Net Income (Loss) Reconciliation for S Corporations With Total Assets of $10 Million or More

2012

Instructions for
Schedule M-3 (Form 1120S)

Department of the Treasury
Internal Revenue Service

Net Income (Loss) Reconciliation for S Corporations With Total Assets of
$10 Million or More
Section references are to the Internal Revenue
Code unless otherwise noted.

General Instructions
Future Developments

For the latest information about
developments related to Schedule M-3
(Form 1120S) and its instructions, such
as legislation enacted after they were
published, go to
www.irs.gov/form1120s.

Purpose of Schedule

Schedule M-3, Part I, asks certain
questions about the corporation's
financial statements and reconciles
financial statement worldwide net
income (loss) for the corporation (or
consolidated financial statement group,
if applicable), as reported on Part I,
line 4a, to income (loss) per the income
statement of the corporation for U.S.
income tax purposes, as reported on
Part I, line 11.
Schedule M-3 Parts II and III
reconcile financial statement net income
(loss) for the U.S. tax return (per
Schedule M-3, Part I, line 11) to total
income (loss) on Form 1120S,
Schedule K, line 18.

Where To File

If the corporation is required to file (or
voluntarily files) Schedule M-3 (Form
1120S), the corporation must file Form
1120S and all attachments, schedules,
including Schedule M-3 (Form 1120S),
and statements at the following
address.
Department of the Treasury
Internal Revenue Service Center
Ogden, UT 84201-0013

Who Must File

Any corporation required to file Form
1120S, U.S. Income Tax Return for an S
Corporation, that reports on Schedule L
of Form 1120S total assets at the end of
the corporation's tax year that equal or
exceed $10 million must complete and
file Schedule M-3 instead of
Schedule M-1, Reconciliation of Income
Oct 01, 2012

(Loss) per Books With Income (Loss)
per Return. A U.S. corporation filing
Form 1120S that is not required to file
Schedule M-3 may voluntarily file
Schedule M-3 instead of Schedule M-1.
A corporation filing Schedule M-3 must
check the box on Form 1120S, item C,
indicating that Schedule M-3 is attached
(whether required or voluntary). A
corporation filing Schedule M-3 must
not file Schedule M-1.
Example 1.
1. U.S. corporation A owns U.S.
subsidiary B and foreign subsidiary F.
For its 2012 tax year, A prepares
consolidated financial statements with B
and F that report total assets of $12
million. A files a U.S. income tax return
with B (a corporation that has made a
qualified subchapter S subsidiary
election) and reports total assets on
Schedule L of $8 million. A's U.S. tax
group is not required to file
Schedule M-3 for the 2012 tax year.
2. U.S. corporation C owns U.S.
subsidiary D. For its 2012 tax year, C
prepares consolidated financial
statements with D, but C and D file
separate U.S. income tax returns. The
consolidated accrual basis financial
statements for C and D report total
assets at the end of the tax year of $12
million after intercompany eliminations.
C reports separate company total
year-end assets on its Schedule L of $7
million. D reports separate company
total year-end assets on its Schedule L
of $6 million. Neither C nor D is required
to file Schedule M-3 for the 2012 tax
year.

Other Issues Affecting
Schedule M-3 Filing
Requirements

If a corporation was required to file
Schedule M-3 for the preceding tax
year, but reports on Schedule L of Form
1120S total assets at the end of the
current tax year of less than $10 million,
the corporation is not required to file
Schedule M-3 for the current tax year.
The corporation may either (a) file
Schedule M-3, or (b) file Schedule M-1,
for the current tax year. However, if the
Cat. No. 48245B

corporation chooses to file
Schedule M-1 for the current tax year,
and for a subsequent tax year the
corporation is required to file
Schedule M-3, the corporation must
complete Schedule M-3 in its entirety
(Part I and all columns in Parts II and III)
for that subsequent tax year.
For purposes of determining whether
the corporation has total assets at the
end of the current tax year of $10 million
or more, the corporation's total assets
must be determined on an overall
accrual method of accounting unless
both of the following apply: (a) the tax
return of the corporation is prepared
using an overall cash method of
accounting, and (b) no includible entity
in the U.S. tax return prepares or is
included in financial statements
prepared on an accrual basis.
Note. See the instructions for Part I,
line 1, for a discussion of non-tax-basis
income statements and related
non-tax-basis balance sheets to be
used in the preparation of Schedule M-3
and of Form 1120S, Schedule L.

Schedule L

If a non-tax-basis income statement and
related non-tax-basis balance sheet is
prepared for any purpose for a period
ending with or within the tax year,
Schedule L must be prepared showing
non-tax-basis amounts. See the
instructions for Part I, line 1, for a
discussion of non-tax-basis income
statements and related non-tax-basis
balance sheets prepared for any
purpose and the impact on the selection
of the income statement used for
Schedule M-3 and the related
non-tax-basis balance sheet amounts
that must be used for Schedule L.
Total assets shown on Schedule L,
line 15, column (d), must equal the total
assets of the corporation as of the last
day of the tax year, and must be the
same total assets reported by the
corporation in the non-tax-basis
financial statements, if any, used for
Schedule M-3. If the corporation does
not prepare non-tax-basis financial
statements, Schedule L must be based

on the corporation's books and records.
The Schedule L balance sheet can
show tax-basis balance sheet amounts
if the corporation is allowed to use
books and records for Schedule M-3
and the corporation's books and records
reflect only tax-basis amounts.
Generally, total assets at the
beginning of the year (Schedule L,
line 15, column (b)) must equal total
assets at the close of the prior year
(Schedule L, line 15, column (d)). For
each Schedule L balance sheet item
reported for which there is a difference
between the current opening balance
sheet amount and the prior closing
balance sheet amount, attach a
statement that reports the balance sheet
item, the prior closing amount, the
current opening amount, and a short
explanation of the difference. In
particular, indicate if the differences
occurred because of acquisitions or
mergers.
For purposes of measuring total
assets at the end of the year, the
corporation's assets may not be netted
or reduced by the corporation's
liabilities. In addition, total assets may
not be reported as a negative amount. If
Schedule L is prepared on a
non-tax-basis method, an investment in
a partnership may be shown as
appropriate under the corporation's
non-tax-basis method of accounting,
including, if required by the
corporation's reporting methodology,
the equity method of accounting for
investments. If Schedule L is prepared
on a tax-basis method, an investment
by the corporation in a partnership must
be shown as an asset and measured by
the corporation's adjusted basis in its
partnership interest. Any liabilities
contributing to such adjusted basis must
be shown on Schedule L as corporate
liabilities. In any event, any investments
or other assets reported on Schedule L
can never be reported as negative
amounts.

Entity Considerations for
Schedule M-3

For purposes of Schedule M-3,
references to the classification of an
entity (for example, as a corporation, a
partnership, or a trust) are references to
the treatment of the entity for U.S.
income tax purposes. An entity that
generally is disregarded as separate
from its owner for U.S. income tax
purposes (disregarded entity) must not
be separately reported on Schedule M-3
except, if required, on Part I, line 7a, 7b,
or 7c. On Schedule M-3, Parts II and III,
any item of income, gain, loss,

deduction, or credit of a disregarded
entity must be reported as an item of its
owner. In particular, the income or loss
of a disregarded entity must not be
reported on Part II, lines 7, 8, or 9 as
from a separate partnership or other
pass-through. The financial statement
income or loss of a disregarded entity
other than a qualified subchapter S
subsidiary (QSub) is included on Part I,
line 7b, if and only if its financial
statement income or loss is included on
Part I, line 11, but not on Part I, line 4a.
The financial statement income or loss
of a QSub is included on Part I, line 7c, if
and only if its financial statement
income or loss is included on Part I,
line 11, but not on Part I, line 4a.
Qualified Subchapter S Subsidiaries
(QSubs). Because a QSub is a
disregarded entity, for purposes of
Schedule M-3, Schedule L, and the tax
return in general, the subsidiary is
deemed to have liquidated into the
parent S corporation. As such, all
QSubs are treated as divisions of the S
corporation parent and they must not be
separately reported on Schedule M-3
except, if required, on Part I, line 7c.

Reportable Entity Partner
Reporting Responsibilities

A reportable entity partner with respect
to a partnership filing Form 1065, U.S.
Return of Partnership Income, is an
entity that (1) owns or is deemed under
these instructions to own, directly or
indirectly, a 50 percent or greater
interest in the income, loss, or capital of
the partnership on any day of the tax
year and (2) was required to complete
Schedule M-3 on its most recently filed
U.S. income tax return or return of
income filed prior to that day.
For the purposes of these
instructions:
1. The parent corporation of a
consolidated tax group is deemed to
own all corporate and partnership
interests owned or deemed to be owned
under these instructions by any member
of the tax consolidated group;
2. The owner of a disregarded entity
is deemed to own all corporate and
partnership interests owned or deemed
to be owned under these instructions by
the disregarded entity;
3. The owner of 50 percent or more
of a corporation by vote on any day of
the corporation tax year is deemed to
own all corporate and partnership
interests owned or deemed to be owned
under these instructions by the
corporation during the corporation tax
year;
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4. The owner of 50 percent or more
of partnership income, loss, or capital
on any day of the partnership tax year is
deemed to own all corporate and
partnership interests owned or deemed
to be owned under these instructions by
the partnership during the partnership
tax year; and
5. The beneficial owner of 50
percent or more of the beneficial interest
of a trust or nominee arrangement on
any day of the trust or nominee
arrangement tax year is deemed to own
all corporate and partnership interests
owned or deemed to be owned under
these instructions by the trust or
nominee arrangement.
A reportable entity partner with
respect to a partnership (as defined
above) must report the following to the
partnership within 30 days of first
becoming a reportable entity partner
and, after first reporting to the
partnership under these instructions,
thereafter within 30 days of the date of
any change in the interest it owns or is
deemed to own, directly or indirectly,
under these instructions, in the
partnership.
1. Name.
2. Mailing address.
3. Taxpayer identification number
(TIN or EIN), if applicable.
4. Entity or organization type.
5. State or country in which it is
organized.
6. Date on which it first became a
reportable entity partner.
7. Date with respect to which it is
reporting a change in its ownership
interest in the partnership, if applicable.
8. The interest in the partnership it
owns or is deemed to own in the
partnership, directly or indirectly (as
defined under these instructions) as of
the date with respect to which it is
reporting.
9. Any change in that interest as of
the date with respect to which it is
reporting.
The reportable entity partner must
retain copies of required reports it
makes to partnerships under these
instructions. Each partnership must
retain copies of the required reports it
receives under these instructions from
reportable entity partners.
Example 2. A, a limited liability
company (LLC) filing a Form 1065 for
2012, is owned 50 percent by U.S.
corporation Z which files Form 1120S. A
owns 50 percent of each of B, C, D, and
E, each also an LLC filing a Form 1065

Instructions for Schedule M-3 (Form 1120S)

for calendar year 2012. Z was first
required to complete Schedule M-3
(Form 1120S) for its corporate tax year
ended December 31, 2011, and filed its
Form 1120S with Schedule M-3 for
2011 on September 15, 2012. As of
September 16, 2012, Z was a reportable
entity partner with respect to A and,
through A, with respect to B, C, D, and
E. On October 5, 2012, Z reports to A,
B, C, D, and E, as it is required to do
within 30 days of September 16, that Z
is a reportable entity partner directly
owning (with respect to A) or deemed to
own indirectly (with respect to B, C, D,
and E) a 50 percent interest. Therefore,
because Z was a reportable entity
partner for 2012, each of A, B, C, D, and
E is required to complete Schedule M-3
(Form 1065) for 2012, regardless of
whether they would otherwise be
required to complete Schedule M-3 for
that year.

Non-Tax-Basis Financial
Statements and Tax-Basis
Financial Statements

Completion of
Schedule M-3

If a non-tax-basis income statement
is prepared that is a certified
non-tax-basis income statement for the
period ending with or within the tax year,
the corporation must check “Yes” for
Part I, line 1a, and use that income
statement for Schedule M-3. If no
certified non-tax-basis income
statement is prepared but an unaudited
non-tax-basis income statement is
prepared for the period ending with or
within the tax year, the corporation must
check “Yes” for Part I, line 1b, and use
that income statement for
Schedule M-3.

A corporation required to file
Schedule M-3 must complete the form
in its entirety. At the time the Form
1120S is filed, all applicable questions
must be answered on Part I, all columns
must be completed on Parts II and III,
and all numerical data required by
Schedule M-3 must be provided. Any
statement required to support a line item
on Schedule M-3 must be attached at
the time Schedule M-3 is filed and must
provide the information required for that
line item.

Specific Instructions
for Part I
Part I. Financial
Information and Net
Income (Loss)
Reconciliation
When To Complete Part I

Part I must be completed for any tax
year for which the corporation files
Schedule M-3.

Line 1. Questions Regarding
the Type of Income Statement
Prepared
For Part I, lines 1 through 12, use only
the financial statements of the U.S.
corporation filing the U.S. income tax
return.

A tax-basis income statement is allowed
for Schedule M-3 and a tax-basis
balance sheet for Schedule L only if no
non-tax-basis income statement and no
non-tax-basis balance sheet was
prepared for any purpose and the books
and records of the corporation reflect
only tax-basis amounts. The corporation
is deemed to have non-tax-basis
income statements and the related
non-tax-basis balance sheets for the
current tax year for purposes of
Schedule M-3 and Schedule L if such
non-tax-basis financial statements were
prepared for and presented to
management, creditors, shareholders,
government regulators, or any other
third parties for a period ending with or
within the tax year.

