In the realm of tax law, a partnership exists when two or more people come together to form a business with the goal of making a profit. One example of this is a business with more than one owner that has not been registered with the government of the state in which it does business, what I like to call the “unregistered” partnerships. This is akin to a sole proprietorship but there are several stakeholders. Looking at the other main example, the IRS also classifies limited liability companies with two or members as partnerships for tax purposes, which makes sense because the IRS doesn’t categorically recognize LLCs as an entity in and of themselves. In other words, LLCs are sole proprietorships, partnerships, or corporations, and this article is about the tax preparation of partnerships, whether those be unregistered partnerships or multiple member limited liability companies.
Unlike an individual’s tax return, which centers on the Form 1040 as the main form from which all other forms and schedules flow into, partnerships must prepare Form 1065. Basically, Form 1065 is the Form 1040 of partnerships, including unregistered partnerships and multi-member LLCs. Glancing at Form 1065, you’ll notice that the top portion of the first page requires quite a bit of information about the partnership itself, information like the name of the partnership, its address, the date the partnership was started, the employee identification number, and the total assets of the partnership. In this first portion of Form 1065 you’ll also be responsible for indicating the method of accounting and the number of Schedules K-1 that are included with the partnership return. We’ll go more into Schedule K-1 later.
On the remainder of the first page of Form 1065, you’ll notice two distinct sections for income and deductions. The first of these two sections is income, which basically asks you to tabulate all the different ways the partnership brought in revenue in a given tax year and then subtract amounts for returns and the cost of goods sold. To calculate the cost of goods sold, use Form 1125-A, which is used by companies that keep fluctuating inventories. This income section culminates on line 8, where you’ll have tabulated the total income (or loss) for the partnership.
The second important accounting section on Form 1065 is the deductions section, which lies right below the income section. The deductions section has categorical business deductions from salaries and wages to employee benefit programs. You’ll note that line 16a is for depreciation, which we will not go into in this article because it’s a rather complicated topic that deserves its own treatment in another post. However, suffice it to say, that in order to figure depreciation, use Form 4562, which is the same form that is used to figure depreciation for individuals and corporations. Additionally, on line 21 of the deductions section you are asked to take the sum of the deductions on lines 9 through 20 to get total deductions. After figuring, subtract total deductions on line 21 from total income (or loss) on line 8 to get the ordinary business income of the partnership.
The final section on the first page of Form 1065, the tax and payment section, pertains to taxes. However, partnerships are known as “pass -through entities” meaning they don’t pay taxes generally, so this section can pretty much be ignored for the purposes of this post.
Pages 2 and 3 of Form 1065, which encompass what’s called “Schedule B” asks a series of mostly yes or no questions about the structure of the partnership. We won’t go into all these here because it would be lengthy but we’ll touch on the most important ones. First, in question 1, on the top of page 2, it asks you to identify the type of partnership it is. As was mentioned earlier, the most common types of partnerships are domestic general partnerships, what I call unregistered, along with domestic limited liability companies. Next, unless you opt out of the centralized partnership audit regime, which is outside the scope of this post, you’ll have to designate a partnership representative, which means articulating one of the partners that the IRS can reach out to should it have any questions about your partnership return. This designation is made below line 25 on page 3.
Next, on page 4, you’ll see Schedule K, Partners’ Distributive Share Items. Remember when I mentioned earlier that partnerships are pass-through entities, meaning they don’t pay taxes themselves? In this section you take the items of income, deductions, credits, and other categorical tax items as indicated and pass them through cumulatively to the partners in total.
Finally, on page 5, you’ll find Schedules L, M-1, and M-2. Schedule L is the balance sheet, which shows assets and liabilities of the partnership. These should be equivalent, or balanced. For example, if total assets are $275,000, then total liabilities should also be $275,000. If the balance sheet is unbalanced, meaning that assets don’t mirror liabilities in total value, then you should go back and reanalyze the partnership’s books because you’ve probably missed something. Furthermore, Schedule M-1 reconciles those amounts that are on the books of the partnership but are not included in a part of the return. Finally, Schedule M-2 keeps track of the value of the partners’ cumulative capital accounts from the beginning of the year to the end of the year.
The last aspect of partnership returns this overview will touch on is the Schedule K-1, which is not included in Form 1065, but is integral to partnership returns. Similar to Schedule K, which was found on page 4 of Form 1065, Schedule K-1 is an accounting of the distributive items, but unlike Schedule K which was cumulative to all partners, each partner receives a Schedule K-1 representing his or her individual share of these distributive items. The amount of each item that a partner receives is based on the internal agreements or default laws pertaining to partnerships in the state where the partnership conducts business. For example if I have a partnership with my two best friends, and we each own a one third interest in the partnership and the partnership had $60,000 in ordinary business income, then line 1 of Schedule K would show the full $60,000, and on our individual Schedules K-1, we would each be allocated $20,000 of $60,000. You can think of Schedule K-1 as the Form W-2 of partnership income because it indicates to the IRS your income, among other items, pertaining to the partnership, similar to the way a Form W-2 indicates income from your employer.
This article was meant to be a basic overview of preparing a partnership return, and therefore many things were not included. As a result, it’s recommended that if you are considering preparation of a partnership return, you should seek the help of a professional, and Dino Tax Co has that level of requisite professional expertise. So, if you’re having problems or issues with your partnership return, or have any tax issues whatsoever, call Dino Tax Co at (713) 397-4678 or email us at email@example.com. We’re always here to help and the first consultation is free. Also, consider liking us on Facebook: www.facebook.com/dinotaxco.