the New Schedule M-3
Developing an Action Plan for Compliance
SEPTEMBER 2006 - Corporate
tax departments are undergoing a period of transition and
adaptation to a new regulatory environment. The Sarbanes-Oxley
Act of 2002 (SOX) began the transformation of the U.S. corporate
regulatory environment. The IRS’s new Schedule M-3 corporate
income tax form continues the effort to increase transparency,
bringing an unprecedented level of sophistication and detail
to tax reporting. It represents one part of the IRS’s
transition toward electronic filing, real-time auditing, and
“less overall taxpayer burden.” The new Schedule
M-3 was first covered in The CPA Journal in “New
Schedule M-3 Expands Reporting for Large Corporations,”
by Walter G. Antognini, August 2005 (www.cpajournal.com).
its laudable goals, the Schedule M-3 raises several challenges
and confusing compliance requirements. To navigate the IRS’s
new compliance requirements, many corporate tax departments
will have to undergo significant changes, implement comprehensive
new processes, and access data that they have never had
to report on before. Businesses
will have to spend more time documenting processes, calculating
tax provisions, and scrutinizing their accounting.
process of readying a corporate tax department for Schedule
M-3 compliance entails several crucial steps:
Understanding the requirements of Schedule M-3;
Identifying the tasks necessary to adjust the tax department—and,
often, other departments, such as information technology
(IT) and accounting—for reporting greater amounts
Developing an action plan to implement these new operations
within the tax department;
Recognizing how this transition will affect the audit
Understanding how technology can help the tax department
comply with Schedule M-3, as well as improve operations
M-3: More Detail, More Data, More Time
M-3 is a critical component of the IRS’s new compliance
efforts. It increases the prominence of taxes in corporate
accounting, making them an integral part of a company’s
overall financial disclosure.
M-3 gives the IRS additional information about tax return
calculations and the differences between book income numbers
and taxable income numbers. Schedule M-3 applies to corporations
with assets of $10 million or greater. It replaces Schedule
M-1, which is filed with Form 1120. M-1 hadn’t been
modified in over 40 years, and required only about a dozen
lines of information. It operated on a shallower level,
designed to go simply from book income adjustments to taxable
contrast, Schedule M-3 gathers over 60 lines of information,
and the IRS requires that each legal entity file its own
Schedule M-3. This means that a consolidated return covering
10 companies requires 10 different Schedule M-3 forms, plus
another for the eliminations companies, and one more for
the consolidated group.
this level of detail gives the IRS much more information,
without agents having to physically visit a company’s
offices to collect data. Because the returns will be filed
electronically, the IRS will have this information promptly.
This new process is designed so that the IRS can avoid thousands
of costly, time-consuming on-site audits for large corporations;
analyze tax data to better prepare for on-site audits; and,
ultimately, allocate resources more efficiently for tax
preparers at greatest risk.
IRS’s intended result is greater effectiveness across
the board, which it hopes will reduce audit cycles to the
point where the IRS is reviewing tax information less than
two years old. Eventually, the IRS hopes the increased efficiency
of this process will reduce the overall taxpayer burden.
financials to the tax return. Schedule M-3
contains three main sections: financial statement reconciliation,
detail of income/loss items, and detail of expenses/deductions.
The detail requested must be presented for both book financial
statements and tax.
the past, Schedule M-1 started with U.S. consolidated book
income instead of worldwide financial income. Now, Schedule
M-3 provides a defined methodology to report the reconciliation
to publicly disclosed financial statements. The new tax
form detail is another example of increased transparency,
requiring companies to expose the type of adjustments they
are making to book numbers to derive taxable income. The
Schedule M-3 information is fundamental to a company’s
accounting structure, and lets the IRS determine whether
all reported income and deducted expense items are proper.
