I am preparing my 1120 Fed. Inc. Tax return and am a little confused about how State Income taxes accrued during the year play in the determination of the Federal Inc. Tax Payable.

Logically, it should look something like this:

Steps

1) First, create the P&L Statement following the IRS 1120 Instructions and arrive to the Net Profit (before State Inc. Tax accrued.

Eg: Net profit: $40,000

2) Determine the State Income Tax payable, based on the above Net Profit.

Eg.: State rate 5.5% on $40,000 ---> State Inc. Tax $2,200

3) Then, deduct the above State Inc. Tax in line 17 of form 1120 (taxes) and re-determine the Federal Taxable Income

Taxable Net Profit will then be: $37,800 ($40,000 - $2,200)

4) Determine Federal Inc. Tax: $37,800 x 15% = $5,670

The 1120 Instructions allow to deduct taxes accrued, except those especifically not allowed. State Income tax seems to be deductible.

Is the above correct?

Thank you!

State income tax is generally deductible for federal tax purposes, so your computations are correct, subject to following paragraph.

Be aware that there are sometimes differences between federal tax law and state law, and these fed-state diffs vary from state to state. If you're taking the do-it-yourself approach to return prep, best thing to do is carefully review the instructions for your state return form. There'll usually be a section devoted to describing those areas in which the state's tax treatment of a certain item deviates from the federal treatment.

Just to make up an example, suppose your 40K of pre-tax net profit includes a Section 179 deduction on an asset of $1,000. Suppose further that your state doesn't allow the Section 179 deduction, and the regular depreciation on that same asset is $200 for this year. In that situation you'd need to add $800 back to your pre-tax net--taking it up to $40,800--and then computing your state tax on that amount.

Thus, your state tax would be 40,800 x 5.5% = 2,244; and your federal taxable income would become 40,000 - 2,244 = 37,756.

You'd also need to remember that next year you'd have a depreciation deduction for that asset on your state return, but not on the federal return.

Very good points made. In addition, if I read the 1120 Instructions correctly, the State Income tax deductible is the accrued State Income Tax, not necessarily the PAID one (I use the accrued method for my books). My accountant, so far, has directly been deducting the PAID amount (therefore, accrued in the previous FY), instead of the accrued amount. So, if now I do the correct thing (deducting the accrued state inc. tax) I guess that I cannot also include the PAID tax that I actiually paid during the year (it belongs to the previous FY).

Technically, the treatment of state income tax on your federal return depends on whether you're cash basis or accrual basis for federal tax purposes. On last year's 1120, look at page 3, Schedule K, Question 1 to see what accounting method you've selected for fed tax purposes.

As a practical matter, I often see companies which are accrual for tax purposes, but nevertheless deducting their corporate state tax on an as-paid (i.e. 'cash') basis. Such treatment usually stems from a desire for simplicity, since the accrual of state income tax is a trickier proposition than computing an accrual for most other expenses. The computations, involving a lot of complex fed-state and book-tax diffs, have to be re-run every time some new piece of info comes to light. Accountants just get tired of correcting their state tax accrual AJE 19 times before the return is finally put to bed, and they decide that the state tax expense is "whatever was paid this year."

Thus, you might want to consider just staying consistent with your accountant's treatment, unless it results in a significant increase to your fed tax liability. Either way, note that down the hall at AskMeHelpDesk (from here, turn right, down to the "Money & Services" hallway; proceed along that corridor 'til you come to a door marked "Taxes") there are some tax whizzes who could probably give you better guidance on this one. You might want to knock on their door with this question before you make your final call on it.

Good luck!

Very interesting reply, and I also agree that many accountants must be using the cash method to simplify the job. In my particular case this FY, using the accrued tax is much more convenient, but if I do that, I believe the IRS might penalize me for not being consistent with previous years. On the other hand, how can I change this? I do want to start using the accrued method because it reflects the reality better. Perhaps if I just include the accrued amount and "discard" the actual payment made this FY for last year, it would be better viewed by the IRS?? I will also tray to get some help "down the hall". THANKS!

ROTFL!

First, taxes are actually a cash basis regardless of what your books are, unless you count it under the "recurring items" thingy. (Maybe that's why the accountant did it when it was paid.)
Publication 535 (2008), Business Expenses

In the long run, it means you should be able to deduct the accrued expense versus what you actually paid. So why did I bother saying that? Well, for one, it might not hurt to check that for sure. And another, I'm not sure what happens if you've been doing it one way and elect to change it. I'd agree to maybe post on the tax forum about that one.

If you're allowed to change it over to accrued, then I personally don't see a reason you couldn't also deduct what you paid this year, since it hasn't been deducted before. You need to check on that, but don't assume you can't count it. When changing something from cash to accrued, it doesn't necessarily mean items like that just fall through the cracks.

However... is there a reason you want to change it? Be easier if you didn't bother. It's nice when book and tax are the same, but your book income and taxable income likely aren't the same anyway.

An excellent point indeed... and the primary reason I punted this one to the Tax Team down the hall. Certain method changes require IRS permission, and I'm not sure where that line is drawn with respect to this particular issue (or just how flexible that line may be, in practice).

Thank you for your point of view. The only reason that I want to change is that I just want to do it the correct way, so... if my accouting is Accrual Basis, I tend to believe that taxes should also go by accrual. In this special year, in addition, is is more convenient to include it as accrued, as the accrued taxes have been quite high.

Don't tell the IRS that reason. LOL. ;)

I do highly agree that you should go "around the corner" to the tax folks.