Financial statements and tax returns measure income by different rules. Schedules M-1, M-2 and M-3 are where the IRS asks the taxpayer to bridge the two. An auditor meets these schedules at the end of the tax work: the net income on the return reconciliation should be the net income in the audited statements, and the reconciling items should match the deferred tax and permanent difference work in the provision.
This page is built on the 2025 Form 1120 and its instructions and the Schedule M-3 instructions for Form 1120, which are the primary sources for the line references. Forms 1120-S and 1065 have their own versions of these schedules. A tax professional applies the rules to a specific return.
What does Schedule M-1 reconcile?
Schedule M-1 on Form 1120 is titled Reconciliation of Income (Loss) per Books With Income per Return. It starts with net income per books and ends with taxable income on page 1, line 28 of the return.
| Line | Caption |
|---|---|
| 1 | Net income (loss) per books |
| 2 | Federal income tax per books |
| 3 | Excess of capital losses over capital gains |
| 4 | Income subject to tax not recorded on books this year |
| 5 | Expenses recorded on books this year not deducted on this return (5a depreciation, 5b charitable contributions, 5c travel and entertainment) |
| 6 | Add lines 1 through 5 |
| 7 | Income recorded on books this year not included on this return (tax-exempt interest is the printed example) |
| 8 | Deductions on this return not charged against book income this year (8a depreciation, 8b charitable contributions) |
| 9 | Add lines 7 and 8 |
| 10 | Income (page 1, line 28): line 6 less line 9 |
The form says the corporation may be required to file Schedule M-3 instead.
The instructions give examples of what goes on line 5c: nondeductible entertainment, meals and qualified transportation expenses, business gifts over $25 and similar items. Line 7 takes tax-exempt interest, which also goes on Schedule K.
A corporation whose total receipts and total assets at year-end are both under $250,000 can answer "Yes" to Schedule K, question 13 and skip Schedules L, M-1 and M-2.
What does Schedule M-2 reconcile?
Schedule M-2 on Form 1120 is the Analysis of Unappropriated Retained Earnings per Books. It rolls the Schedule L, line 25 balance: the beginning balance, net income per books, other increases, distributions (cash, stock, property), other decreases and the ending balance. Net income per books on M-2 line 2 should equal M-1 line 1.
Other forms use M-2 differently. The 1120-S version tracks the accumulated adjustments account and other equity accounts, and the Form 1065 M-2 is the analysis of partners' capital accounts. A partnership's M-1 is titled Reconciliation of Income (Loss) per Books With Analysis of Net Income (Loss) per Return.
When does Schedule M-3 replace Schedule M-1?
A domestic corporation filing Form 1120 whose Schedule L total assets at the end of the year are $10 million or more must file Schedule M-3 instead of Schedule M-1. A corporation below the threshold may file it voluntarily. A corporation required to file for the prior year that reports under $10 million of assets for the current year is not required to file for the current year. Form 1120-S filers with total assets of $10 million or more also file Schedule M-3, and a partnership files one under its own tests, including total assets or adjusted total assets of $10 million or more or a reportable entity partner. A partner that owns at least 50 percent of a partnership's income, loss or capital and was itself required to file Schedule M-3 can pull the partnership in.
A corporation with less than $50 million of total assets can complete Part I of Schedule M-3 and Schedule M-1 in place of Parts II and III. If it does, Schedule M-1 line 1 must equal Schedule M-3, Part I, line 11.
How does M-3 differ in structure?
- Part I starts from the financial statement net income and states which source it is. Line 1 asks whether the group filed a Form 10-K with the SEC, and then asks about a certified audited non-tax-basis income statement and an unaudited one, with priority rules when several exist. Line 4a is worldwide consolidated net income per the income statement, and line 11 is net income per the income statement of the includible corporations.
- Part II reconciles line 11 to taxable income on Form 1120, page 1, line 28, with columns for book income, temporary differences, permanent differences and taxable income.
- Part III does the same for expense and deduction items.
M-3 separates temporary from permanent differences by column, which is the same split the provision needs for deferred taxes. M-1 shows only the net adjustments, with no such split.
