Net Income (Loss) Reconciliation for S Corporations With Total Assets of $10 Million or More

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Instructions for Form 1120S-M3

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2006

Department of the Treasury
Internal Revenue Service

Instructions for Schedule
M–3 (Form 1120S)
Net Income (Loss) Reconciliation for S Corporations With Total Assets of $10
Million or More
Section references are to the Internal
Revenue Code unless otherwise noted.
Contents
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Index . . . . . . . . . . . . . . . . . . . . . . . . 41

General Instructions
Purpose of Form
Schedule M-3 Part I asks certain
questions about the corporation’s
financial statements and reconciles
financial statement net income (loss) for
the consolidated financial statement
group to income (loss) per the income
statement for the U.S. tax return.
Schedule M-3 Parts II and III reconcile
financial statement net income (loss) for
the U.S. tax return (per Schedule M-3,
Part I, line 11) to total income (loss) on
Form 1120S, page 3, Schedule K, line 18.

Who Must File
Schedule M-3 is effective for any tax year
ending on or after December 31, 2006.
For purposes of determining whether a
corporation with a 52-53-week tax year
must file Schedule M-3, such
corporation’s tax year is deemed to end
or close on the last day of the calendar
month nearest to the last day of the 52-53
week tax year. (For further guidance on
52-53 week tax years, see Regulations
section 1.441-2(c)(1).) Any corporation
required to file Form 1120S, U.S. Income
Tax Return for an S Corporation, that
reports on Schedule L of Form 1120S
total assets at the end of the corporation’s
tax year that equal or exceed $10 million
must complete and file Schedule M-3 in
lieu of Schedule M-1, Reconciliation of
Income (Loss) per Books With Income
(Loss) per Return. A U.S. corporation
filing Form 1120S that is not required to
file Schedule M-3 may voluntarily file
Schedule M-3 in place of Schedule M-1.
A corporation filing Schedule M-3 must
check the box on Form 1120S, page 1,
item H, indicating that Schedule M-3 is
attached (whether required or voluntary).

A corporation filing Schedule M-3 must
not file Schedule M-1
Example 1.
1. A.U.S. corporation A owns U.S.
subsidiary Q and foreign subsidiary F. For
its 2006 tax year, A prepares
consolidated financial statements with Q
and F that report total assets of $12
million. A files a U.S. federal income tax
return with Q (a corporation that has
made a qualified subchapter S subsidiary
election) and reports total assets on
Schedule L of $8 million. A’s U.S. tax
group is not required to file Schedule M-3
for the 2006 tax year.
2. B.U.S. corporation C owns U.S.
subsidiary D. For its 2006 tax year, C
prepares consolidated financial
statements with D but C and D file
separate U.S. federal income tax returns.
The consolidated accrual basis financial
statements for C and D report total assets
at the end of the taxable year of $12
million after intercompany eliminations. C
reports separate company total year-end
assets on its Schedule L of $7 million. D
reports separate company total year-end
assets on its Schedule L of $6 million.
Neither C nor D is required to file
Schedule M-3 for the 2006 tax year.

Other Issues Affecting
Schedule M-3 Filing
Requirements
If a corporation was required to file
Schedule M-3 for the preceding tax year
but reports on Schedule L of Form 1120S
total assets at the end of the current tax
year of less than $10 million, the
corporation is not required to file
Schedule M-3 for the current tax year.
The corporation may either (a) file
Schedule M-3, or (b) file Schedule M-1,
for the current tax year. However, if the
corporation chooses to file Schedule M-1
for the current tax year, and for a
subsequent tax year the corporation is
required to file Schedule M-3, the
corporation must complete Schedule M-3
in its entirety (Part I and all columns in
Parts II and III) for that subsequent tax
year.
For purposes of determining for
Schedule M-3 whether the corporation
has total assets at the end of the current
tax year of $10 million or more, the
corporation’s total assets must be
Cat. No. 48245B

determined on an overall accrual method
of accounting unless both of the following
apply: (a) the tax return of the corporation
is prepared using an overall cash method
of accounting, and (b) no includible entity
in the U.S. tax return prepares or is
included in financial statements prepared
on an accrual basis.

Affect on Schedule L
Total assets shown on Schedule L, line
15, column (d), must equal the total
assets of the corporation as of the last
day of the tax year, and must be the
same total assets reported by the
corporation in the financial statements, if
any, used for Schedule M-3. If the
corporation does not prepare financial
statements, Schedule L must be based
on the corporation’s books and records.
The Schedule L balance sheet may show
tax-basis balance sheet amounts if the
corporation is allowed to use books and
records for Schedule M-3 and the
corporation’s books and records reflect
only tax-basis amounts.
For purposes of measuring total assets
at the end of the year, assets may not be
netted or offset against liabilities. In
addition, total assets may not be reported
as a negative number.

Entity Considerations for
Schedule M-3
For purposes of Schedule M-3,
references to the classification of an entity
(for example, as a corporation, a
partnership, or a trust) are references to
the treatment of the entity for U.S. federal
income tax purposes. An entity that
generally is disregarded as separate from
its owner for U.S. federal income tax
purposes (disregarded entity) must not be
separately reported on Schedule M-3
except, if required, on Part I, line 7. On
Schedule M-3, Parts II and III, any item of
income, gain, loss, deduction, or credit of
a disregarded entity must be reported as
an item of its owner. In particular, the
income or loss of a disregarded entity
must not be reported on Part II, lines 7, 8,
or 9 as a separate partnership or other
pass-through. The financial statement
income or loss of a disregarded entity is
included on Part I, line 7, if and only if its
financial statement income or loss is
included on Part I, line 11, but not on Part
I, line 4.

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This section also applies to Qualified
Subchapter S Subsidiaries (QSubs).
Since a QSub is a disregarded entity, for
purposes of Schedule M-3, Schedule L
and the tax return in general, the
subsidiary is deemed to have liquidated
into the parent S corporation. As such, all
QSubs are treated as divisions of the S
corporation parent and they must not be
separately reported on Schedule M-3
except, if required, on Part I, line 7.

Reportable Entity Partner
Reporting Responsibilities
For the purposes of the 2006 Form 1065
Schedule M-3 instructions, a reportable
entity partner with respect to a
partnership filing Form 1065 is an entity
that (1) owns or is deemed to own,
directly or indirectly, under these
instructions a 50 percent or greater
interest in the income, loss or capital of
the partnership on any day of the tax year
on or after June 30, 2006, and (2) was
required to complete Schedule M-3 on its
most recently filed US federal income tax
return or return of income filed prior to
that day.
For the purposes of the 2006 Form
1065 Schedule M-3 instructions: (1) the
parent corporation of a consolidated tax
group is deemed to own all corporate and
partnership interests owned or deemed to
be owned under these instructions by any
member of the tax consolidated group; (2)
the owner of a disregarded entity is
deemed to own all corporate and
partnership interests owned or deemed to
be owned under these instructions by the
disregarded entity; (3) the owner of 50
percent or more of a corporation by vote
on any day of the corporation tax year is
deemed to own all corporate and
partnership interests owned or deemed to
be owned under these instructions by the
corporation during the corporation tax
year; (4) the owner of 50 percent or more
of partnership income, loss, or capital on
any day of the partnership tax year is
deemed to own all corporate and
partnership interests owned or deemed to
be owned under these instructions by the
partnership during the partnership tax
year; and (5) the beneficial owner of 50
percent or more of the beneficial interest
of a trust or nominee arrangement tax
year is deemed to own all corporate and
partnership interests owned or deemed to
be owned under these instructions by the
trust or nominee arrangement.
A reportable entity partner with respect
to a partnership (as defined above) must
report the following to the partnership on
September 15, 2006, or if later, within 30
days of first becoming a reportable entity
partner and, after first reporting to the
partnership under these instructions,
thereafter within 30 days of the date of
any change in the interest it owns or is
deemed to own, directly or indirectly,
under these instructions, in the
partnership: (1) its name, (2) its mailing
address, (3) its taxpayer identification
number (TIN or EIN) if applicable, (4) its

entity or organization type, (5) the state or
country in which it is organized, (6) the
date on which it first became a reportable
entity partner on or after June 30, 2006,
(7) the date with respect to which it is
reporting a change in its ownership
interest in the partnership, if applicable,
(8) the interest in the partnership it owns
or is deemed to own in the partnership,
directly or indirectly (as defined under
these instructions) as of the date with
respect to which it is reporting, and (9)
any change in that interest as of the date
with respect to which it is reporting.
Example 2.
1. On September 16, 2007, A, an LLC
filing a Form 1065 for 2007, is owned 50
percent by U.S. corporation Z which files
Form 1120S. A owns 50 percent of each
of B, C, D, and E, each also an LLC filing
a Form 1065 for calendar year 2007. Z
was first required to complete Form
1120S Schedule M-3 for its corporate tax
year ended December 31, 2006, and filed
its Form 1120S with Schedule M-3 for
2006 on September 15, 2007. As of
September 16, 2007, Z was a reportable
entity partner with respect to A and,
through A, with respect to B, C, D, and E.
On October 5, 2007, Z reports to A, B, C,
D, and E, as it is required to do within 30
days of September 16, that Z is a
reportable entity partner directly owning
(with respect to A) or deemed to own
indirectly (with respect to B, C, D, and E)
a 50 percent interest. Therefore, because
Z was a reportable entity partner for 2007,
each of A, B, C, D, and E is required to
complete Form 1065 Schedule M-3 for
2007, regardless of whether they would
otherwise be required to complete
Schedule M-3 for that year.

Completion of Schedule M-3
A corporation required to file Schedule
M-3 must complete the form in its entirety.
At the time the Form 1120S is filed, all
applicable questions must be answered
on Part I, all columns must be completed
on Parts II and III, and all numerical data
required by Schedule M-3 must be
provided. Any schedule required to
support a line item on Schedule M-3 must
be attached at the time Schedule M-3 is
filed and must provide the information
required for that line item.

Specific Instructions for
Part I
Part I. Financial Information and
Net Income (Loss)
Reconciliation
When To Complete Part I
Part I must be completed for any tax year
for which the corporation files Schedule
M-3.

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Line 1. Questions Regarding the
Type of Income Statement
Prepared
For Schedule M-3, Part I, lines 1 through
11, use only the financial statements of
the U.S. corporation filing the U.S. federal
income tax return. If no financial
statements are prepared for the U.S.
corporation filing Form 1120S Schedule
M-3, the U.S. corporation must enter “
No” on questions 1a and 1b, skip Part I,
lines 2, 3a and 3b, and enter the net
income (loss) per the books and records
of the U.S. corporation on Part I, line 4.

Lines 2 and 3. Questions
Regarding Income Statement
Period and Restatements
Enter the beginning and ending dates on
line 2 for the corporation’s annual income
statement period ending with or within this
tax year.
The questions on Part I, lines 3a and
3b, regarding income statement
restatements refer to the worldwide
consolidated income statement issued by
the corporation filing the U.S. federal
income tax return. Answer “ Yes” on lines
3a and/or 3b if the corporation’s annual
income statement has been restated for
any reason. Attach a short explanation of
the reasons for the restatement in net
income for each annual income statement
period that is restated, including the
original amount and restated amount of
each annual statement period’s net
income.

