What is the purpose of Schedule M-1 in the partnership return?
There is often a difference between the profit or loss on a partnership's accounting books versus what is reported on its tax return. This difference arises due to differences between tax law and generally accepted accounting principals. Some of the differences are due to timing, i.e., when an item of income or expense is recognized, whereas other differences are permanent.
There are four general categories of differences:
- Income subject to tax but not recorded on the books this year;
- Expenses recorded on the books this year but not deducted on this tax return;
- Income recorded on the books this year but not included on this tax return, and;
- Deductions on the tax return but not deducted on the books this year.
In Form 1065, U.S. Return of Partnership Income, Schedule M-1 is used to reconcile the income that the partnership is reporting on the tax return with the income in its accounting records. Not all partnerships are required to complete Schedule M-1.
When is Schedule M-1 not required?
A partnership does not need to complete a Schedules L (Balance Sheet), M-1 (Reconciliation of Income), and M-2 (Analysis of Partner’s Capital Accounts) if it satisfies all of the following four requirements:
- The partnership’s total receipts for the tax year were less than $250,000.
- The partnership’s total assets at the end of the tax year were less than $1 million.
- Schedule K-1s were filed with the return and furnished to the partners on or before the due date (including extensions).
- The partnership is not filing nor is required to file Schedule M-3.
Whether or not the partnership satisfies these four requirements is a Yes/No question on Schedule B (Form 1065) line 4 (line 6 prior to 2018).
To answer this question in the partnership return in TaxSlayer Pro select:
- Schedule B - Other Information
- Does This Partnership Meet All Four Requirements? - The default answer is no, i.e., they do not meet all four requirements and thus must include Schedules L, M-1, and M-2 in the tax return. Answer YES if the partnership meets all four requirements.
Note that even though Schedules L, M-1, and M-2 may not be required for a partnership return, you can still prepare them anyway as a service to your client. They may be required in a subsequent year, so preparing them each year helps the partners understand how the tax return and the books relate as well as makes it easier to prepare them if and when they are required.
Completing Schedule M-1
If the partnership does not meet the four requirements they are required to complete Schedule M-1. To complete Schedule M-1, from the Main Menu of the tax return (Form 1065) select Schedule M-1 – Reconciliation.
There may be no difference between income or loss reported on the tax return and the income or loss reported on their books, and thus no further work needs to be done on the schedule, but by selecting Schedule M-1 in the menu the schedule is created and included in the return.
Here are the Schedule M-1 menu lines in TaxSlayer Pro:
1. Net Income (Loss) Per Books - This is a calculated amount and cannot be edited. It is initially equal to the income or loss on the Form 1065 (and also the last Schedule M-1 menu line) and is adjusted up or down by the amounts entered in this menu. Before making any adjustments, compare this amount to the partnership's actual book income. If they don't match, one or more entries are needed to reconcile the two. Once all the adjustments are made in this menu, this line must equal the net income or loss in the partnership's accounting records.
2. Income Subject to Tax Not Recorded on Books - Enter any income that was included on the tax return but not included on the partnership's books. This is uncommon in 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 - Enter the amount of guaranteed payments made to the partners as indicated in Schedule K. Guaranteed payments don't automatically pull from the return as one kind of guaranteed payment isn't included here: insurance that constitutes medical care for a partner or someone in the partner's family.
4. Depreciation - This is a common adjustment item on Schedule M-1 because a partnership is allowed to utilize accelerated depreciation methods, special depreciation, and 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 the asset will be totally depreciated and the depreciation taken will be the same on both the tax return and the books.
Schedule M-1 includes two separate lines to enter the differences in depreciation. This menu line is for assets where the amount of depreciation taken is greater in the partnership's books than is being claimed on the tax return.
5. Travel and Entertainment - While a business can deduct what it wishes on its books for travel, entertainment, and meals, the IRS limits the amount that a business can take as a deduction on its annual return. Meal deductions can be taken up to 50% of the expenditure, or in certain situations 80%, or, for restaurant expenditures during 2021-2022, 100% of the expenditure. The amount in this menu is pulled from the entries in the Deductions menu and can be adjusted as needed. (See IRS Publication 463 if in doubt about how much of an expenditure can be deducted in the return.)
6. Other Expenses Recorded on Books - Enter here expenses that are reflected on the partnership records but are not deductible in the tax return. The total here should reconcile to Schedule K line 18c. Examples:
- income taxes
- prepaid expenses
- fines and penalties, with exceptions
- lobbying expenses
- certain meals and entertainment
- certain club dues
After selecting this menu line, select New. Choose from one of the prefilled descriptions or select "Enter a description" to create your own, followed by the amount.
7. Expenses Recorded on Books Not on Sch K - This amount is the sum of the amounts entered above for Depreciation, Travel and Entertainment, and Other Expenses Recorded on Books. ("Not on Sch K" means not on Schedule K lines 1 through 13d and line 21.)
8. Tax-Exempt Interest - The amount here, if any, is pulled from the amount entered in Schedule K under the "Other" menu and reconciles to Schedule K line 18a. It cannot be edited.
9. Other Income Not on Sch K - Enter here income that is reflected in the partnership records but not included on the tax return. (PPP loan forgiveness is reported on this line. See here for more information.) The total here should reconcile to Schedule K line 18b.
After selecting this menu line, select New. Enter the description followed by the amount.
10. Income Reported on Books Not on Sch K - This amount is the sum of the amounts entered above for Tax Exempt Interest and Other Income Not on Sch K. ("Not on Sch K" means not on Schedule K lines 1 through 11.)
11. Depreciation - This is the second of the two depreciation lines, and the amounts entered here are for assets where the amount of depreciation taken is greater on the partnership's tax return than on its books. Typically, special and bonus depreciation amounts in excess of what is recognized on the partnership's records are included here.
12. Other Deductions on Sch K - Enter here the deductions on Schedule K lines 1 through 13d and line 21 that aren't reflected in the partnership's books.
After selecting the menu line, select New. Enter the description followed by the amount.
13. Deductions on Sch K Not Charged Against Books - This amount is the sum of the amounts entered above for Depreciation and Other Deductions on Sch K.
14. Income - This is the amount on Schedule K line 1, the income or loss on the tax return that needs to to be reconciled to the book income or loss.
Note: This is a guide on completing Schedule M-1 (Form 1065) in the TaxSlayer Pro program. This is not intended as tax advice.
IRS: Publication 541 - Partnerships
IRS: 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