Erin M' Collins

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Schedule M-3 Reporting Requirements American
Taxation Association
Erin M. Collins Tax Managing Director February
24, 2006
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Tax History Question

• What amendment gave the government power to tax
  income?
• Answer 16th Amendment was ratified in 1913
• How many versions have there been of the Internal
  Revenue Code? What years?
• Answer Code of 1939, Code of 1954, Code of 1986

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Mark Everson, IRS CommissionerJanuary 25, 2005

• In my view, five factors contributed to the
  proliferation of abusive tax shelters.
• First, the tremendous complexity of the tax code
• Second, the cozy relationship among sophisticated
  promoters
• Third, the erosion of professional ethics.
• The fourth reason was an ineffectual regulation
  scheme, and
• Fifth, the IRS largely withdrew from the
  battlefield when it came to enforcement.
  Government response, more transparency of
  abusive tax transactions . . . and issuance of
  new Schedule M-3.

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Pam Olsen, Assistant Secretary for Tax Policy,
January 28, 2004

• The proposed Schedule M-3 will make
  differences between financial accounting net
  income and taxable income more transparent. We
  see benefits to taxpayers and the IRS from the
  new Schedule a reduction in unnecessary audits
  and a swifter focus on those differences that are
  more likely to arise when taxpayers take
  aggressive positions or engage in aggressive
  transactions. In addition, the increased
  transparency will have a deterrent effect.

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Greg JennerActing Assistant Secretary for Tax
Policy
The purpose of this project has been to make
differences between financial accounting net
income and taxable income more transparent.
Schedule M-3 accomplishes this. Schedule M-3
provides information that will identify taxpayers
that may have engaged in aggressive transactions
and therefore should be audited. Large
book-tax differences frequently indicate the
existence of an abusive transaction. The new
Schedule M-3 will enable the IRS to identify
quickly those differences that warrant
additional scrutiny
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Deborah Nolan, IRS Large and Mid-Size Business
Division Commissioner, January 28, 2004

• These changes will enable us to focus our
  compliance resources on returns and issues that
  need to be examined and avoid those that do not.
  Increasing the transparency of corporate tax
  returns is critical to our objective to provide
  certainty to taxpayers sooner and to improve
  overall compliance.

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Donald Korb, IRS Chief Counsel January 24, 2006

• The Schedule M-3 will help us better
  distinguish between high-risk and low-risk
  returns, thereby improving our ability to focus
  our examination resources where they are needed
  most. Increasing transparency and disclosure of
  tax issues are important elements in the Treasury
  and IRS strategy to improve tax compliance.

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Robert Adams, a Senior Industry Advisor in the
IRS LMSB Division

• IRS recognizes the M-3 transition will not be
  easy but the burden would lessen over time.

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Unidentified Client

• The M-3 is doable but very, very, very painful
  and extremely time consuming. I cant imagine
  that the person that designed this form has ever
  had to prepare a complex tax return.

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Environment

• February 7, 1997
• Senators say its time to give the tax man an
  audit
• September 23, 1997 Senators Accuse IRS of
  Heavy-Handed Tactics
• September 24, 1997 IRS Nightmares Get Senate
  Hearings
• September 24, 1997 Taxpayer Details Wrongs at
  Hands of IRS
• September 25, 1997 IRS Employee Testify on
  Abusive Practices
• September 26, 1997 Congress Mulls Ways to Reform
  IRS
• October 10, 1997 Clinton Says IRS Abuses Wont
  be Tolerated

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Environment (cont.)

• November 5, 1997 House Approves IRS Reform Bill
• December 13, 1997 Treasury Secretary Robert
  Rubin Disturbed By IRS Violations
• January 13, 1998 IRS Chief Counsel said on
  Tuesday a new report has uncovered problems with
  the tax-collecting agency's methods across the
  country
• January 28, 1998 IRS Chief Pledges Reform for
  Agency to make it operate more like a business
  that serves taxpayers instead of intimidating
  them, the head of the severely criticized agency
  told Congress Wednesday.

