PRESENT LAW AND BACKGROUND RELATING 

TO CORPORATE TAX REFORM: 

ISSUES OF CONFORMING BOOK AND TAX INCOME 

AND CAPITAL COST RECOVERY 

Scheduled for a Public Hearing 

Before the 

SUBCOMMITTEE ON SELECT REVENUE MEASURES 

of the 

HOUSE COMMITTEE ON WAYS AND MEANS 

on May 9, 2006 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

May 8, 2006 

JCX-16-06 
i 

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

I. EXECUTIVE SUMMARY ......................................................................................................... 2 

II. OVERVIEW OF BUSINESS TAXATION.............................................................................. 3 

A. In General............................................................................................................................ 3 

B. Federal Income Tax Rates .................................................................................................. 4 

C. Choice of Entity .................................................................................................................. 6 

III. SELECTED ISSUES RELATED TO TAXATION OF C CORPORATIONS...................... 11 

A. Differences in Financial Accounting and Federal Income Tax Accounting..................... 11 

1. In general .................................................................................................................... 11 

2. Common book-tax differences.................................................................................... 11 

3. Reporting of book-tax differences to the IRS............................................................. 13 

4. Financial accounting for book-tax differences ........................................................... 13 

5. Fundamental principles creating book-tax differences under present law.................. 15 

6. Discussion of issues related to book-tax conformity .................................................. 16 

B. Cost Recovery................................................................................................................... 20 

1. In general .................................................................................................................... 20 

2. Concept of cost recovery ............................................................................................ 20 

3. Examples: methods of cost recovery ......................................................................... 22 

4. Present-law tax rules................................................................................................... 28 

5. Cost recovery financial accounting rules.................................................................... 29 

6. Summary of economic and accounting consequences of cost recovery 

alternatives .................................................................................................................. 32 

APPENDIX................................................................................................................................... 34 
1 

INTRODUCTION 

The Subcommittee on Select Revenue Measures of the House Committee on Ways and 

Means has scheduled a public hearing for May 9, 2006, on Corporate Tax Reform. This 

document,1

 prepared by the staff of the Joint Committee on Taxation, provides an overview of 

business taxation in the United States and reviews the differences between income reporting for 

financial reporting purposes by domestic public corporations and income measurement for 

computing income tax liability. This document also provides a description of present law and 

background relating to capital cost recovery under the income tax. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Present Law and 

Background Relating to Corporate Tax Reform: Issues of Conforming Book and Tax Income and Capital 

Cost Recovery (JCX-16-06), May 8, 2006. 
2 

I. EXECUTIVE SUMMARY 

Businesses can operate through a variety of legal forms, including C corporations, 

general partnerships, limited partnerships, limited liability companies, S corporations, and sole 

proprietorships. Both tax and non-tax concerns dictate a business’s choice of entity. 

The income of a C corporation is taxed directly to the corporation, and distributions of 

the corporation's after-tax income are taxed to the shareholders as dividends, although generally 

at a preferential rate. The income of pass-through entities such as partnerships, limited liability 

companies, and S corporations is not generally taxed at the entity level; instead, items of income 

and loss pass through to the partners, who include the items in calculating their own taxable 

income. 

In considering corporate tax reform, questions about the differences between financial 

accounting and Federal income tax accounting may arise and some tax reform proposals may 

involve eliminating some or all book-tax differences. It has been argued that book-tax 

conformity may act as a deterrent to aggressive tax positions and abusive tax shelters. In 

addition, book-tax conformity may promote simplification and reduced compliance costs within 

the corporate income tax system. However, there may be circumstances in which corporations 

are not motivated to maximize net income for financial statement purposes and therefore may be 

able to use the greater latitude afforded by financial accounting principles to inappropriately 

reduce taxable income. This raises questions about the ability of book-tax conformity proposals 

to apply consistent rules to similarly situated taxpayers. Finally, book-tax conformity proposals 

may limit the Congress's ability to administer fiscal and social policy via the tax law. 

Another area which may be the subject of tax reform proposals is the treatment of cost 

recovery. Cost recovery refers to the process by which a taxpayer recoups the cost of its 

investment in business or other income-producing property. Examples of cost recovery methods 

include straight-line depreciation, accelerated depreciation, and expensing, the latter two of 

which can be used as a tax policy tool to encourage investment. Another form of investment 

incentive is an investment tax credit. 

Each of the cost recovery methods described above results in the same amount of 

nominal tax deductions over the life of the asset; the incentive effects of accelerated depreciation 

and expensing, relative to straight-line depreciation, are caused by accelerating deductions (and 

thus deferring the payment of tax), which increases the net present value of cash flows related to 

the investment. In contrast, an investment tax credit reduces the amount of nominal tax 

deductions over the life of the asset. However, depending on the parameters used in any given 

investment tax credit proposal, the net present value of cash flows related to the investment (and 

thus the magnitude of the incentive effect) may be higher or lower than under accelerated 

depreciation or expensing. 

For financial accounting purposes, differences in timing of deductions (such as those 

created by the cost recovery methods described above) generally do not impact the amount of 

total tax expense or the effective tax rate reported in a corporation's financial statements. 

However, permanent changes in the total amount of tax (such as those produced by an 

investment tax credit) do affect a corporation's total tax expense and effective tax rate. 
3 

II. OVERVIEW OF BUSINESS TAXATION 

A. In General 

Businesses may be organized in a number of different ways. Owners of a business 

sometimes conduct their activities as “sole proprietorships,” which do not involve legal entities 

separate from the owner. However, for a variety of business or other reasons, a business will 

often be conducted through a separate legal entity. Common reasons to use a separate legal 

entity are the protection of limited liability accorded by State law to the owners of qualifying 

entities (but generally not to sole proprietors), and an improved ability to access capital markets 

for investment capital. 

The tax consequences of using a separate entity depend on the type of entity through 

which the business is conducted. Partnerships, certain closely-held companies that elect to be 

taxed under subchapter S, and limited liability companies that are treated as partnerships are 

treated for Federal income tax purposes as pass-through entities whose owners take into account 

the income (whether or not distributed) or loss of the entity on their own tax returns. Generally, 

an entity whose ownership interests are publicly traded is not entitled to be treated as a 

partnership. 

In contrast, the income of a C corporation2

 is taxed directly at the corporate level. 

Shareholders are taxed on dividend distributions of the corporation’s after-tax income. 

Shareholders are also taxed on any gain (including gain attributable to undistributed corporate 

income) on the disposition of their shares of stock of the corporation. Thus, the income of a C 

corporation may be subject to tax at both the corporate and shareholder levels. 3

 2

 A C corporation is a corporation that is subject to subchapter C of the Code, which provides 

rules for corporate and shareholder treatment of corporate distributions and adjustments. C corporations 

are generally subject to the corporate-level tax rate structure set forth in section 11 of the Code. 

3

 Specialized investment entities organized as C corporations, such as regulated investment 

companies and real estate investment trusts, and certain interests in debt instruments, such as real estate 

mortgage investment conduits, are effectively subject to only one level of tax notwithstanding that their 

ownership interests are publicly traded. Other specialized entities which are beyond the scope of this 

discussion include cooperatives and tax-exempt organizations. 
4 

B. Federal Income Tax Rates 

U.S. individuals (citizens and residents) are taxed at graduated statutory rates ranging 

from 10 percent (for taxable income of up to $7,550 for single filers and up to $15,100 for 

married taxpayers filing joint returns or surviving spouses) to 35 percent (for taxable income 

over $336,550) for taxable year 2006. The intermediate rates are 15 percent, 25 percent, 28 

percent, and 33 percent. The maximum tax rate on net long-term capital gains generally is 15 

percent.4

 Dividends received by an individual from domestic corporations and qualified foreign 

corporations are taxed at the same rates that apply to capital gains.5 

C corporations are taxed at statutory rates ranging from 15 percent (for taxable income up 

to $50,000) to 35 percent (for taxable income over $10,000,000). The intermediate rates are 25 

percent and 34 percent. The benefit of graduated rates below 34 percent is phased out for 

corporations with taxable income between $100,000 and $335,000, and the benefit of the 34 

percent rate is phased out for corporations with taxable income in excess of $15,000,000. 

Corporate long-term capital gains are taxed at the same rates as corporate ordinary income. 

Thus, the maximum tax rate for corporate net long-term capital gains is 35 percent. 

In addition, present law imposes a minimum tax on individuals and corporations to the 

extent their minimum tax liability exceeds their regular tax liability.6

 The alternative minimum 

tax (“AMT”) is imposed on corporations at the rate of 20 percent on the alternative minimum 

taxable income (“AMTI”) in excess of a $40,000 phased-out exemption amount, and on 

individuals at a rate of 26 percent for the first $175,000 of AMTI in excess of a phased-out 

exemption amount and at a rate of 28 percent for amounts in excess of such amount.7

 AMTI is 

the taxpayer’s regular taxable income increased by certain preference items and adjusted by 

determining the tax treatment of certain items in a manner that negates the deferral of income 

resulting from the regular tax treatment of those items. In general, the AMT applies a lower tax 

 4

 Net gain from the sale of collectibles is taxed at a maximum 28 percent rate, while certain gain 

from the sale or exchange of depreciable real estate (i.e., “unrecaptured section 1250 property”) is taxed 

at a maximum 25 percent rate. Under present law, for taxable years beginning after 2008, the maximum 

tax rate applicable to net long-term capital gains (other than collectibles or unrecaptured section 1250 

property) will increase from 15 percent to 20 percent. 

