Basics of Form 1065 Tax Returns
Preparing the IRS Form 1065 (US Return of Partnership Income) can be complicated for many partnerships. The tax filing is used by all domestic partnerships to report their income, deductions, gains, losses, and other financial information.
Each partner receives a Schedule K-1 (Form 1065), which reports their allocable share of the partnership items. After receiving the Schedule K-1, each partner uses this information to complete their own income tax return.
Example Fact Pattern in Video Tutorial
The video tutorial for this post covers a sample 2022 Form 1065 filing for a real estate flip company. The LLC was formed by three separate partners on September 25, 2022, so this is an initial filing for the LLC.
The business purpose of the LLC is to purchase homes, renovate the homes, and then quickly sell the homes for a profit. The LLC does not intend to hold the properties long-term, nor does it intend to rent any of the homes to tenants.
The LLC purchased three homes that were all renovated and flipped for a profit in 2022. The LLC purchased a fourth home in 2022, which the company was still renovating at the end of 2022, so the property was still owned by the LLC.
The company creates both a consolidated income statement and a more detailed profit and loss with separate columns for each building project. Only the consolidated income statement is required for the tax return. The company’s balance sheet reflects the book value of its assets and liabilities at the end of the year. The inventory balance includes the house and all accumulated repair costs.
The company’s balance sheet also reflects the capital account details for each partner. These details are separately stated in Schedule M-2 and Schedule K-1 (Form 1065) for each partner.
The tax return also includes Form 1125-A (Cost of Goods Sold) to reconcile the inventory account details for the home purchases and other inventoried costs.
Step-by-Step Guide for Preparing Form 1065
There are some common procedural steps to prepare every Form 1065 as outlined below:
Gather Background Information on the Partnership
Partnership Agreement: Review the partnership agreement to understand the partners’ allocation of income, deductions, and credits. A partnership has great flexibility in allocating these items to its partners. It is not wise to assume that partnership items should always be allocated using the equity ownership percentages of the partners. The allocations are often much more complicated.
Financial Statements: Prepare and review the financial statements for the partnership. The necessary statements include the income statement, balance sheet, and a capital roll forward for the partners.
Partner Information: Gather information for each partner, including their name, address, taxpayer identification number (TIN), partner’s level of participation (e.g., general partner or limited partner), whether the partner is foreign or domestic, and the type of partner (e.g., individual, corporation, trust, partnership, nonprofit, etc.).
Complete the Basic Information Section
Name and Address: Enter the name of the partnership, employer identification number (EIN), address, date business was started, principal business activity, and business activity code number.
Additional Information: If applicable, indicate whether this is the first or final year the partnership is filing a tax return. The partnership must also disclose whether there has been a change of address or change in partnership name from the prior tax filing. Indicate the accounting method used by the partnership (e.g., cash, accrual, or other method).
Complete the Profit & Loss and Balance Sheet Information
Page 1 of Form 1065 reports the income and expenses from an ordinary trade or business.
The partnership completes Schedule L (Balance Sheets per Books) for the beginning and end of the tax year.
The partnership completes Schedule M-1 to reconcile the net income or loss per books versus the net income calculated for federal tax purposes. For example, a partnership may prepare its internal financial statements using Generally Accepted Accounting Principles (GAAP). There are often differences in what is allowed as a deduction or income inclusion between U.S. GAAP and federal taxable income.
Schedule M-2 (Analysis of Partners’ Capital Accounts) analyzes the changes in partner capital accounts from the beginning to the end of the tax year. This reconciliation includes capital contributions, distributions, net income, and other increases and decreases to partner capital.
Complete Schedule B and Schedule K
Schedule B (Other Information) has various questions and other information required to be disclosed by the partnership. Schedule K (Partners’ Distributive Share Items) summarizes the total income and other partnership items that will eventually be allocated amongst the partners on their respective Schedule K-1s.
Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.)
Prepare a Schedule K-1 (Form 1065) for each of the partners. This form reports each partner’s share of the partnership’s income, deductions, and credits.
Partnerships are flow-through entities, which means they are generally not liable to pay tax directly on the partnership’s income. Instead, each partner receives an allocation of the income as reported on their Schedule K-1. Each partner uses their Schedule K-1 to complete their required income tax return where applicable.
Consider Hiring a Tax Professional
If the partnership’s tax situation is complex, or if you need clarification on any part of the filing process, consider hiring a Certified Public Accountant (CPA) or other tax professional experienced with partnership tax returns.