Taxable Income Vs. Financial Statement Income
by Mark J. O'Donnell and Jim Schmersahl
In the coming months, small business owners face a common challenge: understanding the difference between the net income reported on their financial statements and their taxable income. Let’s start by examining who sets the rules and their motivations.
GAAP: The Financial Reporting Framework
Generally Accepted Accounting Principles (GAAP) are established by the Financial Accounting Standards Board (FASB) in the United States. Their mission is to develop and improve standards for financial accounting and reporting.
Motivation Behind GAAP
The FASB’s primary goal is to ensure consistency, accuracy, and transparency in financial reporting across industries. This standardization is vital because:
1. Reliable Information: GAAP provides investors, lenders, and other stakeholders with trustworthy financial information for decision-making.
2. Facilitating Comparisons: GAAP simplifies comparing financial performance across companies, aiding investors and lenders in making informed choices.
3. Promoting Confidence: Adhering to GAAP builds trust and confidence in the financial markets.
For small businesses, following GAAP enhances their credibility with investors, lenders, and partners by presenting a clear and accurate picture of their financial health.
Tax: The Internal Revenue Code
Tax rules are determined by the United States Congress and codified in the Internal Revenue Code (IRC). The Internal Revenue Service (IRS) interprets and enforces these rules.
Motivation Behind Tax Rules
Tax rules have several key purposes:
1. Funding Government: The primary function is to generate revenue to fund government operations and public services.
2. Social and Economic Policy: Tax rules are used to implement social and economic policies. For example, tax credits for research and development incentivize innovation, while deductions for charitable donations encourage giving.
3. Fairness: Tax rules aim to ensure a fair distribution of the tax burden.
Impact on Small Businesses: Permanent and Timing
Differences
Differences between GAAP and tax rules can significantly impact small businesses, resulting in permanent and timing differences. With planning you may be able to reduce your taxable income (saving tax dollars) and still present an appropriate higher financial statement income.
Permanent Differences
Permanent differences affect your financial statements or your tax return, but not both, and are never reversed. Examples include:
1. Meals and entertainment expenses: An expense for financial reporting, but only 50% deductible for tax purposes, or no deduction, depending on the expense.
2. Fines and penalties: Expensed in financial statements but not deductible for taxes.
Timing Differences (Temporary Differences)
Timing differences occur when revenues or expenses are recognized in different periods for financial reporting and tax purposes. These differences eventually reverse over time. Examples include:
1. Depreciation: GAAP might use straight-line depreciation, while tax rules allow for accelerated methods.
2. Rent income received in advance: Taxable when received but recognized as revenue in financial statements when earned.
As a real-world example, you can buy equipment, for say $200,000, depreciate it for your financials at $20,000 per year, and still write off the whole amount as a tax deduction in the year of purchase. Of course this means no tax depreciation for this equipment in 2026 but the focus is to save tax dollars NOW while still keeping an accurate, higher GAAP basis profit.
Conclusion
While complying with both GAAP and tax rules may seem daunting, it’s essential for financial transparency and meeting legal obligations. With planning you can often reduce your company’s taxable income while still having a robust bottom line. Consulting with a qualified accountant or tax professional can provide valuable guidance in navigating these complexities.
Mark O’Donnell, CPA, is Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727. Jim Schmersahl, CPA, is a Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727.