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Environment (cont.)

• RRA of 98
• Federal Tax Shelter Regulations
• Original temp. and prop. regs issued 2/28/2000.
• Revised temp. and prop. regs issued 8/21/2000.
• Another set of revised temp. and prop. regs
  issued 8/7/2001.
• More Revisions 6/14/2002 (temp. prop.).
• Still More Revisions 10/16/2002 (temp.
  prop.).
• Notice 2003-11 1/17/2003, delays effective date
  of 10/2002 regs.
• Final Regulations 2/28/2003
• Revised Final Regulations released 12/29/2003
• Final 6662 and 6664 Regulations released
  12/29/2003

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Reportable Transactions

• Disclosure of the tax treatment of transaction is
  limited in any manner and advisor receives a fee
  of 250,000 (for C Corps) or 50,000.
  (Confidential Transactions)
• Transaction creates a Book-Tax Difference gt 10
  million
• Transaction gives rise to a 165 loss gt 10
  million in one year or 20 million total
• Fees for the transaction are refundable or
  contingent if tax result is not achieved
• Company holds an asset for 45 days or less and
  claims a foreign tax credit gt 250,000 OR
• Identified by the IRS as abusive either currently
  or at any time before the statute of limitation
  expires
• Listed Transactions or those substantially
  similar to Listed Transactions.

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IRS Stated Goals of Schedule M-3

• Transparency
• Allow IRS to Analyze Return Risk More Efficiently
• Identify returns containing highest compliance
  risk
• Avoid examining returns with little compliance
  risk
• Improve audit cycle time
• Periodically modify the form to highlight
  emerging issues, identify trends, and adapt to
  future changes encountered by large and midsize
  corporations.
• Facilitate tax return selection and issue
  identification through electronic filing.
• Facilitate the use of Limited Issue Focused
  Examination (LIFE) audits through greater
  transparency.

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M-3 Timetable - Key Dates

• January 24, 2004 First draft of Schedule M-3
• March 10, 2004 Draft of Instructions for
  Schedule M-3
• July 7, 2004 Revised draft of Schedule M-3,
  Rev. Proc. 2004-45. Treasury Releases
  Frequently Asked Questions
• August 6, 2004 Treasury Answers M-3 Questions
• October 25, 2004 Treasury releases final
  draft version
• December 2, 2004 IRS releases 16-pages of
  instructions

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M-3 Timetable - Key Dates (cont)

• June 23, 2005 - IRS released revised draft M-3.
  Added two new items, one line for the new
  domestic production activities deduction and
  another line for interest expense.
• Dec. 20, 2005 - IRS released draft M-3 for
  partnerships with 10M or more in adjusted total
  assets, 35M or more in total receipts, or is 50
  or more owned by an LMSB or other taxpayer
  required to file a Schedule M-3 - effective for
  tax years ending on or after 12-31-06

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M-3 Timetable - Key Dates (cont)

• Dec. 13, 2005 IRS released draft Schedule M-3 and
  instructions for corporation that file Forms
  1120PC, 1120L and 1120S. These M-3 will be used
  by property and casualty insurance corporations,
  life insurance corporations, and S corporation
  that have total assets of 10M or more effective
  for tax years ending on or after 12-31-06.
• Jan 6, 2006 - IRS announced elimination of a
  class of reportable transactions involving
  significant book-tax differences. After a review
  comparing reportable transaction submissions and
  the information being provided on Schedule M-3,
  the IRS and Treasury Department have concluded
  that the book-tax difference category of
  reportable transactions is not longer necessary.
  Notice 2006-6.

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• Schedule M Overview

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Schedule M - Tax years ending before December 31,
2004

• Schedule M consists of two components
• Schedule M-1, Reconciliation of Income (Loss) per
  Books With Income per Return, and
• Schedule M-2, Analysis of Unappropriated Retained
  Earnings.
• Schedule M is located on page 4 of Form 1120 and
  is required to be completed by any corporation
  with assets of 25,000 or greater.

