Income Tax Provision for a Startup's First Audit (ASC 740)

What is an income tax provision for a startup's first audit?

An income tax provision is the income tax expense, and the tax assets and liabilities, in financial statements prepared under ASC 740, the US accounting standard for income taxes. It has two parts: current tax, what the company owes on this year's returns, and deferred tax, the change in future tax effects of differences between the books and the returns. An auditor needs it because the statements are not complete without it.

For a startup that loses money, the net expense is often small or zero, but the auditor still needs the schedule behind it: every deferred tax asset, the valuation allowance against them, and the current tax owed.

A provision is not simple when:

• the company has a foreign subsidiary or files in several states;
• a funding round may have triggered a section 382 ownership change;
• a filed return took a position that might not hold up;
• returns were missed, or the books and returns disagree on stock compensation or research costs.

Gather the filed Form 1120s and state returns, loss and credit carryforward schedules, any section 382 study, the stock compensation schedule and the tax depreciation schedule. A full list is under "What do we gather?" below.

We lose money: why is there still current tax?

A loss on the books does not stop every tax. Current tax in a loss year usually comes from three places:

Whether a fixed state minimum belongs in the income tax provision or in operating expenses is an accounting judgment under ASC 740 to agree with the auditor. Delaware's franchise tax is based on shares or capital, not income; see Delaware franchise tax. For which states a company must file in, see business income tax in other states.

What creates deferred tax assets for a startup?

A deferred tax asset is a future tax saving: an amount already lost or expensed on the books that will reduce taxable income or tax later. Each one is measured at the tax rate expected to apply, starting with the 21% federal rate plus any state rate, net of the federal deduction for state tax.

Some items run the other way. Tax depreciation faster than book depreciation creates a deferred tax liability, a future tax cost that offsets the assets.

What is a valuation allowance, and why do most loss-making startups book a full one?

A valuation allowance reduces deferred tax assets to the part that is more likely than not to be used. Under ASC 740, recent cumulative losses are strong evidence against using them, and forecasts of future profit rarely outweigh that history. So most loss-making startups book a full valuation allowance, and the net deferred tax asset on the balance sheet is zero.

The gross assets and the allowance still appear in the tax footnote, so each one must be supported. The allowance is reassessed every year. When the company turns profitable and the evidence changes, releasing it creates a large one-time tax benefit in the statements.

Do research credits and a section 382 limit change the deferred tax assets?

Yes. Both change how much of the deferred tax asset is real, not just how much is reserved.

• Section 174A. Domestic research costs paid in tax years beginning after the end of 2024 can be deducted in full, and remaining amounts capitalized from the three prior years can be deducted in one year or over two (Rev. Proc. 2025-28). That shrinks the research deferred tax asset and grows the loss carryforward instead. Foreign research still runs over 15 years. See deducting US software development and development done abroad.
• Payroll research credit. Credit elected against payroll tax is used against payroll tax, not income tax, so it does not sit in the income tax credit carryforward. See research credit against payroll tax.
• Section 382. After an ownership change, losses and credits from before the change can be used only up to an annual limit (section 383 applies it to credits, 26 U.S.C. 383). Any amount that will expire before the limit lets it be used is written off rather than reserved. How the limit works is in net operating losses for startups.

What is an uncertain tax position, and when does Schedule UTP apply?

An uncertain tax position is a return position that might not hold up if examined. Under ASC 740, a position is recorded only if it is more likely than not to be sustained on its technical merits; the doubtful part is recorded as a liability for unrecognized tax benefits, often called a reserve. Typical startup examples are research credit claims and the split between US and foreign development.

A corporation must file Schedule UTP with Form 1120 only when all four conditions hold (IRS instructions):

A reserve shows up as an added tax liability or a cut to a deferred tax asset, including in the footnotes. A startup with a full valuation allowance can still record one. A position that meets the ASC 740 recognition and measurement test, or that was immaterial to the audited statements, is not reported. Do not file a blank schedule. A corporation that must file also answers "Yes" to Schedule K, question 14 on Form 1120 (Form 1120).

