Schedule M-2 – Analysis of Partner’s Capital Accounts is the section in Form 1065 – U.S. Return of Partnership Income where the partnership reports to the IRS what caused the changes to the partners’ capital accounts on the partnership’s books and records. This section of the tax return is used by the IRS to verify the accuracy of the tax reporting because analyzing the changes to the capital accounts should be consistent with the income reporting and balance sheet (Schedule L). The amounts on Schedule M-2 should equal the total of the amounts reported in Part II, Item L of ALL the partners’ Schedules K-1’s. However, not all partnerships have to do this analysis, and many smaller partnerships do not complete Schedule M-2.
When Schedule M-2 is NOT required to be completed:
A partnership has to complete a Schedule L (Balance Sheet); Schedule M-1 (Reconciliation of Income) and Schedule M-2 (Analysis of Partner’s Capital Accounts) unless it can satisfy ALL of the following four requirements:
- The partnership’s total receipts were less than $250,000 for the tax year
- The partnership’s total assets were less than $1 million at the end of the tax year,
- Schedule K-1’s are filed with the return and furnished to the partners on or before the due date (including extensions),
- The partnership is not filing or required to file Schedule M-3.
If the partnership satisfies these four requirements, the taxpayer will answer ‘YES’ to the Question “Does This Partnership Meet All Four Requirements?’ which is found on Schedule B (Form 1065), Line 4 and the partnership will not complete a Schedule M-2. Note: prior to 2018, the question was found on Schedule B (Form 1065), Line 6.
This question can be accessed in Keystone Tax Solutions Pro from the main menu of the 1065 return by selecting ‘Schedule B’, then changing the answer to the Question
“Does This Partnership Meet All Four Requirements?’ to YES. This question is defaulted to a No answer in the program and the user must affirmatively change the answer to YES to electronically file the return without including a Schedule L (Balance Sheet); Schedule M-1 (Reconciliation of Income) and Schedule M-2 (Analysis of Partner’s Capital Accounts).
When Schedule M-2 is required to be completed:
If the partnership does NOT meet the four requirements set forth in Schedule B (Form 1065), Line 4, the partnership is required to complete Schedule M-2 and submit the changes during the tax year in the partners’ capital accounts as reflected on the partnership’s books and records. As a practical matter, Schedule M-2 would normally not be completed until both Schedule L – (Balance Sheet) and Schedule M-1 – (Reconciliation of Income), have been completed because certain items on the Schedule M-2 must match entries that are calculated on Schedules L and M-1.
To complete a Schedule M-2, from the main menu of the tax return (Form 1065) select Schedule M-2 – Analysis.
To assist in the entry of amounts on the Schedule M-2 – Analysis of Partner’s Capital Accounts, each line of this menu is described below. At the Schedule M-2 Analysis of Partner’s Capital Accounts Menu the user can enter the items that impact the capital accounts of the partners. The only amount that Keystone Tax Solutions Pro will automatically pull to this Schedule M-2 is the Net Income (Loss) per Books, which is reconciled to the Income (Loss) on the Tax Return on Schedule M-1.
1. Balance at Beginning of the Year – This beginning balance amount should match the ending balance amount from last year’s tax return, if the partnership was required to complete Schedule M-2 in the previous tax year. This beginning balance amount is reported on Line 1 of Schedule M-2. The beginning balance amount should also match two other entries that have been made on this tax return (Form 1065) which are discussed below.
On this Form 1065, the beginning balance amount should normally match the amount entered on Schedule L – (Balance Sheet), Line 21. If a Schedule L – (Balance Sheet) was done in the previous year in Keystone Tax Solutions Pro, this beginning capital account amount will pull from the ending capital account amount that was on the balance sheet. To access in Keystone Tax Solutions Pro the entry of Beginning Capital on Schedule L, Line 21, from the main menu of the Form 1065 select ‘Schedule L’, then select ‘Total Liabilities & Capital’ and enter the amount at ‘Partners Capital’. In the event that there is a difference between the amount entered on this Schedule M-2 as the beginning capital account balance and the amount entered on Schedule L, Line 21, an explanation of the differences should be included with the tax return.
This beginning balance amount should also normally match the total of the beginning capital accounts entered in Part II, Item L of all of the partner’s K-1’s. To access in Keystone Tax Solutions Pro an entry in Part II, Item L of the Schedule K-1 (Form 1065) – Partner’s Share of Income, Deductions, Credits, etc. from the individual partner’s K-1 entry menu select ‘Analysis of Partner’s Capital Accounts’.
2. Cash Contributed – In this section the user will enter the total of all cash (including any marketable securities) contributed by any of the partners to the partnership during the year. This cash contributed amount is reported on Line 2a of Schedule M-2.
3. Property Contributed – In this section the user will enter the total of all non-cash property distributed by any of the partners to the partnership during the year. This property contributed amount is reported on Line 2b of Schedule M-2.