Order of priority in accounting
standards. If two or more
non-tax-basis income statements are
both certified non-tax-basis income
statements for the period, the income
statement prepared according to the
following order of priority in accounting
standards shall be used.
1. U.S. Generally Accepted
Accounting Principles (GAAP).
2. International Financial Reporting
Standards (IFRS).
3. Any other International
Accounting Standards (IAS).
4. Other regulatory accrual
accounting.
5. Any other accrual accounting
standard.
6. Any fair market value standard.
7. Any cash basis standard.
If no non-tax-basis income statement
is certified and two or more
non-tax-basis income statements are
prepared, the income statement
prepared according to the first listed of

Instructions for Schedule M-3 (Form 1120S)

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the accounting standards listed above
shall be used.
If no non-tax-basis financial
statements are prepared for a U.S.
corporation filing Schedule M-3 (Form
1120S), the U.S. corporation must
check “No” on questions 1a and 1b, skip
Part I, lines 2, 3a, and 3b, and enter the
net income (loss) per the books and
records of the U.S. corporation on Part I,
line 4a.

Lines 2 and 3. Questions
Regarding Income Statement
Period and Restatements

Enter the beginning and ending dates
on line 2 for the corporation's annual
income statement period ending with or
within the current tax year.
The questions on Part I, lines 3a and
3b, regarding income statement
restatements refer to the worldwide
consolidated income statement issued
by the corporation filing the U.S. income
tax return and used to prepare
Schedule M-3. Answer “Yes” on lines 3a
and/or 3b if the corporation's annual
income statement has been restated for
any reason. Attach a short explanation
of the reasons for the restatement in net
income for each annual income
statement period that is restated,
including the original amount and
restated amount of each annual
statement period's net income.

Line 4. Worldwide Consolidated
Net Income (Loss) per Income
Statement
Report on Part I, line 4a, the worldwide
consolidated net income (loss) per the
income statement (or books and
records, if applicable) of the
corporation.

In completing Schedule M-3, the
corporation must use financial
statement amounts from the financial
statement type checked “Yes” on Part I,
line 1, or from its books and records if
Part I, line 1b, is checked “No.”
If a corporation prepares
non-tax-basis financial statements, the
amount on line 4a must equal the
financial statement net income (loss) for
the income statement period ending
with or within the tax year as indicated
on Part I, line 2.
If the corporation prepares
non-tax-basis financial statements and
the income statement period differs
from the corporation's tax year, the
income statement period indicated on
Part I, line 2, applies for purposes of
Part I, lines 4 through 8.

If the corporation does not prepare
non-tax-basis financial statements and
has checked “No” on Part I, line 1b,
enter the net income (loss) per the
books and records of the U.S.
corporation on Part I, line 4a.
Indicate on Part I, line 4b, which of
the following accounting standards were
used for line 4a.
1. U.S. Generally Accepted
Accounting Principles (GAAP).
2. International Financial Reporting
Standards (IFRS).
3. Tax basis.
4. Other (Specify).
Report on Part I, lines 5a through 10,
as instructed below, all adjustment
amounts required to adjust worldwide
net income (loss) reported on this Part I,
line 4a (whether from financial
statements or books and records), to
net income (loss) of the corporation that
must be reported on Part I, line 11.
Report on line 12a the worldwide
consolidated total assets and total
liabilities amounts for the corporation
using the same financial statements (or
book and records) used for the
worldwide consolidated income (loss)
amount reported on line 4a.

Line 5. Net Income (Loss) of
Nonincludible Foreign Entities

relating to nonincludible foreign entities
whose income (loss) is reported on the
attached statement that are not
reportable on Part I, line 8, the net
amounts of all such consolidation and
elimination entries must be reported on
a separate line on the attached
statement, so that the separate financial
accounting income (loss) of each
nonincludible foreign entity remains
separately stated.
For example, if the net income (after
consolidation and elimination entries) of
a nonincludible foreign
sub-consolidated group is being
reported on line 5a, the attached
supporting statement should report the
income (loss) of each separate
nonincludible foreign legal entity from
each such entity's own financial
accounting net income statement or
books and records, and any
consolidation or elimination entries (for
intercompany dividends, minority
interests, etc.) not reportable on Part I,
line 8, should be reported on the
attached supporting statement as a net
amount on a line separate and apart
from lines that report each nonincludible
foreign entity's separate net income
(loss).

Line 6. Net Income (Loss) of
Nonincludible U.S. Entities

Remove the financial net income
(line 5a) or loss (line 5b) of each foreign
entity that is included on line 4a and is
not an includible entity in the U.S. tax
return (nonincludible foreign entity). In
addition, on Part I, line 8, adjust for
consolidation eliminations and correct
for minority interest and intercompany
dividends between any nonincludible
foreign entity and the entity filing Form
1120S. Do not remove in Part I the
financial net income (loss) of any
nonincludible foreign entity accounted
for on line 4a using the equity method.

Remove the financial net income
(line 6a) or loss (line 6b) of each U.S.
entity that is included on line 4a and is
not an includible entity in the U.S. tax
return (nonincludible U.S. entity). In
addition, on Part I, line 8, adjust for
consolidation eliminations and correct
for minority interest and intercompany
dividends between any nonincludible
U.S. entity and any includible entity. Do
not remove in Part I the financial net
income (loss) of any nonincludible U.S.
entity accounted for on line 4a using the
equity method.

Attach a supporting statement that
provides the name, EIN (if applicable),
and net income (loss) included on
line 4a that is removed on this line 5 for
each separate nonincludible foreign
entity. Also state the total assets and
total liabilities for each such separate
nonincludible foreign entity and include
those assets and liabilities amounts in
the total assets and total liabilities
reported on Part I, line 12b. The
amounts of income (loss) detailed on
the supporting statement should be
reported for each separate
nonincludible foreign entity without
regard to the effect of consolidation or
elimination entries. If there are
consolidation or elimination entries

Attach a supporting statement that
provides the name, EIN, and net income
(loss) included on line 4a that is
removed on this line 6 for each separate
nonincludible U.S. entity. Also state the
total assets and total liabilities for each
such separate nonincludible U.S. entity
and include those assets and liabilities
amounts in the total assets and total
liabilities reported on Part I, line 12c.
The amounts of income (loss) detailed
on the supporting statement should be
reported for each separate
nonincludible U.S. entity without regard
to the effect of consolidation or
elimination entries. If there are
consolidation or elimination entries
relating to nonincludible U.S. entities
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whose income (loss) is reported on the
attached statement that are not
reportable on Part I, line 8, the net
amounts of all such consolidation and
elimination entries must be reported on
a separate line on the attached
statement, so that the separate financial
accounting income (loss) of each
nonincludible U.S. entity remains
separately stated. For example, if the
net income (after consolidation and
elimination entries) of a nonincludible
U.S. sub-consolidated group is being
reported on line 6a, the attached
supporting statement should report the
income (loss) of each separate
nonincludible U.S. legal entity from each
such entity's own financial accounting
net income statement or books and
records, and any consolidation or
elimination entries (for intercompany
dividends, minority interests, etc.) not
reportable on Part I, line 8, should be
reported on the attached supporting
statement as a net amount on a line
separate and apart from lines that report
each nonincludible U.S. entity's
separate net income (loss).

Lines 7a, 7b, and 7c. Net
Income (Loss) of other Foreign
Disregarded Entities, Net
Income (Loss) of Other
Disregarded Entities (Except
Qualified Subchapter S
Subsidiaries), and Net Income
(Loss) of Other Qualified
Subchapter S Subsidiaries
(QSubs)

Include on line 7a the financial income
of any foreign disregarded entity that is
not included on Part I, line 4a, but is
included in Part I, line 11 (other foreign
disregarded entities). Include on line 7b
or 7c the financial net income or (loss)
of each disregarded entity in the U.S.
tax return that is not included in the
consolidated financial group and
therefore not included in the income
reported on Part I, line 4a. Include on
line 7b the financial income of any U.S.
disregarded entity that is not a qualified
subchapter S subsidiary (QSub) or a
foreign disregarded entity and that is not
included in the income reported on Part
I, line 4a, but is included in Part I, line 11
(other disregarded entities). Include on
line 7c the financial income of any QSub
that is not included in the income
reported on line 4a, but is included on
line 11 (other QSub). In addition, on Part
I, line 8, adjust for consolidation
eliminations and correct for minority
interest and intercompany dividends for

Instructions for Schedule M-3 (Form 1120S)

any other disregarded entity or other
QSub.
Attach a supporting statement that
provides the name, EIN, and net income
(loss) per the financial statement or
books and records on this line 7 for
each separate other disregarded entity
or other QSub. Also state the total
assets and total liabilities for each such
separate included entity and include
those assets and liabilities amounts in
the total assets and total liabilities
reported on Part I, line 12d. The
amounts of income (loss) detailed on
the supporting statement should be
reported for each separate other
disregarded entity or other QSub
without regard to the effect of
consolidation or elimination entries
solely between or among the entities
listed. If there are consolidation or
elimination entries relating to such other
disregarded entities or other QSub
whose income (loss) is reported on the
attached statement that are not
reportable on Part I, line 8, the net
amounts of all such consolidation and
elimination entries must be reported on
a separate line on the attached
statement, so that the separate financial
accounting income (loss) of each other
disregarded entity or other QSub
remains separately stated. For example,
if the net income (after consolidation
and elimination entries) of a
sub-consolidated group of other
disregarded entities is being reported
on line 7b, the attached supporting
statement should report the income
(loss) of each separate other
disregarded entity from each entity's
own financial accounting net income
statement or books and records, and
any consolidation or elimination entries
(for intercompany dividends, minority
interests, etc.) not reportable on Part I,
line 8, should be reported on the
attached supporting statement as a net
amount on a line separate and apart
from lines that report each other
disregarded entity's separate net
income (loss).

Line 8. Adjustment to
Eliminations of Transactions
Between Includible Entities and
Nonincludible Entities

Adjustments on Part I, line 8, to reverse
certain financial accounting
consolidation or elimination entries are
necessary to ensure that transactions
between includible entities and
nonincludible U.S. or foreign entities are
not eliminated, in order to report the
correct total amount on Part I, line 11.
Also, additional consolidation entries

and elimination entries may be
necessary on Part I, line 8, related to
transactions between includible entities
that are in the consolidated financial
group and other disregarded entities
and QSubs that are not in the
consolidated financial group but that are
reported on Part I, line 7a, 7b, or 7c, in
order to report the correct total amount
on Part I, line 11.
Include on Part I, line 8, the total of
the following: (a) amounts of any
adjustments to consolidation entries
and elimination entries that are
contained in the amount reported on
Part I, line 4a, required as a result of
removing amounts on Part I, line 5 or 6;
and (b) amounts of any additional
consolidation entries and elimination
entries that are required as a result of
including amounts on Part I, line 7a, 7b,
or 7c. This is necessary in order that the
consolidation entries and intercompany
elimination entries included in the
amount reported on Part I, line 11, are
only those applicable to the financial net
income (loss) of includible entities for
the financial statement period. For
example, adjustments must be reported
on line 8 to remove minority interest and
to reverse the elimination of
intercompany dividends included on
Part I, line 4a, that relate to the net
income of entities removed on Part I,
line 5 or 6, because the income to which
the consolidation or elimination entries
relate has been removed. Also, for
example, consolidation or elimination
entries must be reported on line 8 to
eliminate any intercompany dividends
between entities whose income is
included on Part I, line 7a, 7b, or 7c, and
other entities included in the U.S.
income tax return. See Example 3A, 3B,
and 4 in the instructions for line 11.
If a corporate owner of an interest in
another entity: (a) accounts for the
interest in entity in the owner
corporation's separate general ledger
on the equity method, and (b) fully
consolidates entity in the owner
corporation's consolidated financial
statements, but entity is not includible in
the owner corporation's U.S. income tax
return, then, as part of reversing all
consolidation and elimination entries for
the nonincludible entity, the corporate
owner must reverse on Schedule M-3,
Part I, line 8, the elimination of the equity
income inclusion from entity. If the
owner corporation does not account for
entity on the equity method on its own
general ledger, it will not have
eliminated the equity income for
consolidated financial statement

Instructions for Schedule M-3 (Form 1120S)

-5-

purposes, and therefore will have no
elimination of equity income to reverse.
The attached supporting statement
for Part I, line 8, must identify the type
(for example, minority interest,
intercompany dividends, etc.) and
amount of consolidation or elimination
entries reported, as well as the names
of the entities to which they pertain. It is
not necessary, but it is permitted, to
report intercompany eliminations that
net to zero on Part I, line 8, such as
intercompany interest income and
expense.

Line 9. Adjustment To
Reconcile Income Statement
Period to Tax Year

Include on line 9 any adjustments
necessary to the income (loss) of
includible entities to reconcile
differences between the corporation's
income statement period reported on
line 2 and the corporation's tax year.
Attach a statement describing the
adjustment.

Line 10. Other Adjustments To
Reconcile to Amount on Line 11

Include on line 10 any other
adjustments to reconcile net income
(loss) on Part I, line 4a, through Part I,
line 9, with net income (loss) on Part I,
line 11.

For any adjustments reported on Part
I, line 10, attach a supporting statement
with an explanation of each net
adjustment included on line 10.