Line 4. Worldwide Consolidated
Net Income (Loss) per Income
Statement
Report on Part I, line 4, the worldwide
consolidated net income (loss) per the
income statement (or books and records,
if applicable) of the corporation. In
completing Schedule M-3, the corporation
must use financial statement amounts
from the financial statement type checked
“Yes” on Part I, line 1, or from its books
and records if Part I, line 1b is checked
“No”.
If a corporation prepares financial
statements, the amount on line 4 must
equal the financial statement net income
(loss) for the income statement period
ending with or within the tax year as
indicated on line 2.
If the corporation prepares financial
statements and the income statement
period differs from the corporation’s tax
year, the income statement period
indicated on line 2 applies for purposes of
Part I, lines 4 through 8.
If the corporation does not prepare
financial statements, check “ No” on Part
I, line 1b, and enter the net income (loss)
per the books and records of the U.S.
corporation on Part I, line 4.
Report on Part 1, lines 5a through 10,
as instructed below, all adjustment
amounts required to adjust worldwide net
income (loss) reported on this Part I, line
4 (whether from financial statements or
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books and records), to net income (loss)
of the corporation that must be reported
on Part I, line 11.

Line 5. Net Income (Loss) of
Nonincludible Foreign Entities
Remove the financial statement net
income (line 5a) or loss (line 5b) of each
foreign entity that is included in the
consolidated financial statement group
and is not an includible entity in the U.S.
tax return (nonincludible foreign entity). In
addition, on Part I, line 8, adjust for
consolidation eliminations and correct for
minority interest and intercompany
dividends between any nonincludible
foreign entity and the entity filing Form
1120S. Do not remove in Part I the
financial statement net income (loss) of
any nonincludible foreign entity accounted
for in the financial statements on the
equity method.
Attach a supporting schedule that
provides the name, EIN (if applicable),
and net income (loss) per the financial
statement or books and records included
on line 4 that is removed on this line 5 for
each separate nonincludible foreign
entity. The amounts of income (loss)
detailed on the supporting schedule
should be reported for each separate
nonincludible foreign entity without regard
to the effect of consolidation or
elimination entries. If there are
consolidation or elimination entries
relating to nonincludible foreign entities
whose income (loss) is reported on the
attached schedule that are not reportable
on Part I, line 8, the net amounts of all
such consolidation and elimination entries
must be reported on a separate line on
the attached schedule, so that the
separate financial accounting income
(loss) of each nonincludible foreign entity
remains separately stated. For example, if
the net income (after consolidation and
elimination entries) of a nonincludible
foreign sub-consolidated group is being
reported on line 5a, the attached
supporting schedule should report the
income (loss) of each separate
nonincludible foreign legal entity from
each such entity’s own financial
accounting net income statement or
books and records, and any consolidation
or elimination entries (for intercompany
dividends, minority interests, etc.) not
reportable on Part I, line 8, should be
reported on the attached supporting
schedule as a net amount on a line
separate and apart from lines that report
each nonincludible foreign entity’s
separate net income (loss).

Line 6. Net Income (Loss) of
Nonincludible U.S. Entities
Remove the financial statement net
income (line 6a) or loss (line 6b) of each
U.S. entity that is included in the
consolidated financial statement group
and is not an includible entity in the U.S.
tax return (nonincludible U.S. entity). In
addition, on Part I, line 8, adjust for
consolidation eliminations and correct for
minority interest and intercompany
Instructions for Form 1120S-M3

dividends between any nonincludible U.S.
entity and any includible entity. Do not
remove in Part I the financial statement
net income (loss) of any nonincludible
U.S. entity accounted for in the financial
statements on the equity method.
Attach a supporting schedule that
provides the name, EIN, and net income
(loss) per the financial statement or books
and records included on line 4 that is
removed on this line 6 for each separate
nonincludible U.S. entity. The amounts of
income (loss) detailed on the supporting
schedule should be reported for each
separate nonincludible U.S. entity without
regard to the effect of consolidation or
elimination entries. If there are
consolidation or elimination entries
relating to nonincludible U.S. entities
whose income (loss) is reported on the
attached schedule that are not reportable
on Part I, line 8, the net amounts of all
such consolidation and elimination entries
must be reported on a separate line on
the attached schedule, so that the
separate financial accounting income
(loss) of each nonincludible U.S. entity
remains separately stated. For example, if
the net income (after consolidation and
elimination entries) of a nonincludible
U.S. sub-consolidated group is being
reported on line 6a, the attached
supporting schedule should report the
income (loss) of each separate
nonincludible U.S. legal entity from each
such entity’s own financial accounting net
income statement or books and records,
and any consolidation or elimination
entries (for intercompany dividends,
minority interests, etc.) not reportable on
Part I, line 8, should be reported on the
attached supporting schedule as a net
amount on a line separate and apart from
lines that report each nonincludible U.S.
entity’s separate net income (loss).

Line 7. Net Income (Loss) of Other
Includible Entities
Include the financial statement net
income (line 7a) or loss (line 7b) of each
includible entity in the U.S. tax return that
is not included in the consolidated
financial statement group and therefore
not included in the income reported on
Part I, line 4. Also include on this line 7
the financial statement income of any
disregarded entity that is not included in
the income reported on Part I, line 4 but is
included in Part I, line 11 (other includible
entities). In addition, on Part I, line 8,
adjust for consolidation eliminations and
correct for minority interest and
intercompany dividends for any other
includible entity.
Attach a supporting schedule that
provides the name, EIN, and net income
(loss) per the financial statement or books
and records included on this line 7 for
each separate other includible entity. The
amounts of income (loss) detailed on the
supporting schedule should be reported
for each separate other includible entity
without regard to the effect of
consolidation or elimination entries solely

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between or among the entities listed. If
there are consolidation or elimination
entries relating to such other includible
entities whose income (loss) is reported
on the attached schedule that are not
reportable on Part I, line 8, the net
amounts of all such consolidation and
elimination entries must be reported on a
separate line on the attached schedule,
so that the separate financial accounting
income (loss) of each other includible
entity remains separately stated. For
example, if the net income (after
consolidation and elimination entries) of a
sub-consolidated U.S. group of other
includible entities is being reported on line
7a, the attached supporting schedule
should report the income (loss) of each
separate other includible entity from each
entity’s own financial accounting net
income statement or books and records,
and any consolidation or elimination
entries (for intercompany dividends,
minority interests, etc.) not reportable on
Part I, line 8, should be reported on the
attached supporting schedule as a net
amount on a line separate and apart from
lines that report each other includible
entity’s separate net income (loss).

Line 8. Adjustment to Eliminations
of Transactions Between Includible
Entities and Nonincludible Entities
Adjustments on Part I, line 8, to reverse
certain financial accounting consolidation
or elimination entries are necessary to
ensure that transactions between
includible entities and nonincludible U.S.
or foreign entities are not eliminated, in
order to report the correct total amount on
Part I, line 11. Also, additional
consolidation entries and eliminations
entries may be necessary on Part I, line
8, related to transactions between
includible entities that are in the
consolidated financial statement group
and other includible entities that are not in
the consolidated financial statement
group but that are reported on Part I, line
7, in order to report the correct total
amount on Part I, line 11.
Include on Part I, line 8, the total of the
following: (i) amounts of any adjustments
to consolidation entries and elimination
entries that are contained in the amount
reported on Part I, line 4, required as a
result of removing amounts on Part I, line
5 or 6; and (ii) amounts of any additional
consolidation entries and elimination
entries that are required as a result of
including amounts on Part I, line 7. This is
necessary in order that the consolidation
entries and intercompany eliminations
entries included in the amount reported
on Part I, line 11, are only those
applicable to the financial net income
(loss) of includible entities for the financial
statement period. For example,
adjustments must be reported on line 8 to
remove minority interest and to reverse
the elimination of intercompany dividends
included on Part I, line 4, that relate to the
net income of entities removed on Part I,
line 5 or 6, because the income to which

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Instructions for Form 1120S-M3

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the consolidation or elimination entries
relate has been removed. Also, for
example, consolidation or elimination
entries must be reported on line 8 to
eliminate any intercompany dividends
between entities whose income is
included on Part I, line 7, and other
entities included in the U.S. federal
income tax return.
If a corporate owner of an interest in
another entity (entity): (1) accounts for the
interest in entity in the owner
corporation’s separate general ledger on
the equity method, and (2) fully
consolidates entity in the owner
corporation’s consolidated financial
statements, but entity is not includible in
the owner corporation’s U.S. federal
income tax return, then, as part of
reversing all consolidation and elimination
entries for the nonincludible entity, the
corporate owner must reverse on
Schedule M-3, Part I, line 8, the
elimination of the equity income inclusion
from entity. If the owner corporation does
not account for entity on the equity
method on its own general ledger, it will
not have eliminated the equity income for
consolidated financial statement
purposes, and therefore will have no
elimination of equity income to reverse.
The attached supporting schedule for
Part I, line 8, must identify the type (e.g.,
minority interest, intercompany dividends,
etc.) and amount of consolidation or
elimination entries reported, as well as
the names of the entities to which they
pertain. It is not necessary, but it is
permitted, to report intercompany
eliminations that net to zero on Part I, line
8, such as intercompany interest income
and expense.

Line 9. Adjustment to Reconcile
Income Statement Period to Tax
Year
Include on line 9 any adjustments
necessary to the income (loss) of
includible entities to reconcile differences
between the corporation’s income
statement period reported on line 2 and
the corporation’s tax year. Attach a
schedule describing the adjustment.

Line 10. Other Adjustments
Required To Reconcile to Amount
on Line 11
Include on line 10 any other adjustments
to reconcile net income (loss) on Part I,
line 4, with net income (loss) on Part I,
line 11.
For any adjustments reported on Part
I, line 10, attach a supporting schedule
with an explanation of each net
adjustment included on line 10.

Line 11. Net Income (Loss) per
Income Statement of the
Corporation
Report on line 11 the net income (loss)
per the income statement (or books and
records, if applicable) of the corporation.
Amounts reported in column (a) of Parts II
and III (see instructions below) must be

reported on the same accounting method
as is used to report the amount of net
income (loss) per income statement of the
corporation on Part I, line 11.
Do not, in any event, report on this line
11 the net income of entities not included
in the U.S. federal income tax return for
the tax year. For example, it is not
permissible to remove the income of
non-includible entities on lines 5 and/or 6,
above, then to add back such income on
lines 7 through 10, such that the amount
reported at line 11 includes the net
income of entities not includible in the
U.S. federal income tax return. A principal
purpose of Schedule M-3 is to report on
this Part I, line 11, only the financial
accounting net income of only the entities
included in the U.S. federal income tax
return.
Whether or not the corporation
prepares financial statements, Part I, Line
11, must include all items that impact the
net income (loss) of the corporation even
if they are not recorded in the profit and
loss accounts in the corporation’s general
ledger, including, for example, all
post-closing adjusting entries (including
workpaper adjustments) and dividend
income or other income received from
non-includible entities.
Example 3A. U.S. corporation P files
a Form 1120S U.S. tax return and
prepares certified audited income
statements for GAAP. P owns 100% of
the stock of U.S. corporations DS1
through DS75, between 51% and 99% of
the stock of U.S. corporations DS76
through DS100, and 100% of the stock of
foreign entities FS1 through FS50. P
eliminates all dividend income from DS1
through DS100 and FS1 through FS50 in
financial statement consolidation entries.
Furthermore, P eliminates the minority
interest ownership, if any, of DS76
through DS100 in financial statement
consolidation entries.
P must check “ Yes” on Part I, line 1a.
On Part I, line 4, P must report the
consolidated net income for the
consolidated financial statement group of
P, DS1 through DS100, and FS1 through
FS50. P must remove the net income
(loss) of FS1 through FS50 on Part I,
lines 5a or 5b, as applicable, and remove
on Part I, lines 6a or 6b, as applicable,
any net income (loss) from DS1 through
DS75 where a QSub election has not
been made by P. P must remove the net
income (loss) before minority interests of
DS76 through DS100 on Part I, lines 6a
or 6b, as applicable. P must reverse on
Part I, line 8, the elimination of any
transactions between the includible entity
(P and any QSubs) and the nonincludible
entities (DS1 through DS75 with no QSub
election, DS76 through DS100 and FS1
through FS50), including dividends
received from non-QSub DS1 through
DS75, DS76 through DS100 and FS1
through FS50 and the minority interest’s
share of the net income (loss) of DS76
through DS100.

