Comprehensive Tax Allocation: What It Is and How It Works

What Is Comprehensive Tax Allocation?

Comprehensive tax allocation is a form of tax analysis that identifies the effect of taxation on revenue-generating transactions during a non-standard reporting period. Comprehensive tax allocation allows companies to compare the impact of taxation during an accounting period to that of a particular financial reporting period.

Understanding Comprehensive Tax Allocation

The income and expenses that a company reports in its books often differ compared to its tax filings because there are tax advantages to accelerating or delaying certain transactions on paper. For example, a company may internally write off a cost over several years but choose to claim the expense more rapidly for tax purposes based on changes in income requirements or tax laws.

Comprehensive tax allocation allows companies to reconcile these temporary differences that arise between tax reporting and financial performance reporting timelines. This strategy is also known as comprehensive inter-period tax allocation (or simply, inter-period tax allocation), which is a reference to the two sets of reporting periods that firms use in accounting.

Four classes of transactions can lead to a temporary discrepancy between tax and accounting periods:

• Accelerated reporting of taxable income
• Delayed reporting of taxable income
• Accelerated reporting of deductible expenses
• Delayed reporting of deductible expenses

The most common source of temporary differences is in the handling of asset depreciation, which is considered a deductible expense for tax purposes. The Internal Revenue Service (IRS) grants companies some freedom in how they elect to report these expenses, which can often lead to the type of temporary difference that may require resolution via comprehensive tax allocation.

Example of Comprehensive Tax Allocation

Companies often use straight-line depreciation and accelerated depreciation for the same piece of equipment for different purposes. A firm typically uses straight-line depreciation for accounting purposes while it applies accelerated depreciation principles for tax purposes. 

Suppose that the Acme Construction Company buys a $200,000 crane. IRS laws allow depreciation of the equipment from the time it goes into service until the company recovers its cost basis. This allows Acme a $40,000 depreciation for five years.

However, the firm uses a 10-year straight-line accounting method on the accounting side of Acme's books, which appears as an annual expense of $20,000 for 10 years. Eventually, both methods meet in the same place: a full depreciation of the asset. The temporary difference in the financial life of the crane is resolved using a comprehensive tax allocation.

In practice, firms carry a portfolio of assets subject to a temporary allocation and their accountants must decide how aggressively to allocate the discrepancy. Some firms choose to strictly report tax expenses in the year that they make those payments. If this was the case with Acme, it would stick to the $40,000 annual deduction granted by the IRS. Other firms prefer to allocate according to the book value of depreciation. The IRS has demonstrated some flexibility in this area, and it favors consistency above all.

The Bottom Line

Companies may see discrepancies between their business and tax accounting. This is commonly due to the depreciation of assets that they record. To reconcile this, they can use a tax analysis strategy called comprehensive tax allocation. This lets companies identify how taxation affects sales transactions during non-standard reporting periods.