Who prepares the provision: the company, its tax preparer or the auditor?

The company owns the provision. Management is responsible for the financial statements, including the tax numbers, and the auditor tests them. Often the company's tax preparer or an outside adviser builds the schedules, with someone at the company who understands and approves them.

Auditor independence rules limit what an audit firm may do for an audit client. Help with the provision, if allowed at all, comes with conditions such as management taking responsibility for the result. Ask the audit firm early what it will and will not do, and line up a preparer before fieldwork. For who may keep the books, file the returns and audit, see audited financials for investors.

How does the provision tie to Form 1120 (Schedule M-1 or M-3)?

The provision and the return start from the same book income and explain the same differences. Form 1120 reconciles book income to taxable income on Schedule M-1, which includes "Federal income tax per books" on line 2 (Form 1120). A corporation with year-end assets of $10,000,000 or more files Schedule M-3 instead (Form 1120 instructions).

Schedule M-3 asks which financial statements are the source, uses audited statements when they exist, and splits every difference into temporary and permanent columns, the same split the deferred tax schedule uses (Schedule M-3 instructions). It also reports current and deferred income tax expense and stock option expense on their own lines. Below $50,000,000 of assets, a corporation may complete Part I of Schedule M-3 and use Schedule M-1 for the rest.

If the books change after a return was filed, for example a catch-up of stock compensation, the next return's reconciliation must still tie. The return itself changes only if a tax amount was wrong; see catching up on stock compensation expense.

What do we gather?

• Filed federal Form 1120s, state returns and any foreign subsidiary returns, every year since formation.
• Federal and state loss carryforward schedules by year, and research credit carryforwards.
• A section 382 study, if one was done, and the cap table history of each round.
• The stock compensation schedule by grant, marking incentive and nonqualified options.
• Research cost workpapers splitting US and foreign work, with section 174A choices made.
• The tax depreciation schedule and a list of accruals and prepayments at year-end.
• Year-end trial balance, and notes on any position the company is unsure about.

Example

These examples use round, illustrative figures in US dollars.

Series A SaaS with a $6,000,000 loss carryforward

A software company has $6,000,000 of federal loss carryforwards. At the 21% federal rate, the deferred tax asset is about $1,260,000, before state taxes, research costs and stock compensation. The company has lost money every year since it started, so it records a full valuation allowance of the same amount. The balance sheet shows a net deferred tax asset of zero, and the footnote shows the gross amount and the allowance.

Current tax with no profit

A company in its third year loses $3,000,000 on its books. It owes California's $800 minimum franchise tax, which it and its auditor treat as income tax, and its subsidiary abroad, paid a service fee by the parent, owes $25,000 of local tax. Those amounts are the current part of the provision. The deferred part nets to zero after the valuation allowance.

Assets cross the line

In year one, a company has $4,000,000 of assets and reviewed, not audited, statements: no Schedule UTP and no Schedule M-3. In year two, after a $20,000,000 round, assets at year-end are $18,000,000 and the statements are audited. The year-two Form 1120 files Schedule M-3. The company recorded a reserve for part of its research credit, so it also attaches Schedule UTP and answers "Yes" to Schedule K, question 14. Had it recorded no reserve, it would file no Schedule UTP.

Different for you?

• A funding round may have caused an ownership change: see net operating losses for startups and get startup tax help.
• The books are not audit-ready: see audited financials for investors.
• Stock compensation was never booked: see catching up on stock compensation expense.
• Research costs are mixed US and foreign: see deducting US software development and development done abroad.
• The company has a subsidiary abroad: see QSBS with a foreign subsidiary and get startup tax help for the provision.
• This is the first return: see first corporate return for a pre-revenue startup.
• The auditor needs the provision and no one owns it yet: startup tax help.