Deferred Taxes: US GAAP and the Internal Revenue Code (IRC) Recognition Differences

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By: Jarrell Ochoco


Deferred taxes are a result of the difference in timing recognition between United States tax law under the Internal Revenue Code (IRC), and the standard US accounting method generally accepted accounting principles (GAAP). Join Accountant Jarrell Ochoco for an overview of the differences between these two standards, and how they apply to your business.

The three primary differences between US GAAP and tax law include:

  • Permanent differences.
  • Temporary differences.
  • Net operating losses.

Permanent Differences

A permanent difference is a transaction that is reported differently for financial and tax purposes. It is not recognized as taxable income, but it is income for reporting purposes. The difference between the two will never be eliminated. Permanent differences appear in the tax return or income statement, but never both. They do not contribute to deferred tax accounts.

Permanent differences are a goal of tax planning because they can eliminate tax liability. The following are permanent differences in the United States:

  • Meals
    • Deductible 50% per the IRS.
    • Fully deductible under US GAAP.
  • Entertainment:
    • Non-deductible per the IRS.
    • Fully deductible under US GAAP.
  • Penalties and fines.
    • Non-deductible per the IRS.
    • Fully deductible under US GAAP.
  • Certain tax-exempt interest income, such as municipal interest income.
    • Must be reported as income per US GAAP.
    • Tax-exempt per the IRS.
  • Life insurance expenses.
    • Non-deductible per the IRS.
    • Fully deductible under US GAAP.

Temporary Differences

Temporary differences occur when transactions are recognized for both financial reporting and tax purposes but are recognized at different times.

Due to temporary differences, pre-tax book income, or revenue, could be higher its actual taxable income. This creates a deferred tax liability. When taxable income is higher than pre-tax book income, a company has a deferred tax asset.

an item of revenue expense that over its total life will affect pre-tax accounting income and taxable income in the same total amount but will be recognized in a different amount in any given year for financial reporting and tax purposes.

Some common examples of temporary differences include:

  • Depreciation: Companies must recognize depreciation for tax purposes using MACRS, but they recognize it with the streamlined method for US GAAP.
  • Stock compensation expenses: You recognize these expenses every time they are vested under US GAAP. For tax purposes, you recognize the expense once it is paid out.
  • Revenue received in advance: Per the IRS, you must recognize the revenue as income when it is received. But per US GAAP, you only recognize the revenue when it is earned.
  • Accrued expenses: These are not expenses according to the IRS, but you must recognize them under US GAAP.
  • Prepaid expenses: These must be reported once they are paid, per the IRS. Under US GAAP, you only must recognize prepaid expenses once they are incurred.

Net Operating Losses

A net operating loss (NOL) occurs for tax purposes when taxable deductions exceed taxable revenue. Under US tax law, an NOL to be carried forward indefinitely. A company may offset 80% of its taxable income each year as it applies to the NOL carried forward.

Conclusion

Accounting can be complicated. Let the experts help. Contact your Chugh CPAs, LLP professional for help with taxation and accounting matters.