accounting and director of the MTA Program at the University of Alabama in Tuscaloosa, AL. Blaise Sonnier is a professor at Florida International University in Miami, FL. For more information about this article, contact Prof. Hennig at firstname.lastname@example.org.|