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P reports on Part I, line 11, the
consolidated financial statement net
income (loss) attributable to the
corporation and QSubs. Intercompany
transactions between the corporation and
the QSubs that had been eliminated in
the net income amount on line 4 remain
eliminated in the net income amount on
line 11. Transactions between the
corporation and the nonincludible entities
that are eliminated in the net income
amount on line 4 are included in the net
income amount on line 11 since the
elimination of those transactions were
reversed on line 8.
Example 3B U.S. corporation P owns
60% of corporation DS1 which is fully
consolidated in P’s financial statements.
P does not account for DS1 in P’s
separate general ledger on the equity
method. DS1 has net income of $100
(before minority interests) and pays
dividends of $50, of which P receives
$30. The dividend is eliminated in the
consolidated financial statements. In its
financial statements, P consolidates DS1
and includes $60 of net income ($100
less the minority interest of $40) on Part I,
line 4.
P must remove the $100 net income of
DS1 on Part I, line 6a. P must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of DS1. In
addition, P reverses its elimination of the
$30 intercompany dividend in its financial
statements on Part I, line 8. The net result
is that P includes the $30 dividend from
DS1 at Part I, line 11, and on Part II, line
6, column (a). P’s taxable dividend
income from DS1 must be reported on
Part II, line 6, column (d).
1. U.S. corporation S owns 60% of the
capital and profits interests in U.S. LLC N.
C does not account for N in P’s separate
general ledger on the equity method. N
has net income of $100 (before minority
interests) and makes no distributions
during the tax year. S treats N as a
corporation for financial statement
purposes and as a partnership for U.S.
federal income tax purposes. In its
financial statements, S consolidates N
and includes $60 of net income ($100
less the minority interest of $40) on Part I,
line 4.
S must remove the $100 net income of
N on Part I, line 6a. S must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of N. The
result is that S includes no income for N
on either Part I, line 11, or on Part II, line
7, column (a). S’s taxable income from N
must be reported by S on Part II, line 8,
Income (loss) from U.S. partnerships.
2. U.S. corporation P owns 60% of
corporation DS1, which is fully
consolidated in P’s financial statements.
P accounts for DS1 in P’s separate
general ledger on the equity method. DS1
has net income of $100 (before minority
interests) and pays dividends of $50, of
which P receives $30. The dividend
reduces P’s investment in DS1 for equity
method reporting on P’s separate general
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ledger where P includes its 60% equity
share of DS1 income, which is $60. In its
financial statements, P eliminates the
DS1 equity method income of $60 and
consolidates DS1, including $60 of net
income ($100 less the minority interest of
$40) on Part I, line 4.
P must remove the $100 net income of
DS1 on Part I, line 6a. P must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of DS1 and
the elimination of the $60 of DS1 equity
income. The net result is that P includes
the $60 of equity method income from
DS1 at Part I, line 11, and on Part II, line
5, column (a). P’s taxable dividend
income from its investment in DS1 must
be reported on Part II, line 6, column (d).
3. U.S. corporation C owns 60% of
the capital and profits interests in U.S.
LLC N. C accounts for N in C’s separate
general ledger on the equity method. N
has net income of $100 (before minority
interests) and makes no distributions
during the tax year. C treats N as a
corporation for financial statement
purposes and as a partnership for U.S.
federal income tax purposes. For equity
method reporting on C’s separate general
ledger, C includes its 60% equity share of
N income, which is $60. In its financial
statements, C eliminates the $60 of N net
income ($100 less the minority interest of
$40) on Part I, line 4.
C must remove the $100 net income of
N on Part I, line 6a. C must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of N and the
elimination of the $60 of N equity method
income. The result is that C includes the
$60 of equity method income for N on
Part I, line 11, and on Part II, line 7,
column (a). C’s taxable income from N
must be reported by C on Part II, line 7,
column (d).
Example 4. U.S. corporation P owns
100% of the stock of QSub corporation
DS1. DS1 is included in P’s federal
income tax return, even though DS1 is
not included in P’s consolidated financial
statements on either a consolidated basis
or on the equity method. DS1 has current
year net income of $100 after taking into
account its $40 interest payment to P. P
has net income of $1,040 after
recognition of the interest income from
DS1. Because DS1 is an includible
corporation, 100% of the net income of
both P and DS1 must be reported on
Form 1120S of P’s U.S. federal income
tax return, and the intercompany interest
income and expense must be removed by
consolidation elimination entries.
P must report its financial statement
net income of $1,040 on Part I, line 4, and
reports DS1’s net income of $100 on Part
I, line 7. Then, in order to reflect the full
consolidation of the financial accounting
net income of P and DS1 at Part I, line
11, Net income (loss) per income
statement of the corporation, the following
consolidation and elimination entry is
reported on Part I, line 8: offsetting entries
Instructions for Form 1120S-M3

to remove the $40 of interest income
received from DS1 included by P on line
4, and to remove the $40 of interest
expense of DS1 included in line 7 for a
net change of zero. The result is that Part
1, line 11, reports $1,140: $1,040 from
line 4, and $100 from line 7. Stated
another way, Part I, line 11, includes the
entire $1,000 net income of P, measured
before recognition of the intercompany
interest income from DS1 and the
consolidation of DS1 operations, plus the
entire $140 net income of DS1, measured
before interest expense to P. P’s U.S.
federal income tax group is not required
to include on the attached supporting
schedule for Part I, line 8 the offsetting
adjustment to the intercompany
elimination of interest income and interest
expense (though it is permitted to do so).

Specific Instructions for
Parts II and III
General Format of Parts II and
III
For each line item in Parts II and III,
report in column (a) the amount of net
income (loss) included in Part I, line 11,
and report in column (d) the amount
included in total income (loss) on Form
1120S, page 3, Schedule K, line18.
Note. A schedule or explanation may be
attached to any line even if none is
required.

When To Complete Columns (a)
and (d)
A corporation is not required to complete
columns (a) and (d) of Parts II and III for
the first tax year the corporation is
required to file Schedule M-3, and for all
subsequent years the corporation is
required to file Schedule M-3, the
corporation must complete Schedule M-3
in its entirety. Accordingly, the corporation
must complete columns (a) and (d) of
Parts II and III for all tax years
subsequent to the first tax year the
corporation is required to file Schedule
M-3.
If, for any tax year (or tax years) prior
to the first tax year a corporation is
required to file Schedule M-3, a
corporation voluntarily files Schedule M-3
in lieu of Schedule M-1, then in those
voluntary filing years the corporation is
not required to complete columns (a) and
(d) of Parts II and III. In addition, in the
first tax year the corporation is required to
file Schedule M-3 the corporation is not
required to complete columns (a) and (d)
of Parts II and III.
If a corporation chooses not to
complete columns (a) and (d) of Parts II
and III in the first tax year the corporation
is required to file Schedule M-3 (or in any
year in which the corporation voluntarily
files Schedule M-3), then Part II, line 26,
is reconciled by the corporation in the
following manner:
1. Report the amount from Part I, line
11, on Part II, line 26, column (a);

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2. Leave blank Part II, lines 1 through
25, columns (a) and (d);
3. Leave blank Part III, columns (a)
and (d); and
4. Report on Part II, line 26, column
(d), the sum of Part II, line 26, columns
(a), (b), and (c).
Note. Part II, line 26, column (d), must
equal the amount on Form 1120S, page
3, Schedule K, line18.

When To Complete Columns (b)
and (c)
Columns (b) and (c) of Parts II and III
must be completed for any tax year for
which the corporation files Schedule M-3.
For any item of income, gain, loss,
expense, or deduction for which there is a
difference between columns (a) and (d),
the portion of the difference that is
temporary must be entered in column (b)
and the portion of the difference that is
permanent must be entered in column (c).
If financial statements are prepared by
the corporation in accordance with
generally accepted accounting principles
(GAAP), differences that are treated as
temporary for GAAP must be reported in
column (b) and differences that are
permanent (that is, not temporary for
GAAP) must be reported in column (c).
Generally, pursuant to GAAP, a
temporary difference affects (creates,
increases, or decreases) a deferred tax
asset or liability.
If the corporation does not prepare
financial statements, or the financial
statements are not prepared in
accordance with GAAP, report in column
(b) any difference that the corporation
believes will reverse in a future tax year
(that is, have an opposite effect on total
income (loss) in a future tax year (or
years) due to the difference in timing of
recognition for financial accounting and
U.S. federal income tax purposes) or is
the reversal of such a difference that
arose in a prior tax year. Report in column
(c) any difference that the corporation
believes will not reverse in a future tax
year (and is not the reversal of such a
difference that arose in a prior tax year).
If the corporation is unable to
determine whether a difference between
column (a) and column (d) for an item will
reverse in a future tax year or is the
reversal of a difference that arose in a
prior tax year, report the difference for
that item in column (c).
Example 5. For the 2006, 2007, and
2008 tax years, corporation A has total
assets on the last day of the tax year as
reported on Schedule L, line 15, column
(d), of $8 million, $11 million, and $12
million, respectively. A is required to file
Schedule M-3 for its 2007 and 2008 tax
years.
For A’s 2007 tax year, the first tax year
that A is required to file Schedule M-3, A
is only required to complete Part I and
columns (b) and (c) of Parts II and III.

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For A’s 2008 tax year, A is required to
complete Schedule M-3 in its entirety.
Example 6. Corporation B is a U.S.
corporation that files a U.S. tax return and
prepares GAAP financial statements. In
prior years, B acquired intellectual
property (IP) and goodwill through several
corporate acquisitions. The IP is
amortizable for both U.S. federal income
tax and financial statement purposes. In
the current year, B’s annual amortization
expense for IP is $9,000 for U.S. federal
income tax purposes and $6,000 for
financial statement purposes. In its
financial statements, B treats the
difference in IP amortization as a
temporary difference. The goodwill is not
amortizable for U.S. federal income tax
purposes and is subject to impairment for
financial statement purposes. In the
current year, B records an impairment
charge on the goodwill of $5,000. In its
financial statements, B treats the goodwill
impairment as a permanent difference. B
must report the amortization attributable
to the IP on Part III, line 21, and report
$6,000 in column (a), a temporary
difference of $3,000 in column (b), and
$9,000 in column (d). B must report the
goodwill impairment on Part III, line 19,
and report $5,000 in column (a), a
permanent difference of ($5,000) in
column (c), and $0 in column (d).