5

 Under present law, for taxable years beginning after 2008, dividends received by an individual 

are taxed at ordinary income rates. 

6

 A corporation with average gross receipts of less than $7.5 million for the prior three taxable 

years is exempt from the corporate minimum tax. The $7.5 million threshold is reduced to $5 million for 

the corporation’s first three-taxable year period. 

7

 Under present law, the exemption amount for taxable year 2006 is $45,000 in the case of 

married individuals filing a joint return. The exemption amount is completely phased out for married 

individuals filing a joint return with AMTI in excess of $330,000 and for a corporation with AMTI in 

excess of $310,000. For taxable year 2005, the exemption amount for married individuals filing a joint 

return was $58,000; various proposals which would increase the exemption amounts and the phaseout 

amounts for individuals for taxable year 2006 are currently before the Congress. 
5 

rate to a broader tax base. Specifically, the regular tax base is increased for AMT purposes by 

adding back certain items treated as tax preferences, and disallowing certain deductions and 

credits. 
6 

C. Choice of Entity 

In general

The choice of business structure can have an impact on the liability of the owners of the 

business, the tax treatment of income and deductions, and on the options available to the 

business for financing projects. In practice, this results in considerable variation in the choice of 

entity structure: in 2003, there were 2.0 million C corporation tax returns, 3.3 million S 

corporation tax returns, 2.4 million partnership returns, and 19.7 million non-farm sole 

proprietorship returns. 

C corporations 

A corporation is a business entity organized under a Federal or State statute, or under a 

statute of a Federally recognized Indian tribe, if the statute describes or refers to the entity as 

incorporated or as a corporation.8 The Code taxes a corporation as an entity separate from its 

shareholders. A C corporation’s income generally is taxed when earned at the corporate level 

and is taxed again at the individual level when distributed as dividends9 to its shareholders. 

Corporate deductions and credits reduce only corporate income and are not passed through to 

shareholders. 

Corporate income that is not distributed to shareholders is generally subject to current tax 

at the corporate level only.10 To the extent that income retained at the corporate level is reflected 

in an increased share value, the shareholder may be taxed at capital gains rates upon sale or 

exchange (including certain redemptions) of the stock or upon liquidation of the corporation. In 

addition, foreign investors are generally exempt from U.S. income tax on capital gains, but are 

subject to withholding tax on dividends. Tax-exempt investors are not generally subject to tax 

on corporate distributions or on sales or exchanges of corporate stock. 

Appreciated corporate assets are generally subject to corporate level tax if they are 

distributed to the shareholders, yielding the same tax result as if the assets had been sold by the 

corporation and the proceeds distributed to the shareholders. 

 8

 Treas. Reg. sec. 301.7701-2(b)(1). 

9

 Distributions with respect to stock that exceed corporate earnings and profits are not taxed as 

dividend income to shareholders but are treated as a tax-free return of capital that reduces the 

shareholder’s basis in the stock. Distributions in excess of corporate earnings and profits that exceed a 

shareholder’s basis in the stock are treated as amounts received in exchange for the stock which, in 

general, are taxed to the shareholder at capital gains rates. 

10 An “accumulated earnings tax” can be imposed on certain earnings in excess of $250,000 

($150,000 for certain service corporations in certain fields) accumulated beyond the reasonable needs of 

the business (secs. 531-537). A “personal holding company tax” is imposed on certain undistributed 

personal holding company income, generally where the corporation meets certain closely held stock 

requirements and more than 60 percent of the adjusted ordinary gross income (as defined) consists of 

certain passive-type income such as dividends, interest, and similar items (secs. 541-547). 
7 

In general, amounts paid as reasonable compensation to shareholders who are also 

employees are deductible by the corporation,11 and are taxed as ordinary income at the individual 

level (unless a specific exclusion applies). On the other hand, amounts paid as dividends to 

shareholders generally are not deductible by the corporation and are taxed as income to the 

shareholders (generally at the same preferential rates as apply to capital gains, for dividends 

received prior to 2009). 

In general, interest paid by a C corporation is deductible but dividends paid are not.12 

This creates a tax incentive favoring debt over equity in a corporation’s capital structure. The 

distinction between debt and equity depends on a number of factors. This determination requires 

an examination of the substance of the instrument. The analysis of whether an instrument is debt 

or equity for Federal income tax purposes is not identical to the analysis of whether such 

instrument will be characterized as debt or equity for financial reporting purposes. As a result, 

financial instruments are sometimes specifically structured to obtain desired differing treatment 

for tax and financial reporting purposes. 

A C corporation is generally the entity of choice if a corporation anticipates a public 

offering, because publicly traded partnerships are generally taxed as corporations, and S 

corporations (discussed below) are not permitted to have more than 100 shareholders. 

Partnerships

Advantages of pass-through treatment

Business owners may choose to operate or invest through a “pass-through” entity, such as 

a partnership, limited liability company, or S corporation, either to avoid corporate tax treatment, 

or for non-tax business reasons. Noncorporate tax treatment may be preferred because: (1) 

owners may not wish business earnings to be subject to two levels of tax (once when earned, and 

again when distributed); (2) the average or marginal tax rates for the individual shareholders may 

be lower than that of the corporation; and (3) owners may wish to use losses generated by the 

business to offset income from other sources. 

Federal income tax treatment of partnerships

Partnerships generally are treated for Federal income tax purposes as pass-through 

entities, not subject to tax at the entity level.13 Items of income (including tax-exempt income), 

gain, loss, deduction and credit of the partnership are taken into account in computing the tax of 

 11 Annual compensation in excess of $1 million that is payable to the chief executive officer or 

the four other most highly compensated employees of a public corporation is not deductible unless the 

compensation qualifies as performance-based compensation or another exception applies. Sec. 162(m). 

12 If certain requirements are satisfied, dividends paid on stock held by an employee stock 

ownership plan are deductible by the corporation. Sec. 404(k). 

13 Sec. 701. 
8 

the partners (based on the partnership’s method of accounting and regardless of whether the 

income is distributed to the partners). Each partner takes into income such partner’s distributive 

share of the partnership’s taxable income and the separately allocable items of income, gain, 

loss, deduction, and credit.14 A partner’s deduction for partnership losses is limited to the 

amount of the partner’s adjusted basis in his or her partnership interest.15 To the extent a loss is 

not allowed due to a limitation, it generally is carried forward to the next year. A partner’s basis 

in the partnership interest generally equals the sum of (1) such partner’s capital contribution to 

the partnership, (2) the partner’s distributive share of partnership income, and (3) the partner’s 

share of partnership liabilities, less (1) such partner’s distributive share of losses allowed as a 

deduction and (2) any partnership distributions.16

Partnerships provide partners with a significant amount of flexibility to vary their 

respective shares of partnership income. Unlike corporations, partnerships may allocate items of 

income, gain, loss, deduction and credit among the partners, provided the allocations have 

substantial economic effect. In general, an allocation is permitted to the extent the partner to 

which the allocation is made receives the economic benefit or bears the economic burden of such 

allocation, and the allocation substantially impacts the dollar amounts to be received by the 

partners from the partnership independent of tax consequences. 

Limited liability companies

In the last 30 years,17 States have enacted laws providing for another form of entity, the 

limited liability company (“LLC”). LLCs are generally treated as partnerships for Federal 

income tax purposes. They are neither partnerships nor corporations under applicable State law, 

but they generally provide limited liability to their owners for obligations of the business. Under 

regulations promulgated in 1996, any domestic non-publicly traded unincorporated entity with 

two or more members generally may elect to be treated as either a partnership or a corporation 

for Federal income tax purposes, while any single-member unincorporated entity may elect to be 

treated as a corporation or to be disregarded (i.e., treated as not separate from its owner18) for 

 14 Sec. 702(a). 

15 Sec. 704(d). In addition, “passive loss” and “at-risk” limitations limit the extent to which 

certain types of income can be offset by partnership deductions. These limitations do not apply to 

corporate partners (except certain closely held corporations) and may not be important to individual 

partners who have partner level “passive income” from other investments. 

16 Sec. 705. 

17 The first LLC statute was enacted in Wyoming in 1977. All States (and the District of 

Columbia) now have an LLC statute, though the tax treatment of LLCs for State tax purposes may differ. 

18 Thus, where the single member is an individual, such a disregarded LLC will be treated as a 

sole proprietorship. 
9 

Federal income tax purposes.19 These regulations, known as the “check-the-box” regulations, 

were a response, in part, to the growth of LLCs. 

S corporations

An S corporation provides the Federal income tax advantage of pass-through treatment, 

and also retains the non-tax advantages of corporate status under Federal securities laws and 

State law. An S corporation and its shareholders are generally treated, for Federal income tax 

purposes, more like a partnership and its partners than like a C corporation and its shareholders. 