Line 11. Net Income (Loss) per
Income Statement of the
Corporation

Report on line 11 the net income (loss)
per the income statement (or books and
records, if applicable) of the
corporation. Amounts reported in
column (a) of Parts II and III (see
instructions below) must be reported on
the same accounting method used to
report the amount of net income (loss)
per income statement of the corporation
on Part I, line 11.
Do not, in any event, report on this
line 11 the net income of entities not
included in the U.S. income tax return
for the tax year. For example, it is not
permissible to remove the income of
nonincludible entities on lines 5 and/or
6, above, then to add back such income
on lines 7 through 10, such that the
amount reported at line 11 includes the
net income of entities not includible in
the U.S. income tax return. A principal
purpose of Schedule M-3 is to report on
this Part I, line 11, only the financial

accounting net income of only the
entities included in the U.S. income tax
return.
Whether or not the corporation
prepares financial statements, Part I,
line 11, must include all items that
impact the net income (loss) of the
corporation even if they are not
recorded in the profit and loss accounts
in the corporation's general ledger,
including, for example, all post-closing
adjusting entries (including workpaper
adjustments) and dividend income or
other income received from
nonincludible entities. If the corporation
prepares unconsolidated financial
statements using the same accounting
method used to determine worldwide
consolidated net income (loss) for Part I,
line 4a, and if it uses the equity method
for investments, the amount reported on
Part I, line 11, will equal the amount of
the unconsolidated net income (loss)
reported on the unconsolidated financial
statements. See Example 3B.3 and
3B.4.
Example 3A. U.S. corporation P
files a Form 1120S U.S. tax return and
prepares certified audited income
statements for GAAP. P owns 100% of
the stock of U.S. corporations DS1
through DS75, between 51% and 99%
of the stock of U.S. corporations DS76
through DS100, and 100% of the stock
of foreign entities FS1 through FS50. P
eliminates all dividend income from DS1
through DS100 and FS1 through FS50
in financial statement consolidation
entries. Furthermore, P eliminates the
minority interest ownership, if any, of
DS76 through DS100 in financial
statement consolidation entries.
P must check “Yes” on Part I, line 1a.
On Part I, line 4a, P must report the
consolidated net income for the
consolidated financial statement group
of P, DS1 through DS100, and FS1
through FS50. P must remove the net
income (loss) of FS1 through FS50 on
Part I, lines 5a or 5b, as applicable, and
remove on Part I, lines 6a or 6b, as
applicable, any net income (loss) from
DS1 through DS75 where a QSub
election has not been made by P. P
must remove the net income (loss)
before minority interests of DS76
through DS100 on Part I, lines 6a or 6b,
as applicable. P must reverse on Part I,
line 8, the elimination of any
transactions between the includible
entity (P and any QSubs) and the
nonincludible entities (DS1 through
DS75 with no QSub election, DS76
through DS100 and FS1 through FS50),
including dividends received from
non-QSub DS1 through DS75, DS76

through DS100, and FS1 through FS50
and the minority interest's share of the
net income (loss) of DS76 through
DS100.
P reports on Part I, line 11, the
consolidated financial statement net
income (loss) attributable to the
corporation and QSubs. Intercompany
transactions between the corporation
and the QSubs that had been eliminated
in the net income amount on line 4a
remain eliminated in the net income
amount on line 11. Transactions
between the corporation and the
nonincludible entities that are eliminated
in the net income amount on line 4a are
included in the net income amount on
line 11 since the elimination of those
transactions were reversed on line 8.
Example 3B.
1. U.S. corporation P owns 60% of
corporation DS1 which is fully
consolidated in P's financial statements.
P does not account for DS1 in P's
separate general ledger on the equity
method. DS1 has net income of $100
(before minority interests) and pays
dividends of $50, of which P receives
$30. The dividend is eliminated in the
consolidated financial statements. In its
financial statements, P consolidates
DS1 and includes $60 of net income
($100 less the minority interest of $40)
on Part I, line 4a.
P must remove the $100 net income
of DS1 on Part I, line 6a. P must reverse
on Part I, line 8, the elimination of the
$40 minority interest net income of DS1.
In addition, P reverses its elimination of
the $30 intercompany dividend in its
financial statements on Part I, line 8.
The net result is that P includes the $30
dividend from DS1 at Part I, line 11, and
on Part II, line 6, column (a). P's taxable
dividend income from DS1 must be
reported on Part II, line 6, column (d).
2. U.S. corporation C owns 60% of
the capital and profits interests in U.S.
LLC N. C does not account for N in C's
separate general ledger on the equity
method. N has net income of $100
(before minority interests) and makes no
distributions during the tax year. C
treats N as a corporation for financial
statement purposes and as a
partnership for U.S. income tax
purposes. In its financial statements, C
consolidates N and includes $60 of net
income ($100 less the minority interest
of $40) on Part I, line 4a.
C must remove the $100 net income
of N on Part I, line 6a. C must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of N. The
result is that C includes no income for N
-6-

either on Part I, line 11, or on Part II,
line 7, column (a). C's taxable income
from N must be reported by C on Part II,
line 7, column d.
3. U.S. corporation P owns 60% of
corporation DS1, which is fully
consolidated in P's financial statements.
P accounts for DS1 in P's separate
general ledger on the equity method.
DS1 has net income of $100 (before
minority interests) and pays dividends of
$50, of which P receives $30. The
dividend reduces P's investment in DS1
for equity method reporting on P's
separate general ledger where P
includes its 60% equity share of DS1
income, which is $60. In its financial
statements, P eliminates the DS1 equity
method income of $60 and consolidates
DS1, including $60 of net income ($100
less the minority interest of $40) on Part
I, line 4a.
P must remove the $100 net income
of DS1 on Part I, line 6a. P must reverse
on Part I, line 8, the elimination of the
$40 minority interest net income of DS1
and the elimination of the $60 of DS1
equity income. The net result is that P
includes the $60 of equity method
income from DS1 at Part I, line 11, and
on Part II, line 5, column (a). P's taxable
dividend income from its investment in
DS1 must be reported on Part II, line 6,
column (d).
4. U.S. corporation C owns 60% of
the capital and profits interests in U.S.
LLC N. C accounts for N in C's separate
general ledger on the equity method. N
has net income of $100 (before minority
interests) and makes no distributions
during the tax year. C treats N as a
corporation for financial statement
purposes and as a partnership for U.S.
income tax purposes. For equity method
reporting on C's separate general
ledger, C includes its 60% equity share
of N income, which is $60. In its
financial statements, C eliminates the
$60 of N net income ($100 less the
minority interest of $40) on Part I,
line 4a.
C must remove the $100 net income
of N on Part I, line 6a. C must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of N and the
elimination of the $60 of N equity
method income. The result is that C
includes the $60 of equity method
income for N on Part I, line 11, and on
Part II, line 7, column (a). C's taxable
income from N must be reported by C
on Part II, line 7, column (d).
Example 4. U.S. corporation P
owns 100% of the stock of QSub
corporation DS1. DS1 is included in P's

Instructions for Schedule M-3 (Form 1120S)

federal income tax return, even though
DS1 is not included in P's consolidated
financial statements on either a
consolidated basis or on the equity
method. DS1 has current year net
income of $100 after taking into account
its $40 interest payment to P. P has net
income of $1,040 after recognition of the
interest income from DS1. Because
DS1 is a QSub, 100% of the net income
of both P and DS1 must be reported on
Form 1120S of P's U.S. income tax
return, and the intercompany interest
income and expense must be removed
by consolidation elimination entries.
P must report its financial statement
net income of $1,040 on Part I, line 4a,
and reports DS1's net income of $100
on Part I, line 7c. Then, in order to
reflect the full consolidation of the
financial accounting net income of P
and DS1 at Part I, line 11, the following
consolidation and elimination entries are
reported on Part I, line 8: offsetting
entries to remove the $40 of interest
income received from DS1 included by
P on line 4a, and to remove the $40 of
interest expense of DS1 included in
line 7c for a net change of zero. The
result is that Part I, line 11, reports
$1,140: $1,040 from line 4a, and $100
from line 7c. Stated another way, Part I,
line 11, includes the entire $1,000 net
income of P, measured before
recognition of the intercompany interest
income from DS1 and the consolidation
of DS1 operations, plus the entire $140
net income of DS1, measured before
interest expense to P. P's U.S. income
tax group is not required to include on
the attached supporting statement for
Part I, line 8, the offsetting adjustment to
the intercompany elimination of interest
income and interest expense (though it
is permitted to do so).

Line 12. Total Assets and
Liabilities of Entities Included
or Removed on Part I, Lines 4,
5, 6, and 7

Line 12 must be completed by all
corporations that file Schedule M-3.
Report on lines 12a, 12b, 12c, and 12d
the total amount (not just the
corporation's share) of assets and
liabilities of entities included or removed
on Part I, lines 4, 5, 6, and 7. Assets and
liabilities reported on lines 12a through
12d must be reported as positive
amounts.
On line 12a, enter the worldwide
consolidated total assets and total
liabilities of all of the entities included in
computing Part I, line 4a. On line 12b,
enter the total assets and total liabilities
of the entities removed in completing

Part I, line 5. On line 12c, enter the total
assets and total liabilities removed in
completing Part I, line 6. On line 12d,
enter total assets and total liabilities
included in completing Part I, line 7.

Note. Part II, line 26, column (d), must
equal the amount on Form 1120S,
Schedule K, line 18.

Specific Instructions for
Parts II and III

Columns (b) and (c) of Parts II and III
must be completed for any tax year for
which the corporation files
Schedule M-3.

General Format of Parts II and
III

For each line item in Parts II and III,
report in column (a) the amount of net
income (loss) included in Part I, line 11,
and report in column (d) the amount
included in total income (loss) on Form
1120S, Schedule K, line 18.
Note. A statement or explanation may
be attached to any line even if none is
required.

When To Complete Columns (a)
and (d)
A corporation is not required to
complete columns (a) and (d) of Parts II
and III for the first tax year the
corporation is required to file
Schedule M-3. However, the
corporation must complete columns (a)
and (d) for all tax years subsequent to
the first tax year the corporation is
required to file Schedule M-3.

If, for any tax year (or tax years) prior
to the first tax year a corporation is
required to file Schedule M-3, a
corporation voluntarily files
Schedule M-3 instead of Schedule M-1,
then in those voluntary filing years the
corporation is not required to complete
columns (a) and (d) of Parts II and III. In
addition, in the first tax year the
corporation is required to file
Schedule M-3, the corporation is not
required to complete columns (a) and
(d) of Parts II and III.
If a corporation chooses not to
complete columns (a) and (d) of Parts II
and III in the first tax year the
corporation is required to file
Schedule M-3 (or in any year in which
the corporation voluntarily files
Schedule M-3), then Part II, line 26, is
reconciled by the corporation in the
following manner:
1. Report the amount from Part I,
line 11, on Part II, line 26, column (a);
2. Leave blank Part II, lines 1
through 25, columns (a) and (d);
3. Leave blank Part III, columns (a)
and (d); and
4. Report on Part II, line 26, column
(d), the sum of Part II, line 26, columns
(a), (b), and (c).

Instructions for Schedule M-3 (Form 1120S)

-7-

When To Complete Columns
(b) and (c)

For any item of income, gain, loss,
expense, or deduction for which there is
a difference between columns (a) and
(d), the portion of the difference that is
temporary must be entered in column
(b) and the portion of the difference that
is permanent must be entered in column
(c).
If financial statements are prepared
by the corporation in accordance with
generally accepted accounting
principles (GAAP), differences that are
treated as temporary for GAAP must be
reported in column (b) and differences
that are permanent (that is, not
temporary for GAAP) must be reported
in column (c). Generally, pursuant to
GAAP, a temporary difference affects
(creates, increases, or decreases) a
deferred tax asset or liability.
If the corporation does not prepare
financial statements, or the financial
statements are not prepared in
accordance with GAAP, report in
column (b) any difference that the
corporation believes will reverse in a
future tax year (that is, have an opposite
effect on total income (loss) in a future
tax year (or years) due to the difference
in timing of recognition for financial
accounting and U.S. income tax
purposes) or is the reversal of such a
difference that arose in a prior tax year.
Report in column (c) any difference that
the corporation believes will not reverse
in a future tax year (and is not the
reversal of such a difference that arose
in a prior tax year).
If the corporation is unable to
determine whether a difference between
column (a) and column (d) for an item
will reverse in a future tax year or is the
reversal of a difference that arose in a
prior tax year, report the difference for
that item in column (c).
Example 5. For the 2011, 2012, and
2013 tax years, corporation A has total
assets on the last day of the tax year as
reported on Schedule L, line 15, column
(d), of $8 million, $11 million, and $12
million, respectively. A is required to file
Schedule M-3 for its 2012 and 2013 tax
years.
For A's 2012 tax year, the first tax
year that A is required to file

Schedule M-3, A is only required to
complete Part I and columns (b) and (c)
of Parts II and III.
For A's 2013 tax year, A is required
to complete Schedule M-3 in its entirety.
Example 6. Corporation B is a U.S.
corporation that files a U.S. tax return
and prepares GAAP financial
statements. In prior years, B acquired
intellectual property (IP) and goodwill.
The IP is amortizable for both U.S.
income tax and financial statement
purposes. In the current year, B's annual
amortization expense for IP is $9,000 for
U.S. income tax purposes and $6,000
for financial statement purposes. In its
financial statements, B treats the
difference in IP amortization as a
temporary difference. The goodwill is
not amortizable for U.S. income tax
purposes and is subject to impairment
for financial statement purposes. In the
current year, B records an impairment
charge on the goodwill of $5,000. In its
financial statements, B treats the
goodwill impairment as a permanent
difference. B must report the
amortization attributable to the IP on
Part III, line 21, and report $6,000 in
column (a), a temporary difference of
$3,000 in column (b), and $9,000 in
column (d). B must report the goodwill
impairment on Part III, line 19, and
report $5,000 in column (a), a
permanent difference of ($5,000) in
column (c), and $0 in column (d).