The combined amounts reported on the Schedule M-2 as Cash Contributed and Property Contributed on Schedule M-2, Lines 2a and 2b should match the Total amount reported as ‘Capital contributed during the year’ in Part II, Item L of ALL the partners’ Schedules K-1’s.
4. Net Income (Loss) per Books (Sch. M-1, Line 1) – This amount is pulled from the reconciled book income (loss) amount from the Schedule M-1. Any adjustments to this amount must be made on the Schedule M-1 menu. This book net income or loss is reported on Line 3 of Schedule M-2.
5. Other Increases – In this section the user will itemize any item other than Net Income recognized by the partnership in their accounting records or any cash and/or property contributed. Upon entering this field, the user should select ‘NEW’ and then enter a description of the item and then enter the amount. Although this is not common, items that may result in an increase in the capital account of a partner (or partners) can occur. These ‘Other Increases’ are itemized and reported on Line 4 of Schedule M-2.
6. Total– This is a calculated amount by Keystone Tax Solutions Pro, consisting of the amounts entered (or automatically pulled) for ‘Balance at Beginning of Year’, ‘Cash Contributed’, ‘Property Contributed’ and ‘Other Increases’ ‘Net Income (loss) per Books (Sch. M-1, Line 1)’. This total is reported on Line 5 of Schedule M-2 as the sum of Lines 1 through 4.
7. Cash Distributions – In this section the user will enter the total of all cash (including any marketable securities) distributed to the partners by the partnership during the year. This cash distributed amount is reported on Line 6a of Schedule M-2 and it should match the amount reported on Schedule K, Line 19a. These cash distributions will include any amounts withdrawn or paid to one of the partners during the year.
8. Property Distributions – In this section the user will enter the total of all non-cash property distributed by the partners to the partnership during the year. This includes any property distributed to a partner for personal use or otherwise withdrawn from the partnership. This property distributed amount is reported on Line 6b of Schedule M-2 and it should match the amount reported on Schedule K, Line 19a.
The combined amounts reported on the Schedule M-2 as Cash Distributions and Property Distributions should also match the Total amount reported as ‘Withdrawals and Distributions’ in Part II, Item L of ALL the partners’ Schedules K-1’s.
9. Other Decreases – In this section the user will itemize any item recognized by the partnership that reduced the capital accounts of the partners. Upon entering this field, the user should select ‘NEW’ and then enter a description of the item and then enter the amount. Although this is not common, items that may result in an decrease in the capital account of a partner (or partners) can occur. These other decreases are reported on Line 7 of Schedule M-2.
10. Total– This is a calculated amount by Keystone Tax Solutions Pro consisting of the amounts entered (or automatically pulled) for Balance at Beginning of Year’, ‘Cash Distributed, ‘Property Distributed’ and ‘Other Decreases’.
11. Balance at End of Year – This is the ending capital account balance that Keystone Tax Solutions Pro has calculated based on the entries above. This balance at the end of year amount should, like the beginning capital account balance, match two other entries on this tax return (Form 1065). This ending capital account balance will also become the beginning capital account balance amount for next year’s tax return if the partnership is required to complete Schedule M-2 on next year’s tax return. This calculated ending capital account balance amount is what Keystone Tax Solutions Pro pulls to Line 9 of Schedule M-2.
The ending balance amount that is calculated on this menu and reported on Schedule M-2, Line 9, should match the amount that is entered on Schedule L – Balance Sheet, Line 21, which is automatically pulled to this menu as set forth below. It also should match the Total of the ending capital accounts entered in Part II, Item L of All of the partner’s K-1’s.
12. Schedule L, Line 21 – The amount comes from the Schedule L which Keystone Tax Solutions Pro automatically pulls to this menu. Any edits to this Balance Sheet amount would have to be made on the Schedule L. The amount that has pulled from the Schedule L, Line 21 should match the calculated Ending Capital Account Balance that has been entered on this Schedule M-2.
13. Schedule L, Line 21 Minus Balance at End of Year – In the event that there is a difference between the ending capital account balance amount calculated on the Schedule M-2 and the amount entered as the ending capital account balance on Schedule L, Line 21, that difference will be calculated here. This calculation demonstrates the amount that the Schedule M-2 capital account balance differs with the Schedule L, Line 21 amount. If discrepancies exist between the accounting records of the partnership and what is being reported to the IRS, it should be corrected before filing the return. However, a return can still be electronically filed when there is a discrepancy but such a discrepancy is indicative of errors in either the return or the records of the partnership.
NOTE: This is a guide on entering Form 1065 – U.S. Return of Partnership Income, Schedule M-2 – Analysis of Partners’ Capital Accounts into the Keystone Tax Solutions Pro. This is not intended as tax advice.
Additional Resources:
Publication 541 – Partnerships
Instructions for Form 1065 – U.S. Return of Partnership Income
Creating a Basic Form 1065 – U.S. Return of Partnership Income