In order to make an election to be treated as an S corporation, a corporation must meet certain 

requirements primarily regarding its capital structure and the identity of its shareholders. 

To be eligible to elect S corporation status, a corporation may not have more than 100 

shareholders and may not have more than one class of stock. Only individuals (other than 

nonresident aliens), certain tax-exempt organizations, and certain trusts and estates are permitted 

shareholders. A corporation may elect S corporation status only with the consent of all its 

shareholders, and may terminate its election with the consent of shareholders holding more than 

50 percent of the stock.20 Although there are limitations on the types of shareholders and stock 

structure an S corporation may have, there is no limit on the asset size of such a corporation (as 

there is no limit on the size of a C corporation or partnership). 

For Federal income tax purposes, an S corporation is generally not subject to tax at the 

corporate level.21 Items of income (including tax-exempt income), gain, loss, deduction and 

credit of the corporation are taken into account in computing the tax of the shareholders (under 

the corporation’s method of accounting and regardless of whether the income is distributed to the 

shareholders). A shareholder’s deduction for corporate losses is limited to the sum of the 

shareholder’s adjusted basis in the S corporation stock and the indebtedness of the corporation to 

such shareholder. To the extent a loss is not allowed due to this limitation, the loss generally is 

carried forward to the next year. The shareholder’s basis in the S corporation stock (and debt) is 

reduced by the shareholder’s share of losses and (in the case of stock) by distributions and is 

increased by the shareholder’s share of the corporation’s income.22

There are two principal exceptions to the general pass-through treatment of S 

corporations. Both are applicable only if the corporation was previously a C corporation and are 

generally intended to prevent avoidance of otherwise applicable C corporation tax consequences. 

First, an S corporation is subject to tax on excess net passive investment income (but not in 

excess of its taxable income, subject to certain adjustments), if the corporation has subchapter C 

earnings and profits and has gross receipts more than 25 percent of which are passive investment 

 19 Treas. Reg. sec. 301.7701-3. 

20 Sec. 1362. 

21 Secs. 1363 and 1366. 

22 Sec. 1367. 
10 

income for the year.23 Second, for the first 10 years after a corporation that was previously a 

regular C corporation elects to be an S corporation, certain net “built-in” capital gains of the 

corporation attributable to the period in which it was a C corporation are subject to tax at the 

corporate level.24

In general, an S corporation shareholder is not subject to tax on corporate distributions 

unless the distributions exceed the shareholder’s basis in the stock of the corporation or the 

corporation was formerly a C corporation and has undistributed earnings and profits.25 To the 

extent of such earnings and profits, corporate distributions are treated as dividends of C 

corporations and generally are subject to tax as such in the hands of the shareholders. 

Notwithstanding that they both provide for pass-through treatment, there are several 

significant Federal tax differences between S corporations and partnerships. First, corporate 

liabilities (other than those owed to its shareholders) are not included in a shareholder’s basis for 

the interest in an S corporation. Thus, unlike a partner who can take deductions supported by 

certain partnership indebtedness, S corporation shareholders who wish to obtain similar types of 

deductions are required to individually borrow and contribute or re-lend such amounts to the S 

corporation. Further, S corporations may have only one class of stock, and thus do not offer the 

same flexibility as partnerships to allocate income and losses to different investors. 

 23 Sec. 1375. If the S corporation continues to have C corporation earnings and profits and has 

gross receipts more than 25 percent of which are passive investment income in each year for three 

consecutive years, the S corporation election is automatically terminated (sec. 1362(d)(3)). 

24 Sec. 1374. 

25 Sec. 1368. 
11 

III. SELECTED ISSUES RELATED TO TAXATION OF C CORPORATIONS 

A. Differences in Financial Accounting and Federal Income Tax Accounting 

1. In general 

In considering corporate tax reform, questions about differences between the accounting 

methods employed for financial reporting purposes and those used in calculating taxable income 

(“book-tax differences”) may arise. Some tax reform proposals may involve eliminating some or 

all book-tax differences. Some have noted that the divergence of book and tax reporting 

requirements increase complexity for corporations. Some have also questioned whether a single 

system could serve both financial reporting and tax purposes. 

This section describes some of the common book-tax differences and how they are 

reported to the IRS and the Securities and Exchange Commission (“SEC”). These differences, 

along with the general principles underlying book and tax accounting, are examined in the 

context of potential proposals for complete or partial book-tax conformity. 

The Financial Accounting Standards Board (“FASB”) establishes and interprets the 

financial accounting standards which govern U.S. Generally Accepted Accounting Principles 

(“GAAP”) and which are used by publicly traded companies in compiling their annual reports 

filed with the SEC. The primary purpose of financial reporting is to provide information about a 

company to investors and creditors. By contrast, corporations calculate their taxable income in 

accordance with the Code. The primary purpose of tax accounting is to measure income for the 

purpose of levying the Federal income tax. The tax laws also have been used as instruments of 

social and fiscal policy. The Code generally requires that a corporation’s taxable year and 

overall method of accounting conform to those used for financial reporting purposes.26 

However, many specific differences are permitted (and, in some cases, required) between 

financial accounting and tax accounting. 

2. Common book-tax differences 

Many book-tax differences are caused by the timing of income or expense recognition 

under the two systems. Timing differences are often referred to as “temporary” differences 

because, over time, the total income and expense recognition with respect to these items will be 

the same under the two systems. For example, expenses are generally accrued under GAAP if 

they are probable and their amount can be reasonably estimated; in contrast, expenses generally 

are not deductible for tax purposes until all events have occurred which determine the fact of 

liability and the amount of the liability can be determined with reasonable accuracy.27 These 

general principles often result in the recognition of accrued expenses in earlier years for GAAP 

 26 Secs. 441 and 446. 

27 Sec. 461(h). 
12 

purposes than for tax purposes; however, eventually the same amount of expenses will be 

reported under both systems.28

The treatment of capital costs is another prominent temporary difference; accelerated 

depreciation and expensing for small businesses generally result in deductions for capital costs 

being reflected in taxable income earlier than in book income.29 Other examples include bad 

debts, an estimate of which must be accrued for book purposes while no tax deduction is 

permitted until an account is actually written off, and nonqualified deferred compensation 

expenses, which are accrued as the employee earns them for book purposes but generally are not 

deductible for tax purposes until paid. 

In addition to the temporary differences caused by the timing of income and expense 

recognition, some book-tax differences are caused by the inclusion of an item of income or 

expense for one system but not the other. These are referred to as “permanent differences.” 

Permanent differences include the interest on tax-exempt bonds, nondeductible meals and 

entertainment expenses, fines and penalties, and compensation in excess of tax deductible limits, 

each of which is taken into account as income or expense in determining financial accounting 

income but not taxable income. 

Book income and taxable income may also permanently differ as a result of the rules 

governing consolidated filing of financial reports and tax returns by related corporations. For tax 

purposes, only domestic subchapter C corporations owned at least 80 percent (determined by 

both voting power and value) by a parent corporation may be included in the parent 

corporation’s consolidated filing.30 Financial accounting requires consolidation of subsidiaries 

in which the parent company has direct or indirect financial control, regardless of whether the 

subsidiaries are domestic corporations.31 Thus, consolidated financial statements generally 

 28 If a GAAP estimate ultimately proves incorrect, the company will generally adjust its books 

when the correct amount is determined. For example, corporations often accrue a contingency reserve for 

ongoing legal disputes. Any ultimate payment under a judgment or settlement is generally not deductible 

until paid, at which time the book accrual is adjusted (“trued up”) to reflect the actual amount of the 

payment. 

29 The straight-line method of depreciation is generally used for financial accounting purposes. 

The straight-line method and several accelerated cost recovery methods are discussed in a later section of 

this pamphlet. 

30 Furthermore, inclusion of such corporations is elective for tax purposes, though once an 

election is made all such corporations must be included. 

31 While exceptions apply, holding more than 50 percent of voting power is generally considered 

to constitute financial control. In addition, non-corporate entities such as partnerships are consolidated 

for financial accounting purposes if the parent company has financial control. 
13 

include the income of foreign subsidiaries and controlled subsidiaries owned less than 80 percent 

by the parent. These entities are not included in the parent’s consolidated tax return.32

Some book-tax differences are the result of differing classification of balance sheet 

entries for book and tax purposes. For example, a financial instrument may be classified as 

either debt or equity for one system, with the opposite treatment under the other system. In such 

a case, payments on the instrument would be treated differently (for example, as interest 

payments or as dividend payments) in the calculation of book income and taxable income. 

3. Reporting of book-tax differences to the IRS 

Effective for tax years ending on or after December 31, 2004, the IRS requires 

corporations with total assets in excess of $10 million to file Schedule M-3, a detailed 

reconciliation between net income per financial statements and taxable income.33 The level of 

detail required by schedule M-3 is significantly greater than that required by Schedule M-1, 

which was required for years prior to the effective date of Schedule M-3.34 Treasury officials 

have suggested that the more detailed disclosure will help IRS auditors determine which booktax differences deserve the most focus and also will have a deterrent effect on aggressive tax 

positions.35

4. Financial accounting for book-tax differences 

Under GAAP, income tax expense is generally recognized when the income to which it 

relates is recognized, regardless of when the income is actually taxed. Thus, temporary book-tax 

differences generally do not affect the total tax expense reported by a corporation. For example, 

in the absence of permanent book-tax differences, a corporation which has $100 of book income 

 32 However, certain passive income of foreign subsidiaries and the distributive share of foreign 

pass-through entities (which may or may not be consolidated for GAAP purposes) will be reflected on the 

tax return as income of the parent or investor company. In addition, certain distributions from certain 

non-consolidated entities are included in the parent company’s taxable income even though such entities 

are not included in the consolidated tax return. 