Reporting Requirements
for Parts II and III
General Reporting
Requirements
If an amount is attributable to a reportable
transaction described in Regulations
section 1.6011-4(b) the amount must be
reported in columns (a), (b), (c), and (d),
as applicable, of Part II, line 10, Items
relating to reportable transactions,
regardless of whether the amount would
otherwise be reported on Part II or Part III
of Schedule M-3. Thus, if a taxpayer files
Form 8886, Reportable Transaction
Disclosure Statement, the amounts
attributable to that reportable transaction
must be reported on Part II, line 10.
A corporation is required to report in
column (a) of Parts II and III the amount
of any item specifically listed on Schedule
M-3 that is in any manner included in the
corporation’s current year financial
statement net income (loss) or in an
income or expense account maintained in
the corporation’s books and records, even
if there is no difference between that
amount and the amount included in total
income(loss) unless (a) otherwise
provided in these instructions or (b) the
amount is attributable to a reportable
transaction described in Regulations
section 1.6011-4(b) and is therefore
reported on Part II, line 10. For example,
with the exception of interest income
reflected on a Schedule K-1 received by a
corporation as a result of the
corporation’s investment in a partnership
or other pass-through entity, all interest

income included on Part I, Line 11,
whether from affiliated companies, third
parties, banks, or other entities, whether
from foreign or domestic sources,
whether taxable or exempt from tax and
whether classified as some other type of
income for U.S. federal income tax
purposes (such as dividends), must be
included on Part II, line 11, column (a).
Likewise, all fines and penalties included
in Part I, line 11, paid to a government or
other authority for the violation of any law
for which fines or penalties are assessed
must be included on Part III, line 9,
column (a), regardless of the government
authority that imposed the fines or
penalties, regardless of whether the fines
or penalties are civil or criminal,
regardless of the classification,
nomenclature, or terminology attached to
the fines or penalties by the imposing
authority in its actions or documents.
If a corporation would be required to
report in column (a) of Parts II and III the
amount of any item specifically listed on
Schedule M-3 in accordance with the
preceding paragraph, except that the
corporation has capitalized the item of
income or expense and reports the
amount in its financial statement balance
sheet or in asset and liability accounts
maintained in the corporation’s books and
records, the corporation must report the
proper tax treatment of the item in
columns (b), (c), and (d), as applicable.
Furthermore, in applying the two
preceding paragraphs, a corporation is
required to report in column (a) of Parts II
and III the amount of any item specifically
listed on Schedule M-3 that is included in
the corporation’s financial statements or
exists in the corporation’s books and
records, regardless of the nomenclature
associated with that item in the financial
statements or books and records.
Accurate completion of Schedule M-3
requires reporting amounts according to
the substantive nature of the specific line
items included in Schedule M-3 and
consistent reporting of all transactions of
like substantive nature that occurred
during the tax year. For example, all
expense amounts that are included in the
financial statements or exist in the books
and records that represent some form of “
Bad debt expense, ” must be reported on
Part III, line 25, in column (a), regardless
of whether the amounts are recorded or
stated under different nomenclature in the
financial statements or the books and
records such as: “ Provision for doubtful
accounts”; “Expense for uncollectible
notes receivable”; or “Impairment of trade
accounts receivable.” Likewise, as stated
in the preceding paragraph, all fines and
penalties must be included on Part III, line
9, column (a), regardless of the
terminology or nomenclature attached to
them by the corporation in its books and
records or financial statements.
With limited exceptions, Part II
includes lines for specific items of income,
gain, or loss (income items). (See Part II,
lines 1 through 21.) If an income item is

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described in Part II, lines 1 through 21,
report the amount of the item on the
applicable line, regardless of whether
there is a difference for the item. If there
is a difference for the income item, or only
a portion of the income item has a
difference and a portion of the item does
not have a difference, and the item is not
described in Part II, lines 1 through 21,
report and describe the entire amount of
the item on Part II, line 22.
With limited exceptions, Part III
includes lines for specific items of
expense or deduction (expense items).
(See Part III, lines 1 through 28.) If an
expense item is described on Part III,
lines 1 through 28, report the amount of
the item on the applicable line, regardless
of whether there is a difference for the
item. If there is a difference for the
expense item, or only a portion of the
expense item has a difference and a
portion of the item does not have a
difference and the item is not described in
Part III, lines 1 through 28, report and
describe the entire amount of the item on
Part III, line 29.
If there is no difference between the
financial accounting amount and the
taxable amount of an entire item of
income, loss, expense, or deduction and
the item is not described or included in
Part II, lines 1 through 21, or Part III, lines
1 through 28, report the entire amount of
the item in column (a) and (d) of Part II,
line 25.
Separately stated and adequately
disclosed. Each difference reported in
Parts II and III must be separately stated
and adequately disclosed. In general, a
difference is adequately disclosed if the
difference is labeled in a manner that
clearly identifies the item or transaction
from which the difference arises. For
further guidance about adequate
disclosure, see Regulations section
1.6662-4(f), Rev. Proc. 2004-45, 2004-31
I.R.B. 140 and Rev. Proc. 2005-75,
2005-50 I.R.B. 1137. If a specific item of
income, gain, loss, expense, or deduction
is described on Part II, lines 7 through 21,
or Part III, lines 1 through 28, and the line
does not indicate to “ attach schedule” or
“attach details,” and the specific
instructions for the line do not call for an
attachment of a schedule or statement,
then the item is considered separately
stated and adequately disclosed if the
item is reported on the applicable line and
the amount(s) of the item(s) are reported
in the applicable columns of the
applicable line. See the instructions
beginning on page
for specific
additional information required to be
provided for amounts reported on Part II,
lines 1 through 6.
Note. A schedule or explanation may be
attached to any line even if none is
required.
Except as otherwise provided,
differences for the same item must be
combined or netted together and reported
as one amount on the applicable line of
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Schedule M-3. However, differences for
separate items must not be combined or
netted together. Each item (and
corresponding amount attributable to that
item) must be separately stated and
adequately disclosed on the applicable
line of Schedule M-3, or any schedule
required to be attached even if the
amounts are below a certain dollar
amount.
Example 7. Corporation C is a
calendar year taxpayer that placed in
service ten depreciable fixed assets in
2001. C was required to file Schedule M-3
for its 2006 tax year and is required to file
Schedule M-3 for its 2007 tax year. C’s
total depreciation expense for its 2007 tax
year for five of the assets is $50,000 for
income statement purposes and $70,000
for U.S. federal income tax purposes. C’s
total annual depreciation expense for its
2007 tax year for the other five assets is
$40,000 for income statement purposes
and $30,000 for U.S. federal income tax
purposes. In its financial statements, C
treats the differences between financial
statement and U.S. federal income tax
depreciation expense as giving rise to
temporary differences that will reverse in
future years. C must combine all of its
depreciation adjustments. Accordingly, C
must report on Part III, line 24, for its
2007 tax year income statement
depreciation expense of $90,000 in
column (a), a temporary difference of
$10,000 in column (b), and U.S. federal
income tax depreciation expense of
$100,000 in column (d).
Example 8. Corporation D is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. On December 31, 2007, D
establishes three reserve accounts in the
amount of $100,000 for each account.
One reserve account is an allowance for
accounts receivable that are estimated to
be uncollectible. The second reserve is
an estimate of coupons outstanding that
may have to be paid. The third reserve is
an estimate of future warranty expenses.
In its financial statements, D treats the
three reserve accounts as giving rise to
temporary differences that will reverse in
future years. The three reserves are
expenses in D’s 2007 financial
statements but are not deductions for
U.S. federal income tax purposes in 2007.
D must not combine the Schedule M-3
differences for the three reserve
accounts. D must report the amounts
attributable to the allowance for
uncollectible accounts receivable on Part
III, line 25, Bad debt expense, and must
separately state and adequately disclose
the amounts attributable to each of the
other two reserves, pending litigation and
warranty costs, on a required, attached
schedule that supports the amounts at
Part III, line 29.
Example 9. Corporation E is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
Instructions for Form 1120S-M3

2007 tax year. On January 2, 2007, E
establishes an allowance for uncollectible
accounts receivable (bad debt reserve) of
$100,000. During 2007, E increased the
reserve by $250,000 for additional
accounts receivable that may become
uncollectible. Additionally, during 2007 E
decreases the reserve by $75,000 for
accounts receivable that were discharged
in bankruptcy during 2007. The balance in
the reserve account on December 31,
2007, is $275,000. The $100,000 amount
to establish the reserve account and the
$250,000 to increase the reserve account
are expenses on E’s 2007 financial
statements but are not deductible for U.S.
federal income tax purposes in 2007.
However, the $75,000 decrease to the
reserve is deductible for U.S. federal
income tax purposes in 2007. In its
financial statements, E treats the reserve
account as giving rise to a temporary
difference that will reverse in future tax
years. E must report on Part III, line 25,
for its 2007 tax year income statement
bad debt expense of $350,000 in column
(a), a temporary difference of ($275,000)
in column (b), and U.S. federal income
tax bad debt expense of $75,000 in
column (d).
Example 10. Corporation F is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. During 2007, F incurs
$200 of meals and entertainment
expenses that F deducts in computing net
income per the income statement. $50 of
the $200 is subject to the $50% limitation
under section 274(n). In its financial
statements, F treats the limitation on
deductions for meals and entertainment
as a permanent difference. Because
meals and entertainment expenses are
specifically described in Part III, line 8,
Meals and entertainment, F must report
all of its meals and entertainment
expenses on this line, regardless of
whether there is a difference. Accordingly,
F must report $200 in column (a), $25 in
column (c), and $175 in column (d). F
must not report the $150 of meals and
entertainment expenses that are
deducted in F’s financial statement net
income and are fully deductible for U.S.
federal income tax purposes on Part II,
line 25, Other items with no differences,
and the $50 subject to the limitation under
section 274(n) on Part III, line 8.

Part II. Reconciliation of
Net Income (Loss) per
Income Statement of the
Corporation With Total
Income (Loss) per Return
Lines 1 Through 6. Additional
Information for Each
Corporation
For any item reported on Part II, lines 1,
and 3 through 5, attach a supporting
schedule that provides the name of the

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entity for which the item is reported, the
type of entity (corporation, partnership,
etc.), the entity’s EIN (if applicable), and
the item amounts for columns (a) through
(d). See the instructions for Part II, lines 2
and 6, for the specific information
required for those particular lines.

Line 1. Income (Loss) From
Equity Method Foreign
Corporations
Report on line 1, column (a), the income
statement income (loss) included in Part I,
line 11, for any foreign corporation
accounted for on the equity method and
remove such amount in column (b) or (c),
as applicable. Report the amount of
dividends received and other taxable
amounts received or includible from
foreign corporations on Part II, lines 2
through 4, as applicable.