Reporting Requirements
for Parts II and III
General Reporting
Requirements

If an amount is attributable to a
reportable transaction described in
Regulations section 1.6011-4(b), the
amount must be reported in columns
(a), (b), (c), and (d), as applicable, of
Part II, line 10, regardless of whether the
amount would otherwise be reported on
Part II or Part III of Schedule M-3. Thus,
if a taxpayer is required to file Form
8886, Reportable Transaction
Disclosure Statement, the amounts
attributable to that reportable
transaction must be reported on Part II,
line 10.
A corporation is required to report in
column (a) of Parts II and III the amount
of any item specifically listed on
Schedule M-3 that is in any manner
included in the corporation's current
year financial statement net income
(loss) or in an income or expense
account maintained in the corporation's
books and records, even if there is no
difference between that amount and the

amount included in total income (loss)
unless (a) otherwise provided in these
instructions or (b) the amount is
attributable to a reportable transaction
described in Regulations section
1.6011-4(b) and is therefore reported on
Part II, line 10. For example, with the
exception of interest income reflected
on a Schedule K-1 received by a
corporation as a result of the
corporation's investment in a
partnership or other pass-through entity,
all interest income included on Part I,
line 11, whether from affiliated
companies, third parties, banks, or other
entities, whether from foreign or
domestic sources, whether taxable or
exempt from tax, and whether classified
as some other type of income for U.S.
income tax purposes (such as
dividends), must be included on Part II,
line 11, column (a). Likewise, all fines
and penalties included in Part I, line 11,
paid to a government or other authority
for the violation of any law for which
fines or penalties are assessed must be
included on Part III, line 9, column (a),
regardless of the government authority
that imposed the fines or penalties,
regardless of whether the fines or
penalties are civil or criminal, regardless
of the classification, nomenclature, or
terminology attached to the fines or
penalties by the imposing authority in its
actions or documents.
If a corporation would be required to
report in column (a) of Parts II and III the
amount of any item specifically listed on
Schedule M-3 in accordance with the
preceding paragraph, except that the
corporation has capitalized the item of
income or expense and reports the
amount in its financial statement
balance sheet or in asset and liability
accounts maintained in the
corporation's books and records, the
corporation must report the proper tax
treatment of the item in columns (b), (c),
and (d), as applicable.
Furthermore, in applying the two
preceding paragraphs, a corporation is
required to report in column (a) of Parts
II and III the amount of any item
specifically listed on Schedule M-3 that
is included in the corporation's financial
statements or exists in the corporation's
books and records, regardless of the
nomenclature associated with that item
in the financial statements or books and
records. Accurate completion of
Schedule M-3 requires reporting
amounts according to the substantive
nature of the specific line items included
in Schedule M-3 and consistent
reporting of all transactions of like
substantive nature that occurred during
-8-

the tax year. For example, all expense
amounts that are included in the
financial statements or exist in the
books and records that represent some
form of “Bad debt expense,” must be
reported on Part III, line 25, in column
(a), regardless of whether the amounts
are recorded or stated under different
nomenclature in the financial
statements or the books and records
such as: “Provision for doubtful
accounts”; “Expense for uncollectible
notes receivable”; or “Impairment of
trade accounts receivable.” Likewise, as
stated in the preceding paragraph, all
fines and penalties must be included on
Part III, line 9, column (a), regardless of
the terminology or nomenclature
attached to them by the corporation in
its books and records or financial
statements.
With limited exceptions, Part II
includes lines for specific items of
income, gain, or loss (income items).
(See Part II, lines 1 through 21.) If an
income item is described in Part II, lines
1 through 21, report the amount of the
item on the applicable line, regardless of
whether there is a difference for the
item. If there is a difference for the
income item, or only a portion of the
income item has a difference and a
portion of the item does not have a
difference, and the item is not described
in Part II, lines 1 through 21, report and
describe the entire amount of the item
on Part II, line 22.
With limited exceptions, Part III
includes lines for specific items of
expense or deduction (expense items).
(See Part III, lines 1 through 28.) If an
expense item is described on Part III,
lines 1 through 28, report the amount of
the item on the applicable line,
regardless of whether there is a
difference for the item. If there is a
difference for the expense item, or only
a portion of the expense item has a
difference and a portion of the item does
not have a difference and the item is not
described in Part III, lines 1 through 28,
report and describe the entire amount of
the item on Part III, line 31.
If there is no difference between the
financial accounting amount and the
taxable amount of an entire item of
income, loss, expense, or deduction
and the item is not described or
included in Part II, lines 1 through 21, or
Part III, lines 1 through 28, report the
entire amount of the item in columns (a)
and (d) of Part II, line 25.
Separately stated and adequately
disclosed. Each difference reported in
Parts II and III must be separately stated

Instructions for Schedule M-3 (Form 1120S)

and adequately disclosed. In general, a
difference is adequately disclosed if the
difference is labeled in a manner that
clearly identifies the item or transaction
from which the difference arises. For
further guidance about adequate
disclosure, see Regulations section
1.6662-4(f). If a specific item of income,
gain, loss, expense, or deduction is
described on Part II, lines 7 through 21,
or Part III, lines 1 through 28, and the
line does not indicate to “attach
statement,” and the specific instructions
for the line do not call for an attachment
of a statement, then the item is
considered separately stated and
adequately disclosed if the item is
reported on the applicable line and the
amount(s) of the item(s) are reported in
the applicable columns of the applicable
line. See the instructions for Part II, lines
1 through 6, for specific additional
information required to be provided for
these particular lines.
Note. A statement or explanation may
be attached to any line even if none is
required.
Except as otherwise provided,
differences for the same item must be
combined or netted together and
reported as one amount on the
applicable line of Schedule M-3.
However, differences for separate items
must not be combined or netted
together. Each item (and corresponding
amount attributable to that item) must
be separately stated and adequately
disclosed on the applicable line of
Schedule M-3, or any statement
required to be attached, even if the
amounts are below a certain dollar
amount.
Required statements for Part II,
line 22, and Part III, line 31. A
separate statement must be attached to
Schedule M-3 (Form 1120S) that
includes a detailed description of each
item and adjustment entered on Part II,
line 22, and Part III, line 31.
The description for each amount
entered in column (a) must be readily
identifiable to the name of the account
in the financial statements or books and
records of the taxpayer, under which the
amount in column (a) was recorded in
the accounting records. Also, the
description for each amount entered in
column (a) must include detailed
information supporting each adjustment
reported in columns (b) and (c),
including how the adjustment is
identified in the accounting records. The
entire description is considered the tax
description for the amount reported in

column (d) for each item reported on
Part II, line 22, or Part III, line 31.
Each description should adequately
describe all four columns of Part II,
line 22, or Part III, line 31. If additional
information is required to provide an
acceptable description, provide a
supporting statement.
Example 7. Corporation C is a
calendar year taxpayer that placed in
service ten depreciable fixed assets in
2006. C was required to file
Schedule M-3 for its 2011 tax year and
is required to file Schedule M-3 for its
2012 tax year. C's total depreciation
expense for its 2012 tax year for five of
the assets is $50,000 for income
statement purposes and $70,000 for
U.S. income tax purposes. C's total
annual depreciation expense for its
2012 tax year for the other five assets is
$40,000 for income statement purposes
and $30,000 for U.S. income tax
purposes. In its financial statements, C
treats the differences between financial
statement and U.S. income tax
depreciation expense as giving rise to
temporary differences that will reverse
in future years. C must combine all of its
depreciation adjustments. Accordingly,
C must report on Part III, line 24, for its
2012 tax year income statement
depreciation expense of $90,000 in
column (a), a temporary difference of
$10,000 in column (b), and U.S. income
tax depreciation expense of $100,000 in
column (d).
Example 8. Corporation D is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. On
December 31, 2012, D establishes
three reserve accounts in the amount of
$100,000 for each account. One
reserve account is an allowance for
accounts receivable that are estimated
to be uncollectible. The second reserve
is an estimate of coupons outstanding
that may have to be paid. The third
reserve is an estimate of future warranty
expenses. In its financial statements, D
treats the three reserve accounts as
giving rise to temporary differences that
will reverse in future years. The three
reserves are expenses in D's 2012
financial statements but are not
deductions for U.S. income tax
purposes in 2012. D must not combine
the Schedule M-3 differences for the
three reserve accounts. D must report
the amounts attributable to the
allowance for uncollectible accounts
receivable on Part III, line 25, Bad debt
expense, and must separately state and
adequately disclose the amounts

Instructions for Schedule M-3 (Form 1120S)

-9-

attributable to each of the other two
reserves, coupons outstanding and
warranty costs, on a required, attached
statement that supports the amounts at
Part III, line 31.
D must also provide a description for
each reserve that meets the
requirements for Part III, line 31,
discussed earlier under Required
statements for Part II, line 22, and Part
III, line 31. In this example, an
acceptable description would be
"Coupon Issue Reserves - Rewards
Expense" and "Future Warranty
Expense Reserve."
Note. There is no need to add the title
of the reserve account to the description
if the account name for the amount in
column (a) is already part of the
adjustment description.
Example 9. Corporation E is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. On
January 2, 2012, E establishes an
allowance for uncollectible accounts
receivable (bad debt reserve) of
$100,000. During 2012, E increased the
reserve by $250,000 for additional
accounts receivable that may become
uncollectible. Additionally, during 2012
E decreases the reserve by $75,000 for
accounts receivable that were
discharged in bankruptcy during 2012.
The balance in the reserve account on
December 31, 2012, is $275,000. The
$100,000 amount to establish the
reserve account and the $250,000 to
increase the reserve account are
expenses on E's 2012 financial
statements but are not deductible for
U.S. income tax purposes in 2012.
However, the $75,000 decrease to the
reserve is deductible for U.S. income
tax purposes in 2012. In its financial
statements, E treats the reserve
account as giving rise to a temporary
difference that will reverse in future tax
years. E must report on Part III, line 25,
for its 2012 tax year income statement
bad debt expense of $350,000 in
column (a), a temporary difference of
($275,000) in column (b), and U.S.
income tax bad debt expense of
$75,000 in column (d).
Example 10. Corporation F is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year.
During 2012, F incurs $200 of meals
and entertainment expenses that F
deducts in computing net income per
the income statement. $50 of the $200

is subject to the 50% limitation under
section 274(n). In its financial
statements, F treats the limitation on
deductions for meals and entertainment
as a permanent difference. Because
meals and entertainment expenses are
specifically described in Part III, line 8, F
must report all of its meals and
entertainment expenses on this line,
regardless of whether there is a
difference. Accordingly, F must report
$200 in column (a), $25 in column (c),
and $175 in column (d). F must not
report the $150 of meals and
entertainment expenses that are
deducted in F's financial statement net
income and are fully deductible for U.S.
income tax purposes on Part II, line 25,
Other items with no differences, and the
$50 subject to the limitation under
section 274(n) on Part III, line 8.

Part II. Reconciliation of
Net Income (Loss) per
Income Statement of the
Corporation With Total
Income (Loss) per Return

For any item reported on Part II, lines 1,
and 3 through 5, attach a supporting
statement that provides the name of the
entity for which the item is reported, the
entity's EIN (if applicable), the type of
entity (corporation, partnership, etc.),
and the item amounts for columns (a)
through (d). See the instructions for Part
II, lines 2 and 6, for the specific
information required for those particular
lines.

Line 1. Income (Loss) From
Equity Method Foreign
Corporations

Report on line 1, column (a), the
financial income (loss) included in Part I,
line 11, for any foreign corporation
accounted for on the equity method and
remove such amount in column (b) or
(c), as applicable. Report the amount of
dividends received and other taxable
amounts received or includible from
foreign corporations on Part II, lines 2
through 4, as applicable.

Line 2. Gross Foreign
Dividends Not Previously
Taxed

Except as otherwise provided in this
paragraph, report on line 2, column (d),
the amount (before any withholding tax)
of any foreign dividends included in
current year total income (loss) on Form
1120S, Schedule K, line 18, and report
on line 2, column (a), the amount of
dividends from any foreign corporation
included in Part I, line 11. Do not report

on line 2 any amounts that must be
reported on Part II, line 3, or dividends
that were previously taxed and must be
reported on Part II, line 4. (See the
instructions below for Part II, lines 3 and
4.) Report withholding taxes on Part III,
line 31, Other expense/deduction items
with differences, or Part II, line 25, Other
items with no difference, as applicable.
For any dividends reported on Part II,
line 2, that are received on a class of
voting stock of which the corporation
directly or indirectly owned 10% or more
of the outstanding shares of that class at
any time during the tax year, report on
an attached supporting statement (1)
the name of the dividend payer, (2) the
payer's EIN (if applicable), (3) the class
of voting stock on which the dividend
was paid, (4) the percentage of the
class directly or indirectly owned, and
(5) the amounts for columns (a) through
(d).

Line 3. Subpart F, QEF, and
Similar Income Inclusions

Report on line 3, column (d), the amount
included in income under section 951
(relating to Subpart F), gains or other
income inclusions resulting from
elections under sections 1291(d)(2) and
1298(b)(1), and any amount included in
income pursuant to section 1293
(relating to qualified electing funds). The
amount of Subpart F income
corresponds to the total of the amounts
reported by the corporation on line 6,
Schedule I, of all Forms 5471,
Information Return of U.S. Persons With
Respect To Certain Foreign
Corporations. The amount of qualified
electing fund income corresponds to the
total of the amounts reported by the
corporation on line 3(a), Part II, of all
Forms 8621, Information Return by a
Shareholder of a Passive Foreign
Investment Company or Qualified
Electing Fund.
Also include on line 3 PFIC
mark-to-market gains and losses under
section 1296. Do not report such gains
and losses on Part II, line 14.