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Schedule M - Tax years ending on or after
December 31, 2004

• Schedule M
• Schedule M-1 and Schedule M-2 OR
• Schedule M-2 and New Schedule M-3, Net Income
  (Loss) Reconciliation for Corporations with Total
  Assets of 10 Million or More.
• New Schedule M-3 expands the current Schedule
• M-1, which has not been updated in several
  decades.

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Schedule M Overview (Contd)

• Schedule M-1 reconciles a corporation's financial
  accounting income or loss with the taxable income
  or loss reported on the Form 1120.
• These adjustments are often referred to as
  Schedule M items or book/tax differences.

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Schedule M Overview (Contd)

• Schedule M-1 begins with net income (loss) per
  books (after federal income tax), followed by the
  adjustments necessary to reconcile book income to
  the corporations taxable income (before any
  deduction for dividends received and net
  operating losses)
• The schedule is then divided into four categories
  of book/tax differences
• Income subject to tax not recorded on books.
• Expenses recorded on books not deductible for
  tax.
• Income recorded on books not included in return.
• Deductions in return not charged against book
  income.

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What is a Schedule M-3?

• Like Schedule M-1, Schedule M-3 will provide the
  IRS with information about book-tax differences
• Schedule M-3 will provide MUCH greater detail
  than Schedule M-1 because it requires a taxpayer
  to
• Separately state each transaction giving rise to
  abook-tax difference (no materiality threshold,
  i.e.,no dollar or percentage de minimis test),
  and
• Taxpayers will now be required to identify
  whethereach difference is permanent or temporary

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Schedule M-3

• Very complex with extensive detail required
• Instructions are 16 pages
• Many new requirements for taxpayers
• Schedule M-1 10 line items
• Schedule M-3 92 line items
• Transition year - First year taxpayer required
  to complete Schedule M-3
• Complete Part I
• Complete Columns b and c of Part II and Part III
• Year after transition year
• Must complete all portions of Schedule M-3

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Who Must File Schedule M-3?

• C corporations and U.S. consolidated groups
  filing Form 1120 with at least 10 million in
  assets must begin using new Schedule M-3 (in lieu
  of Schedule M-1) for tax years ending on or after
  December 31, 2004.
• Partnerships with 10M or more in adjusted total
  assets, 35M or more in total receipts, or is 50
  or more owned by an LMSB or other taxpayer
  required to file a Schedule M-3 - effective for
  tax years ending on or after 12-31-06. (40 pages
  of instructions)
• Corporation that file Forms 1120PC, 1120L and
  1120S. These M-3 will be used by property and
  casualty insurance corporations, life insurance
  corporations, and S corporation that have total
  assets of 10M or more effective for tax years
  ending on or after 12-31-06. (40 pages of
  instructions)

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Who is NOT Required to File Schedule M-3?

• Taxpayers not required to file Schedule M-3 are
• C corporations and U.S. consolidated groups with
  less than 10 million in assets

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Schedule M-3 is made up of three parts 
  Part One Financial Information and Net Income
(Loss) Reconciliation asks questions about the
corporations financial statements.   Part Two
Reconciliation of Net Income (Loss) per Income
Statement of Includible Corporations with Taxable
Income per return.   Part Three
Reconciliation of Net Income (Loss) per income
Statement of Includible Corporations with Taxable
Income per Return Expense/Deduction Items.
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How Many Schedule M-3s Does a Taxpayer Need to
Fill Out?

• Special rules for consolidated groups
• Example Parent with 3 subs 6 schedule M-3s
• One consolidated Schedule M-3 with Parts I, II,
  and III completed to reflect activity for the
  entire consolidated group
• One Schedule M-3 for parent and each subsidiary
  for its own activity in Parts II and Parts III
• One Schedule M-3 to eliminate differences related
  to intercompany transactions and to include
  limitations on deductions (e.g., charitable
  contribution and capital loss limitations) and
  carryover amounts (e.g., charitable contribution
  and capital loss carryovers)

