There are many forms of business structures like Limited Liability Companies (LLCs), S corporations, C corporations, and partnerships. Each form has unique tax characteristics e.g. partnerships have pass-through income, which means that the business is not taxed on the corporate level. Instead, the partnership income, credits, and deductions are passed to its shareholders who are then taxed.
Form 1065 is an important document used by flow-through entities like partnerships and multi-member LLCs, to record business income and expenses.
This document also serves as the foundation for preparing K-1 forms, which finalizes taxable business profits. Partners and investors include K-1s with their income tax returns during tax season.
This post will act as an in-depth guide to form 1065, preparation tips, and common misconceptions.
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What is Form 1065 and when is it needed?
As discussed above, Form 1065 is one of the more important tax forms and is used to record business income, expenses, deductions, and credits for flow-through entities. These include multi-member LLCs and partnerships. Some other structures that use this form include foreign partnerships with US income, nonprofit religious organizations, and LLPs. Foreign partnerships need to complete this form if more than 1% of their business is in the US or earn more than $20,000 from US-based activity.
Sometimes, business owners can be confused if their firm is structured as a partnership. One resource that they can use to determine if they need to fill out form 1065 is the partnership agreement. This important document clearly defines business roles, registered states and of course, the business structure. It can distinguish between general partnership, limited partnership (LP) and limited liability partnership (LLP). The main difference between general and limited partnerships is that the main partners in an LLP or LP have limited personal liability. For example, their personal assets are protected in legal situations like lawsuits. On the other hand, general partnerships have unlimited liability and their personal assets can be used to pay business creditors in lawsuits.
1. Gather relevant information
The first major step when preparing form 1065 is the gather relevant information. This information could include fundamental statements like the income statement and balance sheet. Business owners should also use their employer identification numbers (EINs), business activity codes, accounting method, partner general information, distributions, and any issued 1099s. Organizing these items might seem daunting, which is why the most important pieces of information like the income statement, balance sheet, and EIN are more precisely defined below:
- Income statement: This is one of the most important financial statements and shows the revenue, expenses and net profit of a business. The main formula of this statement is revenue – expenses = net profit. It’s important to include important line items like cost of goods sold, advertising expenses, and fixed expenses like rent. Luckily, this statement can be easily created and updated with quality tax software like Quickbooks or Zoho Books. It’s also wise to update this document throughout the year as it’s used to prepare Schedule Cs on tax returns.
- Balance Sheet: Like the income statement, the balance sheet is used to gauge a business’s financial health. It shows the assets, liability, and equity which are interrelated with the income statement. The main balance sheet equation is assets = liabilities + shareholders’ equity and includes important assets like cash reserves as well as real estate.
- EIN: An EIN or employer identification number is required to file any partnership return and is an important tool for expanding businesses. For example, businesses that want to hire employees must apply for an EIN with the IRS. This number identifies their business and is imperative for crucial tasks, like sending out employee W-2s.
2. Fill out the general info section
The General info section is relatively easy to complete. This information is at the very top of form 1065 and partners must include the name of the partnership, address, EIN, business activity, business code, date founded, and accounting method. The business activity is a short summary of the business’s purpose like logistics or marketing consulting. The business code is more detailed and this IRS resource has specific codes for various industries.
The accounting method is either accrual or cash accounting with the main difference between the two having different treatment of future income or expenses. For instance, accrual accounting uses accounts payable and accounts receivable, which reflect future payouts and received payments respectively. Conversely, cash accounting only records payouts and received payments when received.
3. Complete Form 1065 income & deductions section
The income and deduction sections are derived from the income statement, which is why it’s crucial to always have an updated one. Fortunately, top-notch software will allow any business to do this.
Businesses use the income statement to transfer information to the revenue, cost of goods sold, profit and deduction sections. Many of the deduction line items like rent, depreciation and employee benefits overlap with the income statement. Businesses that need to file form 1065 need to realize that investment income from rental real estate or investment portfolios won’t go here but instead will be included on Schedule K.
Other net income derived from entities like partnerships, trusts and estates are reflected in this section as well. However, it’s imperative to include separate schedules with these line items which define more details about each entity for tax purposes.
4. Move on to Form 1065 Schedule B
Schedule B isn’t like the personal tax return version as it doesn’t reflect interest and dividend income. On the other hand, it goes into detail regarding business structures and outside ownership. In fact, it asks questions about individuals owning more than 50% of the entity, as well as other businesses having more than a 50% ownership in the entity.
This section also determines if a partnership needs to fill out other sections like Schedules L, M-1, and M-2. The schedule L is simply the balance sheet, an M-1 reconciles income/expenses and M-2 analyzes a partner’s capital account. These forms might seem complex, but later sections will go into detail regarding each one. Also, partnerships that satisfy the four requirements below don’t have to complete these statements:
- 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.
