Net income computed on the basis of financial reporting often differs from taxable income due to...

Net income computed on the basis of financial reporting often differs from taxable income due to permanent differences.

1. What are permanent difference between the two?

2. How do they arise?

Expert Solution

The difference in accounting for tax between financial statement and tax returns created a permanent and temporary.

A permanent difference is the difference between the tax expense and tax payable caused by an item that does not reverse overtime.

In other words it is the difference between financial accounting and tax accounting that is never eliminated.

So, a permanent difference is an accounting transaction that the company reports for book purpose but that it can't report for tax purposes.

Permanent difference arise because GAAP allows reporting for a particular transaction buy the IRC does not. As with temporary differences, quite a few accounting events lead to a permanent difference.

Five common permanent differences are penalties and fine, meals and entertainment,life insurance proceeds, interest on municipal bonds and the special dividend received deduction.

Penalty and Fine- These expenses occur when a business break civil, criminal or statutory law( and gets caught)

The company deducts any fines assessed against book income , but IRC162(f) disallows a penalty for tax purposes.

Meals and entertainment- Companies can expense 100% of the cost to provide business related meals and entertainment . But IRC 274(n) for tax purpose only 50% of the cost, unless certain exceptions apply.

Life insurance Proceeds- If a corporation receives life insurance upon the death of an employee, it is income for financial accounting but never be taxable income.

Interest on municipal bonds-Municipal bonds are debt instruments , a local government issues to funda project, such as new highway. Under GAAP we can add this income to net income but for federal tax, it is generally never taxed( some states are exceptional).

Special dividend received deduction-Dividends a company receives from other business in which they have ownership are taxable at less than 100%, depending on the amount of ownership. For financial accounting purposes, we can include all dividends a company receives as income.

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