with total assets of $10 million or more must file the new
IRS Schedule M-3 with Form 1120. The form was required for
C corporations that file Form 1120 for the first tax year
ending on or after December 31, 2004. The IRS has extended
Schedule M-3 to partnerships filing Form 1065, S corporations
filing Form 1120S, and insurance companies filing Form 1120PC
or L for tax years ending on or after December 31, 2006.
is disheartening news for many tax preparers, because there
are several aspects of Schedule M-3 that are new, complex,
or otherwise confusing, and require additional guidance
from the IRS. In addition, gaining an understanding of the
form’s instructions and the steps necessary to complete
Schedule M-3 will require increased preparation time.
information required by Schedule M-3 isn’t easy to
obtain, and most tax preparers don’t have it at their
fingertips. Information that used to take extensive time
to develop during a tax examination is now required at the
time of filing. Learning how to gather and report these
numbers can be difficult. For example, most companies will
need to work with their accounting and IT departments to
change data collection and tax information processes in
order to comply with this new level of detail.
documents, however, can ease the transition. For example,
expanded Form 1120 instructions were revised in January
2005. And the IRS has released several frequently asked
questions (FAQ) documents as well as other instructions.
corporations section of the IRS website (www.irs.gov) features
a Schedule M-3 page that includes published material about
the schedule, including Schedule M-3 instructions and FAQs.
The FAQs are arranged and keyed to the line items and sections
of the Schedule M-3 instructions. Moreover, in April 2005
the IRS announced the formation of a stakeholder group to
answer questions about Schedule M-3. It represents a unique
partnership between government and taxpayers to ease the
way for Schedule M-3 compliance and to answer questions
not covered by IRS materials.
IRS has requested that the following groups assist tax preparers
by eliminating duplication, answering questions via e-mail,
and offering taxpayers anonymity:
not affiliated with any of the participating stakeholder
groups listed above can submit their questions to the IRS
an Action Plan
action plan will help companies develop the internal processes
necessary to tackle Schedule M-3. An added benefit is that
once an action plan is in place, the methodology can be
a resource for new laws or changes that a tax department
might face in years to come. Tax departments should take
the following steps to develop their action plan: education,
preparation, assessment, analysis, and implementation.
first phase of an action plan is to educate the tax department
on relevant compliance issues and discuss key concerns,
possible obstacles, and how to prepare for these changes.
part of this phase, companies should examine their current
processes, and ask if aspects of the company’s procedures—such
as performance gap analysis and staff maturity—will
impede the implementation of the action plan. Any shortcomings
should be addressed at the outset.
all relevant information should be gathered, including IRS
publications, forms, and instructions; Treasury FAQs; and
compliance software documentation.
departments should also examine how compliance software
can help the company comply with Schedule M-3. The following
are key questions: Is the tax department automating everything,
or will calculations be made off-line? Are major software
upgrades needed in order for this compliance to succeed?
is imperative that tax departments educate themselves to
prepare for major software changes that might occur. This
includes learning the codes for Schedule M-3, and making
sure their automation runs smoothly. The right compliance
software can dramatically streamline a company’s tax
processes, making the adjustment to Schedule M-3 much easier.
But even the best software programs require a skilled and
well-informed tax department that possesses a clear vision
of how to improve access to detailed financial and tax information
and how to automate the compliance process.
a company must establish an overall understanding of its
compliance needs and consider whether the tax department
is ready to proceed with the project. The strategy for adjusting
to Schedule M-3 and other upcoming filing requirements depends
on a company’s internal organization and the nature
of its business. An analysis of Schedule M-3 will help identify
the key issues an organization will face. For
example, a company must review all types of items with differences
between book and tax treatment in order to gain an understanding
of the detailed classification and information required
to accurately complete the form.
a project team is the next step. The team’s leader
will take ownership and responsibility for the project’s
success. This person should create a project plan, recruit
the team, track their progress, and manage the project budget
assembled, the team should establish a methodology to prepare
a gap analysis. In other words, the team should create a
system that lets the tax department outline their current
process and data flow while understanding the methodology
behind their processes. They should then use these tools
to identify gaps between the tax department’s current
capabilities and those needed to comply with Schedule M-3.