Pay close attention to questions 8 and 14 if the partnership has foreign bank accounts or partners. If the partnership has a foreign partner, it would be required to include forms 8805, and the section 1446 withholding tax. The main purpose of the supplemental forms would be to reflect any federal income tax withholding of the foreign partner’s income.
Related to this, the IRS place high scrutiny on any organization with substantial foreign assets or partners as these methods were used to evade taxes in the past. In fact, the US has some of the strictest rules regarding expat banking, which require investors to report foreign bank accounts with the FBAR and 8938 forms. It’s crucial to pay close attention to these rules as non-compliance will lead to hefty fines and even jail time in extreme situations.
5. Fill out Form 1065 Schedule K
Schedule K reflects a partnership’s income, deductions, and credits for the year. These can also include income from different sources like stock market investments and rental real estate. Schedule K greatly differs from the general income and deductions section as it places a higher emphasis on passive income. Passive income can come from a variety of sources, but the two biggest sources as defined by the IRS are rental real estate and royalties. A common royalty example could be an artist receiving payments from a song he or she recorded years ago.
This section also goes into more detail regarding credits, which represent a dollar for dollar tax reduction. For example, a $2,000 credit reduces taxes by exactly $2,000 while a $2,000 deduction only reduces taxes by $500 (assuming a 25% tax bracket). It allows partnerships to claim various credits, including a low-income housing credit, which incentivizes real estate developers to build low-income housing through tax benefits.
6. Complete Form 1065 Schedule L
The Schedule L is simply a balance sheet which breaks down assets, liability, and partnership equity. The assets column has many line items which include tangible and intangible assets. Some tangible assets are cash, land, and inventory with intangible assets including amortization. Amortization is simply the depreciation of an intangible asset like goodwill or a loan payable.
The liabilities section has mostly items related to loans and accounts payable. It also has a section for current liabilities, which represent short term loans that are due in less than a year. Fortunately, many reliable accounting software programs like Quickbooks and Xero allow users to create as well as automatically update balance sheets. Clients who have these programs can have the information flow directly from the balance sheet report to Schedule L, which makes it easier to calculate partnership tax.
7. Fill out Form 1065 Schedule M-1
Schedule M-1 is also referred to as the reconciliation schedule, which compares reporting differences between tax and bookkeeping methods. These differences are summarized on this schedule and some common discrepancies include the 50% meal deduction, tax-exempt interest income as well as travel/entertainment.
For example, taxpayers can deduct 50% of qualified meals that they have with clients. There are many rules around this such as the meal not being too lavish and requiring a business representative to be present. The tax method of recording this expense would be to prorate the total meal expenses as recorded by the bookkeeping method by 50%.
If there are significant differences, this form can be a great way to pinpoint the fine details. This method can ensure tax compliance and accuracy. However, there are times where there would be no discrepancies between the two standards. Yet, this form is still required if businesses don’t satisfy the four main bullet points seen under the schedule B headline of this post.
8. Finish with Form 1065 Schedule M-2
This area shows a partner’s beginning and ending capital account. It also derives from the fundamental balance sheet equation which is assets = liabilities + equity and the partner’s capital account can be seen as the equity portion. It also shows any capital and distributions which could be cash or property made throughout the year.
Schedule M-2 is especially important as the IRS uses this to verify the equity section in schedule L (balance sheet). It also needs to match the total of the amounts reported in Part II, Item L of every partners’ schedules K-1s. Therefore, it’s important to ensure each of the three schedules (L, M-1, and M-2) are filled out accurately as they are deeply interrelated.
Common Form 1065 misconceptions
This form is due around the 15th day of March every year and can be extended to September 15th for late filers. These dates change slightly and can be found on the IRS direct website.
A few common misconceptions about form 1065 are:
- Determining the number of forms per year for each partner: Partnerships only need to file one form 1065 per year. This document aggregates all income, expenses, and deductions throughout the year. From there, it’s divided into multiple K-1 forms for each partner. A partner’s K-1 form can vary based on factors like business ownership, capital contributed and involvement.
- Not including foreign partners: LLCs can have foreign partners, but the partnership has to take on new responsibilities. For instance, the partnership will need to withhold income on behalf of the foreign partner and comply with U.S expat tax laws. Each foreign partner needs a US tax identification number and files a US tax return. Also, partnerships that have foreign bank accounts need to pay close attention to FBAR and FinCEN requirements.
LLCs and partnerships are very important and common business structures that are pass-through entities. They aren’t taxed at the corporate level but record taxable profits on form 1065. All parties have to pay taxes on these profits which are also included in each person tax return.
IRS Form 1065 is relatively complex, which is why it’s smart to consider having an accountant fill it out. The accountant or tax preparer can use software like TurboTax to ensure accuracy and save time when completing this task as well as making tax payments. This guide teaches business professionals how to properly fill out this form and common misconceptions to avoid.
Disclaimer: This post is not tax advice, but education. Consult a CPA or tax advisor for tax advice.