From book income to taxable income
The Schedule M-1 (or M-3 for larger corporations) reconciles book income to taxable income:
Book income + federal income tax expense + excess capital losses + income subject to tax not on the books + expenses recorded on the books not deducted for tax − income on the books not subject to tax − deductions on the return not charged against book income = taxable income
| Permanent differences | Temporary differences |
|---|---|
| Municipal bond interest | Depreciation (MACRS/bonus vs. book) |
| Federal income tax expense | Bad debts (allowance vs. direct write-off) |
| Key-person life insurance premiums and proceeds | Warranty and other accrued liabilities |
| Fines and penalties | Unearned revenue timing |
| 50% of business meals | Charitable contribution carryforwards |
IMPORTANT — the reason it matters: Only temporary differences create deferred tax assets and liabilities. Permanent differences never reverse and therefore affect the effective tax rate instead. This links directly to FAR's deferred tax topic.
Net operating losses
Post-2017 NOLs are carried forward indefinitely with no carryback (limited exceptions), and the deduction is limited to 80% of taxable income computed before the NOL deduction.
EXAMPLE: A corporation has a $500,000 NOL carryforward and current-year taxable income (before the NOL) of $400,000. The deduction is limited to 80% × $400,000 = $320,000, leaving $80,000 of taxable income and a $180,000 NOL carried forward.
Other key limitations
- Charitable contributions — 10% of taxable income (before the charitable deduction, DRD, and certain carrybacks), 5-year carryforward
- Capital losses — offset capital gains only; carry back 3 years, forward 5
- Business interest (§163(j)) — generally limited to 30% of adjusted taxable income, with disallowed amounts carried forward; small business exception applies
- Accumulated earnings tax and personal holding company tax — penalty regimes discouraging the use of a corporation to shelter income from shareholder-level tax
EXAM TIP: Estimated tax payments for corporations are generally due quarterly; large corporations (generally $1 million or more of taxable income in a prior year) may not rely on the prior-year safe harbor except for the first installment.