Line 2. Gross Foreign
Dividends Not Previously Taxed
Except as otherwise provided in this
paragraph, report on line 2, column (d),
the amount (before any withholding tax)
of any foreign dividends included in
current year total income (loss) on Form
1120S, page 3, Schedule K, line 18 and
report on line 2, column (a), the amount of
dividends from any foreign corporation
included in Part I, line 11. Do not report
any amounts that are reported on Part II,
line 3, or dividends that were previously
taxed and must be reported on Part II,
line 4. (See the instructions below for Part
II, lines 3 and 4.) Report withholding taxes
on Part III, line 29, Other expense/
deduction items with differences, or Part
II, line 25, Other items with no difference,
as applicable.
For any dividends reported on Part II,
line 2, that are received on a class of
voting stock of which the corporation
directly or indirectly owned 10% or more
of the outstanding shares of that class at
any time during the tax year, report on an
attached supporting schedule (1) the
name of the dividend payer, (2) the
payer’s EIN (if applicable), (3) the class of
voting stock on which the dividend was
paid, (4) the percentage of the class
directly or indirectly owned, and (5) to (8)
the item amounts for columns (a) through
(d).

Line 3. Subpart F, QEF, and
Similar Income Inclusions
Report on line 3, column (d), the amount
included in income under section 951
(relating to Subpart F), gains or other
income inclusions resulting from elections
under sections 1291(d)(2) and 1298(b)(1),
and any amount included in income
pursuant to section 1293 (relating to
qualified electing funds). The amount of
Subpart F income corresponds to the total
of the amounts reported by the
corporation on line 6, Schedule I, of all
Forms 5471, Information Return of U.S.
Persons With Respect to Certain Foreign
Corporations. The amount of qualified
electing fund income corresponds to the

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total of the amounts reported by the
corporation on line 3(a), Part II, of all
Forms 8621, Return by a Shareholder of
a Passive Foreign Investment Company
or Qualified Electing Fund.
Also include on line 3 PFIC
mark-to-market gains and losses under
section 1296. Do not report such gains
and losses on Part II, line 14.

Line 4. Gross Foreign
Distributions Previously Taxed
Report on line 4, column (a), any
distributions received from foreign
corporations that were included in Part I,
line 11, and that were previously taxed for
U.S. federal income tax purposes. For
example, include in column (a) amounts
that are excluded from income under
sections 959 and 1293(c). Remove such
amount in column (b) or (c), as
applicable. Report the full amount of the
distribution before any withholding tax.
Report withholding taxes on Part III, line
29, Other expense/deduction items with
differences, or Part II, line 25, Other items
with no differences, as applicable. Since
previously taxed foreign distributions are
not currently taxable, line 4, column (d) is
shaded. (Also, see instructions above for
Part II, line 2.)

Line 5. Income (Loss) From
Equity Method U.S.
Corporations
Report on line 5, column (a), the income
statement income (loss) included in Part I,
line 11, for any U.S. corporation
accounted for on the equity method and
remove such amount in column (b) or (c),
as applicable. Report on Part II, line 6,
dividends received from any U.S.
corporation accounted for on the equity
method.

Line 6. U.S. Dividends Not
Eliminated in Tax Consolidation
Report on line 6, column (a), the amount
of dividends included in Part I, line 11,
that were received from any U.S.
corporation. Report on line 6, column (d),
the amount of any U.S. dividends
included in total income (loss) on Form
1120S, page 3, Schedule K, line 18 (that
is, taxable dividends received from any
U.S. corporation that is not a QSub.).
For any dividends reported on Part II,
line 6, that are received on classes of
voting stock in which the corporation
directly or indirectly owned 10% or more
of the outstanding shares of that class at
any time during the tax year, report on an
attached supporting schedule for Part II,
line 6, (1) the name of the dividend payer,
(2) the payer’s EIN (if applicable), (3) the
class of voting stock on which the
dividend was paid, (4) the percentage of
the class directly or indirectly owned, and
(5) to (8) the item amounts for columns
(a) through (d).

Line 7. Income (Loss) From U.S.
Partnerships and Line 8.
Income (Loss) From Foreign
Partnerships
For any interest owned by the corporation
that is treated as an investment in a
partnership for U.S. federal income tax
purposes (other than an interest in a
disregarded entity), report amounts on
Part II, line 7 or 8, as described below:
1. In column (a), the sum of the
corporation’s distributive share of income
or loss from a U.S. or foreign partnership
that is included in Part I, line 11;
2. In column (b) or (c), as applicable,
the sum of all differences, if any,
attributable to the corporation’s
distributive share of income or loss from a
U.S. or foreign partnership;
and
3. In column (d), the sum of all
amounts of income, gain, loss, or
deduction attributable to the corporation’s
distributive share of income or loss from a
U.S. or foreign partnership (i.e., the sum
of all amounts reportable on the
corporation’s Schedule(s) K-1 received
from the partnership (if applicable)),
without regard to any limitations
computed at the partner level.
For each partnership reported on line 7
or 8, attach a supporting schedule that
provides the name, EIN (if applicable),
end of year profit-sharing percentage (if
applicable), end of year loss-sharing
percentage (if applicable), and the
amount reported in column (a), (b), (c), or
(d) of lines 7 or 8, as applicable.
Example 11. U.S. corporation H is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. H has an investment in a
U.S. partnership USP. H prepares
financial statements in accordance with
GAAP. In its financial statements, H treats
the difference between financial
statement net income and taxable income
from its investment in USP as a
permanent difference. For its 2007 tax
year, H’s financial statement net income
includes $10,000 of income attributable to
its share of USP’s net income. H’s
Schedule K-1 from USP reports $5,000 of
ordinary income, $7,000 of long-term
capital gains, $4,000 of charitable
contributions, and $200 of section 179
expense. H must report on Part II, line 7,
$10,000 in column (a), a permanent
difference of ($2,200) in column (c), and
$7,800 in column (d).

Line 9. Income (Loss) From
Other Pass-Through Entities
For any interest in a pass-through entity
(other than an interest in a partnership
reportable on Part II, line 7 or 8, as
applicable) owned by the corporation
(other than an interest in a disregarded
entity), report the following on line 9:
1. In column (a), the sum of the
corporation’s distributive share of income

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or loss from the pass-through entity that is
included in Part I, line 11;
2. In column (b) or (c), as applicable,
the sum of all differences, if any,
attributable to the pass-through entity;
and
3. In column (d), the sum of all taxable
amounts of income, gain, loss, or
deduction reportable on the corporation’s
Schedules K-1 received from the
pass-through entity (if applicable).
For each pass-through entity reported
on line 9, attach a supporting schedule
that provides that entity’s name, EIN (if
applicable), the corporation’s end of year
profit-sharing percentage (if applicable),
the corporation’s end of year loss-sharing
percentage (if applicable), and the
amounts reported by the corporation in
column (a), (b), (c), or (d) of line 9, as
applicable.

Line 10. Items Relating to
Reportable Transactions
Any amounts attributable to any
reportable transactions (as described in
Regulations section 1.6011-4) must be
included on Part II, line 10, regardless of
whether the difference, or differences,
would otherwise be reported elsewhere in
Part II or Part III. Thus, if a taxpayer files
Form 8886 for any reportable transaction
described in Regulations section 1.6011-4
the amounts attributable to that reportable
transaction must be reported on Part II,
line 10. In addition, all income and
expense amounts attributable to a
reportable transaction must be reported
on Part II, line 10, columns (a) and (d),
even if there is no difference between the
financial statement amounts and the
taxable amounts.
Each difference attributable to a
reportable transaction must be separately
stated and adequately disclosed. A
corporation will be considered to have
separately stated and adequately
disclosed a reportable transaction on line
10 if the corporation sequentially numbers
each Form 8886 and lists by identifying
number on the supporting schedule for
Part II, line 10, each sequentially
numbered reportable transaction and the
amounts required for Part II, line 10,
columns (a) through (d).
In lieu of the requirements of the
preceding paragraph, a corporation will
be considered to have separately stated
and adequately disclosed a reportable
transaction if the corporation attaches a
supporting schedule that provides the
following for each reportable transaction:
1. A description of the reportable
transaction disclosed on Form 8886 for
which amounts are reported on Part II,
line 10;
2. The name and tax shelter
registration number, if applicable, as
reported on lines 1a and 1b, respectively,
of Form 8886; and
3. The type of reportable transaction
(i.e., listed transaction, confidential
transaction, transaction with contractual
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protection, etc.) as reported on line 2 of
Form 8886.
If a transaction is a listed transaction
described in Regulations section
1.6011-4(b)(2), the description also must
include the description provided on line 3
of Form 8886. In addition, if the reportable
transaction involves an investment in the
transaction through another entity such as
a partnership, the description must
include the name and EIN (if applicable)
of that entity as reported on line 5 of Form
8886.
Example 12. Corporation J is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. J incurred seven different
abandonment losses during its 2007 tax
year. One loss of $12 million results from
a reportable transaction described in
Regulations section 1.6011-4(b)(5),
another loss of $5 million results from a
reportable transaction described in
Regulations section 1.6011-4(b)(4), and
the remaining five abandonment losses
are not reportable transactions. J
discloses the reportable transactions
giving rise to the $12 million and $5
million losses on separate Forms 8886
and sequentially numbers them X1 and
X2, respectively. J must separately state
and adequately disclose the $12 million
and $5 million losses on Part II, line 10.
The $12 million loss and the $5 million
loss will be adequately disclosed if J
attaches a supporting schedule for line 10
that lists each of the sequentially
numbered forms, Form 8886-X1 and
Form 8886-X2, and with respect to each
reportable transaction reports the
appropriate amounts required for Part II,
line 10, columns (a) through (d).
Alternatively, J’s disclosures will be
adequate if the description provided for
each loss on the supporting schedule
includes the names and tax shelter
registration numbers, if any, disclosed on
the applicable Form 8886, identifies the
type of reportable transaction for the loss,
and reports the appropriate amounts
required for Part II, line 10, columns (a)
through (d). J must report the losses
attributable to the other five abandonment
losses on Part II, line 21e, regardless of
whether a difference exists for any or all
of those abandonment losses.
Example 13. Corporation K is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. K enters into a transaction
with contractual protection that is a
reportable transaction described in
Regulations section 1.6011-4(b)(4). This
reportable transaction is the only
reportable transaction for K’s 2007 tax
year and results in a $7 million capital
loss for both financial statement purposes
and U.S. federal income tax purposes.
Although the transaction does not result
in a difference, K is required to report on
Part II, line 10, the following amounts: ($7
million) in column (a), zero in columns (b)
Instructions for Form 1120S-M3

and (c), and ($7 million) in column (d).
The transaction will be adequately
disclosed if K attaches a supporting
schedule for line 10 that (a) sequentially
numbers the Form 8886 and refers to the
sequentially-numbered Form 8886-X1
and (b) reports the applicable amounts
required for line 10, columns (a) through
(d). Alternatively, the transaction will be
adequately disclosed if the supporting
statement for line 10 includes a
description of the transaction, the name
and tax shelter registration number, if
any, and the type of reportable
transaction disclosed on Form 8886.

