REG, Regulation

Sources for Book-Tax Differences: Schedule M-1 and M-3

Last reviewed 2026-10-08

The standards and authorities behind PocketCPA's REG lessons on Book-Tax Differences: Schedule M-1 and M-3. The topic rests on IRC / Schedule M-3.

About this topic

A corporation reports one profit figure to its investors and a different one to the government, and both are correct. Financial accounting and tax accounting answer different questions, so a corporation keeps GAAP books for investors and then reconciles to a separate measure of taxable income for the return.

Key points

• Schedule M-1 reconciles book income to taxable income by identifying permanent and temporary differences.
• Permanent differences (e.g., municipal bond interest, meals limitation) affect the book-tax reconciliation but never reverse.
• Temporary differences (e.g., depreciation methods, warranty accruals) reverse over time and create deferred tax assets or liabilities.
• Schedule M-3 is required for corporations with total assets of $10 million or more and provides greater detail than M-1.

What the lessons cover

1. Why book and tax income diverge
2. Permanent differences
3. Sec. 291: the corporate preference cutbacks
4. Temporary differences
5. Reading the reconciliation
6. Charitable contributions: the 1 percent floor and the 10 percent ceiling
7. Economic performance, related parties, and deferred compensation
8. Income taxed before it is earned: advance payments and installment sales
9. Costs capitalized for tax: Sec. 263A, start-up, organizational, and prepaid items
10. The dividends-received deduction and the Sec. 246(b) limitation

Authoritative references

Where these rules sit in the Code. Each entry names the section, then breaks out the subsections that carry separate rules.