Line 4. Gross Foreign
Distributions Previously Taxed

Report on line 4, column (a), any
distributions received from foreign
corporations that were included in Part I,
line 11, and that were previously taxed
for U.S. income tax purposes. For
example, include in column (a) amounts
that are excluded from income under
sections 959 and 1293(c). Remove
such amount in column (b) or (c), as
applicable. Report the full amount of the
distribution before any withholding tax.
-10-

Report withholding taxes on Part III,
line 31, Other expense/deduction items
with differences, or Part II, line 25, Other
items with no differences, as applicable.
Since previously taxed foreign
distributions are not currently taxable,
line 4, column (d) is shaded. (Also, see
instructions above for Part II, line 2.)

Line 5. Income (Loss) From
Equity Method U.S.
Corporations

Report on line 5, column (a), the
financial income (loss) included in Part I,
line 11, for any U.S. corporation
accounted for on the equity method and
remove such amount in column (b) or
(c), as applicable. Report on Part II,
line 6, dividends received from any U.S.
corporation accounted for on the equity
method.

Line 6. U.S. Dividends Not
Eliminated in Tax Consolidation

Report on line 6, column (a), the amount
of dividends included in Part I, line 11,
that were received from any U.S.
corporation. Report on line 6, column
(d), the amount of any U.S. dividends
included in total income (loss) on Form
1120S, Schedule K, line 18 (that is,
taxable dividends received from any
U.S. corporation that is not a QSub).

For any dividends included on Part II,
line 6, that are received on classes of
voting stock in which the corporation
directly or indirectly owned 10% or more
of the outstanding shares of that class at
any time during the tax year, report on
an attached supporting statement for
Part II, line 6, (1) the name of the
dividend payer, (2) the payer's EIN (if
applicable), (3) the class of voting stock
on which the dividend was paid, (4) the
percentage of the class directly or
indirectly owned, and (5) the item
amounts for columns (a) through (d).

Line 7. Income (Loss) From
U.S. Partnerships and Line 8.
Income (Loss) From Foreign
Partnerships

For any interest owned by the
corporation that is treated as an
investment in a partnership for U.S.
income tax purposes (other than an
interest in a disregarded entity), report
amounts on Part II, line 7 or 8, as
described below.
1. In column (a), the sum of the
corporation's distributive share of
income or loss from a U.S. or foreign
partnership that is included in Part I,
line 11.

Instructions for Schedule M-3 (Form 1120S)

2. In column (b) or (c), as
applicable, the sum of all differences, if
any, attributable to the corporation's
distributive share of income or loss from
a U.S. or foreign partnership.
3. In column (d), the sum of all
amounts of income, gain, loss, or
deduction attributable to the
corporation's distributive share of
income or loss from a U.S. or foreign
partnership (that is, the sum of all
amounts reportable on the corporation's
Schedule(s) K-1 received from the
partnership (if applicable)), without
regard to any limitations computed at
the partner level.
For each partnership reported on
line 7 or 8, attach a supporting
statement that provides the name, EIN
(if applicable), end of year profit-sharing
percentage (if applicable), end of year
loss-sharing percentage (if applicable),
and the amount reported in column (a),
(b), (c), or (d) of lines 7 or 8, as
applicable.
Example 11. U.S. corporation H is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. H
has an investment in a U.S. partnership
USP. H prepares financial statements in
accordance with GAAP. In its financial
statements, H treats the difference
between financial statement net income
and taxable income from its investment
in USP as a permanent difference. For
its 2012 tax year, H's financial statement
net income includes $10,000 of income
attributable to its share of USP's net
income. H's Schedule K-1 from USP
reports $5,000 of ordinary income,
$7,000 of long-term capital gains,
$4,000 of charitable contributions, and
$200 of section 179 expense. H must
report on Part II, line 7, $10,000 in
column (a), a permanent difference of
($2,200) in column (c), and $7,800 in
column (d).

Line 9. Income (Loss) From
Other Pass-Through Entities

For any interest in a pass-through entity
(other than an interest in a partnership
reportable on Part II, line 7 or 8, as
applicable) owned by the corporation
(other than an interest in a disregarded
entity), report the following on line 9:
1. In column (a), the sum of the
corporation's distributive share of
income or loss from the pass-through
entity that is included in Part I, line 11;
2. In column (b) or (c), as
applicable, the sum of all differences, if

any, attributable to the pass-through
entity; and
3. In column (d), the sum of all
taxable amounts of income, gain, loss,
or deduction reportable on the
corporation's Schedules K-1 received
from the pass-through entity (if
applicable).
For each pass-through entity
reported on line 9, attach a supporting
statement that provides that entity's
name, EIN (if applicable), the
corporation's end of year profit-sharing
percentage (if applicable), the
corporation's end of year loss-sharing
percentage (if applicable), and the
amounts reported by the corporation in
column (a), (b), (c), or (d) of line 9, as
applicable.

Line 10. Items Relating to
Reportable Transactions

Any amounts attributable to any
reportable transactions (as described in
Regulations section 1.6011-4(b)) must
be included on Part II, line 10,
regardless of whether the difference, or
differences, would otherwise be
reported elsewhere in Part II or Part III.
Thus, if a taxpayer is required to file
Form 8886 for any reportable
transaction described in Regulations
section 1.6011-4(b), the amounts
attributable to that reportable
transaction must be reported on Part II,
line 10. In addition, all income and
expense amounts attributable to a
reportable transaction must be reported
on Part II, line 10, columns (a) and (d),
even if there is no difference between
the financial amounts and the taxable
amounts.
Each difference attributable to a
reportable transaction must be
separately stated and adequately
disclosed. A corporation will be
considered to have separately stated
and adequately disclosed a reportable
transaction on line 10 if the corporation
sequentially numbers each Form 8886
and lists by identifying number on the
supporting statement for Part II, line 10,
each sequentially numbered reportable
transaction and the amounts required
for Part II, line 10, columns (a) through
(d).
In lieu of the requirements of the
preceding paragraph, a corporation will
be considered to have separately stated
and adequately disclosed a reportable
transaction if the corporation attaches a
supporting statement that provides the
following for each reportable
transaction:

Instructions for Schedule M-3 (Form 1120S)

-11-

1. A description of the reportable
transaction disclosed on Form 8886 for
which amounts are reported on Part II,
line 10;
2. The name and reportable
transaction or tax shelter registration
number, if applicable, as reported on
lines 1a and 1c, respectively, of Form
8886; and
3. The type of reportable transaction
(that is, listed transaction, confidential
transaction, transaction with contractual
protection, etc.) as reported on line 2 of
Form 8886.
If a transaction is a listed transaction
described in Regulations section
1.6011-4(b)(2), the description also
must include the description provided
on line 3 of Form 8886. In addition, if the
reportable transaction involves an
investment in the transaction through
another entity such as a partnership, the
description must include the name and
EIN (if applicable) of that entity as
reported on line 5 of Form 8886.
Example 12. Corporation J is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. J
incurred seven different abandonment
losses during its 2012 tax year. One
loss of $12 million results from a
reportable transaction described in
Regulations section 1.6011-4(b)(5),
another loss of $5 million results from a
reportable transaction described in
Regulations section 1.6011-4(b)(4), and
the remaining five abandonment losses
are not reportable transactions. J
discloses the reportable transactions
giving rise to the $12 million and $5
million losses on separate Forms 8886
and sequentially numbers them X1 and
X2, respectively. J must separately state
and adequately disclose the $12 million
and $5 million losses on Part II, line 10.
The $12 million loss and the $5 million
loss will be adequately disclosed if J
attaches a supporting statement for
line 10 that lists each of the sequentially
numbered forms, Form 8886-X1 and
Form 8886-X2, and with respect to each
reportable transaction reports the
appropriate amounts required for Part II,
line 10, columns (a) through (d).
Alternatively, J's disclosures will be
adequate if the description provided for
each loss on the supporting statement
includes the names and reportable
transaction or tax shelter registration
numbers, if any, disclosed on the
applicable Form 8886, identifies the
type of reportable transaction for the
loss, and reports the appropriate

amounts required for Part II, line 10,
columns (a) through (d). J must report
the losses attributable to the other five
abandonment losses on Part II, line 21e,
regardless of whether a difference
exists for any or all of those
abandonment losses.
Example 13. Corporation K is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. K
enters into a transaction with contractual
protection that is a reportable
transaction described in Regulations
section 1.6011-4(b)(4). This reportable
transaction is the only reportable
transaction for K's 2012 tax year and
results in a $7 million capital loss for
both financial accounting purposes and
U.S. income tax purposes. Although the
transaction does not result in a
difference, K is required to report on
Part II, line 10, the following amounts:
($7 million) in column (a), zero in
columns (b) and (c), and ($7 million) in
column (d). The transaction will be
adequately disclosed if K attaches a
supporting statement for line 10 that (a)
sequentially numbers the Form 8886
and refers to the sequentially-numbered
Form 8886-X1 and (b) reports the
applicable amounts required for line 10,
columns (a) through (d). Alternatively,
the transaction will be adequately
disclosed if the supporting statement for
line 10 includes a description of the
transaction, the name and tax shelter
registration number, if any, and the type
of reportable transaction disclosed on
Form 8886.

Line 11. Interest Income

Report on Part II, line 11, column (a),
the total amount of interest income
included on Part I, line 11, and report on
Part II, line 11, column (d), the total
amount of interest income included on
Form 1120S, Schedule K, line 18, that is
not required to be reported elsewhere
on Schedule M-3. In columns (b) or (c),
as applicable, adjust for any amounts
treated for U.S. income tax purposes as
interest income that are treated as some
other form of income for financial
accounting purposes, or vice versa. For
example, adjustments to interest
income resulting from adjustments
made in accordance with the
instructions for Part II, line 16, should be
made in columns (b) and (c) of this
line 11.
Complete Part II of Form 8916-A,
Supplemental Attachment to
Schedule M-3. Enter the amounts from
line 6, columns (a) through (d) of Form

8916-A, on Schedule M-3, Part II,
line 11, columns (a) through (d), as
applicable. Attach Form 8916-A.
Do not report on this line 11 or
include on Form 8916-A amounts
reported in accordance with instructions
for Part II, lines 7, 8, 9, 10, and 20.

Line 12. Total Accrual to Cash
Adjustment

This line is completed by a corporation
that prepares financial statements (or
books and records, if permitted) using
an overall accrual method of accounting
and uses an overall cash method of
accounting for U.S. income tax
purposes (or vice versa). With the
exception of amounts required to be
reported on Part II, line 10, the
corporation must report on Part II,
line 12, a single amount net of all
adjustments attributable solely to the
use of the different overall methods of
accounting (for example, adjustments
related to accounts receivable,
accounts payable, compensation,
accrued liabilities, etc.), regardless of
whether a separate line on
Schedule M-3 corresponds to an item
within the accrual to cash reconciliation.
Differences not attributable to the use of
the different overall methods of
accounting must be reported on the
appropriate lines of Schedule M-3 (for
example, a depreciation difference must
be reported on Part III, line 24).
Example 14. Corporation L is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. L
prepares financial statements in
accordance with GAAP using an overall
accrual method of accounting. L uses
an overall cash method of accounting
for U.S. income tax purposes. L's
financial statements for the year ending
December 31, 2012, report accounts
receivable of $35,000, an allowance for
bad debts of $10,000, and accounts
payable of $17,000 related to current
year acquisition and reorganization
legal and accounting fees. In addition,
for L's year ending December 31, 2012,
L reported financial statement
depreciation expense of $15,000 and
depreciation for U.S. income tax
purposes of $25,000. For L's 2012 tax
year using an overall cash method of
accounting, L does not recognize the
$35,000 of revenue attributable to the
accounts receivable, cannot deduct the
$10,000 allowance for bad debt, and
cannot deduct the $17,000 of accounts
payable. In its financial statements, L
treats both the difference in overall
-12-

accounting methods used for financial
statement and U.S. income tax
purposes and the difference in
depreciation expense as temporary
differences. L must combine all
adjustments attributable to the
differences related to the overall
accounting methods on Part II, line 12.
As a result, L must report on Part II,
line 12, $8,000 in column (a) ($35,000 –
$10,000 – $17,000), ($8,000) in column
(b), and zero in column (d). L must not
report the accrual to cash adjustment
attributable to the legal and accounting
fees on Part III, line 17, Current year
acquisition and reorganization of legal
and accounting fees. Because the
difference in depreciation expense does
not relate to the use of the cash or
accrual method of accounting, L must
report the depreciation difference on
Part III, line 24, Depreciation, and report
$15,000 in column (a), $10,000 in
column (b), and $25,000 in column (d).

Line 13. Hedging Transactions

Report on line 13, column (a), the net
gain or loss from hedging transactions
included on Part I, line 11. Report in
column (d) the amount of income (loss)
from hedging transactions as defined in
section 1221(b)(2). Use columns (b)
and (c) to report all differences caused
by treating hedging transactions
differently for financial accounting
purposes and for U.S. income tax
purposes. For example, if a portion of a
hedge is considered ineffective under
GAAP but still is a valid hedge under
section 1221(b)(2), the difference must
be reported on line 13. The hedge of a
capital asset, which is not a valid hedge
for U.S. income tax purposes but may
be considered a hedge for GAAP
purposes, must also be reported here.
Report hedging gains and losses
computed under the mark-to-market
method of accounting on line 13 and not
on Part II, line 14.
Report any gain or loss from
inventory hedging transactions on
line 13 and not on Part II, line 15.

