What is the purpose of Schedule M-1 in the S corp return?
There is often a difference between the profit or loss on a company's accounting books versus what is reported on its tax return. This difference arises due to differences between tax law and generally accepted accounting principals. Some of the differences are due to timing, i.e., when an item of income or expense is recognized, whereas other differences are permanent.
There are four general categories of differences:
- Income subject to tax but not recorded on the books this year;
- Expenses recorded on the books this year but not deducted on this tax return;
- Income recorded on the books this year but not included on this tax return, and;
- Deductions on the tax return but not deducted on the books this year.
In Form 1120-S, U.S. Income Tax Return for an S Corporation, Schedule M-1 is used to reconcile the income that the S corporation is reporting on the tax return with the income in its accounting records. Not all S corporations are required to complete Schedule M-1.
When is Schedule M-1 not required?
An S corporation does not need to complete Schedules L (Balance Sheet) and M-1 (Reconciliation of Income) if it satisfies both of these conditions:
- The S corporation’s total receipts for the tax year were less than $250,000.
- The S corporation’s total assets at the end of the tax year were less than $250,000.
Whether or not the S corporation satisfies these two conditions is a Yes/No question on Schedule B (Form 1120-S) line 11 (line 10 prior to 2018).
To answer this question in the S corporation return in TaxSlayer Pro select:
- Schedule B - Other Information
- Receipts and Assets at year end less than 250,000 - The default answer is no, i.e., either or both of the receipts and assets were $250,000 or more for the year, and thus the tax return must include Schedules L and M-1. Answer YES if both were less than $250,000 for the year.
A corporation with total assets of $10 million or more on the last day of the year must file Schedule M-3 (Form 1120-S) instead of Schedule M-1. Additionally, a corporation that isn't required to file Schedule M-3 can voluntarily choose to file it anyway instead of Schedule M-1.
Note that even though Schedules L and M-1 may not be required for an S corporation return, you can still prepare them anyway as a service to your client. They may be required in a subsequent year, so preparing them each year helps the shareholder(s) understand how the tax return and the books relate as well as makes it easier to prepare them if and when they are required.
Completing Schedule M-1
If the S corporation does not satisfy the two conditions and their total assets are less than $10 million, they are required to complete Schedule M-1. To complete Schedule M-1, from the Main Menu of the tax return (Form 1120-S) select Schedule M-1 – Reconciliation.
There may be no difference between income or loss reported on the tax return and the income or loss reported on the corporation's books, and thus no further work needs to be done on the schedule, but by selecting Schedule M-1 in the menu the schedule is created and included in the return.
Here are the Schedule M-1 menu lines in TaxSlayer Pro:
1. Net Income (Loss) Per Books - This is a calculated amount and cannot be edited. It is initially equal to the last line in the menu and is adjusted up or down by the amounts entered in this menu. Before making any adjustments, compare this amount to the corporation's actual book income. If they don't match, one or more entries are needed in Schedule M-1 to reconcile the two. Once all the adjustments are made in this menu, this line must equal the net income or loss in the corporation's accounting records.
2. Income Subject to Tax Not Recorded on Books - Enter any income that was included on Schedule K lines 1, 2, 3c, 4, 5a, 6, 7, 8a, 9, and 10 but not recorded on the corporation's books this year. If the corporation operates on an accrual basis, there may be an entry to make due to a timing difference.
3. Depreciation - This is a common adjustment item on Schedule M-1 because a corporation is allowed to utilize accelerated depreciation methods, special depreciation, and bonus depreciation. Many times a business will use a less-accelerated depreciation method (such as straight line) in their accounting records which can produce a lower depreciation amount than initially claimed on the tax return. Whichever depreciation method is used will over the life of the asset produce the same amount of depreciation. However, this difference in methodology will produce a greater amount of depreciation expense in the initial and early years when claiming depreciation on the tax return and a lesser amount on the business records. This trend will reverse in the later years, and eventually the asset will be totally depreciated and the depreciation taken will be the same on both the tax return and the books.
Schedule M-1 includes two separate lines to enter the differences in depreciation. This menu line is for assets where the amount of depreciation taken is greater in the corporation's books than is being claimed on the tax return.
4. Travel and Entertainment - While a business can deduct what it wishes on its books for travel, entertainment, and meals, the IRS limits the amount that a business can take as a deduction on its annual return. Meal deductions can be taken up to 50% of the expenditure, or in certain situations 80%, or, for restaurant expenditures during 2021-2022, 100% of the expenditure. The amount in this menu is pulled from the entries in the Deductions menu and can be adjusted as needed. (See IRS Publication 463 if in doubt about how much of an expenditure can be deducted in the return.)
6. Other Expenses on Books not on Schedule K - Enter here expenses that are reflected on the corporation records but are not deductible in the tax return. The total here should reconcile to Schedule K line 16c. Examples:
- certain club dues
- lobbying expenses
- certain meals and entertainment
- fines and penalties, with exceptions
- prepaid expenses (related to a farm that operates on a cash basis)
- income taxes
After selecting this menu line, select New. Choose from one of the prefilled descriptions or select "Enter a description" to create your own, followed by the amount.
6. Expenses Recorded on Books Not on Sch K - This amount is the sum of the amounts entered above for Depreciation, Travel and Entertainment, and Other Expenses Recorded on Books. ("Not on Sch K" means not on Schedule K lines 1 through 12 and 16f.)
7. Tax-Exempt Interest - The amount here, if any, is pulled from the amount entered in Schedule K under the "Items Affecting Shareholder Basis" menu and reconciles to Schedule K line 16a. It generally should not be edited, but an entry field is provided to enter an adjustment if needed that will be added to or subtracted from the amount pulled from Schedule K.
8. Other Income on Books Not on Sch K - Enter here income that is reflected in the corporation records but not included on the tax return. (PPP loan forgiveness is reported on this line. See here for more information.) The total here should reconcile to Schedule K line 16b.
After selecting this menu line, select New. Enter the description followed by the amount.
9. Income Recorded on Books Not on Sch K - This amount is the sum of the amounts entered above for Tax Exempt Interest and Other Income Not on Schedule K. ("Not on Sch K" means not on Schedule K lines 1 through 10.)
10. Depreciation - This is the second of the two depreciation lines, and the amounts entered here are for assets where the amount of depreciation taken is greater on the corporation's tax return than on its books. Typically, special and bonus depreciation amounts in excess of what is recognized on the corporation's records are included here.
11. Other Deductions included on Schedule K - Enter here the deductions on Schedule K lines 1 through 12 and line 16f that aren't reflected in the corporation's books, if any.
After selecting the menu line, select New. Enter the description followed by the amount.
12. Deductions on Sch K Not Charged Against Books - This amount is the sum of the amounts entered above for Depreciation and Other Deductions on Schedule K.
13. Income (Loss) (from Schedule K, Line 18) - This is the amount on Schedule K line 18, the amount of income or loss on the tax return that needs to to be reconciled to the book income or loss on menu line 1.
Note: This is a guide on completing Schedule M-1 (Form 1120-S) in the TaxSlayer Pro program. This is not intended as tax advice.
Additional Information:
IRS: Instructions for Form 1120-S - U.S. Income Tax Return for an S Corporation
Creating a Basic Form 1120-S - U.S. Income Tax Return for an S Corporation