How to Account for Permanent Differences in Business Taxes

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Permanent differences arise when income or expenses on a company's financial statements are never taxable or deductible on the income tax return, or when income or expenses are recognized on the income tax return but are never recorded in the financial statement. Unlike temporary differences, which eventually reverse and equal out between the financial statements and the income tax return, permanent differences never reverse.

Recognize tax exempt income in the company's financial statements. Municipal bond interest is included in a business's financial accounting, but these income items are not taxable on the federal income tax return. This income is also tax-free on the state income tax return for in-state taxpayers.

Include fines, IRS and state tax penalties, and any associated interest expense in the company's financial accounting. Do not deduct these on federal or state income tax returns. Federal and state income tax codes exclude fines from violations of law and penalties and interest imposed by the IRS or state taxing agencies from the company's income tax returns.

Exclude from business tax returns any expenses for life insurance premiums paid for policies taken out on key corporate officers or key employees. They are never deductible on the income tax returns, but they are deductible in the company's financial accounting.

Calculate depletion of a natural resource fully on a company's financial statements, but the depletion deduction may be permanently limited on the company's income tax returns. For example, if a lumber company plants trees and loses those trees in a forest fire, the full market value of the trees may be deductible on the company's income statement. For income tax purposes, however, the deduction is limited to the actual cost of the trees.

Take a deduction on a corporate tax return for certain dividend income from another corporation. While this income is reported as part of a company's financial statement income, it is deducted from the taxable income on the tax return.

Tips & Warnings

  • There are some income items which may result in permanent differences in state income taxes, but not federal income taxes. For example, Treasury bond interest is taxable on the federal income tax return, but is tax-exempt on state income tax returns.

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