Temporary differences versus permanent differences

• Define a temporary difference using the basis-difference test in Statement 109
• Classify common book-tax differences as taxable, deductible or permanent
• Explain why permanent differences move the effective tax rate and temporary differences do not
• Identify basis differences that are not temporary differences

The basis test

A temporary difference is a difference between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount is recovered or settled. That definition comes from Statement 109 paragraphs 11 through 13, and it is a balance sheet test, not an income statement test.

• A taxable temporary difference produces taxable amounts later. Example: equipment with a book basis of $600,000 and a tax basis of $400,000 after accelerated tax depreciation. Recovering the book amount produces $200,000 more taxable income than book income. This creates a deferred tax liability.
• A deductible temporary difference produces deductions later. Example: a warranty reserve of $90,000 that is deductible only when claims are paid. Settling the liability produces $90,000 of deductions. This creates a deferred tax asset.

Paragraph 15 adds that some temporary differences have no matching book asset or liability, such as organization costs expensed for books but deducted later for tax. The test is still whether a future taxable or deductible amount will result.

Permanent differences

A permanent difference is an item that enters book income or taxable income but never the other. Common examples for a U.S. corporation:

• Interest on state and municipal bonds that is excluded from federal gross income.
• Fines and penalties paid to a government for the violation of a law, which are not deductible.
• Life insurance proceeds, and premiums on policies where the company is the beneficiary.

Permanent differences never reverse, so they create no deferred tax. Their full effect lands in the effective tax rate and shows up in the rate reconciliation under the nontaxable or nondeductible items category, as the rate reconciliation lesson explains.

Basis differences that are not temporary differences

Statement 109 paragraph 14 gives a test case: the excess of cash surrender value of life insurance over premiums paid. If the company expects to surrender the policy, the excess is a temporary difference because surrender produces taxable income. If the company expects to hold the policy until the insured dies, the excess is not a temporary difference because no taxable amount will ever result. The same balance can be either, depending on how the asset is expected to be recovered. Document management's intent.

Other areas where the label is a judgment call:

• Outside basis differences in subsidiaries, where ASC 740-30 has exceptions (see the cross-border lesson).
• Goodwill, where only the portion deductible for tax creates deferred taxes (see the business combinations lesson).
• Stock compensation, where the deferred tax asset follows book cost, not the eventual deduction (see the stock compensation lesson).

What auditors check

Start from a schedule of every book-tax difference, then confirm the label on each:

• Tie the difference list to the return's Schedule M-1 or M-3 lines. The book-tax differences page maps the schedules.
• For each temporary difference, compare the cumulative difference to an actual balance sheet basis difference. A deferred tax balance that does not tie to a basis difference is a red flag.
• For each permanent difference, confirm the tax law that makes it permanent. Items labeled permanent because nobody tracked the reversal are a frequent misstatement.
• Watch for items that change character: a temporary difference that will never reverse (for example, because an asset will not be sold) needs fresh analysis.

Permanent and temporary differences at Bayfront Marine Supply Co.