The Income Statement — The Tax Basis

by Mark J. O'Donnell

We are taking an intermission from our explanation of the financials. Why? Because It’s tax season! Soon you will be receiving your business tax returns from your accountant. Your business’s taxable income will likely differ from your financial statement’s GAAP (generally accepted accounting principles) income. Many small business owners are understandably confused by the difference and too often surprised by a larger-than-expected tax bill.

GAAP and tax accounting are similar but are not the same. The root of the difference is that they have different purposes. The internal revenue code has very different objectives than GAAP. As we have already covered, GAAP attempts to measure the income earned in each period. It is a comprehensive method of accounting developed over many years by brilliant accounting professionals. The internal revenue code is a set of rules developed by congress (definitely not accountants) to raise revenue under the heavy influence of politics, social policy, and economic policy. Accordingly, the two approaches to measuring ‘income’ can differ significantly.

The differences between GAAP and tax accounting vary widely by company size and industry. There are too many items to cover here. However, you can classify most differences as either ‘permanent’ or ‘timing.’

A timing difference recognizes tax income or expense sooner or later than GAAP. A good example is the depreciation of equipment. Certain provisions in the internal revenue code allow you to expense the equipment when you purchase it. GAAP spreads the expense over several years. Compared to GAAP, the tax expense is greater in the first year and less in the following years. However, at the end of the life of the property, when it’s fully depreciated, both methods have expensed the cost of the equipment. In any one of the years, the comparative expense will be different, but in the end, it’s the same. The difference is timing. Sooner is almost always better for a tax deduction than later.

A permanent difference is typically an expense that is either partially or entirely disallowed for tax purposes. As an example, tickets for an event are not deductible, ever. The difference between GAAP and tax income is permanent.
To understand how this applies to your company, ask your tax accountant to prepare and explain a reconciliation of GAAP income before tax to taxable income. Ask them to label the timing and permanent differences.

If you are an accrual basis taxpayer, it might look like this
GAAP income before tax 100,000
Depreciation (timing) (25,000)
Life insurance on shareholder (permanent) 5,000
Blues season tickets (permanent) 5,500
Taxable income 85,500

This exercise is interesting for last year but also very useful for tax planning purposes. In the fall of 2023, request a draft of the same schedule as of October 31 or November 30. Knowing the impact of the timing and permanent differences before year-end will allow you to take action to manage (reduce) your 2023 income tax.

Mark O’Donnell, CPA, is Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727.