• Sec. 103(a) excludes from gross income the interest on any State or local bond, subject only to the three exceptions in Sec. 103(b).
  • A private activity bond that is not a qualified bond.
  • An arbitrage bond.
  • A bond not in registered form.
  • Sec. 265(a)(1) and (a)(2) complete the pairing by disallowing expenses allocable to wholly exempt income and interest on debt incurred or continued to purchase or carry tax-exempt obligations.
• Sec. 275(a)(1) allows no deduction for federal income taxes, and Sec. 275(a)(4) extends the denial to foreign income taxes where the taxpayer elects the Sec. 901 credit. This is the authority for the second line of Schedule M-1.
• Sec. 274 carries the entertainment and meals disallowances in separate subsections that must be applied in order.
  • (a)(1)(A) and (a)(1)(B) deny any deduction for an entertainment, amusement or recreation activity or a facility used for one.
  • (a)(2)(A) treats club dues and fees as facility items.
  • (a)(3) independently denies membership in any club organized for business, pleasure, recreation or other social purpose.
  • (a)(4) denies qualified transportation fringes.
  • (b)(1) caps business gifts at 25 dollars per recipient per year.
  • (n)(1) cuts food and beverage expense to 50 percent, with exceptions listed at (n)(2).
  • (o) denies the operation of an employer eating facility and Sec. 119(a) meals, with a carve-out for Sec. 274(e)(8) and (n)(2)(C) expenses added by Pub. L. 119-21 sec. 70305 for amounts paid or incurred after December 31, 2025.
• Sec. 162 supplies four permanent disallowances that a ledger will describe in four different ways.
  • (c)(1) and (c)(2) for illegal bribes and kickbacks.
  • (e)(1)(A) through (D) for influencing legislation, campaign participation, influencing the general public on legislative matters, and direct communication with a covered executive branch official.
  • (f)(1) for amounts paid to a government in relation to a violation of law, with the restitution and compliance exception at (f)(2).
  • (m)(1) for a covered employee's remuneration above 1,000,000 dollars at a publicly held corporation as defined in (m)(2) and (m)(3).
• Sec. 264(a)(1) disallows premiums on any life insurance policy where the taxpayer is directly or indirectly a beneficiary, and Sec. 101(a)(1) excludes the death benefit. Sec. 101(j)(1) limits that exclusion on an employer-owned contract to premiums paid unless the notice and consent requirements are met. The two provisions are a matched pair and both are permanent.
• Sec. 267 carries two rules with opposite classifications.
  • (a)(1) disallows any loss on a sale or exchange between persons specified in (b), and it is permanent to the seller.
  • (a)(2) merely postpones a deduction for an expense or interest to the day the related cash-basis payee includes it, and it is temporary.
  • (b)(2) covers an individual and a corporation more than 50 percent in value of the outstanding stock of which that individual owns.
  • (b)(3) covers two corporations in the same controlled group.
• Sec. 461(h) is the economic performance regime.
  • (h)(4) defines the all events test, and (h)(1) bars it from being met before economic performance.
  • (h)(2)(A) through (D) locate economic performance by liability type, with workers compensation and tort placed on a payment basis by (h)(2)(C).
  • (h)(3)(A) grants the recurring item exception on four conditions, including the 8.5-month window at (h)(3)(A)(ii).
  • (h)(3)(C) withholds that exception from workers compensation and tort.
  • (h)(5) turns the subsection off where another provision specifically allows a reserve.
• Sec. 451 governs the timing of income.
  • (a) includes an item in the year received unless the method of accounting says otherwise.
  • (b)(1)(A) bars the all events test from being met later than financial-statement revenue recognition.
  • (c)(1)(A) includes an advance payment on receipt, and (c)(1)(B) allows the election that defers the remainder to the immediately following year.
  • (c)(2) makes the election a method of accounting.
  • (c)(4)(B) excludes rent, subchapter L insurance premiums, financial instruments, third-party warranty payments and Sec. 83 property from the definition of an advance payment.
• Sec. 453 carries the installment method.
  • (a) applies it by default.
  • (b)(1) defines an installment sale as a disposition with at least one payment after the close of the year.
  • (b)(2)(A) and (b)(2)(B) except dealer dispositions and inventory.
  • (c) states the gross profit ratio, and (d) permits election out.
• Sec. 166(a)(1) allows a deduction for a debt that becomes worthless in the year and (a)(2) for the part charged off on a partially recoverable debt, with (b) measuring the deduction by adjusted basis. Neither reaches an estimate, which is why the book allowance produces the difference.
• Sec. 168(k) is the bonus regime as amended by Pub. L. 119-21.
  • (k)(1)(A) allows 100 percent of adjusted basis, with basis reduced by (k)(1)(B).
  • (k)(2)(A) defines qualified property.
  • (k)(7) permits an election out by class.
  • (k)(9) excludes certain regulated utility and floor-plan-financing businesses.
  • (k)(10) permits the elective 40 percent substitution for the first taxable year ending after January 19, 2025.
  • (k)(6) and (k)(8) stand repealed by sec. 70301(b)(1)(B).
• Sec. 179(b) limits expensing in three layers.
  • (b)(1) the dollar limitation.
  • (b)(2) the dollar-for-dollar reduction above the investment threshold.
  • (b)(3)(A) the active business taxable income ceiling, with the indefinite carryforward at (b)(3)(B) and the computation rule at (b)(3)(C).