33 The IRS is authorized to prescribe the forms which must be used and the information which 

must be provided by taxpayers when filing their income tax returns. (Sec. 6011(a)). 

34 Schedule M-1 is still in use for certain taxpayers, including those corporations not required to 

file Schedule M-3. See appendix for copies of Schedule M-1 and Schedule M-3. While all book-tax 

differences must be reported, some of the most common items include cost recovery, bad debts, and 

nonqualified deferred compensation. 

35 IRS News Release IR-2004-14, January 28, 2004. 
14 

before taxes in Year 1 and $100 of book income before taxes in Year 2 will book $35 of income 

tax expense in each year regardless of how much tax is actually paid in each of the two years. 36

The temporary differences created as a result of accelerated cost recovery for tax 

purposes provide an example. Consider a corporation with $200 of gross receipts in each of 

Years 1 and 2, and a $200 capital expenditure in Year 1 for a piece of equipment the cost of 

which is eligible for immediate expensing for tax purposes but must be depreciated over two 

years ($100 per year) for book purposes. Assuming no other book-tax differences, the 

corporation will have book income before taxes of $100 ($200 gross receipts less $100 book 

depreciation) in Year 1 and in Year 2. The corporation will have taxable income of zero ($200 

gross receipts less $200 cost recovery) and a tax liability of zero in Year 1. The corporation will 

have taxable income of $200 ($200 gross receipts, with no remaining cost recovery) and tax 

liability of $70 in Year 2. Note that the total pre-tax income for the two years combined is $200 

for both book and tax purposes, and that the $200 of taxable income over the two years results in 

$70 of income tax. For book purposes, the total $70 of tax is recognized in the years in which 

the income to which it relates is recognized, which in this case is 50 percent in each year.37 

Accordingly, the corporation will accrue a $35 tax expense in each year. 

Unlike temporary differences, permanent book-tax differences do affect the total amount 

of tax expense reported under GAAP. For example, consider a corporation which has $600 of 

gross income but incurs a $100 fine during the year. Net book income before taxes is, therefore, 

$500. Because the fine is not deductible for tax purposes, the taxable income is $600 and the 

corporation will owe $210 in Federal income tax.38 The $100 book-tax income difference 

related to the nondeductible fine is permanent, so its effect (an additional $35 in tax expense) is 

reflected in the financial statements in the period in which the permanent item (i.e., the 

nondeductible fine) occurs. For the year, the corporation reports $210 of tax expense and net 

income after taxes of $290.39 

The distinction between temporary and permanent book-tax differences is reflected in the 

corporation’s effective tax rate, which is a term financial accountants use to refer to the 

company’s total tax expense (per books) divided by pretax book income. A corporation which 

has only temporary differences and no permanent differences will generally have an effective tax 

rate in each year equal to the statutory tax rate. However, because permanent differences change 

the total amount of tax to be paid over time, they also cause a company’s effective tax rate to 

 36 The examples in this pamphlet assume a Federal income tax rate of 35 percent on all corporate 

taxable income. In addition, all other income taxes, including foreign and State income taxes, are 

ignored. 

37 This is consistent with the financial accounting objective of matching the costs of generating 

income with the income to which the costs relate by reporting them in the same accounting period. 

38 $600 taxable income at 35 percent tax rate results in $210 tax. 

39 $500 net income before taxes, reduced by $210 tax expense, results in $290 net income after 

taxes. 
15 

differ from the statutory rate. In the example above involving the permanent difference for a 

nondeductible fine, the company’s effective Federal tax rate for the year is 42 percent rather than 

35 percent. 

5. Fundamental principles creating book-tax differences under present law 

Book income and taxable income differ, in part, because of the different fundamental 

purposes they serve. 

The primary purpose of financial reporting is to provide information about a company to 

investors and creditors.40 Accordingly, the system of financial reporting values accuracy and 

conservatism. The system is tolerant of judgment and estimates in some cases, even though they 

might differ somewhat from one practitioner to the next, in an effort to present the most accurate 

picture of a company’s financial position and income.41 

The primary purpose of tax accounting is to measure income for the purpose of levying 

the income tax. The system favors objectivity, administrability, and consistency among 

taxpayers. For this reason, the use of judgment and estimates is generally avoided. The tax laws 

are also used as a fiscal and social policy tool, creating incentives for certain taxpayer behaviors 

which the Congress wishes to encourage. Such incentives, while serving what are considered to 

be important policy objectives, generally create deviations between book income and taxable 

income. 

These differences of purpose between financial accounting and tax accounting were 

noted by Justice Blackmun in Thor Power Tool Company v. Commissioner: 

The presumption petitioner postulates is insupportable in light of the vastly 

different objectives that financial and tax accounting have. The primary goal of 

financial accounting is to provide useful information to management, 

shareholders, creditors, and others properly interested; the major responsibility of 

the accountant is to protect these parties from being misled. The primary goal of 

the income tax system, in contrast, is the equitable collection of revenue; the 

major responsibility of the Internal Revenue Service is to protect the public fisc. 

Consistently with its goals and responsibilities, financial accounting has as its 

foundation the principle of conservatism, with its corollary that “possible errors in 

 40 Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by 

Business Enterprises (November 1978), lists three objectives of financial reporting. In short, they are (1) 

to provide information that is useful to present and potential investors and creditors and other users in 

making rational investment, credit, and similar decisions; (2) to provide information to help those persons 

in assessing the amounts, timing, and uncertainty of prospective cash flows; and (3) to provide 

information about the economic resources of an enterprise, the claims to those resources, and the effects 

of events that change its resources and claims thereto. 

41 It is thought that the judgment of a practitioner who is intimately familiar with a company’s 

financial circumstances, even though it may not be exactly the same as another practitioner, may present a 

more accurate reflection of those circumstances than would the application of an objective rule. 
16 

measurement [should] be in the direction of understatement rather than 

overstatement of net income and net assets.” In view of the Treasury’s markedly 

different goals and responsibilities understatement of income is not destined to be 

its guiding light. Given this diversity, even contrariety, of objectives, any 

presumptive equivalency between tax and financial accounting would be 

unacceptable. 

This difference in objectives is mirrored in numerous differences of treatment. 

Where the tax law requires that a deduction be deferred until “all the events” have 

occurred that will make it fixed and certain, United States v. Anderson, 269 U.S. 

422, 441, 46 S.Ct. 131, 134, 70 L.Ed. 347 (1926), accounting principles typically 

require that a liability be accrued as soon as it can reasonably be estimated. 

Conversely, where the tax law requires that income be recognized currently under 

“claim of right,” “ability to pay,” and “control” rationales, accounting principles 

may defer accrual until a later year so that revenues and expenses may be better 

matched. Financial accounting, in short, is hospitable to estimates, probabilities, 

and reasonable certainties; the tax law, with its mandate to preserve the revenue, 

can give no quarter to uncertainty. This is as it should be. Reasonable estimates 

may be useful, even essential, in giving shareholders and creditors an accurate 

picture of a firm’s overall financial health; but the accountant’s conservatism 

cannot bind the Commissioner in his efforts to collect taxes. “Only a few reserves 

voluntarily established as a matter of conservative accounting,” Mr. Justice 

Brandeis wrote for the Court, “are authorized by the Revenue Acts.” Brown v. 

Helvering, 291 U.S., at 201-202, 54 S.Ct., at 360. 

Finally, a presumptive equivalency between tax and financial accounting would 

create insurmountable difficulties of tax administration. Accountants long have 

recognized that “generally accepted accounting principles” are far from being a 

canonical set of rules that will ensure identical accounting treatment of identical 

transactions. “Generally accepted accounting principles,” rather, tolerate a range 

of “reasonable” treatments, leaving the choice among alternatives to management. 

Such, indeed, is precisely the case here. Variances of this sort may be tolerable in 

financial reporting, but they are questionable in a tax system designed to ensure as 

far as possible that similarly situated taxpayers pay the same tax. If management’s 

election among “acceptable” options were dispositive for tax purposes, a firm, 

indeed, could decide unilaterally-within limits dictated only by its accountants-the 

tax it wished to pay. Such unilateral decisions would not just make the Code 

inequitable; they would make it unenforceable. 42

6. Discussion of issues related to book-tax conformity 

Reform proposals seeking to increase conformity between book and tax accounting may 

take various forms, including complete conformity, partial conformity, or the requirement that a 

 42 439 U.S. 522, 542-544 (1979). 
17 

corporation employ a certain book accounting method as a condition of employing that method 

for tax purposes. 

