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Explaining the GAAP between Book and Taxable Income

5 min readBy: Erica York

Recently, a study identified dozens of large companies that paid no income taxes in 2020. While such studies get headlines and may seem shocking, the reality is much more mundane: taxable profits (or losses) are determined by taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. laws, whereas book profits (or losses) are determined by accounting standards. There are real, legitimate reasons why tax laws differ from accounting standards, which can result in book profits but tax losses for a given company in a given year.

Tax laws and accounting rules are not the same—Congress writes tax laws and accountants write accounting rules

Book income refers to the income that a company reports on its publicly filed financial statement and is defined using Generally Accepted Accounting Principles (GAAP). The Financial Accounting Standards Board (FASB) sets rules and guidelines with the purpose of creating a standard by which investors can evaluate different firms.

Taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. refers to the amount of income that a company reports on its tax return. The rules defining taxable income were designed by members of Congress to raise revenue for government activities and encourage or penalize certain behaviors.

Businesses don’t use “loopholes,” they follow the rules enacted by Congress

Much like homeowners who take the mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. or parents who take the child tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. , businesses utilize deductions and credits that Congress has enacted to encourage or discourage certain behavior.

For instance, Congress enacted accelerated depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. to incentivize investment, which means when a business buys a machine or builds a factory, tax rules allow for faster and larger upfront deductions than allowed under accounting rules. Accelerated deprecation leads to short-term gaps between book and taxable income over the period when the tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. s are larger. Business tax credits like that for research & development (R&D) costs also lead to gaps in taxable and book incomeBook income is the amount of income corporations publicly report on their financial statements to shareholders. This measure is useful for assessing the financial health of a business but often does not reflect economic reality and can result in a firm appearing profitable while paying little or no income tax. .

If some corporations paid little to no income taxes in a given year due to depreciation deductions or the R&D tax credit, the only way they benefited from such provisions was by investing in capital or performing R&D, economically beneficial activities recognized by tax rules Congress enacted.

Tax rules were written to smooth out effects of business cycles

If some corporations paid zero corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es because they were carrying forward past losses, it should be seen as a normal feature of the U.S. tax code, not a cause for concern. Deductions for carried-forward losses ensure firms are taxed on profitability over time and not penalized for losses that don’t align with calendar years. Tax losses can be carried forward for 20 years with some limitations, so many companies could be carrying forward losses from the financial crisis or other company-specific downturns.

There is symmetry in the tax code: A deduction for one is a tax liability for another

Timing differences of when stock-based employee compensation is deducted from book versus taxable income contribute to book-tax gapThe tax gap is the difference between taxes legally owed and taxes collected. The gross tax gap in the U.S. accounts for at least 1 billion in lost revenue each year, according to the latest estimate by the IRS (2011 to 2013), suggesting a voluntary taxpayer compliance rate of 83.6 percent. The net tax gap is calculated by subtracting late tax collections from the gross tax gap: from 2011 to 2013, the average net gap was around 1 billion. s as well. In the time between when the compensation is issued and deducted from book income and when it vests for the employee and is deducted from taxable income, the stock value may have changed. Book income is greater than taxable income if the stock value has increased when vested, and vice versa if the stock value has declined.

But what is deducted for the corporation is taxable for the employee receiving it. A full analysis must recognize that recipients of stock-based compensation will pay personal income taxes on that income.

Big companies are auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. ed at the highest rates and Congress keeps an eye on corporate refunds

The largest corporations have relatively high audit rates—of the 619 companies with assets over $20 billion in 2019, 50 percent were audited by the IRS compared to the overall corporate audit rate of 0.7 percent. Further, the Joint Committee on Taxation must review any C corporation refunds above $5 million.

Large companies pay taxes in other countries too

Foreign profits also create a wedge between taxable income and book income, as the federal corporate income tax applies to a portion of foreign income under the Tax Cuts and Jobs Act’s base erosion and profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. guardrails, such as the tax on global intangible low-taxed income (GILTI).

Note, however, that foreign income of U.S. corporations is also fully subject to corporate tax in the foreign country in which it is earned. The U.S. tax code offers corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s tax credits for the taxes they pay to foreign governments on their foreign income, which helps mitigate the double tax that arises when both a foreign government and the U.S. government try to tax the same foreign income.

Take the long view: A multiyear horizon is necessary to accurately analyze corporate taxes

A one-year snapshot of corporate tax situations paints an inaccurate picture of the taxes paid by corporations. Provisions like accelerated depreciation cause short-term gaps in book and taxable income due to timing differences, but over the life of an asset the same nominal deductions are taken for both calculations. Deductions for past losses help smooth out tax liability over time to avoid penalizing companies with volatile earning patterns.

Over a multiyear horizon, timing differences between book and tax income largely disappear, making the two measures more consistent.

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