Line 11. Interest income
Report on Part II, line 11, column (a), the
total amount of interest income included
on Part I, line 11, and report on Part II,
line 11, column (d), the total amount of
interest income included on Form 1120S,
page 3, Schedule K, line 18, that is not
required to be reported elsewhere on
Schedule M-3 In columns (b) or (c), as
applicable, adjust for any amounts treated
for U.S. federal income tax purposes as
interest income that are treated as some
other form of income in the financial
statements, or vice versa. For example,
adjustments to interest income resulting
from adjustments made in accordance
with instructions for Part II, line 16, should
be made in columns (b) and (c) of this line
11.
Do not report on this line 11 amounts
reported in accordance with instructions
for Part II, lines 7, 8, 9, 10, and 20.

Line 12. Total Accrual to Cash
Adjustment
This line is completed by a corporation
that prepares financial statements (or
books and records, if permitted) using an
overall accrual method of accounting and
uses an overall cash method of
accounting for U.S. federal income tax
purposes (or vice-versa). With the
exception of amounts required to be
reported on Part II, line 10, the
corporation must report on Part II, line 12,
a single amount net of all adjustments
attributable solely to the use of the
different overall methods of accounting
(e.g., adjustments related to accounts
receivable, accounts payable,
compensation, accrued liabilities, etc.),
regardless of whether a separate line on
Schedule M-3 corresponds to an item
within the accrual to cash reconciliation.
Differences not attributable to the use of
the different overall methods of
accounting must be reported on the
appropriate lines of Schedule M-3 (e.g., a
depreciation difference must be reported
on Part III, line 24).
Example 14. Corporation L is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. L prepares financial
statements in accordance with GAAP
using an overall accrual method of
accounting. L uses an overall cash

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method of accounting for U.S. federal
income tax purposes. L’s financial
statements for the year ending December
31, 2007, report accounts receivable of
$35,000, an allowance for bad debts of
$10,000, and accounts payable of
$17,000 related to current year
acquisition and reorganization legal and
accounting fees. In addition, for L’s year
ending December 31, 2007, L reported
financial statement depreciation expense
of $15,000 and depreciation for U.S.
federal income tax purposes of $25,000.
For L’s 2007 tax year using an overall
cash method of accounting, L does not
recognize the $35,000 of revenue
attributable to the accounts receivable,
cannot deduct the $10,000 allowance for
bad debt, and cannot deduct the $17,000
of accounts payable. In its financial
statements, L treats both the difference in
overall accounting methods used for
financial statement and U.S. federal
income tax purposes and the difference in
depreciation expense as temporary
differences. L must combine all
adjustments attributable to the differences
related to the overall accounting methods
on Part II, line 12. As a result, L must
report on Part II, line 12, $8,000 in column
(a) ($35,000 -$10,000 - $17,000),
($8,000) in column (b), and zero in
column (d). L must not report the accrual
to cash adjustment attributable to the
legal and accounting fees on Part III, line
17, Current year acquisition or
reorganization legal and accounting fees.
Because the difference in depreciation
expense does not relate to the use of the
cash or accrual method of accounting, L
must report the depreciation difference on
Part III, line 24, Depreciation, and report
$15,000 in column (a), $10,000 in column
(b), and $25,000 in column (d).

Line 13. Hedging Transactions
Report on line 13, column (a), the net
gain or loss from hedging transactions
included in net income per the income
statement. Report in column (d) the
amount of income (loss) from hedging
transactions as defined in section 1221
(b)(2). Use columns (b) and (c) to report
all differences caused by treating hedging
transactions differently for financial
accounting purposes and for U.S. federal
income tax purposes. For example, if a
portion of a hedge is considered
ineffective under GAAP but still is a valid
hedge under section 1221(b)(2), the
difference must be reported on line 13.
The hedge of a capital asset, which is not
a valid hedge for U.S. federal income tax
purposes but may be considered a hedge
for GAAP purposes, must also be
reported here.
Report hedging gains and losses
computed under the mark-to-market
method of accounting on line 13 and not
on Part II, line 14.
Report any gain or loss from inventory
hedging transactions on line 13 and not
on Part II, line 15.

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Line 14. Mark-to-Market Income
(Loss)
Report on line 14 any amount
representing the mark-to-market income
or loss for any securities held by a dealer
in securities, a dealer in commodities
having made a valid election under
section 475(e), or a trader in securities or
commodities having made a valid election
under section 475(f). “ Securities” for
these purposes are securities described
in section 475(c)(2) and section 475(e)(2).
“ Securities”do not include any items
specifically excluded from sections
475(c)(2) and 475(e)(2), such as certain
contracts to which section 1256(a)
applies.
Report hedging gains and losses
computed under the mark-to-market
method of accounting on Part II, line 13,
Hedging transactions, and not on line 14.

Line 15. Cost of Goods Sold
Report on line 15 any amounts deducted
as part of cost of goods sold during the
tax year, regardless of whether the
amounts would otherwise be reported
elsewhere in Part II or Part III. However,
do not report the items mentioned in the
next paragraph on this line 15. Examples
of amounts that must be included on line
15 are amounts attributable to inventory
valuation, such as amounts attributable to
cost-flow assumptions, additional costs
required to be capitalized (including
depreciation) such as section 263A costs,
inventory shrinkage accruals, inventory
obsolescence reserves, and lower of cost
or market (LCM) write-downs.
Do not report the following on this line
15:
• Amounts reportable on Part II, line 10;
• Any gain or loss from inventory hedging
transactions reportable on Part II, line 13;
• Mark-to-market income or (loss)
associated with the inventories of dealers
in securities under section 475 reportable
on Part II, line 14;
• Section 481(a) adjustments related to
cost of goods sold or inventory valuation
reportable on Part II, line 17;
• Fines and penalties reportable on Part
III, line 9; and
• Judgments, damages, awards and
similar costs, reportable on Part III, line
10.
For the amount reported on Part II, line
15, attach Form 8916-A and report
amounts for each item listed on Form
8916-A in columns (a) through (d).
Example 15: Corporation C is a
calendar year taxpayer that placed in
service ten depreciable fixed assets in
2000. C was required to file Schedule M-3
for its 2005 tax year and is required to file
Schedule M-3 for its 2006 tax year. C’s
total depreciation expense for its 2006 tax
year for five of the assets is $50,000 for
income statement purposes and $70,000
for U.S. federal income tax purposes. C’s
total annual depreciation expense for its
2006 tax year for the other five assets is
$40,000 for income statement purposes

and $30,000 for U.S. federal income tax
purposes. In addition, C incurs $200 of
meals and entertainment expenses that C
deducts in computing net income per the
income statement. All $200 of is subject
to the $50% limitation under section
274(n). In its financial statements, C
treats the $50,000 depreciation and $100
of the meals and entertainment as other
costs in computing Cost of Goods Sold.
Accordingly, C must include on Part II,
line 15, in column (a), the $50,000 of
depreciation and $100 of meals and
entertainment. C must also include a
temporary difference of $20,000 in
column (b) a permanent difference of
$(50) in column (c) and $70,050 in
column (d) [$70,000 depreciation and $50
meals]. In addition, C must report: on Part
III, line 24, for its 2006 tax year income
statement, depreciation expense of
$40,000 in column (a), a temporary
difference of $(10,000) in column (b) and
$30,000 in column (d); and on Part III, line
8, meals and entertainment expense of
$100 in column (a), a permanent
difference of $(50) in column (c), and $50
in column (d). All other COGS items
would be added to the amounts included
on Part II, line 15 detailed in this example
and reported on Part II, line 15, in the
appropriate columns.

Line 16. Sale Versus Lease (for
Sellers and/or Lessors)
(Also see the instructions at Part III, line
28, for purchasers and/or lessees.)
Asset transfer transactions with
periodic payments characterized for
financial accounting purposes as either a
sale or a lease may, under some
circumstances, be characterized as the
opposite for tax purposes. If the
transaction is treated as a lease, the
seller/lessor reports the periodic
payments as gross rental income and
also reports depreciation expense or
deduction. If the transaction is treated as
a sale, the seller/lessor reports gross
profit (sale price less cost of goods sold)
from the sale of assets and reports the
periodic payments as payments of
principal and interest income.
On Part II, line 16, column (a), report
the gross profit or gross rental income for
financial income purposes for all sale or
lease transactions that must be given the
opposite characterization for U.S. federal
income tax purposes. On Part II, line 16,
column (d), report the gross profit or
gross rental income for federal income tax
purposes. Interest income amounts for
such transactions must be reported on
Part II, line 11, Interest income, in column
(a) or (d), as applicable. Depreciation
expense for such transactions must be
reported on Part III, line 24, Depreciation,
in column (a) or (d), as applicable. Use
columns (b) and (c) of Part II, lines 11 and
16, and Part III, line 24, as applicable to
report the differences between column (a)
and (d).
Example 16. Corporation M sells and
leases property to customers. M is a

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calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. For financial accounting
purposes, M accounts for each
transaction as a sale. For U.S. federal
income tax purposes, each of M’s
transactions must be treated as a lease.
In its financial statements, M treats the
difference in the financial accounting and
the U.S. federal income tax treatment of
these transactions as temporary. During
2007, M reports in its financial statements
$1,000 of sales and $700 of cost of goods
sold with respect to 2007 lease
transactions. M receives periodic
payments of $500 in 2007 with respect to
these 2007 transactions and similar
transactions from prior years and treats
$400 as principal and $100 as interest
income. For financial income purposes, M
reports gross profit of $300 ($1,000
-$700) and interest income of $100 from
these transactions. For U.S. federal
income tax purposes, M reports $500 of
gross rental income (the periodic
payments) and (based on other facts)
$200 of depreciation deduction on the
property. On its 2007 Schedule M-3, M
must report on Part II, line 11, $100 in
column (a), ($100) in column (b), and
zero in column (d). In addition, M must
report on Part II, line 16, $300 of gross
profit in column (a), $200 in column (b),
and $500 of gross rental income in
column (d). Lastly, M must report on Part
III, line 24, $200 in column (b) and (d).

Line 17. Section 481(a)
Adjustments
With the exception of a section 481(a)
adjustment that is required to be reported
on Part II, line 10, for reportable
transactions, any difference between an
income or expense item attributable to an
authorized (or unauthorized) change in
method of accounting made for U.S.
federal income tax purposes that results
in a section 481(a) adjustment must be
reported on Part II, line 17, regardless of
whether a separate line for that income or
expense item exists in Part II or Part III.
Example 17. Corporation N is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. N was depreciating certain
fixed assets over an erroneous recovery
period and, effective for its 2007 tax year,
N receives IRS consent to change its
method of accounting for the depreciable
fixed assets and begins using the proper
recovery period. The change in method of
accounting results in a positive section
481(a) adjustment of $100,000 that is
required to be spread over four tax years,
beginning with the 2007 tax year. In its
financial statements, N treats the section
481(a) adjustment as a temporary
difference. N must report on Part II, line
17, $25,000 in columns (b) and (d) for its
2007 tax year and each of the
subsequent three tax years (unless N is
otherwise required to recognize the
remainder of the 481(a) adjustment
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earlier). N must not report the section
481(a) adjustment on Part III, line 24.

Line 18. Unearned/Deferred
Revenue
Report on line 18, column (a), amounts of
revenues included in Part I, line 11, that
were deferred from a prior financial
accounting year. Report on line 18,
column (d), amounts of revenues
recognizable for U.S. federal income tax
purposes in the current tax year that are
recognized for financial accounting
purposes in a different year. Also report
on line 18, column (d), any amount of
revenues reported on line 18, column (a),
that are recognizable for U.S. federal
income tax purposes in the current tax
year. Use columns (b) and (c) of line 18,
as applicable, to report differences
between column (a) and (d).
Line 18 must not be used to report
income recognized from long-term
contracts. Instead, use line 19.

