Corporations in the United States are subject to RULES imposed by at least two sets of policy makers. For financial reporting (which addresses book income), corporations follow the rules set forth by U.S. Generally Accepted Accounting Principles (GAAP). These principles are intended to match expenses with revenue, which generally permits a corporation to accelerate its income recognition while deferring its expenses. For tax reporting (which involves taxable income), corporations follow the rules set forth by the Internal Revenue Code (IRC). These rules are intended to determine the tax liability of a corporation.
In many ways, the IRC encourages corporations to accelerate deductions (i.e., expenses) and, in some situations, exclude income to motivate corporations to undertake projects that they otherwise might not take on. As a result, net income on the financial statements rarely equals taxable income.
BOOK AND TAXABLE INCOME
Probably the most common book-to-tax difference is that book depreciation (the depreciation method used for financial reporting) tends to be the same amount each year while tax depreciation (the depreciation method used for taxable income to calculate the tax owed) is typically based on the modified accelerated cost recovery system (MACRS) and tends to have higher depreciation in earlier years and lower depreciation in later years.
In addition, some corporations may be eligible to take §179 immediate expensing depreciation, which allows businesses to deduct up to a set dollar amount in the year of acquisition, or even first-year bonus depreciation, which allows businesses to deduct a percentage of the cost in the year of acquisition.
In either case, this is a temporary difference because the amount of depreciation taken over the life of the asset will be the same for both financial and tax reporting if no salvage value is part of the calculation, which usually isn’t used in depreciation computation.
A permanent difference between book and tax income is municipal bond interest or dividends received. Municipal bond interest is usually totally excluded from taxable income, and dividends received from a share of stock ownership of a corporation is usually fully or partially excluded from taxable income. For financial reporting, however, both income items are included in financial income, and, as such, the difference doesn’t reverse in the future and is thus permanent.
INFLATION REDUCTION ACT OF 2022
The Inflation Reduction Act of 2022 (IRA) brings back the alternative minimum tax (AMT)—which was eliminated by the Tax Cuts and Jobs Act of 2017—but adds a twist. The new AMT version applies a 15% tax on applicable corporations’ “adjusted financial statement income” for taxable years after December 31, 2022. IRA §10101 defines an “applicable corporation” to be “any corporation (other than an S corporation, a regulated investment company, or a real estate investment trust), which meets the average annual adjusted financial statement income test.”
A corporation meets the average annual adjusted financial statement income test for any taxable year if the average annual adjusted financial statement income of the corporation for the three-taxable-year period including the current year exceeds $1 billion.
Once a corporation is determined to be an applicable corporation, it would continue to be one unless it has a change in ownership, or the Secretary of the Treasury may set a specified number of consecutive taxable years that the corporation doesn’t meet the income test (considering the facts and circumstances of the taxpayer), or it may just determine that it wouldn’t be appropriate to continue treating the corporation as an applicable corporation.
In addition, the Secretary of the Treasury is tasked with issuing regulations or other guidance on determining the adjusted financial statement income in situations where there is:- A different financial statement and taxable income year-end.
- A different company grouping for the consolidated financial statement of income than the consolidated income tax return.
- A dividend received from a corporation included in the amount of the dividends received by that corporation.
- Partnership earnings received from a partnership interest included up to the amount of the earning.
- Pro rata share of the net income of any controlled foreign corporation.
- Financial statement net operating losses.
The Democratic Caucus of the U.S. Senate quoting the Joint Committee of Taxation estimates that the 15% corporate AMT is projected to raise $222 billion. The Wall Street Journal’s research last year during the initial reporting of the proposed corporate AMT said that 236 companies in the S&P 500 reported more than $1 billion or more in profits and more than 60 of them reported effective tax rates or the tax expense as a share of pretax income less than 15% in 2019 and 2020.
OPPOSITION TO MINIMUM TAX
Not everyone is in favor of this proposal. Stakeholders in the municipal bond market oppose the minimum tax on this bond interest because it would reduce the value of these investments. Tax-exempt bonds are the primary way in which state and local governments raise capital for many public projects. Because the interest from municipal bonds is generally tax-exempt for federal and domestic state income tax purposes, investors accept a lower rate of interest on these bonds as opposed to taxable bonds. As a result, state and local governments incur less interest on their bonds and can provide more services to their residents.
Several state and local stakeholders sent a letter to congressional leaders dated November 1, 2021, in opposition to the taxation of municipal bond interest, noting the tax-exempt bonds are the primary means for state and local governments to finance many essential public projects. The American Institute of Certified Public Accountants raised concerns to Congress, noting that this tax proposal presents a fundamental shift in taxation of U.S. entities and could result in uncertainty and costly compliance requirements.
ADDED COMPLEXITY
Right before the IRA was passed in the Senate, an exception was added to the computation of the adjusted financial statement income for depreciation. Book income tends to be the same amount each year and not accelerated, as noted previously. Yet now accelerated depreciation is allowed for the computation of adjusted financial statement income. Another exception was included that allows tax amortization relating to the qualified wireless spectrum used in the trade or business of a wireless telecommunications carrier instead of the financial statement amortization.
Putting in book-to-tax differences adds more complexity and complications. The apparent rationale of introducing this new form of taxation is to promote the view that Congress wants to ensure that large corporations pay their fair share. But when the corporate tax rates increase, the consumer may be the one who ultimately pays the price.
© 2022 A.P. Curatola
November 2022
