Is Schedule M-1 required to be filed with your client’s tax return? Read this article to learn more.
In many cases there is a difference between what a partnership reflects on its financial records as its yearly profit (or loss) and what is reported as the partnership’s actual taxable profits or loss. These differences arise because of the way in which the IRS accounts for the business’s operations and the way in which the business accounts for its operations. Therefore, the IRS requires that certain partnerships report the differences in accounting or book income (or loss) and taxable income (or loss).
Schedule M-1 is the section of the Form 1065 – U.S. Return of Partnership Income where the entity reconciles the income that the partnership is reporting on the tax return (Form 1065) to the income that the entity has on its accounting records or books. However, not all partnerships have to do this reconciliation, and many smaller partnerships do not complete Schedule M-1.
When Schedule M-1 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 on Schedule B (Form 1065), Line 4, “Does This Partnership Meet All Four Requirements?’ and the partnership would not complete a Schedule M-1. 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-1 is required:
If the partnership does NOT meet the four requirements set forth in Schedule B (Form 1065), Line 6, the partnership is required to reconcile any differences between the book income (loss) of the partnership to the income (loss) being reported on the tax return. To complete Schedule M-1, from the main menu of the tax return (Form 1065) select Schedule M-1 – Reconciliation. Many times there are no differences between the book income (loss) and the income (loss) reported on the tax return and no adjustments will be made. Yet, the Schedule M-1 still needs to be created and included in the return.
To assist in the entry of the amounts on the Schedule M-1 – Reconciliation of Income Entry Menu, each line of this menu is described below. At this Schedule M-1 Income Reconciliation Menu the user can adjust certain items that are different from book income (loss) to the income (loss) on the tax return, and the program will pull certain items from other areas of the return.
1. Net Income (Loss) Year – This is a calculated amount by Keystone Tax Solutions Pro. This amount is not keyed directly into the tax return and cannot be directly edited. Instead, this book income amount is obtained by adding and/or subtracting the adjusting entries to the income or loss that is reported on this tax return. Once all the adjustments are made on this menu on Lines 2-12, the book income should match (or reconcile) with the actual income (or loss) that is reflected on the partnerships accounting records. If the actual book income does not match the calculated amount reflected on this Line 1, additional adjusting entries would be necessary.
2. Income Subject to Tax Not Reported on the Books – In this section the user will enter any income that was included on the tax return but not included on the books of the business. This is not a common item on a partnership return, particularly for any entity that operates on a Cash Basis for accounting and tax reporting. Occasionally, due to the timing of gains or other income items, an entry may be required in this menu.
3. Guaranteed Payments – The payments made to all of the partners as Guaranteed Payments will be entered in this section. These Guaranteed Payments do not automatically pull from either the Deductions or Schedule K sections of the Form 1065.
4. Depreciation – This is a common adjustment item on the M-1 because a taxpayer is allowed to utilize acceleration depreciation methods, special and/or bonus depreciation. Many times a business will use a less accelerated depreciation method (such as straight line) in their accounting records which can produce a lower depreciation amount than initially claimed on the tax return, Whichever depreciation method is used will over the life of the asset produce the same amount of depreciation. However, this difference in methodology will produce a greater amount of depreciation expense in the initial and early years when claiming depreciation on the tax return and a lesser amount on the business records. This trend will reverse in the later years, and eventually (when the asset is totally depreciated), the depreciation taken will be the same on both the tax return and the books of the business.
On the M-1 reconciliation there are two separate lines to enter the differences in depreciation. In this section the depreciation adjustment amount entered would represent the assets where the amount of depreciation taken is greater on the books of the partnership than what is being claimed on the tax return.
5. Travel and Entertainment – The IRS limits the amount that a business can take as a deduction for Meals, and Entertainment to 50% or in certain situations to 80%. These deductions are limited on the tax return but on the books of the business, there is no such limitation and the financial records of the business will expense 100% of these expenditures to determine book income (or loss). The excluded amounts on the tax return will be automatically pulled by Keystone Tax Solutions Pro based on the entries made under Deductions for Meal and Entertainment expenses.
