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Thursday, March 3, 2011

Schedule M-3: Scarier Than Semicolons?

by Carla Haire, CPA, MT

When I was a new tax preparer, my greatest fears revolved around when to use semicolons in business writing. Like many who share such fears, I’ve managed to avoid semicolons all these years. However, thanks in part to the collapse of Enron, my career is now fraught with perils more frightening than punctuation. I’m here to write about one in particular, something that leaves even seasoned preparers like me quaking in their dress shoes: the Schedule M-3.

Oh, if only we could go back to the simple, early days when there was only the sweet, complacent Schedule M-1 to reveal the book-to-tax differences for a corporation or partnership! Today, Schedule M-3 is required for any entity with assets in excess of $10 million. With today’s rising property costs and inflation, a commercial building alone can bring total assets to an amount greater than that.

This means the Schedule M-3 looms on the horizon for many preparers of corporate and partnership tax returns. Since I’m one of those preparers, I suppose I should learn a few things about the M-3, such as, is it truly more terrifying than semicolons? I sure hope not!

The M-3: Where To Begin?

Oh, my. Have you seen this “schedule”? It’s three pages long, not including the required peripheral forms, statements, and attachments. It’s involved, it’s complicated, and it has foreign-sounding phrases like “Subpart F, QEF, and similar income inclusions.” Huh? At least there aren’t any semicolons!

Let’s Try the Instructions ...

Okay, I am a reasonable, fairly well-educated person. Am I going to let this form get the best of me? Not for an instant! I’m currently preparing a corporate (1120) return, so I’ll just read the Schedule M-3 instructions for that form. That should work, shouldn’t it?

Oops, not so easy. Those instructions are 27 pages long! Who has time for that? In early March, no less?

Clearly, the M-3 instructions—for Form 1120, not to mention Forms 1120S and 1065—will need to be a project for the summer, when I’m not so busy.

Let’s Try the Software ...

My tax software does so many things automatically, so I’m sure it will help me here. I’ll just prepare my client’s corporate return, confident that all the correct amounts will magically appear on the required lines of the forms and schedules. All I’ll have to do is enter the data and print and e-file the return. Right?

Hold your horses! Now that I’ve run the prepared return, what are all these EF messages about, telling me I can’t e-file because the information is incomplete, incorrect, or doesn’t otherwise add up?

It seems I’m back to reading words I don’t understand, reviewing instructions I don’t have time to thoroughly study, and trying to comprehend where to put what on the data-entry screens.

Deep breath. Let’s look at an EF message and figure out where I went wrong.

Finding the Missing Information

This message tells me that the Schedule M-3 reconciliation totals (Part II, line 30) don’t match the amount reported on Form 1120, page 1, line 28 (Taxable income before NOL deduction and special deductions).

Hmph. I know my line 28 is correct. So what gives?

What gives is that the software has carried to Schedule M-3 only the amounts I’ve typed in data entry. But it needs more information—information I never provided.

Should I be surprised that the software can produce only those amounts on the schedule that are readily evident from my data entry? Unless the little men inside the software have somehow riffled through the working papers and financial statements on my desk to discover the amounts and scurried back into the software while I was glassy-eyed from reading instructions, the software simply cannot know what amount to report on the Schedule M-3 lines—not to mention the columns—being incorporated into the reconciliation totals.

And how does the software know for sure which differences are permanent and which are temporary? I’m not even sure I know at this point!

Entering the Missing Data

Now that I know what’s missing, my job should be easy enough. I’ll just open the M3 screens in the software and type the missing amounts. Finally, this is starting to make sense!

Oh, goodness! Where have they hidden lines 1 through 13 for Part II? Well, wouldn’t you know it, the IRS requires statements for certain lines—statements that must be reported in a specified format. In Drake, that means more screens, with even more detailed information, to complete.

Reporting Amounts With No Differences

Super! I’ve spent more time on this than planned, but I’ve finally figured out all these special lines, and I’ve reconciled the amounts the software carried for meals and entertainment limitations, depreciation adjustments, tax-exempt interest, and the cost of goods sold.

But ... oh, dear. What am I supposed to do with the rest of the income and expense amounts, those that don’t have a specific line, where tax and book amounts are the same? Aha! There it is: line 28 on page 2, part II of Schedule M-3, which reads “Other items with no differences.” That’s exactly the field I need in order to have the column d amount to tie to the tax return. Yes!

All I need to do is calculate the difference between the amounts reported on the other lines of Parts II and III, and the amount reported on Form 1120, page 1, line 28, and enter the result on the “Other items with no differences” line. Whew! All done with that beast of a schedule. Time for an early vacation!

Those Darn Consolidations

Not so fast, mister! In Part I, line 4a asks for “Worldwide consolidated net income (loss) from income statement source identified in Part I, line 1,” and the program is telling me that my line 4a doesn’t tie to the corporation’s income statement. Sigh. How can I have missed something if my reconciliation totals are correct?

Is it time to start over? Do I need a good cry?

Heck no, buddy! The income statement is on a consolidated basis, and I apparently didn’t include the includible amounts from the other includible or nonincludible entities. (Is “nonincludible” even a real word?)

Since these amounts don’t belong on Parts II or III, I guess it’s back to the never-ending instructions.

Well, lo and behold, I didn’t have to go far. The instructions for Part I, line 7—only eight pages in!—clearly explain how to handle the “Net Income (Loss) of Other Includible Foreign Disregarded Entities, Other Includible U.S. Disregarded Entities, and Other Includible Entities” (if only I knew the difference). Off to screen M3 in Drake to enter that one amount that will call this schedule “complete.”

Wouldn’t you know it—no easy direct-entry fields here. Guess I’ll click this link to screen M3S for more required statements.

Now, what’s this about assets and liabilities on screen M3S? And what do those have to do with the book-to-tax net income or (loss) reconciliation? I’ll take these extra steps, since both the IRS and the software require them, but I am not happy about this. It’s no wonder the software doesn’t complete the schedule for me.

Final Thoughts

If I have to prepare this schedule in the future, I’m raising my fees. So what if my client ends up selling that commercial building to pay them. And if I lose the client? Hey, at least I won’t have to prepare a Schedule M-3 again!

That monster done, it’s now time to prepare the next return. Egad! Another return that requires a Schedule M-3. This one is going on extension! Guess I know how I’ll be spending my summer: reading Schedule M-3 instructions and taking CPE on consolidated financial statements and tax returns.

Maybe once I’ve conquered those, I’ll feel brave enough to take on those devilish semicolons!

Carla Haire, CPA, MT, was born at an early age to her mother and father. She is a Tax Analyst with Drake’s federal tax development group, where she specializes in the business tax packages. Before coming to Drake in 2002, she worked in public accounting in south Florida. She and her husband, Wayne, live in Franklin, NC, where they enjoy hiking and spending time with family. While she’s not as intimidated by the Schedule M-3 as she’d like you to believe, she really is a little scared of semicolons.