Line 14. Mark-to-Market Income
(Loss)

Report on line 14 any amount
representing the mark-to-market income
or loss for any securities held by a
dealer in securities, a dealer in
commodities having made a valid
election under section 475(e), or a
trader in securities or commodities
having made a valid election under
section 475(f). “Securities” for these
purposes are securities described in
section 475(c)(2) and “commodities” are

Instructions for Schedule M-3 (Form 1120S)

described in section 475(e)(2).
“Securities” do not include any items
specifically excluded from sections
475(c)(2) and 475(e)(2), such as certain
contracts to which section 1256(a)
applies.
Report hedging gains and losses
computed under the mark-to-market
method of accounting on Part II, line 13,
Hedging transactions, and not on
line 14.
Traders in securities and commodities. For a trader in securities or
commodities that made a valid election
under section 475(f) to use the
mark-to-market method to account for
securities or commodities held in
connection with a trading business that
files Form 4797, Sales of Business
Property, any Schedule M-3 entries
required as a result of marking to market
these securities or commodities are
reported as follows: (a) mark-to-market
gains and losses from Form 4797,
line 10, are included on Part II, line 14,
of Schedule M-3 (Form 1120S); (b) any
other Schedule M-3 entries required
based on other results (non
mark-to-market gains and losses)
included in the total reported on Form
4797, line 17, should be reported on
Part II, line 21d, of Schedule M-3 (Form
1120S), unless the instructions for
Schedule M-3 require the amounts to be
reported on another line.

Line 15. Cost of Goods Sold

Report on line 15 any amounts
deducted as part of cost of goods sold
during the tax year, regardless of
whether the amounts would otherwise
be reported elsewhere in Part II or Part
III.
Examples of amounts that must be
included as cost of goods sold items are
amounts attributable to inventory
valuation, such as amounts attributable
to cost-flow assumptions, additional
costs required to be capitalized
(including depreciation) such as section
263A costs, inventory shrinkage
accruals, inventory obsolescence
reserves, and lower of cost or market
(LCM) write-downs.
Complete Part I of Form 8916-A.
Enter the amounts from line 8, columns
(a) through (d) of Form 8916-A, on
Schedule M-3, Part II, line 15, columns
(a) through (d), as applicable. Attach
Form 8916-A.
Note. The entries in columns (a) and
(d) of Schedule M-3, line 15, are
negative amounts.
Do not report the following on line 15
or on Form 8916-A.

Amounts reportable on Part II, line 10.
Any gain or loss from inventory
hedging transactions reportable on Part
II, line 13.
Amounts reportable on Part II, line 16.
Amounts reportable on Part II, line 19.
Mark-to-market income or (loss)
associated with the inventories of
dealers in securities under section 475
reportable on Part II, line 14.
Section 481(a) adjustments related to
cost of goods sold or inventory valuation
reportable on Part II, line 17.
Fines and penalties reportable on
Part III, line 9.
Judgments, damages, awards, and
similar costs, reportable on Part III,
line 10.
Amounts included on Part III, line 28.
Example 15. Corporation C is a
calendar year taxpayer that placed in
service ten depreciable fixed assets in
2006. C was required to file
Schedule M-3 for its 2011 tax year and
is required to file Schedule M-3 for its
2012 tax year. C's total depreciation
expense for its 2012 tax year for five of
the assets is $50,000 for financial
accounting purposes and $70,000 for
U.S. income tax purposes. C's total
annual depreciation expense for its
2012 tax year for the other five assets is
$40,000 for financial accounting
purposes and $30,000 for U.S. income
tax purposes. In addition, C incurs $200
of meals and entertainment expenses
that C deducts in computing net income
for financial accounting purposes. All
$200 of the meals and entertainment
expenses is subject to the 50%
limitation under section 274(n). In its
financial statements, C treats the
$50,000 depreciation and $100 of the
meals and entertainment as other costs
in computing cost of goods sold. C must
include on Form 8916-A and on
Schedule M-3, Part II, line 15, in column
(a), the $50,000 of depreciation and
$100 of meals and entertainment. C
must also include a temporary
difference of $20,000 in column (b), a
permanent difference of ($50) in column
(c), and $70,050 in column (d) ($70,000
depreciation and $50 meals and
entertainment expenses). In addition, C
must report on Part III, line 24, for its
2012 tax year income statement,
depreciation expense of $40,000 in
column (a), a temporary difference of
($10,000) in column (b), and $30,000 in
column (d); and on Part III, line 8, meals
and entertainment expense of $100 in
column (a), a permanent difference of
($50) in column (c), and $50 in column
(d). All other cost of goods sold items
would be added to the amounts

Instructions for Schedule M-3 (Form 1120S)

-13-

included on Part II, line 15, detailed in
this example and reported on Form
8916-A and on Part II, line 15, in the
appropriate columns.

Line 16. Sale Versus Lease (for
Sellers and/or Lessors)

Note. Also see the instructions at Part
III, line 28, Purchase Versus Lease (for
Purchasers and/or Lessees).
Asset transfer transactions with periodic
payments characterized for financial
accounting purposes as either a sale or
a lease may, under some
circumstances, be characterized as the
opposite for tax purposes. If the
transaction is treated as a lease, the
seller/lessor reports the periodic
payments as gross rental income and
also reports depreciation expense or
deduction. If the transaction is treated
as a sale, the seller/lessor reports gross
profit (sale price less cost of goods sold)
from the sale of assets and reports the
periodic payments as payments of
principal and interest income.
On Part II, line 16, column (a), report
the gross profit or gross rental income
for financial accounting purposes for all
sale or lease transactions that must be
given the opposite characterization for
U.S. income tax purposes. On Part II,
line 16, column (d), report the gross
profit or gross rental income for federal
income tax purposes. Interest income
amounts for such transactions must be
reported on Part II, line 11, in column (a)
or (d), as applicable. Depreciation
expense for such transactions must be
reported on Part III, line 24, in column
(a) or (d), as applicable. Use columns
(b) and (c) of Part II, lines 11 and 16,
and Part III, line 24, as applicable to
report the differences between column
(a) and (d).
Example 16. Corporation M sells
and leases property to customers. M is
a calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. For
financial accounting purposes, M
accounts for each transaction as a sale.
For U.S. income tax purposes, each of
M's transactions must be treated as a
lease. In its financial statements, M
treats the difference in the financial
accounting and the U.S. income tax
treatment of these transactions as
temporary. During 2012, M reports in its
financial statements $1,000 of sales and
$700 of cost of goods sold with respect
to 2012 lease transactions. M receives
periodic payments of $500 in 2012 with
respect to these 2012 transactions and
similar transactions from prior years and

treats $400 as principal and $100 as
interest income. For financial
accounting purposes, M reports gross
profit of $300 ($1,000 – $700) and
interest income of $100 from these
transactions. For U.S. income tax
purposes, M reports $500 of gross
rental income (the periodic payments)
and (based on other facts) $200 of
depreciation deduction on the property.
On its 2012 Schedule M-3, M must
report on Part II, line 11, $100 in column
(a), ($100) in column (b), and zero in
column (d). In addition, M must report
on Part II, line 16, $300 of gross profit in
column (a), $200 in column (b), and
$500 of gross rental income in column
(d). Lastly, M must report on Part III,
line 24, $200 in column (b) and (d).

Line 17. Section 481(a)
Adjustments

With the exception of a section 481(a)
adjustment that is required to be
reported on Part II, line 10, for
reportable transactions, any difference
between an income or expense item
attributable to an authorized (or
unauthorized) change in method of
accounting made for U.S. income tax
purposes that results in a section 481(a)
adjustment must be reported on Part II,
line 17, regardless of whether a
separate line for that income or expense
item exists in Part II or Part III.
Example 17. Corporation N is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. N
was depreciating certain fixed assets
over an erroneous recovery period and,
effective for its 2012 tax year, N
receives IRS consent to change its
method of accounting for the
depreciable fixed assets and begins
using the proper recovery period. The
change in method of accounting results
in a positive section 481(a) adjustment
of $100,000 that is required to be
spread over four tax years, beginning
with the 2012 tax year. In its financial
statements, N treats the section 481(a)
adjustment as a temporary difference. N
must report on Part II, line 17, $25,000
in columns (b) and (d) for its 2012 tax
year and each of the subsequent three
tax years (unless N is otherwise
required to recognize the remainder of
the 481(a) adjustment earlier). N must
not report the section 481(a) adjustment
on Part III, line 24.

Line 18. Unearned/Deferred
Revenue

Report on line 18, column (a), amounts
of revenues included in Part I, line 11,
that were deferred from a prior financial
accounting year. Report on line 18,
column (d), amounts of revenues
recognizable for U.S. income tax
purposes in the current tax year that are
recognized for financial accounting
purposes in a different year. Also report
on line 18, column (d), any amount of
revenues reported on line 18, column
(a), that are recognizable for U.S.
income tax purposes in the current tax
year. Use columns (b) and (c) of line 18,
as applicable, to report the differences
between column (a) and (d).
Line 18 must not be used to report
income recognized from long-term
contracts. Instead, use line 19.

Line 19. Income Recognition
From Long-Term Contracts

Report on line 19 the amount of net
income or loss for financial statement
purposes (or books and records, if
applicable) or U.S. income tax purposes
for any contract accounted for under a
long-term contract method of
accounting.

Line 20. Original Issue Discount
and Other Imputed Interest

Report on line 20 any amounts of
original issue discount (OID) and other
imputed interest. The term “original
issue discount and other imputed
interest” includes, but is not limited to:
1. The excess of a debt instrument's
stated redemption price at maturity over
its issue price, as determined under
section 1273;
2. Amounts that are imputed interest
on a deferred sales contract under
section 483;
3. Amounts treated as interest or
OID under the stripped bond rules under
section 1286; and
4. Amounts treated as OID under
the below-market interest rate rules
under section 7872.

Line 21a. Income Statement
Gain/Loss on Sale, Exchange,
Abandonment, Worthlessness,
or Other Disposition of Assets
Other Than Inventory and
Pass-Through Entities

Report on line 21a, column (a), all gains
and losses on the disposition of assets
except for (a) gains and losses on the
disposition of inventory, and (b) gains
and losses allocated to the corporation
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from a pass-through entity (for example,
on Schedule K-1) that are included in
the net income (loss) of the corporation
reported on Part I, line 11. Reverse the
amount reported in column (a) in
column (b) or (c), as applicable. The
corresponding gains and losses for U.S.
income tax purposes are reported on
Part II, lines 21b through 21g, as
applicable.

Line 21b. Gross Capital Gains
From Schedule D, Excluding
Amounts From Pass-Through
Entities

Report on line 21b gross capital gains
reported on Schedule D (Form 1120S),
Capital Gains and Losses and Built-in
Gains, or Form 8949, Sales and Other
Dispositions of Capital Assets,
excluding capital gains from
pass-through entities, which must be
reported on Part II, lines 7, 8, or 9, as
applicable.

Line 21c. Gross Capital Losses
From Schedule D, Excluding
Amounts From Pass-Through
Entities, Abandonment Losses,
and Worthless Stock Losses

Report on line 21c gross capital losses
reported on Schedule D (Form 1120S)
or Form 8949, excluding capital losses
from (a) pass-through entities, which
must be reported on Part II, lines 7, 8, or
9, as applicable; (b) abandonment
losses, which must be reported on Part
II, line 21e; and (c) worthless stock
losses, which must be reported on Part
II, line 21f.

Line 21d. Net Gain/Loss
Reported on Form 4797,
Line 17, Excluding Amounts
From Pass-Through Entities,
Abandonment Losses, and
Worthless Stock Losses

Report on line 21d the net gain or loss
reported on line 17 of Form 4797,
excluding amounts from (a)
pass-through entities, which must be
reported on Part II, lines 7, 8, or 9, as
applicable; (b) abandonment losses,
which must be reported on Part II,
line 21e; and (c) worthless stock losses,
which must be reported on Part II,
line 21f. The amount reported on
line 21d is the amount that would have
been carried to line 17 of Form 4797 in
the case of a corporation that is not an S
corporation.
Note. Traders in securities or
commodities that have made a valid
election under section 475(f) to use the

Instructions for Schedule M-3 (Form 1120S)

mark-to-market method to account for
securities or commodities, see the
instructions for Part II, line 14, earlier.

Line 21e. Abandonment Losses

Report on line 21e any abandonment
losses, regardless of whether the loss is
characterized as an ordinary loss or a
capital loss.

Line 21f. Worthless Stock
Losses

Report on line 21f any worthless stock
loss, regardless of whether the loss is
characterized as an ordinary loss or a
capital loss. Attach a statement that
separately states and adequately
discloses each transaction that gives
rise to a worthless stock loss and the
amount of each loss.

Line 21g. Other Gain/Loss on
Disposition of Assets Other
Than Inventory

Report on line 21g any gains or losses
from the sale or exchange of property
other than inventory that are not
reported on lines 21b through 21f.