6. Other Expenses Reported on Books – In this section the expenses that are reflected on the partnership records but are not deductible on the tax return are entered. Examples of these are income taxes, fines and penalties, lobbying expenses, and club dues. Upon entering this field, the user will be required to itemize these expenses. The user should select ‘NEW’ and they will be provided a menu containing the most common expenditures that are not deductible on the Form 1065 and also provided an option to include a description of any less common item not on the list. The user will select the appropriate item and enter the adjustment amount. This will be repeated for each adjusting expense reported on the books of the partnership but not deducted on the tax return. The total of these adjusting entries should match what the user has entered on Form 1065 Schedule K, Line 18c.
7. Expenses Recorded on Books Not on Sch K – This is a calculated amount consisting of the amounts entered (or automatically pulled) on for Depreciation, Travel and Entertainment and Other Expenses Reported on Books (above entries 4-6).
8. Tax-Exempt Interest – In this section any tax-exempt interest that was recognized on the books of the partnership as interest income will be entered. This amount is not pulled from the tax return. This amount is what the user entered as tax-exempt interest on Form 1065, Schedule K, Line 18a. In Keystone Tax Solutions Pro, tax-exempt interest is entered from the main menu of the 1065 return by selecting ‘Schedule K- Distributive Share Items’, then ‘Other’, then ‘Tax Exempt Interest Income’.
9. Other Income Not on Sch K – In this section the income items that are reflected on the partnership records but are not included on the tax return are entered. Upon entering this field, the user will be required to itemize these other tax exempt income items. The user should select ‘NEW’ and they will enter a description of the item and then enter the adjustment amount. This will be repeated for each adjusting income item reported on the books of the partnership but not deducted on the tax return. The total of these adjusting entries will match what the user has entered on Form 1065 Schedule K, Line 18b. In Keystone Tax Solutions Pro, the total of these items would be entered from the main menu of the 1065 return by selecting ‘Schedule K- Distributive Share Items’, then ‘Other’, then ‘Other Tax Exempt Income’.
10. Income Reported on Books Not on Sch K – This is a calculated amount consisting of the amounts entered for ‘Tax Exempt Income’ and ‘Other Income Not on Sch K’ (above entries 8-9).
11. Depreciation – As stated above, on the M-1 reconciliation there are two separate lines to enter the differences in depreciation. In this section the depreciation adjustment amount entered would represents the assets where the amount of depreciation taken is greater on the tax return of the partnership than what is being recognized on the books of the partnership. Typically special and bonus depreciation amounts in excess of what is recognized on the partnership’s records will need to be included in this adjustment entry.
12. Other Deductions on Sch K – In this section the deduction items that are reflected on the partnership records but are not included on the tax return are entered. Upon entering this field, the user will be required to itemize these deduction items. The user should select ‘NEW’ and they will enter a description of the item and then enter the adjustment amount. This will be repeated for each adjusting deduction item reported on the books of the partnership but not deducted on the tax return. The total of these adjusting entries will match what the user has entered on Form 1065 Schedule K, Line 18c. In Keystone Tax Solutions Pro, the total of these items would be entered from the main menu of the 1065 return by selecting ‘Schedule K- Distributive Share Items’, then ‘Other’, then ‘Nondeductible Expenses’.
13. Deductions on Sch K Not Charged Against Books – This is a calculated amount consisting of the amounts entered for “Depreciation” and ‘Other Deductions on Sch K’ (above entries 12-13).
14. Income – This amount is automatically pulled from the tax return (Form 1065) and corresponds to Schedule K, Line 1 of the Analysis of Net Income (Loss). This is the tax income (loss) amount that has to be reconciled to the book income (loss) amount that is on Schedule M-1, Line 1.
NOTE: This is a guide on entering Form 1065, Schedule M-1 Reconciliation of Income (Loss) per Books With Income (Loss) per Return into the Keystone Tax Solutions Pro program. 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
Form 1065 – Schedule L – Balance Sheets per Books
Form 1065 – Schedule M-2 – Analysis of Partners’ Capital Accounts