A worked M-1 and M-2
Illustrative numbers only. A C corporation below the M-3 threshold has pretax book income of $600,000. It has $12,000 of nondeductible meals, $15,000 of tax-exempt interest and tax depreciation that exceeds book depreciation by $80,000. The federal rate is 21%.
Book tax expense is the tax on pretax income adjusted for the permanent items. The temporary difference only moves tax between current and deferred.
- Pretax income adjusted for permanent items: $600,000 + $12,000 - $15,000 = $597,000. Tax at 21%: $125,370.
- Net income per books: $600,000 - $125,370 = $474,630.
- Taxable income: $600,000 + $12,000 - $15,000 - $80,000 = $517,000. Current tax at 21%: $108,570.
- Deferred tax on the $80,000 temporary difference: $16,800. Current plus deferred: $125,370.
| Schedule M-1 | Amount |
|---|---|
| 1 Net income per books | $474,630 |
| 2 Federal income tax per books | $125,370 |
| 5c Nondeductible meals | $12,000 |
| 6 Total of lines 1 through 5 | $612,000 |
| 7 Tax-exempt interest | $15,000 |
| 8a Excess tax depreciation | $80,000 |
| 9 Total of lines 7 and 8 | $95,000 |
| 10 Taxable income (line 6 less line 9) | $517,000 |
For Schedule M-2, assume beginning unappropriated retained earnings of $1,200,000 and cash dividends of $150,000. Beginning balance plus net income per books is $1,674,630. Less distributions of $150,000 gives an ending balance of $1,524,630, which should agree to Schedule L, line 25. The illustration treats the whole $80,000 as an 8a line item for simplicity. In practice the preparer may reflect book depreciation on line 5a and tax depreciation on line 8a separately.
How does the audit use these schedules?
These are practice procedures, not requirements of the standards:
- Tie line 1. M-1 line 1, or M-3 Part I, to the net income in the audited financial statements. If the books closed after the return was prepared, expect a difference caused by late entries.
- Tie line 2. M-1 line 2 should be total book income tax expense, current and deferred. Compare it with the provision. The income tax provision workbook is where that number lives.
- Walk the differences. Each temporary item should map to a deferred tax asset or liability. Each permanent item should appear in the effective tax rate reconciliation. See effective tax rate reconciliation and deferred tax assets and liabilities.
- Return-to-provision. Differences between the prior-year provision estimate and the filed return are accounted for as changes in estimate in the period identified.
- Tie M-2. Beginning retained earnings should agree to the prior-year ending balance and to the audited equity rollforward. See statement of stockholders' equity.
- Check the threshold. Look at whether total assets reached $10 million so that the correct schedule was filed.
Frequently asked questions
What is the difference between Schedule M-1 and M-3?
M-1 is a short reconciliation of book income to taxable income with net adjustments. M-3 is a longer reconciliation that starts from a stated financial statement source and separates temporary and permanent differences in columns. M-3 replaces M-1 for corporations with total assets of $10 million or more.
Is Schedule M-1 required for every corporation?
No. A corporation with total receipts and total assets under $250,000 can check "Yes" on Schedule K, question 13 and skip Schedules L, M-1 and M-2.
Should M-1 line 1 equal audited net income?
It should equal net income per the books used for the return. For an audited client those books should be the audited financial statements, and any difference needs an explanation.
What does Schedule M-2 reconcile?
On Form 1120, it reconciles unappropriated retained earnings per books, which is Schedule L, line 25.
Sources
- IRS, Form 1120, U.S. Corporation Income Tax Return (2025), Schedules K, L, M-1 and M-2: irs.gov/form1120
- IRS, Instructions for Form 1120 (2025), Schedule M-1 and Schedule M-3 sections: irs.gov
- IRS, Instructions for Schedule M-3 (Form 1120) (06/2025): irs.gov
- IRS, Instructions for Form 1120-S (2025) and Form 1065 (2025), Schedule M-3 filing requirements: irs.gov/instructions/i1120s, irs.gov/instructions/i1065
- IRC section 11(b), the 21 percent corporate rate
Related
- Book-tax differences
- ASC 740 income taxes for private companies
- Income tax provision workbook
- Audit program: income taxes
- Business tax returns: 1065, 1120, 1120-S
- IRC 163(j) business interest limitation
- Net operating losses and Section 382
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error