Line 22. Other Income (Loss)
Items With Differences

Separately state and adequately
disclose on Part II, line 22, all items of
income (loss) with differences that are
not otherwise listed on Part II, lines 1
through 21. Attach a statement that
itemizes the type of income (loss) and
the amount of each item and provides a
description that states the income (loss)
name for book purposes for the amount
recorded in column (a) and describes
the adjustment being recorded in
column (b) or (c). The entire description
completes the tax description for the
amount included in column (d) for each
item separately stated on this line.
The attached statement should have
five columns. The first column has the
description for the next four columns.
The second column is column (a)
income (loss) per income statement,
third column is column (b) temporary
difference, the fourth column is column
(c) permanent difference, and the fifth
column is column (d) income (loss) per
tax return. Every item listed on the
attached statement for line 22 must
always have columns (a) + (b) + (c) =
(d). Each item with amounts in columns
(a), (b), (c), and (d) will be totaled and
included as one line on line 22.
If any “comprehensive income” as
defined by Statement of Financial
Accounting Standards (SFAS) No. 130
is reported on this line, describe the
item(s) in detail. Examples of sufficiently

detailed descriptions include “Foreign
currency translation
adjustments—comprehensive income”
and “Gains and losses on
available-for-sale
securities—comprehensive income.”

Line 23. Total Income (Loss)
Items

Combine lines 1 through 22 and enter
the total on line 23.
Note. Line 15, Cost of goods sold,
columns (a) and (d), are negative
amounts which will affect the totals
entered on line 23.

Line 24. Total Expense/
Deduction Items

Report on Part II, line 24, columns (a)
through (d), as applicable, the negative
of the amounts reported on Part III,
line 32, columns (a) through (d). For
example, if Part III, line 32, column (a),
reflects an amount of $1 million, then
report on Part II, line 24, column (a), ($1
million). Similarly, if Part III, line 32,
column (b), reflects an amount of
($50,000), then report on Part II, line 24,
column (b), $50,000.

Line 25. Other Items With No
Differences

If there is no difference between the
financial accounting amount and the
taxable amount of an entire item of
income, gain, loss, expense, or
deduction and the item is not described
or included in Part II, lines 1 through 22,
or Part III, lines 1 through 31, report the
entire amount of the item in columns (a)
and (d) of line 25. If a portion of an item
of income, loss, expense, or deduction
has a difference and a portion of the
item does not have a difference, do not
report any portion of the item on line 25.
Instead, report the entire amount of the
item (that is, both the portion with a
difference and the portion without a
difference) on the applicable line of Part
II, lines 1 through 22, or Part III, lines 1
through 31. See Example 10, earlier.

Line 26. Reconciliation Totals

If a corporation chooses not to complete
columns (a) and (d) of Parts II and III in
the first tax year the corporation is
required to file Schedule M-3 (or for any
year in which the corporation voluntarily
files Schedule M-3), Part II, line 26, is
reconciled by the corporation in the
following manner:
1. Report the amount from Part I,
line 11, on Part II, line 26, column (a);
2. Leave blank Part II, lines 1
through 25, columns (a) and (d);

Instructions for Schedule M-3 (Form 1120S)

-15-

3. Leave blank Part III, columns (a)
and (d); and
4. Report on Part II, line 26, column
(d), the sum of Part II, line 26, columns
(a), (b), and (c).

Part III. Reconciliation of
Net Income (Loss) per
Income Statement of the
Corporation With Total
Income (Loss) per
Return—Expense/
Deduction Items

Note. Expense amounts that reduce
financial accounting income must be
reported on Part III, column (a), as
positive amounts. Deduction amounts
that reduce taxable income must be
reported on Part III, column (d), as
positive amounts. Amounts reported on
Part II, line 24, must be the negative of
the amounts reported on Part III, line 32.

Lines 1 Through 6. Income Tax
Expense

If the corporation does not distinguish
between current and deferred income
tax expense in its financial statements
(or its books and records, if applicable),
report income tax expense as current
income tax expense using lines 1, 3,
and 5, as applicable.

Line 7. Equity-Based
Compensation

Report on line 7 any amounts for
equity-based compensation or
consideration that are reflected as
expense for financial accounting
purposes (column (a)) or deducted in
the U.S. income tax return (column (d))
other than amounts reportable
elsewhere on Schedule M-3, Parts II
and III. Examples of amounts reportable
on line 7 include payments attributable
to stock options (including incentive
stock options and nonqualified stock
options), employee stock purchase
plans (ESPPs), phantom stock options,
phantom stock units, stock warrants,
stock appreciation rights, and restricted
stock, regardless of whether such
payments are made to employees or
non-employees, or as payment for
property or compensation for services.

Line 8. Meals and
Entertainment

Report on line 8, column (a), any
amounts paid or accrued by the
corporation during the tax year for
meals, beverages, and entertainment
that are accounted for in financial
accounting income, regardless of the
classification, nomenclature, or

terminology used for such amounts, and
regardless of how or where such
amounts are classified in the
corporation's financial income statement
or the income and expense accounts
maintained in the corporation's books
and records. Report only amounts not
otherwise reportable elsewhere on
Schedule M-3, Parts II and III (for
example, Part II, line 15).

Line 9. Fines and Penalties

Report on line 9 any fines or similar
penalties paid to a government or other
authority for the violation of any law for
which fines or penalties are assessed.
All fines and penalties expensed in
financial accounting income (paid or
accrued) must be included on this line 9,
column (a), regardless of the
government or other authority that
imposed the fines or penalties,
regardless of whether the fines and
penalties are civil or criminal, regardless
of the classification, nomenclature, or
terminology used for the fines or
penalties by the imposing authority in its
actions or documents, and regardless of
how or where the fines or penalties are
classified in the corporation's financial
income statement or the income and
expense accounts maintained in the
corporation's books and records. Also
report on line 9, column (a), the reversal
of any overaccrual of any amount
described in this paragraph. See section
162(f) for additional guidance.
Report on line 9, column (d), any
such amounts as described in the
preceding paragraph that are includible
in taxable income, regardless of the
financial accounting period in which
such amounts were or are included in
financial accounting net income.
Complete columns (b) and (c) as
appropriate.
Do not report on this Part III, line 9,
amounts required to be reported in
accordance with instructions for Part III,
line 10.
Do not report on this Part III, line 9,
amounts recovered from insurers or any
other indemnitors for any fines and
penalties described above.

Line 10. Judgments, Damages,
Awards, and Similar Costs

Report on line 10, column (a), the
amount of any estimated or actual
judgments, damages, awards,
settlements, and similar costs, however
named or classified, included in
financial accounting income, regardless
of whether the amount deducted was
attributable to an estimate of future
anticipated payments or actual

payments. Also report on line 10,
column (a), the reversal of any
overaccrual of any amount described in
this paragraph.
Report on line 10, column (d), any
such amounts as are described in the
preceding paragraph that are includible
in taxable income, regardless of the
financial accounting period in which
such amounts were or are included in
financial accounting net income.
Complete columns (b) and (c) as
appropriate.
Do not report on this Part III, line 10,
amounts required to be reported in
accordance with instructions for Part III,
line 9.
Do not report on this Part III, line 10,
amounts recovered from insurers or any
other indemnitors for any judgments,
damages, awards, or similar costs
described above.

Line 11. Pension and
Profit-Sharing

Report on line 11 any amounts
attributable to the corporation's pension
plans, profit-sharing plans, and any
other retirement plans.

Line 12. Other Post-Retirement
Benefits

Report on line 12 any amounts
attributable to other post-retirement
benefits not otherwise includible on Part
III, line 11 (for example, retiree health
and life insurance coverage, dental
coverage, etc.).

Line 13. Deferred
Compensation

Report on line 13, column (a), any
compensation expense included in the
net income (loss) amount reported in
Part I, line 11, that is not deductible for
U.S. income tax purposes in the current
tax year and that was not reported
elsewhere on Schedule M-3, column
(a). Report on line 13, column (d), any
compensation deductible in the current
tax year that was not included in the net
income (loss) amount reported in Part I,
line 11, for the current tax year and that
is not reportable elsewhere on
Schedule M-3. For example, report
originations and reversals of deferred
compensation subject to section 409A
on line 13.

Line 15. Charitable
Contribution of Intangible
Property

Report on line 15 any charitable
contribution of intangible property, for
example, contributions of:
-16-

Intellectual property, patents
(including any amounts of additional
contributions allowable by virtue of
income earned by donees subsequent
to the year of donation), copyrights,
trademarks;
Securities (including stocks and their
derivatives, stock options, and bonds);
Conservation easements (including
scenic easements or air rights);
Railroad rights of way;
Mineral rights; and
Other intangible property.

Line 16. Current Year
Acquisition or Reorganization
Investment Banking Fees

Report on line 16 any investment
banking fees paid or incurred in
connection with a taxable or tax-free
acquisition of property (for example,
stock or assets) or a tax-free
reorganization. Report on this line any
investment banking fees incurred at any
stage of the acquisition or
reorganization process including, for
example, fees paid or incurred to
evaluate whether to investigate an
acquisition, fees to conduct an actual
investigation, and fees to consummate
the acquisition. Also include on this
line 16 investment banking fees incurred
in connection with the liquidation of a
subsidiary, a spin-off of a subsidiary, or
an initial public stock offering.

Line 17. Current Year
Acquisition or Reorganization
Legal and Accounting Fees

Report on line 17 any legal and
accounting fees paid or incurred in
connection with a taxable or tax-free
acquisition of property (for example,
stock or assets) or tax-free
reorganization. Report on this line any
legal and accounting fees incurred at
any stage of the acquisition or
reorganization process including, for
example, fees paid or incurred to
evaluate whether to investigate an
acquisition, fees to conduct an actual
investigation, and fees to consummate
the acquisition. Also include on this line
legal and accounting fees incurred in
connection with the liquidation of a
subsidiary, a spin-off of a subsidiary, or
an initial public stock offering.

Line 18. Current Year
Acquisition/Reorganization
Other Costs

Report on line 18 any other fees paid or
incurred in connection with a taxable or
tax-free acquisition of property (for
example, stock or assets) or a tax-free
reorganization not otherwise reportable

Instructions for Schedule M-3 (Form 1120S)

on Schedule M-3 (for example, Part III,
line 16 or 17). Report on this line any
fees paid or incurred at any stage of the
acquisition or reorganization process
including, for example, fees paid or
incurred to evaluate whether to
investigate an acquisition, fees to
conduct an actual investigation, and
fees to consummate the acquisition.
Also include on this line other
acquisition/reorganization costs
incurred in connection with the
liquidation of a subsidiary, a spin-off of a
subsidiary, or an initial public stock
offering.

Line 19. Amortization/
Impairment of Goodwill

Report on line 19 amortization of
goodwill or amounts attributable to the
impairment of goodwill.

Line 20. Amortization of
Acquisition, Reorganization,
and Start-Up Costs

Report on line 20 amortization of
acquisition, reorganization, and start-up
costs. For purposes of columns (b), (c),
and (d), include amounts amortizable
under section 167, 195, or 248.

Line 21. Other Amortization or
Impairment Write-Offs

Report on line 21 any amortization or
impairment write-offs not otherwise
includible on Schedule M-3.

Line 22. Section 198
Environmental Remediation
Costs

Report on line 22, column (a), any
amounts attributable to environmental
remediation costs included on Part I,
line 11. Report in columns (b), (c), and
(d), as applicable, any deductible
amounts attributable to environmental
remediation costs described in section
198 that are paid or incurred during the
current tax year.

Line 23a. Depletion—Oil & Gas
Report on line 23a, column (a), any oil
and gas depletion included on Part I,
line 11.

Line 23b. Depletion—Other
than Oil & Gas

Report on line 23b any depletion
expense/deduction other than oil and
gas that is not required to be reported
elsewhere on Schedule M-3 (for
example, on Part II, line 7, 8, 9, or 15).

Line 24. Depreciation

Report on line 24 any depreciation
expense that is not required to be
reported elsewhere on Schedule M-3

(for example, on Part II, line 7, 8, 9, or
15).

Line 25. Bad Debt Expense

Report on line 25, column (a), any
amounts attributable to an allowance for
uncollectible accounts receivable or
actual write-offs of accounts receivable
included on Part I, line 11. Report in
column (d) the amount of bad debt
expense deductible for federal income
tax purposes under section 166.

Line 26. Interest Expense

Report on Part III, line 26, column (a),
the total amount of interest expense
included on Part I, line 11, and report on
Part III, line 26, column (d), the total
amount of interest deduction included
on Form 1120S, Schedule K, line 18,
that is not required to be reported
elsewhere on Schedule M-3. In columns
(b) or (c), as applicable, include any
adjustments for any amounts treated for
U.S. income tax purposes as interest
deduction that are treated as some
other form of expense for financial
accounting purposes, or vice versa. For
example, adjustments to interest
expense/deduction resulting from
adjustments made in accordance with
the instructions for Part III, line 28,
Purchase versus lease (for purchasers
and/or lessees), should be made in
columns (b) and (c), as applicable, of
this line 26.
Complete Part III of Form 8916-A.
Enter the amounts from line 5, columns
(a) through (d) of Form 8916-A, on
Schedule M-3, Part III, line 26, columns
(a) through (d), as applicable. Attach
Form 8916-A.
Do not report on this Form 8916-A
and line 26 amounts reported in
accordance with the instructions for Part
II, lines 7, 8, 9, and 10.

Line 27. Corporate Owned Life
Insurance Premiums

Report on line 27 all amounts of
insurance premiums attributable to any
life insurance policy if the corporation is
directly or indirectly a beneficiary under
the policy or if the policy has a cash
value. Report in column (d) the amount
of the premiums that are deductible for
federal income tax purposes.