One potential feature of these proposals which may be attractive is the creation of a 

“healthy tension” between a company’s desire to have high book income and its desire to have 

low taxable income. Assuming this tension exists under any given proposal, management will be 

constrained in taking aggressive positions for either book or tax purposes, because such positions 

by definition will either cost the company additional tax dollars (in the case of aggressive book 

positions) or result in diminished book income (in the case of aggressive tax positions). In 

addition, the greater flexibility of the GAAP rules in allowing judgment and estimates might be 

deemed acceptable for the tax system because the tension serves to keep judgment calls balanced 

between potential overstatement and understatement of income. It has been suggested that booktax conformity could be an effective tool in discouraging the use of corporate tax shelters. In 

1999, a Treasury department report stated that eliminating the book-tax disparity would 

“significantly limit the allure and benefit of corporate tax shelters to public corporations.”43 The 

staff of the Joint Committee on Taxation, in its report on the investigation of Enron Corporation 

and related entities, noted that the difference between tax and financial accounting created an 

incentive for the company to engage in such transactions.44

In addition, book-tax conformity proposals may represent simplification and reduce 

compliance costs since the appropriate treatment of conformed items of income and loss would 

have to be determined only once, rather than two or more times (including potentially for the 

alternative minimum tax) under the current system. 

Opponents of conformity proposals may argue that the differing fundamental principles 

on which the book and tax accounting systems are based, as discussed above, offer sufficient 

reason to maintain the status quo. Furthermore, the benefits of conformity may be limited by the 

existence of many potential circumstances under which the healthy tension does not exist 

because the company is not motivated to report higher book income. In these cases, companies 

may instead use the relative flexibility of GAAP rules to minimize book (and therefore taxable) 

income with no negative consequences.45

One potential category of corporations not motivated to maximize financial accounting 

profits may be corporations which are not publicly traded and which do not rely on financial 

statements for borrowing purposes. In addition, some publicly traded corporations may not be 

 43 U.S. Department of the Treasury, The Problem of Corporate Tax Shelters: Discussion, 

Analysis and Legislative Proposals, July 1999. 

44 For a summary of the Joint Committee staff’s findings on this issue, see Joint Committee on 

Taxation, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and 

Compensation Issues, and Policy Recommendations (JCS-3-03), February 2003, pp. 8-10. 

45 For example, if taxable income were conformed to book income, corporations not motivated to 

maximize book income may exercise judgment under GAAP to create reserves or write down the value of 

depreciated assets in order to reduce book (and therefore taxable) income. 
18 

motivated to maximize profits in particularly profitable years because they perceive steady 

earnings growth over a period of years as more valued by investors than a pattern of earnings 

which peaks and then falls. Still other public companies may view investor behavior as not 

driven by financial accounting net income. Because the primary purpose of GAAP is to convey 

information, a company’s net income number may be less important than the overall package of 

information conveyed. In a book-tax conformity environment, corporations that choose 

accounting methods which minimize book and taxable income would be free to provide to 

investors supplemental information such as the amount by which net income would be higher if 

the alternative method were chosen. In some industries, even this may be seen as unnecessary 

because investors may rely more on other financial data (such as gross revenue) rather than net 

income. 

On the other side of the healthy tension, proponents of book-tax conformity may see the 

desire to keep taxable income lower as moderating aggressive behavior in financial accounting. 

However, it should be noted that companies with large tax loss carryforwards may have little or 

no incentive to minimize current-year taxable income, freeing them to take aggressive 

accounting positions. 

The consideration of book-tax conformity proposals requires judgments regarding the 

role of fiscal and social policy in the Federal tax law. Generally, economic and social incentives 

enacted by Congress in the Code result in book-tax differences because such policies represent 

departures from the GAAP goal of calculating income in the most accurate way for investors. 

Accordingly, whichever tax incentives remain untouched by a book-tax conformity proposal will 

necessarily be outside the scope of the proposal or will otherwise constitute an exception to the 

proposal. 

A related consideration is the question of who would promulgate the rules governing 

calculation of a conformed book and taxable income. Proposals which levy a tax on financial 

accounting income, determined under GAAP, could be criticized for placing the determination of 

Federal revenues in the hands of FASB. Alternatively, proposals which rely on the Congress to 

set out new accounting standards to be used for both financial accounting and tax purposes 

would contradict decades of practice in the accounting and auditing fields, as sanctioned by the 

Securities and Exchange Commission.46 

In addition to the policy arguments for and against book-tax conformity, administrative 

issues may arise in attempting to define specific details of conformity proposals. A fundamental 

question for any such proposal is to whom the proposal would apply. In particular, resolution of 

consolidation issues may be difficult. Under present law, foreign subsidiaries of U.S. parent 

corporations are generally eligible for deferral and are not included in the consolidated U.S. tax 

 46 “The Securities and Exchange Commission (SEC) has statutory authority to establish financial 

accounting and reporting standards for publicly held companies under the Securities Exchange Act of 

1934. Throughout its history, however, the Commission’s policy has been to rely on the private sector for 

this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the 

public interest.” (Excerpted from “Facts about FASB” on the website of the Financial Accounting 

Standards Board, http://www.fasb.org/facts/index.shtml#mission, last accessed May 8, 2006.) 
19 

return of the parent corporation even though they are included in the U.S. parent’s consolidated 

financial statements. Thus, a proposal that maintains deferral for earnings of foreign subsidiaries 

might necessarily involve sacrificing book-tax conformity as it relates to consolidation. In 

addition, decisions would have to be made regarding fundamentally different treatment of 

noncorporate business entities between book and tax systems. 

Many of these difficulties do not arise under proposals with more limited scope, such as 

those in which a corporation must employ a certain book accounting method as a condition of 

employing that method for tax purposes. For example, under present law the use of the last-infirst-out (“LIFO”) inventory accounting method is predicated on using that method for financial 

reporting purposes. While such a proposal avoids the issues of consolidation differences and 

treatment of noncorporate entities, the concept may be more easily applied to overall accounting 

methods (like LIFO) rather than to potentially abusive transactions. Because abusive tax shelters 

often involve a series of transactions, each of whose tax consequences are combined to produce 

the inappropriate result, it may be difficult to define the scope of a transaction to which a book 

treatment limitation would apply. 
20 

B. Cost Recovery 

1. In general 

One important area in which the tax rules and financial accounting rules differ is cost 

recovery. Cost recovery also raises other issues in addition to book-tax divergence. The choice 

of cost recovery rules has an effect on the after-tax rate of return from business assets. As a 

matter of policy, should these rules be neutral as to a taxpayer’s choice whether or in which 

assets to invest? Alternatively, should cost recovery rules be used to encourage investment 

generally or investment in particular kinds of assets? To address these questions, this section 

first describes the concept of cost recovery and provides numerical examples to illustrate certain 

economic and tax effects of various forms of cost recovery rules. Then this section summarizes 

the present law tax rules and the financial accounting rules for cost recovery. 

2. Concept of cost recovery47

In business taxation, cost recovery refers to the process by which a taxpayer recoups the 

cost of its investment in business or other income-producing property.48 The tax rules permit this 

recoupment through the allowance of deductions for depreciation. In his opinion in the 1927 

U.S. Supreme Court case United States v. Ludey, Justice Brandeis provided the following 

explanation of depreciation: 

The depreciation charge permitted as a deduction from the gross income in 

determining the taxable income of a business for any year represents the 

reduction, during the year, of the capital assets through wear and tear of the plant 

used. The amount of the allowance for depreciation is the sum which should be 

set aside for the taxable year, in order that, at the end of the useful life of the plant 

in the business, the aggregate of the sums set aside will (with the salvage value) 

suffice to provide an amount equal to the original cost. The theory underlying 

this allowance for depreciation is that by using up the plant, a gradual sale is made 

of it. The depreciation charged is the measure of the cost of the part which has 

been sold. When the plant is disposed of after years of use, the thing then sold is 

not the whole thing originally acquired. The amount of the depreciation must be 

 47 Portions of this discussion are drawn from Boris I. Bittker & Lawrence Lokken, Federal 

Taxation of Income, Estates and Gifts (3d. ed. 1999) at ¶23.1. 

48 The tax rules allow cost recovery both for tangible assets and for intangible property such as 

copyrights and patents with limited useful lives. The term “depreciation” sometimes is used only when 

referring to cost recovery for tangible property, while “amortization” is used in describing cost recovery 

for intangible property such as patents and copyrights. Section 167(a), however, which allows a 

depreciation deduction for “the exhaustion, wear and tear (including a reasonable allowance for 

obsolescence) of property used in the trade or business, or of property held for the production of income,” 

encompasses both tangible and intangible property. 
21 

deducted from the original cost of the whole in order to determine the cost of that 

disposed of in the final sale of properties.49

The American Institute of Certified Public Accountants (AICPA) has provided a similar 

explanation: 

Depreciation accounting is a system of accounting which aims to distribute the 

cost or other basic value of tangible capital assets, less salvage (if any), over the 

estimated useful life of the unit (which may be a group of assets) in a systematic 

and rational manner. It is a process of allocation, not of valuation. Depreciation 

for the year is the portion of the total charge under such a system that is allocated 

to the year.50

Both Justice Brandeis’s and the AICPA’s explanations refer to salvage value. Although 

for many years the tax rules required taxpayers to estimate the salvage value of depreciable 

assets and permitted depreciation deductions only to the extent that a taxpayer’s cost basis in an 

asset exceeded the asset’s salvage value, since 1981 the depreciation rules have ignored salvage 

values, and a taxpayer is permitted to take deductions for the depreciation of an asset until its 

adjusted basis in the asset has been reduced to zero. 