analysis will be discussed in greater detail below, but
it should be noted here that identifying gaps is vital to
a successful action plan. For example, a tax department
that groups multiple expenses into a single category now
has to divide the sum into specific lines of detail. If
the department can’t currently achieve this level
of detail, this represents a critical gap that must be closed.
the project team is meticulous in its gap analysis, it will
be able to successfully develop the procedures necessary
to improve the data collection process. One obstacle, however,
is that many required details might not be accessible, such
as reportable transactions, property dispositions, or a
breakout of other line items for Parts II and III of Schedule
M-3. An internal escalation procedure can help the tax department
identify who can supply missing information, in order to
keep the process moving forward. If the project team discovers
a tax-book difference or an adjustment item, for example,
the team should be able to contact the individual who can
classify that item correctly.
implementing the action plan, the project team should review
its final requirements, identify risk areas due to business
issues or company structure, and note all tools needed to
complete the tasks (e.g., an Excel template).
the project team must gather data to assess the “as-is”
environment (i.e., the current state of the tax department).
This includes obtaining a list of current tax destinations
(or the codes in the tax compliance software, if applicable),
a full list of how the department currently breaks out that
detail, the current Schedule M-1 information, and a list
of the categories that must be adjusted for compliance with
team should also obtain a description of what will be automated
in the current compliance system, to determine whether any
manual input tasks should be automated. Likewise, the team
must prepare a detailed analysis of the Schedule M-3 form
to understand what is required and where the department
must improve. Last, the project team should obtain any current
documentation on their general ledger detail and overall
adjustment process to prepare for the gap analysis.
gap analysis takes the tax department’s current adjustments
and tax codes and maps them to the Schedule M-3 code. The
project team should be able to tell if it can satisfy Schedule
M-3’s required level of detail presently, if the detail
is in the system but is not broken out, or if the tax department
must find someone who can supply the necessary detail.
the project team starts to implement tasks and recommend
changes, it should look for additional detail in the general
ledger. If it can automate that process, it can increase
efficiency down the line, while also establishing internal
control over the data flow from the general ledger to the
tax compliance system. If the process is manual, the tax
department should, at a minimum, have controls and documented
procedures for how to obtain general ledger system data,
whether manually keyed or imported using software.
creating the codes and mapping them in the tax software,
it is crucial to test the system. The tax department must
be certain everything ties out—now that things are
broken down into greater detail—and that the right
items are in the right places on the Schedule M-3 form.
Test, and Recommend Changes
gap detection is complete and all documentation is in place,
it is time to explore ways of helping the tax department
prepare for Schedule M-3 compliance. With the process fresh
in everyone’s mind, the team can probably generate
several good ideas.
company’s tax compliance or service providers can
also help identify ways to better control data and automate
processes to go beyond mere compliance and improve the company’s
bottom line. The goal is always to establish the most efficient
process for the future.
companies have already documented their processes this year—certainly
for SOX section 404 compliance efforts—and are well
positioned to make improvements. These often include improving
data control and security and automating procedures.
Is the Key
it comes to SOX compliance, tax departments should eliminate
manual processes to reduce human error and the risk of manipulation.
The first step is decreasing dependency on spreadsheets.
all tax departments rely heavily on inefficient, error-prone
Excel spreadsheets. This reliance makes it difficult to
move process controls to an automated solution. Eliminating
human error is the most important reason to move toward
automation. According to Computerworld magazine’s
May 24, 2004, issue, 20% to 40% of spreadsheets contain
errors. Indeed, a recent audit by the University of Hawaii
of 54 spreadsheets showed that 91% contained at least one
can improve their processes and compliance with SOX section
404 by leveraging technology. Automating the process allows
companies to achieve better controls over the preparation
of the financial statements and tax documents. Automated
processes are also a major focus of the PCAOB, which considers
the provision process and calculations when certifying financial
statements. In its inspection of the Big Four, the PCAOB
discovered that each had multiple instances of error in
the provision process.
