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 rental real estate LLC. The owners formed the LLC on January 15, 2022, so this will be an initial year return.
The LLC purchased a rental property in Miami, Florida, and generated rental income of $42,000 in 2022. The company was also looking to buy a second rental property in Belize. To start the process, the LLC opened a non-U.S. bank account in Belize. As of the end of 2022, the LLC did not purchase a piece of real estate in Belize.
The LLC generated interest income of $191 in 2022. The interest income comprises U.S. bank interest of $70 and foreign interest income of $121 on the Belize bank account. The LLC must also disclose its ownership interest in a non-U.S. bank account using an FBAR filing.
The Schedule K-1 for each partner also includes the Schedule K-3 to report the separate U.S. and foreign interest income. This information is valuable for partners completing Form 1116 (Foreign Tax Credit).
The company’s balance sheet reflects the assets, liabilities, and partners’ capital at the beginning and end of each year. The company separately states its cash balances, the cost basis of the building and land, loan origination costs as an intangible asset, and the amount of accumulated depreciation and amortization expenses.
The balance sheet also includes the capital account details for each partner, including the current year’s capital contributions, distributions, and income allocations. These details are separately stated in Schedule M-2 and Schedule K-1 (Form 1065) for each partner.
The tax return includes a Form 8825 (Rental Real Estate Income) to report the rental income, expenses, depreciation, and amortization for the property. Because the LLC only has one rental property for 2022, all of the details are included in one column on Form 8825.
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), Enrolled Agent (EA), or other tax professional experienced with partnership tax returns.