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Inside the new Schedule M-3: developing an action plan for compliance.

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 (

Despite 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.

The 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 of detail;

* Developing an action plan to implement these new operations within the tax department;

* Recognizing how this transition will affect the audit process; and

* Understanding how technology can help the tax department comply with Schedule M-3, as well as improve operations overall.

Schedule M-3: More Detail, More Data, More Time

Schedule 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.

Schedule 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 income.

In 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.

Naturally, 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.

The 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.

Reconciling 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.

In 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.

Who Must File

Corporations 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.

This 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.

The 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.

Several 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.

The corporations section of the IRS website ( 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.

The IRS has requested that the following groups assist tax preparers by eliminating duplication, answering questions via e-mail, and offering taxpayers anonymity:

* The American Bar Association (

* The AICPA (

* The American Taxation Association (

* The Association for Computers and Taxation (

* Manufacturers Alliance/MAPI: (

* The Tax Executives Institute (

Taxpayers not affiliated with any of the participating stakeholder groups listed above can submit their questions to the IRS at

Developing an Action Plan

A well-devised 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.


The 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.

As 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.

Next, all relevant information should be gathered, including IRS publications, forms, and instructions; Treasury FAQs; and compliance software documentation.

Tax 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?

It 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.

Finally, 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.


Mobilizing 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 and timeline.

Once 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. Gap 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.

If 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.

Before 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).


Next, 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 Schedule M-3.

The 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

The 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.

When 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.

After 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.

Implement, Test, and Recommend Changes

After 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.

The 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.

Many 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.

Automation Is the Key

When 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.

Almost 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 error.

Companies 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.

The provision process is high-risk, and using manual procedures (such as homegrown 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.

For 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.

Automation 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.

Considerations for an Automated Tax Solution

There are several questions a company should consider when choosing an automated tax technology system:

Data 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.

Printing. 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.

Diagnostics. 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.

Detail 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.

Impact on the Audit Process

The 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.

The 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 substantial differences.

No 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.

Donna Castellano is a senior product manager and leads content development and education for Vertex's income tax solutions. Vertex Inc. ( 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 [c] 2005 RIA. Reprinted with permission.
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Title Annotation:corporate taxation; data collection process
Author:Castellano, Donna
Publication:The CPA Journal
Geographic Code:1USA
Date:Sep 1, 2006
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