provision process is high-risk, and using manual procedures
(such as home-grown spreadsheets or desktop databases) increases
the risk of errors. Manual processes are also insecure,
easily cracked, and don’t offer an audit trail. Despite
these compelling arguments for automation, a majority of
U.S. companies use Excel as their provision package, ignoring
cases where spreadsheet errors have had a material impact
on financial results.
example, a PricewaterhouseCoopers white paper of July 2004
noted that a large bank was unaware for months that a trader
was making fraudulent transactions by manipulating the bank’s
spreadsheet models. A properly designed automated technology
solution would have detected this activity.
reduces the risk of errors, and also lets companies easily
map Schedule M-3 to streamline their transition process
and complete the return. Once an automated process is in
place, integration tools can take adjustment information
and bring it up to the return—completing, in essence,
at least half of the return. The right integrated tax system
allows tax departments to accelerate the transition process
and reuse hard work put into the e-return. Now, instead
of doing twice the work, companies can use automated processes
to create a shared flow of information.
for an Automated Tax Solution
are several questions a company should consider when choosing
an automated tax technology system:
flow. Does the data flow automatically? Do
employees have to enter data manually into the system, or
is there integrated mapping that automatically channels
data into the forms? An automated system reduces the time
necessary to complete the Schedule M-3, reduces manual data-entry
errors, and increases the consistency of reporting and presentation.
Can columns (a) and (d) in Schedule M-3 be suppressed, and
the data flow to those columns easily removed? Is the tax
department ready to complete the full Schedule M-3 for this
tax year? With an automated system, tax preparers can work
ahead to identify challenges or information gaps. It also
lets companies understand which numbers tie out and which
need more detail, in order to plan for the requirements
of the entire Schedule M-3 for the next tax year.
Does the company’s tax system provide diagnostics?
Does it help reconcile information, provide diagnostic notes,
notify users that items don’t tie out, or send an
alert when a required line is incomplete? Automatic alerts
can help companies identify potential errors or areas that
need to be reviewed for accuracy.
attachments. Are tax department processes
able to provide all the detail attachments? There are multiple
lines on the Schedule M-3 that require tax preparers to
attach additional information, providing a more detailed
breakdown of the numbers on that specific line. An automated
system negates the need to complete these forms manually,
and ensures the company is complying with IRS requirements.
on the Audit Process
IRS says information requested on Schedule M-3 reflects
about 20% of the on-site work it performs for a company
audit. As a result, the IRS believes that Schedule M-3 will
reduce on-site audit time by 20%. That’s the good
news. The bad news: The IRS has additional information and
can spend more time reviewing it and preparing for specific
questions to investigate on audit.
IRS also hopes Schedule M-3 will increase efficiency and
reduce the traditional 70-to-73-month lag time between receiving
a tax return and performing an audit. Most important, Schedule
M-3 increases transparency and helps the IRS identify trends.
The additional lines of information let the IRS track commonalities,
such as the percentage of corporations that have activity
on a specific line detailing an income or expense item with
matter how the IRS ultimately uses Schedule M-3, the form
is not to be taken lightly. Because it can be compared to
20% of an on-site audit, it should be given proportionate
deference and attention. Tax professionals must plan to
spend more time analyzing how transactions will be reported
on their tax returns. The right action plan will empower
any company to establish the processes necessary to properly
file Schedule M-3, reduce audit risk, and create a more
efficient tax department.
Castellano is a senior product manager and leads
content development and education for Vertex’s income
tax solutions. Vertex Inc. (www.vertexinc.com)
is a provider of tax technology solutions. This article is
an updated version of the original article, “Schedule
M-3: More Detail, More Data, More Time,” published in
the August 2005 Derivatives: Financial Products Report. Copyright
© 2005 RIA. Reprinted with permission.