Line 28. Purchase Versus
Lease (for Purchasers and/or
Lessees)

Note. Also see the instructions for
sellers and/or lessors in the instructions
for Part II, line 16.
Asset transfer transactions with periodic
payments characterized for financial

Instructions for Schedule M-3 (Form 1120S)

-17-

accounting purposes as either a
purchase or a lease may, under some
circumstances, be characterized as the
opposite for tax purposes.
If a transaction is treated as a lease,
the purchaser/lessee reports the
periodic payments as gross rental
expense. If the transaction is treated as
a purchase, the purchaser/lessee
reports the periodic payments as
payments of principal and interest and
also reports depreciation expense or
deduction with respect to the purchased
asset.
Report in column (a) gross rent
expense for a transaction treated as a
lease for financial accounting purposes
but as a sale for U.S. income tax
purposes. Report in column (d), gross
rental deductions for a transaction
treated as a lease for U.S. income tax
purposes but as a purchase for financial
accounting purposes. Report interest
expense for such transactions on Part
III, line 26, in column (a) or (d), as
applicable. Report depreciation
expense or deductions for such
transactions on Part III, line 24, in
column (a) or (d), as applicable. Use
columns (b) and (c) of Part III, lines 24,
26, and 28, as applicable, to report the
differences between column (a) and (d)
for such recharacterized transactions.
Example 18. U.S. corporation X
acquired property in a transaction that,
for financial accounting purposes, X
treats as a lease. X is a calendar year
taxpayer that was required to file
Schedule M-3 for its 2011 tax year and
is required to file Schedule M-3 for its
2012 tax year. Because of its terms, the
transaction is treated for U.S. income
tax purposes as a purchase and X must
treat the periodic payments it makes
partially as payment of principal and
partially as payment of interest. In its
financial statements, X treats the
difference between the financial
accounting and U.S. income tax
treatment of this transaction as a
temporary difference. During 2012, X
reports in its financial statements $1,000
of gross rental expense that, for U.S.
income tax purposes, is recharacterized
as a $700 payment of principal and a
$300 payment of interest, accompanied
by a depreciation deduction of $1,200
(based on other facts). On its 2012
Schedule M-3, X must report the
following on Part III, line 28: column (a),
$1,000, its financial accounting gross
rental expense; column (b), ($1,000);
and column (d), zero. On Part III, line 26,
X reports zero in column (a) and $300 in
columns (b) and (d) for the interest
deduction. On Part III, line 24, X reports

zero in column (a) and $1,200 in
columns (b) and (d) for the depreciation
deduction.

Line 29. Research and
Development Costs

Report in column (a) the amount of
expenses included in net income
reported on Part I, line 11, that are
related to research and development
expense. Report in column (d) the
amount of deductions included in Form
1120S, line 21, and/or separately
reported on Form 1120S, Schedule K,
that are recognized and reported as
Section 174 research and experimental
expenditures consistent with the
corporation’s adopted method of
accounting for such expenditures. In
column (c), as applicable, include any
adjustments for any amounts treated for
U.S. income tax purposes as research
or experimental expenditures that are
treated as some other form of expense
for financial accounting purposes, or
vice versa. Report any difference in
timing recognition in column (b). For
example, if the taxpayer's financial
accounting method does not specify
otherwise, column (b) adjustments
include adjustments for timing
differences between financial and tax
accounting for: (1) deferral and
amortization of research expenditures,
(2) reduction of section 174
expenditures under section 280C or
section 482, (3) costs attributable to
obtaining a patent, (4) research in social
sciences, and (5) cost elements for
property of a character subject to
depreciation.
Section 174 provides two methods
for the treatment of research and
experimental expenditures paid or
incurred by a taxpayer in connection
with the taxpayer’s trade or business.
These expenditures may be treated as
expenses not chargeable to a capital
account and deducted in the year in
which they are paid or incurred, or they
may be deferred and amortized.
Example 19. Corporation X is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax return and is required to file
Schedule M-3 for its 2012 tax year.
During 2012, X incurred $100,000 of
research and development costs that X
recognized as an expense in its
financial statements. Also, X incurred
$20,000 in attorney fees in obtaining a
patent application that X capitalized and
amortized in its financial statements. X
recognized a $2,000 amortization
deduction. In compliance with its
adopted method of accounting under

section 174, X deducts research and
experimental expenditures for U.S.
income tax purposes. Accordingly, X
must report $100,000 in column (a),
$20,000 in column (b), and $120,000 in
column (d). X must also report $2,000 in
column (a), ($2,000) in column (b), and
$0 in column (d) on Part III, line 21,
Other amortization or impairment
write-offs.
Example 20. Assume the same
facts as Example 19 except Corporation
X elected to capitalize and amortize its
research and expenditures over 60
months with respect to all its research
programs for U.S. tax purposes. X first
realized benefits from such
expenditures on August 1. Accordingly,
X must report $100,000 in column (a), a
temporary difference of ($90,000)
($20,000 less ($120,000/60 months X
55 months)) in column (b), and $10,000
in column (d).
Example 21. Corporation X is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax return and is required to file
Schedule M-3 for its 2012 tax year. X
adopted the current expense method for
research and experimental
expenditures for U.S. income tax
purposes. During 2012, X incurred
$50,000 of research and development
costs that X recognized as an expense
in its financial statements. Also, X
undertook to develop a new machine for
its business. X expended $30,000 on
the project of which $10,000 represents
actual costs of material, labor, and
component cost to construct the
machine, and $20,000 represents
research costs not attributable to the
machine itself. X capitalized all costs of
$30,000 related to the machine and
recognized $6,000 of depreciation
expense in its financial statements. X’s
depreciation expense on the $10,000 of
costs related to the machine itself was
$2,000 for U.S. income tax purposes.
Accordingly, X must report $50,000 in
column (a), $20,000 (research costs
which are not attributable to the
machine itself) in column (b), and
$70,000 in column (d). X must also
report $6,000 in column (a), ($4,000) in
column (b), and $2,000 in column (d) on
Part III, line 24, Depreciation.
Example 22. Corporation X is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax return and is required to file
Schedule M-3 for its 2012 tax year.
During 2012, X incurred $10,000 of
research and development costs related
to social sciences that it recognized as
an expense in its financial statements. X
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adopted the current expense method to
research and experimental
expenditures for U.S. income tax
purposes. Because such costs are not
allowable costs under section 174, X
must report $10,000 in column (a),
permanent difference ($10,000) in
column (c), and $0 in column (d). If such
costs are otherwise deductible for U.S.
income tax purposes, X must report this
item of expense on Part III, line 31,
Other expense/deduction items with
differences.
Example 23. Corporation X is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax return and is required to file
Schedule M-3 for its 2012 tax year.
During 2012, X paid $75,000 to acquire
or in-license intangible assets under a
collaborative arrangement with another
company that X recognized as a
research and development expense in
its financial statements. X adopted the
current expense method for research
and experimental expenditures for U.S.
income tax purposes. Because
payments made to acquire rights to a
product or technology are excluded
costs from the definition of research and
experimental expenditures, X must
report $75,000 in column (a), ($75,000)
in column (c), and $0 in column (d). X
must report any amortization otherwise
allowable related to the payments on
Part III, line 21, Other amortization or
impairment write-offs.

Line 30. Section 118 Exclusion

Report on line 30 any inducements
received in the current year and treated
as contributions to the capital of a
corporation by a non-shareholder.
Report in column (a) any income
amount as a negative number and any
expense amount as a positive number.

Corporations must identify on an
accompanying statement referencing
line 30 the fair market value of land or
other property (including cash) provided
to the corporation by any
non-shareholder, including a
governmental unit or civic group, as an
inducement, or for any other purpose.
Include inducements for the corporation
to locate its business in a particular
state, municipality, community, or
locality for the purpose of enabling the
corporation to expand its existing
operating facilities, including corporate
headquarters, distribution center(s), or
factory(ies) (“inducements”).
On the accompanying statement also
identify any inducements that include
refundable or transferable tax credits,

Instructions for Schedule M-3 (Form 1120S)

including transferable credits that were
sold.
The statement must separately state,
adequately disclose, and identify all of
the dollar amounts summarized by this
line. An accompanying statement is
required even if there are no dollar
amounts reported on line 30.

Line 31. Other Expense/
Deduction Items With
Differences

Separately state and adequately
disclose on Part III, line 31, all items of
expense/deduction that are not
otherwise listed on Part III, lines 1
through 30.
Attach a statement that describes
and itemizes the type of expense/
deduction and the amount of each item,
and provides a description that states
the expense/deduction name for book
purposes for the amount recorded in
column (a) and describes the
adjustment being recorded in column
(b) or (c). The entire description
completes the tax description for the
amount included in column (d) for each
item separately stated on this line.
The statement of details attached to
the Schedule M-3 for line 31 must
separately state and adequately
disclose the nature and amount of the
expense related to each reserve and/or
contingent liability. The appropriate level
of disclosure depends upon each
taxpayer’s operational activity and the
nature of its accounting records. For
example, if a corporation’s net income
amount reported in the income
statement includes anticipated
expenses for a discontinued operation
as a single amount, and its general
ledger or other books, records, and
work papers provide details for the
anticipated expenses under more
explanatory and defined categories
such as employee termination costs,
lease cancellation costs, loss on sale of

equipment, etc., a supporting statement
that lists those categories of expenses
and their details will satisfy the
requirement to separately state and
adequately disclose. In order to
separately state and adequately
disclose the employee termination
costs, it is not required that an
anticipated termination cost amount be
listed for each employee, or that each
asset (or category of asset) be listed
along with the anticipated loss on
disposition.
The attached statement should have
five columns. The first column has the
description for the next four columns.
The second column is column (a)
expense per income statement, the third
column is column (b) temporary
difference, the fourth column is column
(c) permanent difference, and the fifth
column is column (d) deduction per tax
return. Every item listed on the attached
statement for line 31 must always have
columns (a) + (b) + (c) = (d). Each item
with amounts in columns (a), (b), (c),
and (d) will be totaled and included as
one line on line 31.
Comprehensive income. If any
“comprehensive income” as defined by
SFAS No. 130 is reported on this line,
describe the item(s) in detail as, for
example, “Foreign currency translation
adjustments—comprehensive income”
and “Gains and losses on
available-for-sale
securities—comprehensive income.”
Reserves and contingent liabilities.
Report on line 31 amounts related to the
change in each reserve or contingent
liability that is not required to be
reported elsewhere on Schedule M-3.
For example: (1) amounts relating to
changes in reserves for litigation must
be reported on Part III, line 10,
Judgments, damages, awards, and
similar costs; and (2) amounts relating
to changes in reserves for uncollectible
accounts receivable must be reported
on Part III, line 25, Bad debt expense.
See Example 8, Example 9, and
Example 24.
Report on line 31, the amortization of
various items of prepaid expense, such
as prepaid subscriptions and license
fees, prepaid insurance, etc.

Report on line 31, column (a),
expenses included in net income
reported on Part I, line 11, that are
related to reserves and contingent
liabilities. Report on line 31, column (d),
amounts related to liabilities for reserves
and contingent liabilities that are
deductible in the current tax year for
U.S. income tax purposes. Examples of
reserves that are allowed for book
purposes, but not for tax purposes,
include warranty reserves, restructuring
reserves, reserves for discontinued
operations, and reserves for
acquisitions and dispositions. Only
report on line 31 items that are not
required to be reported elsewhere on
Schedule M-3, Parts II and III.
Example 24. Corporation Q is a
calendar year taxpayer that was
required to file Schedule M-3 for its
2011 tax year and is required to file
Schedule M-3 for its 2012 tax year. On
July 1 of each year, Q has a fixed
liability for its annual insurance
premiums on its home office building
that provides a 12-month coverage
period beginning July 1 through June
30. In addition, Q historically prepays 12
months of advertising expense on July
1. On July 1, 2012, Q prepays its
insurance premium of $500,000 and
advertising expenses of $800,000. For
financial accounting purposes, Q
capitalizes and amortizes the prepaid
insurance and advertising over 12
months. For U.S. income tax purposes,
Q deducts the insurance premium when
paid and amortizes the advertising over
the 12-month period. In its financial
statements, Q treats the differences
attributable to the financial statement
treatment and U.S. income tax
treatment of the prepaid insurance and
advertising as temporary differences.
Q also has a legal expense reserve
where $300,000 was expensed for
financial accounting purposes and a
($100,000) temporary difference was
calculated to arrive at the income tax
deduction of $200,000. The statement
attached to Q's return for Part III, line 31,
must be separately stated and
adequately disclosed as follows:

Line 31—Example 24
Statement Concerning Other Expense/Deduction Items With Differences
Description

Column (a) Expense Column (b) Temporary
per Income Statement
Difference

Column (c)
Column (d) Deduction
Permanent Difference
per Tax Return

Prepaid insurance premium
expensed not capitalized

$250,000

$250,000

-0-

$500,000

Legal expense reserve

$300,000

($100,000)

-0-

$200,000

Total line 31

$550,000

$150,000

-0-

$700,000

Instructions for Schedule M-3 (Form 1120S)

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Line 32. Total Expense/
Deduction Items

Report on Part II, line 24, columns (a)
though (d), as applicable, the negative
of the amounts reported on Part III,

line 32, columns (a) through (d), as
applicable. Report positive amounts as
negative and negative amounts as
positive. For example, if Part III, line 32,
column (a), reflects an amount of $1

-20-

million, then report on Part II, line 24,
column (a), ($1 million). Similarly, if Part
III, line 32, column (b), reflects an
amount of ($50,000), then report on Part
II, line 24, column (b), $50,000.

Instructions for Schedule M-3 (Form 1120S)