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 How Many Schedules M-3s Does A Taxpayer File ?
Parts I, II, and III of a Schedule M-3 by the
parent reflecting Part I information for the
entire group, and its own activity in Parts II
and III.   Parts II and III of Schedule M-3 by
each of the three subsidiaries reflecting their
respective activity.   Parts II and III of a
consolidating Schedule M-3 to account for items
such as differences between financial statement
net income and taxable income related to
intercompany transactions and adjustments made at
the consolidated group level not attributable to
any specific group member.   One consolidated
Schedule M-3 with Parts I, II and III resulting
from consolidating those Schedules M-3s described
above.
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M-3, Part I Financial Information and Net
Income (Loss) Reconciliation

• General information identification of public
  filings
• Information on restatements
• Elimination of income from entities not included
  in federal consolidated income tax return
• Computes the consolidated income statement net
  income or loss of all includible corporations in
  theU.S. consolidated tax return and listed in
  Form 851

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Permanent v. Temporary Differences

• Taxpayers report Temporary differences in Parts
  II and III, column (b) and Permanent
  differences in Parts II and III,column (c)
• If corporation uses GAAP
• Treat any item as temporary that GAAP treats as
  temporary
• Treat other items as permanent
• If corporation does not use GAAP or prepare
  financial statements
• Temporary - if it will reverse in future year or
  it is a reversal from a prior year
• Permanent - if it will not reverse in a future
  year or it is not a reversal from a prior year
• Treat as permanent if unable to determine

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M-3, Part II - Income (Loss) Items

• Lines 1-25 (with 6 subparts) - 31 specific line
  itemsof income (loss) items
• Line 26 any difference not included in lines
  1-25
• Line 29 No differences in book/tax treatment
  andnot included in Lines 1-25

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M-3, Part II (cont.) Reportable Transactions
Line 12

• All items related to a transaction for which you
  file a Form 8886 are reported in Columns a
  through d of Line12, Part II
• Do not report any item on a specified line
• Report on Line 12 even if there is no difference
• Example - Two abandonment losses
• One reportable transaction with 18 million loss
• Part II, Line 12 Reportable transaction with
  18 million loss with required statement or
  attachment
• One not a reportable transaction with 15 million
  loss
• Part II, Line 23e - 15 million with no statement
  or attachment

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M-3, Part II (cont.) Reportable Transactions
Line 12

• Each difference for each Form 8886 must be
  separately statedand adequately disclosed
• Sequentially numbers each Form 8886 and lists by
  identifying number on the supporting schedule the
  amounts required foreach column of Line 12 for
  each Form 8886 or
• Attaches a schedule for each Form 8886
• Describes the reportable transaction for which
  amounts are reported on Line 12
• Provides name and any required identifying number
  on Form 8886
• Provides type of reported transaction
• For listed transactions, include description on
  Line 3 of Form 8886
• If reportable transaction is from indirect
  ownership, e.g., partnership, include name and
  EIN as on Line 5 of Form 8886

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Reportable Transaction Disclosure

• If a transaction reported on Schedule M-3 meets
  any of the reportable transaction criteria (e.g.,
  section 165 loss transaction), the taxpayer must
  still complete a Form 8886 and send it to OTSA

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New Schedule M-3

• Corporation required to report in Parts II and
  III any item listed in the Schedule M-3 that is
  included in the financial statements or books and
  records
• Even if no difference with tax
• Dormant or inactive corporations
• No separate Schedule M-3, but parent must list
• Disregarded entity
• No separate Schedule M-3 treated as items of
  owner

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M-3, Part III Expense/Deduction Items

• Lines 1-34 Specific line items of
  expense/deductions
• Line 35 All other differences not included in
  lines 1-34
• Line 29, Part II All items with no differences
  inbook/tax treatment and not included in Lines
  1-34

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Practical Issues Associated with M-3

• Systems Issues
• Reclassification post GL
• Need to disclose detail behind each transaction
  not just net numbers
• Support schedules showing each item in the line
  will need to be attached
• Inconsistency with Classifications of income
  statement items
• GAAP reconciling items
• Increased Compliance Burden

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Q A