The Supreme Court and the AICPA explanations differ in their description of the role of 

valuation in determining depreciation allowances. Justice Brandeis writes that a business’s 

depreciation deduction for a year “represents the reduction, during the year, of the capital assets 

through wear and tear.” The AICPA definition, by contrast, states that depreciation accounting 

“is a process of allocation, not of valuation.” The AICPA’s statement is a more accurate 

reflection of the role of valuation in the present tax rules than is Justice Brandeis’s (which was 

written in 1927). The amount of a depreciation deduction allowed to a taxpayer in any given 

year for a capital asset generally does not reflect the actual reduction in the value of that asset in 

that year. 

Valuation can be seen, however, as part of the theoretical basis of the depreciation 

allowance. Justice Brandeis writes that the theory of this allowance is that by using up an asset 

over time, a taxpayer makes a “gradual sale” of that asset, and the depreciation deduction in a 

given year measures the cost of the portion of the asset “sold” in that year. This “gradual sale” 

theory reflects the tension between the principles of realization and income measurement. Under 

an ideal income tax, tax liability would be determined in part by changes in the value of a 

taxpayer’s assets even in the absence of a realization event such as a sale of those assets. In fact, 

however, changes in asset value generally do not affect tax liability unless there is a realization 

event. If a depreciation deduction were a proxy for the decline in the value of an asset that a 

taxpayer does not sell, the allowance of the deduction might be seen as moving the tax rules 

toward true income measurement and away from realization. Justice Brandeis rationalized this 

departure from realization through the fiction of a partial sale of an asset each year, with the 

 49 274 U.S. 295, 300-301 (1927). 

50 AICPA, Accounting Terminology Bulletin No. 1 (1953). 
22 

value of the portion fictionally sold represented by the amount of depreciation allowed as a 

deduction. The amount of a depreciation deduction under present law, though, generally does 

not approximate the decline in value of a taxpayer’s assets (or, if it does approximate economic 

depreciation, it does so coincidentally). Consequently, in any year, the depreciation allowance 

for a particular asset may cause a taxpayer’s taxable income attributable to that asset to be either 

more or less than the taxpayer’s economic income from the asset. 

The fact that depreciation deductions cause a mismeasurement of economic income from 

an asset when those deductions do not reflect the decline in value of the asset might not, in itself, 

be cause for concern. As described previously, if salvage value is ignored and a taxpayer is 

permitted to recover over time the entire cost of an asset, its depreciation deductions over the life 

of an asset will be the same, and its taxable income from the cash flow generated by the asset 

will be the same, regardless of the manner in which the taxpayer allocates those deductions over 

time. As will be illustrated next, however, the timing of depreciation deductions can vary greatly 

depending on the particulars of the chosen rules, and timing differences can have a significant 

effect on the real cost of a taxpayer’s tax liability. 

3. Examples: methods of cost recovery 

The following examples illustrate the economic and tax effects of several possible 

methods of cost recovery: (1) straight-line depreciation, a method in which a taxpayer’s 

depreciation deduction for a given asset is the same each year; (2) accelerated depreciation, 

under which a taxpayer’s depreciation allowance for an asset is greatest in the first year in which 

the asset is used and declines over time; (3) expensing, in which a taxpayer is permitted to deduct 

the entire cost of an asset in the year in which the taxpayer acquires the asset; and (4) use of a tax 

credit to provide cost recovery or recovery of amounts different from the cost of the asset.51

Each example assumes the following facts. A taxpayer buys a machine for $10,000. The 

machine is used for five years. It generates $3,000 net cash flow annually. It has no salvage 

value. The taxpayer’s tax rate is 35 percent. The discount rate is 6 percent. The taxpayer is 

assumed to derive other taxable income so that any net decrease in income tax liability (shown in 

each table as a negative number) attributable to the machine can be used to offset the taxpayer’s 

tax liability from its other income sources. The present value (PV) figures in the tables are 

derived by assuming that nominal dollars are paid (in the case of taxes) or received (in the case 

of cash flow) at the end of each year and by discounting these nominal dollars back to when the 

machine was purchased, the beginning of year one. Thus, nominal year one dollars paid or 

received are discounted one year in deriving the present value of those dollars, nominal year two 

dollars are discounted two years, and so forth. 

 51 These examples provide a comparison of the cash flow and tax effects of the different 

methods of cost recovery. Other issues such as the relative complexity of each method, recordkeeping and administrability aspects of each method, and the use of methods in combination 

with each other also would have to be taken into account in selecting among cost recovery 

methods. 
23 

Table 1.−Straight Line Depreciation 

Unrecovered

Cost 

Dollars 

Received 

Cost 

Recovery

Taxable 

Income 

35- 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

After-Tax 

Cash 

Flow 

Year 1 $10,000 $3,000 $2,000 $1,000 $350 $330 $2,650 $2,500 

Year 2 8,000 3,000 2,000 1,000 350 311 2,650 2,358 

Year 3 6,000 3,000 2,000 1,000 350 294 2,650 2,225 

Year 4 4,000 3,000 2,000 1,000 350 277 2,650 2,099 

Year 5 2,000 3,000 2,000 1,000 350 262 2,650 1,980 

End/total $0 $15,000 $10,000 $5,000 $1,750 $1,474 $13,250 $11,162 

Table 2.−Accelerated Depreciation 

Unrecovered

Cost 

Dollars 

Received 

Cost 

Recovery

Taxable 

Income 

35 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

AfterTax 

Cash 

Flow 

Year 1 $10,000 $3,000 $4,000 -$1,000 -$350 -$330 $3,350 $3,160 

Year 2 6,000 3,000 2,400 600 210 187 2,790 2,483 

Year 3 3,600 3,000 1,440 1,560 546 458 2,454 2,060 

Year 4 2,160 3,000 1,080 1,920 672 532 2,328 1,844 

Year 5 1,080 3,000 1,080 1,920 672 502 2,328 1,740 

End/total $0 $15,000 $10,000 $5,000 $1,750 $1,349 $13,250 $11,287 
24 

Table 3.−Expensing 

Unrecovered

Cost 

Dollars 

Received 

Cost 

Recovery

Taxable 

Income 

35 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

AfterTax 

Cash 

Flow 

Year 1 $10,000 $3,000 $10,000 -$7,000 -$2,450 -$2,311 $5,450 $5,142

Year 2 0 3,000 0 3,000 1,050 934 1,950 1,735

Year 3 0 3,000 0 3,000 1,050 882 1,950 1,637

Year 4 0 3,000 0 3,000 1,050 832 1,950 1,545

Year 5 0 3,000 0 3,000 1,050 785 1,950 1,457

End/total $0 $15,000 $10,000 $5,000 $1,750 $1,122 $13,250 $11,516

Economic and tax results

Several observations can be made about these examples. First, in each example, by the 

end of year five, the last year in which the machine is used, the taxpayer has recovered the entire 

cost of the machine, $10,000. Second, measured in nominal or total combined annual dollars, 

the total amount of cash flow ($15,000), income after cost recovery ($5,000), and tax paid 

($1,750) is the same under each of the three methods of depreciation. Third, the amount of the 

taxpayer’s total eventual tax liability expressed in present value terms at the outset of the 

taxpayer’s investment − the number printed at the bottom of the third to last column of each 

example − varies significantly among the three examples. The present value of after-tax cash 

flows likewise varies among the examples. The initial present value of all future tax liabilities 

attributable to the income generated by the machine is greatest under straight-line depreciation, 

somewhat less under accelerated depreciation, and least under expensing. The present value of 

after-tax cash flows is the smallest under straight-line depreciation, greater under accelerated 

depreciation, and greater again under expensing. The reason for these relationships is that 

expensing accelerates cost recovery relative to accelerated and straight-line depreciation, and 

accelerated depreciation yields more up-front cost recovery than does straight-line. In the end, 

the entire cost of the machine is recovered under all three methods, but front-loading of 

depreciation deductions and the concomitant lessening of a taxpayer’s tax liability in the early 

years increase the present value of cash flows. 

Tax depreciation compared with economic depreciation

In the examples above, straight-line depreciation is the least favorable method of cost 

recovery for taxpayers. An even less taxpayer-favorable rule might require a taxpayer to wait 

until an asset is used up or sold before recovering any portion of the cost of the asset. The rate of 

cost recovery − straight-line, accelerated, or immediate deduction − is not the only variable that 

affects the present values of taxes and cash flows associated with an asset. The period over 

which costs are recovered also has an effect on these present values. 
25 

To analyze how closely any combination of recovery rates and periods replicates 

economic depreciation, the pattern of an asset’s economic depreciation must be understood. 