  • (b)(6) the inflation adjustment for tax years beginning after 2025, using calendar year 2024 as the base.
• Sec. 280F caps cost recovery on a passenger automobile.
  • (a)(1)(A)(i) through (iv) set the statutory 10,000, 16,000, 9,600 and 5,760 ceilings for the 1st, 2nd, 3rd and each succeeding taxable year in the recovery period.
  • (a)(1)(B) releases the unrecovered basis after the recovery period, at no more than 5,760 a year.
  • (a)(1)(B)(iv) treats each released amount as a Sec. 168 depreciation deduction.
  • (a)(1)(B)(iii) allows nothing for a year unless a depreciation deduction would be allowable.
  • (a)(2) applies subsection (a) before subsection (b) and before any personal-use reduction.
  • (b)(1) forces Sec. 168(g) ADS on listed property not predominantly used in a qualified business use.
  • (b)(2) recaptures excess depreciation into gross income, and (b)(3) defines predominantly as exceeding 50 percent.
  • (d)(1) subjects a Sec. 179 deduction on listed property to the same limits.
  • (d)(4)(A) and (B) define listed property.
  • (d)(5)(A) and (B) define a passenger automobile by the 6,000 pound test, substituting gross vehicle weight for a truck or van.
  • (d)(7)(A) and (B) index each dollar amount in subsection (a) for automobiles placed in service after 2018, and (d)(8) defines unrecovered basis.
  • Sec. 168(k)(2)(F)(i) increases only the (a)(1)(A)(i) limitation, by 8,000, for a passenger automobile that is qualified property.
  • (k)(2)(F)(iii) confines its reduced substitutes to automobiles acquired before September 28, 2017.
• Sec. 291 applies its cutbacks only in the case of a corporation.
  • (a)(1) converts 20 percent of the excess of the Sec. 1245 hypothetical over the Sec. 1250 amount into ordinary income.
  • (e)(2) takes both property definitions from Sec. 1245(a)(3) and Sec. 1250(c).
  • (c)(2) withholds the paragraph from a Sec. 169 certified pollution control facility.
  • (a)(2) cuts Sec. 613 percentage depletion on iron ore and coal by 20 percent of the deduction's excess over adjusted basis.
  • (a)(3) cuts a financial institution preference item by 20 percent.
  • (e)(1)(B) defines that item as a Sec. 585(a)(2) bank's interest on debt carrying tax-exempt obligations acquired after December 31, 1982 and before August 8, 1986.
  • (e)(1)(A) stands repealed, and (e)(1)(B)(ii) supplies the ratio default.
  • (a)(4) cuts the Sec. 169 amortizable basis of a certified pollution control facility by 20 percent, which (c)(1) then recovers under Sec. 168.
  • (b)(1) cuts 30 percent of an integrated oil company's Sec. 263(c) costs, and any corporation's Sec. 616(a) or 617(a) costs.
  • (b)(2) allows that amount ratably over 60 months from the month the costs are paid or incurred.
  • (b)(3) preserves its Sec. 1254 character, (b)(4) defines integrated oil company by reference to Sec. 613A(d)(2) and (4), and (b)(5) keeps the same basis out of Sec. 611 cost depletion.
  • Sec. 1363(b)(4) extends Sec. 291 to an S corporation only where it or a predecessor was a C corporation in any of the 3 immediately preceding taxable years.
  • Sec. 1211(a) allows a corporation's capital losses only against capital gains, which is where the character shift reaches taxable income.
  • Sec. 1212(a)(1)(A) and (B) carry the disallowed loss back 3 years and forward 5, as a short-term capital loss.
• Sec. 170 governs the charitable band.
  • (a)(1) requires payment within the year, and (a)(2) permits the accrual-basis election for a board-authorized contribution paid by the 15th day of the fourth month.
  • (b)(2)(A)(i) and (ii) create the 1 percent floor and 10 percent ceiling.
  • (b)(2)(D) computes the base without the charitable deduction, Part VIII deductions other than Sec. 248, NOL and capital loss carrybacks, and Sec. 199A(g).
  • (d)(2)(A) through (D) carry the excess forward five years FIFO, extend the carryforward to the floored amount only in a ceiling-breaching year, and trim it against an NOL carryover.
  • The individual analogue is the 0.5 percent floor at (b)(1)(I) against the contribution base defined at (b)(1)(H).
• Sec. 195(a), (b)(1) and (c)(1) and Sec. 248(a), (b) and (c) are the parallel start-up and organizational regimes.
  • The immediate allowance is 5,000 dollars, reduced but not below zero by expenditures above 50,000.
  • The remainder is amortized over 180 months from the month the business begins.
  • The Sec. 248 election is due no later than the return, including extensions.
• Sec. 243 and Sec. 246 are read together, and Sec. 246 contains no carryforward.
  • 243(a)(1) sets the 50 percent rate.
  • 243(c)(1), with the definition at 243(c)(2), sets the 65 percent rate for a 20-percent owned corporation.
  • 243(a)(3), with the definition at 243(b)(1), sets the 100 percent rate for a qualifying dividend.
  • 246(b)(1) caps the aggregate against a modified taxable income.
  • 246(b)(3) applies the cap in a 65 percent pass, then a 50 percent pass on a reduced base.
  • 246(b)(2) disapplies the cap in an NOL year.
  • 246(c)(1) denies the deduction on stock held 45 days or less in the surrounding 91-day period.
• Sec. 11(b) fixes the corporate rate at 21 percent, which is the multiplier for every deferred balance in this lesson.
• Sec. 263A for the capitalization of purchasing, handling and storage costs into inventory.
• Sec. 404(a)(5) for deducting nonqualified deferred compensation in the employee's inclusion year.

How PocketCPA uses these sources

Every lesson is written in original words and cites the paragraph each rule comes from. No standard's text is reproduced. How lessons and questions are written and checked is set out in our methodology.

See also

• Sources for every REG topic
• Free REG sample questions
• The CPA exam glossary