K-1 Reporting – Variances Between GAAP and Tax Reporting

Written by James F. Hahn, CPA LMC Tax Supervisor

Many small to mid-sized companies are required to have audited financial statements prepared. This is normally due to lending requirements or regulatory requirements specific to certain industries. These financial statements are generally prepared using Generally Accepted Accounting Principles (GAAP).  For certain transactions, GAAP may differ from US tax reporting.  Owners of passthrough entities (Partnerships and S-Corporations) may look at the net income on the financial statements and apply their ownership percentages anticipating that this will be the taxable income reported on their K-1.  When receiving their K-1 form, this income can be significantly different from their calculations, which leads to the question “Why is my K-1 different from the financial statements?”  The following are some of the adjustments that may have been made:

Separately Stated Items/Nondeductible Items

While some of these are not differences between GAAP and tax reporting, there are specific items that are reported separately from ordinary income on the K-1.  The most common examples are interest income, guaranteed payments (partnerships), gains or losses, Section 179 depreciation (more on that later in the article) and charitable contributions.  There are other items which, while not differences in GAAP to tax reporting, are not deductible expenses and will increase taxable income.  Common examples include 50% of business meals, entertainment expenses, officers’ life insurance and personal use of company owned vehicles.

Depreciation Differences

GAAP accounting for depreciation differs from tax depreciation in numerous ways.  While there are some accelerated methods available for GAAP accounting, the most common method is to depreciate long-lived assets over their useful life using a straight-line method.  For improvements made to rented property, these are normally depreciated using the length of lease method, whereby these additions are depreciated at a pace that they will be fully depreciated when the lease term is completed.  For tax purposes buildings are depreciated on a straight-line basis with lives which are consistent with GAAP depreciation lives, but for building improvements, leasehold improvements, furniture & equipment taxpayers are allowed to expense most or all of these costs using either Section 179 depreciation or bonus depreciation.  With Section 179 depreciation, assets are 100% expensed in the year they are placed in service.  There are limitations to the use of Section 179 and as described previously this is separately stated on the K-1 and not deducted from ordinary income.  If not qualifying for Section 179, bonus depreciation is available.  For 2024, 60% of assets placed in service can be depreciated using bonus depreciation with the remainder depreciated over the life of the asset.  In general, tax depreciation will be higher than GAAP depreciation in the year the asset is placed in service, lowering taxable income. However, in subsequent years, tax depreciation is lower than GAAP depreciation ,increasing taxable income from GAAP income.

Rent Expense/Lease Costs

Operating leases must be accounted for using Accounting Standards Codifications (ASC) 842. Under ASC 842, an asset is established based on the present value of lease payments and then amortized over the life of the lease.  The annual amortization is in effect rental expense for the year.  For tax purposes, rent is recorded as the amounts paid or accrued during the year.  In general, if rent increases each year of the lease term, rent expense for tax purposes will be lower in the earlier years, increasing taxable income. In later years, rent expense will be higher, reducing taxable income compared to GAAP income.

Uniform Capitalization Costs Under Section 263A

Code Section 263A—Uniform Capitalization was enacted as part of the 1986 Tax Reform Act and has remained practically unchanged since.  The concept of 263A is that the production of goods includes both direct and indirect costs, which should be included as part of Cost of Goods Sold (COGS). The basic calculation is that a percentage is applied to each category of indirect expenses and that amount is reclassified from operating costs to COGS.  The percentage of capitalized costs to total indirect costs is then applied to ending inventory and the amount calculated is added to ending inventory.  This calculation must be performed each year. If the percentages remain stable and the inventory levels are greater in the current year than in the prior year, COGS is reduced which increases taxable income. However, if inventory levels are lower in the current year as compared to the prior year, the COGS is increased and taxable income is therefore decreased.

State Pass-Through Entity Taxes

Due to the limitations on state and local taxes of $10,000 from the Tax Cuts and Jobs Act (TCJA), many states enacted a pass-through entity tax (PTET) which can be deducted against Federal income.  Because these amounts are a passthrough credit to owners, the PTET payments are recorded as distributions and are not an expense on the financial statements.  This is the case for both GAAP reporting and non-GAAP reporting.  As a result of the pass-through entity tax deduction, taxable income is reduced.

Although there are other differences between book and taxable income, these are some of the main differences that taxpayers may encounter. Please contact your LMC advisor should you have any questions about this topic.