Under the assumption that an asset produces level cash flows over its useful life − not always a 

realistic assumption because of the declining efficiency of some assets and, relatedly, because of 

increasing maintenance costs as some assets age − the asset declines in value more slowly in its 

early years than in its later years. 

The value of an asset or, put differently, the amount someone would pay for the asset, at 

any time is the value at that time of all income the asset is expected to generate in the future. An 

asset’s value, in other words, is the present value of its expected future cash flows. The decline 

in value of an asset from the beginning of one year to the end of that year − the asset’s economic 

depreciation − is represented by the difference between the present values of the expected future 

cash flows at the beginning and at the end of the year. 

Assume an asset generates $1,000 in cash flow each year for five years, and assume a 

discount rate of 6 percent. The value at the beginning of year one of the future cash flows 

($1,000 each year for five years) is $4,212; this is the amount a taxpayer would pay for the asset. 

By the end of year one, the value of the future cash flows ($1,000 each year for four years) 

declines to $3,465. In its first year of use, the asset thus has declined in value by $747. The 

pattern of depreciation over the five years is illustrated in the following table: 

Table 4.−Economic Depreciation 

Year PV at Beginning PV at End Depreciation 

1 $4,212 $3,465 $747 

2 3,465 2,673 792 

3 2,673 1,833 840 

4 1,833 943 890 

5 943 0 943 

As can be seen in this table, the depreciation in the value of the asset is smallest during 

the first year and increases with each subsequent year. For an asset that generates constant cash 

flows, therefore, tax depreciation rules that matched economic depreciation would backload cost 

recovery to a greater extent than straight-line depreciation rules do. 
26 

Expensing as an incentive for capital investment

Matching economic depreciation is only one possible goal of cost recovery rules. 

Another possible goal is to provide an incentive for capital investment. Expensing − under 

which, as illustrated previously, a current deduction is allowed for the entire cost of an asset − is 

one way to provide this incentive.52 Under certain assumptions, including that tax rates are the 

same at the beginning and at the end of an investment, allowing a current deduction for the cost 

of an investment is equivalent to exempting from tax the return on the investment. 

A simple example can illustrate this point. Assume a taxpayer earns $1,000 in taxable 

income (in addition to taxable income from other sources) and invests the amount remaining 

after tax is imposed on the $1,000. The asset yields a 10-percent return and is sold after one 

year. The tax rate is 35 percent. In the first scenario, no deduction is allowed for the cost of an 

investment, but the return on the investment is exempt from tax. The taxpayer therefore is taxed 

on the $1,000 when it is earned and is left with $650 ($1,000 - .35($1,000)) to invest. The $650 

investment yields a 10-percent return. After one year, the investment has grown to $715, and 

when the investment is sold, the proceeds are exempt from tax. In the second scenario, the 

taxpayer is allowed a deduction for an investment (that is, the taxpayer is allowed to expense the 

investment) but is taxed when the proceeds from the investment are used for consumption. The 

deduction for the cost of the investment (which can be used to as an offset against other taxable 

income) has the effect of eliminating the tax on the $1,000 of earnings, and the taxpayer can 

invest the entire $1,000. After one year, the investment is worth $1,100. The taxpayer sells the 

investment (and does not use the proceeds for a deductible investment). The $1,100 in proceeds 

therefore is subject to a 35-percent tax, and the taxpayer is left with $715 ($1,100 - .35($1,100)) 

after tax. The taxpayer is in the same position as where no deduction was allowed for the initial 

investment but the return on the investment was free of tax. 

Tax credit as an incentive for capital investment

Expensing is one way of providing an incentive for capital investment. Another method 

is through the use of tax credits. For much of the period from 1962 through 1985, the tax rules 

included an investment tax credit for the purchase of tangible property and certain other kinds of 

property for use in a business or profit-seeking activity. The credit amount initially was seven 

percent of the cost of the property and was increased to 10 percent.53 The following table shows 

the effects of a five-percent income tax credit under the assumptions used in Tables 1 through 3: 

A machine with a five-year life is purchased for $10,000, the machine generates annual cash 

flow (net of expenses) of $3,000, and the discount rate is six percent. As is shown in the table, 

the five-percent investment credit generates a $500 tax savings (five percent of $10,000) in year 

one and requires the taxpayer to reduce its basis in the machine by $500 in that year (from 

 52 Any method of cost recovery that is faster than economic depreciation provides a tax 

incentive for investment in the property for which the recovery method is available. 

53 See Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts (3d. 

ed. 1999) at ¶27.2.1. 
27 

$10,000 to $9,500). The table assumes the taxpayer then is required to use straight-line 

depreciation in recovering its remaining cost. 

Table 5.−Investment Tax Credit 

Unrecovered 

Cost 

Dollars 

Received 

Cost 

Recovery 

Taxable 

Income 

35 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

AfterTax 

Cash 

Flow 

Year 1 $9,500* $3,000 $1,900 $1,100 -$115** -$108 $3,115 $2,939

Year 2 7,600 3,000 1,900 1,100 385 343 2,615 2,327

Year 3 5,700 3,000 1,900 1,100 385 323 2,615 2,196

Year 4 3,800 3,000 1,900 1,100 385 305 2,615 2,071

Year 5 1,900 3,000 1,900 1,100 385 288 2,615 1,954

End/total $0 $15,000 $9,500*** $5,500 $1,425 $1,151 $13,575 $11,487

* After initial basis reduction for 5-percent investment credit equaling $500. 

** Including $500 investment credit. 

*** Not including $500 initial basis reduction from investment tax credit. 

Table 5 reveals that under the assumptions of the depreciation examples discussed above, 

the combination of the investment tax credit and straight-line depreciation produces a greater 

present value after-tax cash flow than does accelerated depreciation in the absence of the 

investment credit, and it produces slightly less present value after-tax cash flow than does 

expensing. More broadly, however, through the choice of, among other features, a credit rate, an 

investment credit can be designed to replicate the economic and tax results of a given set of 

depreciation rules. 

The most favorable cost recovery method described above, expensing, can, as discussed 

previously, have the same after-tax effects as would exempting from tax the return on an 

investment. Certain rules (including investment credits) can produce a result better than 

exemption. From 1981 until 1986, “the tax benefits of the combination of the investment tax 

credit and accelerated depreciation were more generous for some equipment than if the full cost 

of the investment were deducted immediately − a result more generous than exempting all 

earnings on the investment from taxation.”54 This result had the effect of encouraging 

 54 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-

87), May 4, 1987, p. 98. 
28 

investment in equipment qualifying for generous treatment even if the investment would have 

been unprofitable in the absence of the tax rules. 

4. Present-law tax rules 

In general

The present-law cost recovery rules are not as simple as any of the stylized approaches 

described above (though the pattern of cost recovery in the accelerated depreciation example 

matches the pattern of cost recovery under one permitted method of depreciation described 

below), but they do include features of some of the approaches. The cost recovery rules do not 

match tax depreciation with economic depreciation. In most circumstances, the rules permit 

accelerated depreciation, and in some cases require (or permit) straight-line depreciation. In 

some cases the rules permit limited expensing. 

Depreciation provisions

A taxpayer is allowed to recover through annual depreciation deductions the cost of 

certain property used in a trade or business or for the production of income. The amount of the 

depreciation deduction allowed with respect to tangible property for a taxable year is determined 

under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different 

types of property are generally assigned applicable recovery periods and depreciation methods. 

The recovery periods applicable to most tangible personal property (generally tangible property 

other than residential rental property and nonresidential real property) range from three to 25 

years. The depreciation methods generally applicable to tangible personal property are, as the 

MACRS name suggests, forms of accelerated depreciation. The permitted methods are the 200-

percent and 150-percent declining balance methods, switching to the straight-line method for the 

taxable year in which the depreciation deduction would be maximized.55

 Recovery periods for real property generally are longer than those for personal 

property, and the depreciation method is less favorable to taxpayers. In general, the recovery 

periods applicable to real property are 39 years for non-residential real property and 27.5 years 

for residential rental property. The depreciation method for real property is the straight-line 

method. 

Under MACRS, a taxpayer is permitted to recover its full basis in depreciable property 

over the applicable recovery period; there is no need to estimate salvage value. Moreover, under 

MACRS the applicable recovery period need not (and typically does not) correspond to the 

actual economic life of the asset subject to depreciation. In general, however, MACRS generally 

provides for longer recovery periods for longer lived assets. 

 55 For certain property, including tangible property used predominantly outside the United States, 

tax-exempt use property, tax-exempt bond-financed property, and certain other property, the MACRS 

“alternative depreciation system” of section 168(g) applies, generally increasing recovery periods and 

requiring straight-line depreciation. 
29 

Expensing provisions

Since 1958, the Code has permitted limited expensing. Under present-law section 179, a 

taxpayer with a sufficiently small amount of annual investment costs may elect to deduct at least 

a portion of those costs currently. For taxable years beginning in 2003 through 2007, the 

maximum amount a taxpayer may expense is $100,000 of the cost of qualifying property placed 

in service for the taxable year.56 In general, qualifying property is defined as depreciable 

tangible personal property that is purchased for use in the active conduct of a trade or business. 