Line 19. Income Recognition
From Long-Term Contracts
Report on line 19 the amount of net
income or loss for financial statement
purposes (or books and records, if
applicable) or U.S. federal income tax
purposes for any contract accounted for
under a long-term contract method of
accounting.

Line 20. Original Issue Discount
and Other Imputed Interest
Report on line 20 any amounts of original
issue discount (OID) and other imputed
interest. The term 00original issue
discount and other imputed interest’’
includes, but is not limited to:
1. The difference between issue price
and the stated redemption price at
maturity of a debt instrument, which may
be wholly or partially realized on the
disposition of a debt instrument under
section 1273;
2. Amounts that are imputed interest
on a deferred sales contract under
section 483;
3. Amounts treated as interest or OID
under the stripped bond rules under
Section 1286; and
4. Amounts treated as OID under the
below-market interest rate rules under
Section 7872.

Line 21a. Income Statement
Gain/loss on Sale, Exchange,
Abandonment, Worthlessness,
or Other Disposition of Assets
Other Than Inventory and
Pass-Through Entities
Report on line 21a, column (a) all gains
and losses on the disposition of assets
except for (a) gains and losses on the
disposition of inventory, and (b) gains and
losses allocated to the corporation from a
pass-through entity (e.g., on Schedule
K-1) that are included in the net income
(loss) per income statement of the
corporation reported on Part I, line 11.
Instructions for Form 1120S-M3

Reverse the amount reported in column
(a) in column (b) or (c), as applicable. The
corresponding gains and losses for U.S.
federal income tax purposes are reported
on Part II, lines 21b through 21g, as
applicable.

Line 21b. Gross Capital Gains
From Schedule D, Excluding
Amounts From Pass-Through
Entities
Report on line 21b, gross capital gains
reported on Schedule D, excluding capital
gains from pass-through entities, which
must be reported on Part II, lines 7, 8, or
9, as applicable.

Line 21c. Gross Capital Losses
From Schedule D, Excluding
Amounts From Pass-Through
Entities, Abandonment Losses,
and Worthless Stock Losses
Report on line 21c, gross capital losses
reported on Schedule D, excluding capital
losses from (a) pass-through entities,
which must be reported on Part II, lines 7,
8, or 9, as applicable; (b) abandonment
losses, which must be reported on Part II,
line 21e; and (c) worthless stock losses,
which must be reported on Part II, line
21f.

Line 21d. Net Gain/Loss
Reported on Form 4797, Line
17, Excluding Amounts From
Pass-Through Entities,
Abandonment Losses, and
Worthless Stock Losses
Report on line 21d the net gain or loss
reported on line 17 of Form 4797, Sales
of Business Property, excluding amounts
from (a) pass-through entities, which must
be reported on Part II, lines 7, 8, or 9, as
applicable; (b) abandonment losses,
which must be reported on Part II, line
21e; and (c) worthless stock losses,
which must be reported on Part II, line
21f.

Line 21e. Abandonment Losses
Report on line 21e any abandonment
losses, regardless of whether the loss is
characterized as an ordinary loss or a
capital loss.

Line 21f. Worthless Stock
Losses
Report on line 21f any worthless stock
loss, regardless of whether the loss is
characterized as an ordinary loss or a
capital loss. Attach a schedule that
separately states and adequately
discloses each transaction that gives rise
to a worthless stock loss and the amount
of each loss.

Line 21g. Other Gain/Loss on
Disposition of Assets Other
Than Inventory
Report on line 21g any gains or losses
from the sale or exchange of property
other than inventory and that are not
reported on lines 21b through 21f.

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Line 22. Other Income (Loss)
Items With Differences
Separately state and adequately disclose
on Part II, line 22, all items of income
(loss) with differences that are not
otherwise listed on Part II, lines 1 through
21. Attach a schedule that itemizes the
type of income (loss) and the amount of
each item.
If any “comprehensive income” as
defined by Statement of Financial
Accounting Standards (SFAS) No. 130 is
reported on this line, describe the item(s)
in detail. Examples of sufficiently detailed
descriptions include “Foreign currency
translation adjustments” and “gains and
losses on available-for-sale securities.”

Line 24. Total Expense/
Deduction Items
Report on Part II, line 24, columns (a)
through (d), as applicable, the negative of
the amounts reported on Part III, line 30,
columns (a) through (d). For example, if
Part III, line 30, column (a), reflects an
amount of $1 million then report on Part
II, line 24, column (a), ($1 million).
Similarly, if Part III, line 30, column (b),
reflects an amount of ($50,000), then
report on Part II, line 24, column (b),
$50,000.

Line 25. Other Items With No
Differences
If there is no difference between the
financial accounting amount and the
taxable amount of an entire item of
income, gain, loss, expense, or deduction
and the item is not described or included
in Part II, lines 1 through 22, or Part III,
lines 1 through 29, report the entire
amount of the item in columns (a) and (d)
of line 25. If a portion of an item of
income, loss, expense, or deduction has
a difference and a portion of the item
does not have a difference, do not report
any portion of the item on line 25. Instead,
report the entire amount of the item (i.e.,
both the portion with a difference and the
portion without a difference) on the
applicable line of Part II, lines 1 through
22, or Part III, lines 1 through 29. See
Example 10 on page
.

Line 26. Reconciliation Totals.
Combine lines 23 through 25.
If a corporation chooses not to complete
columns (a) and (d) of Parts II and III in
the first tax year the corporation is
required to file Schedule M-3 (or for any
year in which the corporation voluntarily
files Schedule M-3), Part II, line 26, is
reconciled by the corporation in the
following manner:
1. Report the amount from Part I, line
11, on Part II, line 26, column (a);
2. Leave blank Part II, lines 1 through
25, columns (a) and (d);
3. Leave blank Part III, columns (a)
and (d); and
4. Report on Part II, line 26, column
(d), the sum of Part II, line 26, columns
(a), (b), and (c).

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Part III. Reconciliation of
Net Income (Loss) per
Income Statement of the
Corporation With Total
Income (Loss) per Return
— Expense/ Deduction
Items
Lines 1 Through 6. Income Tax
Expense
If the corporation does not distinguish
between current and deferred income tax
expense in its financial statements (or its
books and records, if applicable), report
income tax expense as current income
tax expense using lines 1, 3, and 5, as
applicable.

Line 7. Equity-Based
Compensation
Report on line 7 any amounts for
equity-based compensation or
consideration that are reflected as
expense in the financial statements
(column (a)) or deducted in the U.S.
federal income tax return (column (d))
other than amounts reportable elsewhere
on Schedule M-3, Parts II and III .
Examples of amounts reportable on line 7
include payments attributable to stock
options (including incentive stock options
and nonqualified stock options),
employee stock purchase plans (ESPPs),
phantom stock options, phantom stock
units, stock warrants, stock appreciation
rights, and restricted stock, regardless of
whether such payments are made to
employees or non-employees, or as
payment for property or compensation for
services.

Line 8. Meals and
Entertainment
Report on line 8, column (a), any amounts
paid or accrued by the corporation during
the tax year for meals, beverages, and
entertainment that are accounted for in
financial accounting income, regardless of
the classification, nomenclature, or
terminology used for such amounts, and
regardless of how or where such amounts
are classified in the corporation’s financial
income statement or the income and
expense accounts maintained in the
corporation’s books and records. Report
only amounts not otherwise reportable
elsewhere on Schedule M-3, Parts II and
III (e.g., Part II, line 15).

Line 9. Fines and Penalties
Report on line 9 any fines or similar
penalties paid to a government or other
authority for the violation of any law for
which fines or penalties are assessed. All
fines and penalties expensed in financial
accounting income (paid or accrued) must
be included on this line 9, column (a),
regardless of the government or other
authority that imposed the fines or
penalties, regardless of whether the fines
and penalties are civil or criminal,

regardless of the classification,
nomenclature, or terminology used for the
fines or penalties by the imposing
authority in its actions or documents, and
regardless of how or where the fines or
penalties are classified in the
corporation’s financial income statement
or the income and expense accounts
maintained in the corporation’s books and
records. Also report on line 9, column (a),
the reversal of any overaccrual of any
amount described in this paragraph. See
section 162(f) for additional guidance.
Report on line 9, column (d), any such
amounts as are described in the
preceding paragraph that are includible in
taxable income, regardless of the
financial accounting period in which such
amounts were or are included in financial
accounting net income. Complete
columns (b) and (c), as appropriate.
Do not report on this Part III, line 9,
amounts required to be reported in
accordance with instructions for Part III,
line 10.
Do not report on this Part III, line 9,
amounts recovered from insurers or any
other indemnitors for any fines and
penalties described above.

Line 10. Judgments, Damages,
Awards, Similar Costs
Report on line 10, column (a), the amount
of any estimated or actual judgments,
damages, awards, settlements, and
similar costs, however named or
classified, included in financial accounting
income, regardless of whether the
amount deducted was attributable to an
estimate of future anticipated payments or
actual payments. Also report on line 10,
column (a), the reversal of any
overaccrual of any amount described in
this paragraph.
Report on line 10, column (d), any
such amounts as are described in the
previous paragraph that are includible in
taxable income, regardless of the
financial accounting period in which such
amounts were or are included in financial
accounting net income. Complete
columns (b) and (c), as appropriate.
Do not report on this Part III, line 10,
amounts required to be reported in
accordance with instructions for Part III,
line 9.
Do not report on this Part III, line 10,
amounts recovered from insurers or any
other indemnitors for any judgments,
damages, awards, or similar costs
described above.

Line 11. Pension and
Profit-Sharing
Report on line 11 any amounts
attributable to the corporation’s pension
plans, profit-sharing plans, and any other
retirement plans.

Line 12. Other Post-Retirement
Benefits
Report on line 12 any amounts
attributable to other post-retirement

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benefits not otherwise includible on Part
III, line 11, for example, retiree health and
life insurance coverage, dental coverage,
etc.

Line 13. Deferred
Compensation
Report on line 13, column (a), any
compensation expense included in the
net income (loss) amount reported in Part
I, line 11 that is not deductible for U.S.
federal income tax purposes in the
current tax year and that was not reported
elsewhere on Schedule M-3, column (a).
Report on line 13, column (d), any
compensation deductible in the current
tax year that was not included in the net
income (loss) amount reported in Part I,
line 11 for the current tax year and that is
not reportable elsewhere on Schedule
M-3. For example, report originations and
reversals of deferred compensation
subject to section 409A on line 13.

Line 15. Charitable Contribution
of Intangible Property
Report on line 15 any charitable
contribution of intangible property, for
example, contributions of:
• Intellectual property, patents (including
any amounts of additional contributions
allowable by virtue of income earned by
donees subsequent to the year of
donation), copyrights, trademarks;
• Securities (including stocks and their
derivatives, stock options, and bonds);
• Conservation easements (including
scenic easements or air rights);
• Railroad rights of way;
• Mineral rights; and
• Other intangible property.