The $100,000 amount is reduced (but not below zero) by the amount by which the cost of 

qualifying property placed in service during the taxable year exceeds $400,000. The $100,000 

and $400,000 amounts are indexed for inflation.57 Certain additional rules govern section 179 

computations and eligibility and the coordination of section 179 with other rules.58

5. Cost recovery financial accounting rules 

In general

For financial accounting purposes, the straight-line method of depreciation is generally 

used for cost recovery. Thus, the cost of a capital asset is generally recovered in equal expense 

amounts during each year of its depreciable life.59 Therefore, use of a cost recovery method 

other than straight-line (or a different recovery period) for tax purposes will produce book-tax 

differences. 

Book-tax differences

Straight-line depreciation (over a different recovery period), accelerated depreciation, and 

expensing each produce only temporary book-tax differences. The pattern and length of cost 

 56 Additional section 179 incentives are provided for qualified property used by a business in the 

New York Liberty Zone (sec. 1400L(f)), an empowerment zone (sec. 1397A), a renewal community (sec. 

1400J), or the Gulf Opportunity Zone (sec. 1400N(e)). 

57 For taxable years beginning in 2008 and thereafter, a taxpayer with a sufficiently small amount 

of annual investment may elect to deduct up to $25,000 of the cost of qualifying property placed in 

service for the taxable year. The $25,000 amount is reduced (but not below zero) by the amount by which 

the cost of qualifying property placed in service during the taxable year exceeds $200,000. 

58 The amount eligible to be expensed for a taxable year may not exceed the taxable income 

derived in that year from the active conduct of a trade or business (determined without regard to section 

179). Any amount that is not allowed as a deduction because of the taxable income limitation may be 

carried forward to succeeding taxable years (subject to similar limitations). No general business credit 

under section 38 is allowed with respect to any amount for which a deduction is allowed under section 

179. An expensing election is made under certain rules prescribed by the Secretary. 

59 Recovery periods for financial accounting purposes are generally intended to reflect an asset’s 

useful life, and therefore often differ from the recovery periods used for tax purposes. 
30 

recovery deductions for tax purposes differ from those for book purposes, but over the life of the 

property the cumulative deductions will be the same for book and tax. 

Temporary differences do not affect the total amount of tax expense reported by a 

corporation for the year. However, temporary differences do affect the amount of cash taxes 

paid by the corporation for the year. In order to keep the total tax expense constant, corporations 

book an accrued tax expense (or benefit) to reflect the portion of the year’s tax expense which 

will be paid (or refunded) in a future year. This accrual is known as deferred tax expense (or 

benefit) and results in an asset (or liability) on the company’s balance sheet. These balance sheet 

items are referred to as deferred tax assets and deferred tax liabilities. 

Table 6 reflects the financial accounting results where the straight-line method of 

depreciation is used for both book and taxable income, using the same facts as those employed in 

table 1, above. Because the cost recovery method and recovery period are identical, book and 

taxable income are equal in each year. The company’s cash tax expense is equal to its book tax 

expense, which (in the absence of permanent differences) is 35 percent of book income. 

Table 6.−Example Using Straight-Line Depreciation for Both Book and Tax 

Book 

Income 

Taxable 

Income 

Book-Tax 

Difference 

Deferred 

Tax 

Expense 

Current 

(Cash) 

Tax 

Expense 

Total Tax 

Expense 

Effective 

Tax Rate 

Year 1 $1,000 $1,000 $0 $0 $350 $350 35% 

Year 2 1,000 1,000 0 0 350 350 35% 

Year 3 1,000 1,000 0 0 350 350 35% 

Year 4 1,000 1,000 0 0 350 350 35% 

Year 5 1,000 1,000 0 0 350 350 35% 

Totals $5,000 $5,000 $0 $0 $1,750 $1,750 35% 

Table 7 reflects the financial accounting results if accelerated depreciation is permitted 

for tax purposes while straight-line depreciation is used for financial accounting. While the 

pattern of income differs, the cumulative taxable income over the five-year period is equal to 

cumulative book income. Because the capital costs are recovered earlier under accelerated 

depreciation, taxable income is less than book income in the early years and greater than book 

income in the later years. 

On an annual basis, the temporary book-tax differences are accounted for by accruing 

deferred tax expense. For example, in year one, book income exceeds taxable income by $2,000. 

That difference represents the excess of tax depreciation deductions over book depreciation 

expense in year one. Because this difference will exactly offset over the life of the asset, it is 

also offset for financial accounting purposes when calculating income tax expense. This offset is 

accomplished by accruing a deferred tax expense equal to 35 percent of the book-tax difference, 
31 

or $700. Following across the row, the $1,000 taxable loss produces a current tax benefit 

(negative expense) of $350 as calculated in Table 2. Netting the deferred tax expense of $700 

against the current tax benefit of $350, the total tax expense on the financial statements in year 

one is $350, or 35 percent of book income. 

Table 7.− Example Using Straight-Line Depreciation for Book; 

Accelerated Depreciation for Tax 

Book 

Income 

Taxable 

Income 

Book-Tax 

Difference

Deferred 

Tax 

Expense 

Current 

(Cash) 

Tax 

Expense 

Total Tax 

Expense 

Effective 

Tax Rate

Year 1 $1,000 -$1,000 $2,000 $700 -$350 $350 35% 

Year 2 1,000 600 400 140 210 350 35% 

Year 3 1,000 1,560 -560 -196 546 350 35% 

Year 4 1,000 1,920 -920 -322 672 350 35% 

Year 5 1,000 1,920 -920 -322 672 350 35% 

Totals $5,000 $5,000 $0 $0 $1,750 $1,750 35% 

While the net present value of cash flows under the accelerated depreciation method is 

higher than under the straight-line method (see Tables 1 and 2), the tax expense and effective tax 

rates reported on the financial statements are unchanged under the two methods, in each year and 

on a cumulative basis. 

Investment tax credit

In contrast to the straight-line depreciation, accelerated depreciation, and expensing 

methods of cost recovery, an investment tax credit reduces the total cash taxes paid over the life 

of an asset as well as the total tax expense and effective tax rate reported on the financial 

statements. 

Table 8 reflects the financial accounting results of a five-percent investment tax credit, 

using the same facts as Table 5 above.60 Contrary to the examples in Tables 6 and 7, the $500 

investment tax credit in year one is a permanent reduction in the company’s tax expense. 

During year one, book depreciation exceeds tax depreciation by $100, but the tax basis of 

the capital asset is reduced by $500 under the investment tax credit rules. Thus, the book basis 

of the asset exceeds the tax basis of the asset by $400 at the end of year one. To reflect the 

 60 See discussion of Table 5, above, for calculation of taxable income and current (cash) tax 

expense figures in Table 8. 
32 

future book depreciation expense in excess of tax deductions, a $140 deferred tax expense (35 

percent of the basis difference) is accrued in year one. When netted against the cash tax benefit 

of $115, total tax expense for year one is only $25, or 2.5 percent of year one book income. The 

effective tax rate is reduced because the tax expense has been permanently reduced by the 

investment tax credit. 

Over the life of the asset, as the temporary difference from year one reverses and the 

company experiences no further permanent book-tax differences, the effective tax rate returns to 

35 percent of book income each year. However, on a cumulative basis, because the total tax 

expense has been reduced, the average effective tax rate over the life of the asset, for financial 

statement purposes, is reduced as well. 

Table 8.−Example Using Straight-Line Depreciation for Book; 

5 Percent Investment Tax Credit for Tax 

Book 

Income 

Taxable 

Income 

ITC Basis 

Adjustment

Book Tax 

Difference

Deferred 

Tax 

Expense 

Current 

(Cash) 

Tax 

Expense 

Total 

Tax 

Expense 

Effective 

Tax 

Rate 

Year 1 $1,000 $1,100 -$500 -$400 $140 -$115 $25 2.5% 

Year 2 1,000 1,100 0 100 -35 385 350 35.0% 

Year 3 1,000 1,100 0 100 -35 385 350 35.0% 

Year 4 1,000 1,100 0 100 -35 385 350 35.0% 

Year 5 1,000 1,100 0 100 -35 385 350 35.0% 

Totals $5,000 $5,500 -$500 $0 $0 $1,425 $1,425 28.5% 

6. Summary of economic and accounting consequences of cost recovery alternatives 

As demonstrated above, straight-line depreciation, accelerated depreciation, and 

expensing differ only in the timing of deductions. By altering the timing of deductions (and 

therefore the timing of payment of tax), these alternatives do not change the total amount of tax 

paid over the life of the asset or the tax expense reported in a taxpayer’s financial statements, but 

they do have important economic effects by impacting the net present value of future cash flows 

from the investment. 

An investment tax credit system, depending on its parameters, can be designed to 

produce either a higher or lower net present value of future cash flows than the timing methods 

described above, and therefore may be more or less desirable to taxpayers than those methods. 61 

 61 Important parameters impacting the comparison include, in particular, the credit percentage 

and which cost recovery method is used to recover remaining basis after the credit. 
33 

While the impact on net present value of future cash flows can be higher or lower, the investment 

tax credit results in less total tax paid over the life of an asset, and lower tax expense reported in 

a taxpayer’s financial statements. 
34 

APPENDIX 
35 
36 
37