Line 16. Current Year
Acquisition or Reorganization
Investment Banking Fees
Report on line 16 any investment banking
fees paid or incurred in connection with a
taxable or tax-free acquisition of property
(e.g., stock or assets) or a tax-free
reorganization. Report on this line any
investment banking fees incurred at any
stage of the acquisition or reorganization
process including, for example, fees paid
or incurred to evaluate whether to
investigate an acquisition, fees to conduct
an actual investigation, and fees to
consummate the acquisition. Also include
on this line 16 investment banking fees
incurred in connection with the liquidation
of a subsidiary, a spin-off of a subsidiary,
or an initial public stock offering.

Line 17. Current Year
Acquisition or Reorganization
Legal and Accounting Fees
Report on line 17 any legal and
accounting fees paid or incurred in
connection with a taxable or tax-free
acquisition of property (e.g., stock or
assets) or tax-free reorganization. Report
on this line any legal and accounting fees
incurred at any stage of the acquisition or
reorganization process including, for
example, fees paid or incurred to evaluate
whether to investigate an acquisition, fees
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to conduct an actual investigation, and
fees to consummate the acquisition. Also
include on this line 17 legal and
accounting fees incurred in connection
with the liquidation of a subsidiary, a
spin-off of a subsidiary, or an initial public
stock offering.

Line 24. Depreciation

Line 18. Current Year
Acquisition/Reorganization
Other Costs

Line 25. Bad Debt Expense

Report on line 18 any other fees paid or
incurred in connection with a taxable or
tax-free acquisition of property (e.g., stock
or assets) or a tax-free reorganization not
otherwise reportable on Schedule M-3
(e.g., Part III, line 16 or 17). Report on
this line any fees paid or incurred at any
stage of the acquisition or reorganization
process including, for example, fees paid
or incurred to evaluate whether to
investigate an acquisition, fees to conduct
an actual investigation, and fees to
consummate the acquisition. Also include
on this line 18 other acquisition/
reorganization costs incurred in
connection with the liquidation of a
subsidiary, a spin-off of a subsidiary, or
an initial public stock offering.

Line 19. Amortization/
Impairment of Goodwill
Report on line 19 amortization of goodwill
or amounts attributable to the impairment
of goodwill.

Line 20. Amortization of
Acquisition, Reorganization,
and Start-Up Costs
Report on line 20 amortization of
acquisition, reorganization, and start-up
costs. For purposes of column (b), (c),
and (d), include amounts amortizable
under sections 167, 195, or 248.

Line 21. Other Amortization or
Impairment Write-Offs
Report on line 21 any amortization or
impairment write-offs not otherwise
includible on Schedule M-3.

Line 22. Section 198
Environmental Remediation
Costs
Report on line 22, column (a), any
amounts attributable to environmental
remediation costs included in the net
income per the income statement. Report
in columns (b), (c), and (d), as applicable,
any deductible amounts attributable to
environmental remediation costs
described in section 198 that are paid or
incurred during the current tax year.

Line 23a. Depletion – Oil & Gas
Report on line 23a, column (a), any oil
and gas depletion included in Part I, line
11.

Line 23b. Depletion – Other
than Oil & Gas
Report on line 23b any depletion
expense/deduction other than oil and gas
that is not required to be reported
Instructions for Form 1120S-M3

elsewhere on Schedule M-3 (e.g., on Part
II, lines, 7, 8, 9, or 15).
Report on line 24 any depreciation
expense that is not required to be
reported elsewhere on Schedule M-3
(e.g., on Part II, lines, 7, 8, 9, or 15).
Report on line 25, column (a), any
amounts attributable to an allowance for
uncollectible accounts receivable or
actual write-offs of accounts receivable
included in net income per the income
statement. Report in column (d) the
amount of bad debt expense deductible
for federal income tax purposes in
accordance with section 166.

Line 26. Interest Expense
Report on Part III, line 26, column (a), the
total amount of interest expense included
on Part I, line 11, and report on Part III,
line 26, column (d), the total amount of
interest deduction included on Form
1120S, page 3, Schedule K, line 18, that
is not reported elsewhere on Schedule
M-3. In columns (b) or (c), as applicable,
adjust for any amounts treated for U.S.
federal income tax purposes as interest
deduction that are treated as some other
form of expense in the financial
statements, or vice versa. For example,
adjustments to interest expense /
deduction resulting from adjustments
made in accordance with instructions for
Part III, line 28, Purchase versus lease
(for purchasers and/or lessees), should
be made in columns (b) and (c), as
applicable, of this line 26.
Do not report on this line 26 amounts
reported in accordance with instructions
for (i) Part II, lines 7, 8 and 9, Income
(loss) from U.S. partnerships, foreign
partnerships and other pass-through
entities, and (ii) Part II, line 10, Items
relating to reportable transactions.

Line 27. Corporate Owned Life
Insurance Premiums
Report on line 27 all amounts of
insurance premiums attributable to any
life insurance policy if the corporation is
directly or indirectly a beneficiary under
the policy or if the policy has a cash
value. Report in column (d) the amount of
the premiums that are deductible for
federal income tax purposes.

Line 28. Purchase Versus Lease
(for Purchasers and/or
Lessees)
Note: Also see the instructions at Part II,
line 16, for sellers and/or lessors.
Asset transfer transactions with
periodic payments characterized for
financial accounting purposes as either a
purchase or a lease may, under some
circumstances, be characterized as the
opposite for tax purposes.
If a transaction is treated as a lease,
the purchaser/lessee reports the periodic
payments as gross rental expense. If the

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transaction is treated as a purchase, the
purchaser/lessee reports the periodic
payments as payments of principal and
interest and also reports depreciation
expense or deduction with respect to the
purchased asset.
Report on Part III, line 28, column (a),
gross rent expense for a transaction
treated as a lease for income statement
purposes but as a sale for U.S. federal
income tax return purposes. Report on
Part III, line 28, column (d), gross rental
deductions for a transaction treated as a
lease for U.S. federal income tax
purposes but as a purchase for income
statement purposes. Report interest
expense or deduction amounts for such
transactions on Part III, line 26, in column
(a) or (d), as applicable. Report
depreciation expense or deductions for
such transactions on Part III, line 24, in
column (a) or (d), as applicable. Use
columns (b) and (c) of Part III, lines 24,
26, and 28, as applicable, to report the
differences between column (a) and (d)
for such recharacterized transactions.
Example 18. U.S. corporation X
acquired property in a transaction that, for
financial accounting purposes, X treats as
a lease. X is a calendar year taxpayer
that was required to file Schedule M-3 for
its 2006 tax year and is required to file
Schedule M-3 for its 2007 tax year. For
U.S. federal income tax purposes,
because of its terms, the transaction is
treated for U.S. federal income tax
purposes as a purchase and X must treat
the periodic payments it makes partially
as payment of principal and partially as
payment of interest. In its financial
statements, X treats the difference
between the financial accounting and
U.S. federal tax treatment of this
transaction as a temporary difference.
During 2007, X reports in its financial
statements $1,000 of gross rental
expense that, for federal income tax
purposes, is recharacterized as a $700
payment of principal and a $300 payment
of interest, accompanied by a
depreciation deduction of $1,200 (based
on other facts). On its 2007 Schedule
M-3, X must report the following on Part
III, line 28: column (a) $1,000, its financial
accounting gross rental expense; column
(b), ($1,000); and column (d), zero. On
Part III, line 26, X reports zero in column
(a) and $300 in columns (b) and (d) for
the interest deduction. On Part III, line 24,
X reports zero in column (a) and $1,200
in columns (b) and (d) for the depreciation
deduction.

Line 29. Other Expense/
Deduction Items With
Differences
Report on Part III, line 29, all items of
expense/deduction that are not otherwise
listed on Part III, lines 1 through 28.
Comprehensive income. If any
“comprehensive income” as defined by
SFAS No. 130 is reported on this line,
describe the item(s) in detail as, for
example, “Foreign currency translation

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adjustments” and “ Gains and losses on
available-for-sale securities.”

Reserves and contingent liabilities.
Report on line 29 each reserve or
contingent liability that is not required to
be reported elsewhere on Schedule M-3.
Report on line 29, column (a), expenses
included in net income reported on Part I,
line 11, that are related to reserves and
contingent liabilities. Report on line 29,
column (d), amounts related to liabilities
for reserves and contingent liabilities that
are deductible in the current tax year for
U.S. federal income tax purposes.
Examples of items that must be reported
on line 29 include warranty reserves,
restructuring reserves, reserves for
discontinued operations, and reserves for
acquisitions and dispositions. Only report
on line 29 items that are not required to
be reported elsewhere on Schedule M-3,
Parts II and III. For example, the expense
for a reserve for inventory obsolescence
must be reported on Part II, line 15.
The schedule of details attached to the
return for line 29 must separately state
and adequately disclose the nature and
amount of the expense related to each
reserve and/or contingent liability. The
appropriate level of disclosure depends
upon each taxpayer’s operational activity
and the nature of its accounting records.
For example, if a corporation’s net income
amount reported in the income statement
includes anticipated expenses for a

discontinued operation as a single
amount, and its general ledger or other
books, records, and workpapers provide
details for the anticipated expenses under
more explanatory and defined categories
such as employee termination costs,
lease cancellation costs, loss on sale of
equipment, etc., a supporting schedule
that lists those categories of expenses
and their details will satisfy the
requirement to separately state and
adequately disclose. In order to
separately state and adequately disclose
the employee termination costs, it is not
required that an anticipated termination
cost amount be listed for each employee,
or that each asset (or category of asset)
be listed along with the anticipated loss
on disposition.
Example 19. Corporation Q is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. On July 1 of each year, Q
has a fixed liability for its annual
insurance premiums that provides a
12-month coverage period beginning July
1 through June 30. In addition, Q
historically prepays 12 months of
advertising expense on July 1. On July 1,
2007, Q prepays its insurance premium of
$500,000 and advertising expenses of
$800,000. For financial statement
purposes, Q capitalizes and amortizes the
prepaid insurance and advertising over 12

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months. For U.S. federal income tax
purposes, Q deducts the insurance
premium when paid and amortizes the
advertising over the 12-month period. In
its financial statements, Q treats the
differences attributable to the financial
statement treatment and U.S. federal
income tax treatment of the prepaid
insurance and advertising as temporary
differences. Q must separately state and
adequately disclose on Part III, line 29, its
prepaid insurance premium and report
$250,000 in column (a) ($500,000/12
months X 6 months), $250,000 in column
(b), and $500,000 in column (d). Q must
also separately state and adequately
disclose on Part II, line 25, Other items
with no differences, its prepaid advertising
and report $400,000 in column (a) and
(d).

Line 30. Total Expense/ Deduction
Items
Report on Part II, line 24, columns (a)
though (d), as applicable, the negative of
the amounts reported on Part III, line 30,
column (a) through (d), as applicable. For
example, if Part III, line 30, column (a),
reflects an amount of $1 million, then
report on Part II, line 24, column (a), ($1
million). Similarly, if Part III, line 30,
column (b), reflects an amount of
($50,000), then report on Part II, line 24,
column (b), $50,000.

Instructions for Form 1120S-M3

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Index

W
Who must file . . . . . . . . . . . . . . . 1

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Instructions for Form 1120S-M3

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