Instructions for Form 1065 Schedule M-3

Form 1065, U.S. Return of Partnership Income, is the tax return for domestic partnerships. Certain partnerships must also file Schedule M-3, which reconciles the partnership’s financial accounting “book” income with the taxable income reported to the IRS. The schedule systematically adjusts the book figures to arrive at the final tax figures. This process provides the IRS with a clear picture of how a partnership’s financial results are translated into its tax liability.

Determining the Filing Requirement for Schedule M-3

A partnership must file Schedule M-3 if it meets any one of several specific tests. If the partnership’s total assets are $10 million or more at the end of the tax year, filing is mandatory. This amount is determined based on the figure reported on Schedule L, line 14, column (d) of Form 1065.

Another threshold is based on total receipts. If a partnership’s total receipts for the tax year are $35 million or more, it must file Schedule M-3. Total receipts are the gross amounts received from all business operations.

A filing requirement is also triggered if an entity partner owns, directly or indirectly, 50% or more of the partnership’s capital, profit, or loss, and that partner was required to file its own Schedule M-3 for its most recently filed tax year.

Even if a partnership does not meet these mandatory requirements, it can file Schedule M-3 voluntarily to provide a clearer reconciliation than what is offered on the simpler Schedule M-1. For partnerships required to file Schedule M-3 but have total assets of less than $50 million, a modified option is available; they can complete Part I and then use Schedule M-1 for the detailed reconciliation.

Key Concepts and Required Information

Before beginning Schedule M-3, the partnership’s income statement, balance sheet, and detailed trial balance must be gathered. “Book income” refers to the net income reported on the partnership’s financial statements, prepared under standards like Generally Accepted Accounting Principles (GAAP). The reconciliation process hinges on identifying “book-tax differences,” which fall into two main types: permanent and temporary.

Permanent differences are items of income or expense recognized for book purposes but never for tax purposes, or vice versa. An example is tax-exempt interest income from municipal bonds, which is recorded as income on the books but is excluded from taxable income. Other examples include entertainment expenses and certain penalties, which are expensed on the books but are not deductible for tax purposes.

Temporary differences arise when an item of income or expense is recognized in different periods for book and tax purposes, and these differences will eventually reverse over time. A frequent example is depreciation, where a partnership might use the straight-line method for its financial statements but an accelerated method like MACRS for its tax return. This creates a temporary difference that reverses as the asset ages. Other common temporary differences include adjustments for bad debt expense and warranty costs.

Completing Part I Financial Information and Reconciliation

Part I of Schedule M-3 establishes the starting point for the reconciliation by identifying the partnership’s worldwide financial income. The first step is to check the box indicating the source of the income statement, such as a certified audited statement or the partnership’s internal books and records.

Next, the preparer enters the worldwide consolidated net income for the entire financial reporting group on line 4, which must match the net income on the top-level entity’s financial statements. Subsequent lines then adjust this worldwide figure to isolate the specific net income of the partnership filing the tax return. These adjustments remove the income or loss from other entities, such as subsidiary partnerships, that are included in the consolidated financial statement but file their own separate tax returns.

The form requires adjustments for other partnerships and disregarded entities. For example, line 7 subtracts the financial income of entities that are part of the consolidated financial statement but not the partnership’s U.S. tax return. Line 8 adds back the book income of entities included in the tax return but not in the initial worldwide income figure.

After making these adjustments, the process culminates on line 11, “Net income (loss) per income statement of the partnership,” which is the starting point for the detailed reconciliation in Parts II and III.

Completing Parts II and III Detailed Reconciliation

Part II focuses on reconciling net income, while Part III addresses the reconciliation of expense and deduction items. Both parts are structured as a grid with four columns: column (a) for the book amount, column (b) for temporary differences, column (c) for permanent differences, and column (d) for the tax amount. The sum of columns (a), (b), and (c) must equal the amount in column (d).

In Part II, the preparer addresses income and loss items. For each line item, such as interest income or dividends, the amount recorded in the partnership’s financial statements is entered in column (a). For interest income, a temporary difference in column (b) might be related to market discount on bonds, while a permanent difference in column (c) would be tax-exempt interest from municipal bonds.

For income from other partnerships, the book income reported under the equity method is entered in column (a). The adjustments in columns (b) and (c) reflect the differences between that book figure and the allocable share of taxable income reported on the Schedule K-1 received from the other partnership.

Part III applies the same four-column logic to expenses and deductions. For the depreciation line, column (a) shows the depreciation expense from the income statement. Column (b) will contain the temporary difference between book depreciation (often straight-line) and tax depreciation (often accelerated, like MACRS).

For meals and entertainment expenses, the full amount expensed on the books is entered in column (a). The portion of these expenses that is non-deductible for tax purposes, such as the 50% limitation on business meals or the 100% disallowance of entertainment expenses, is entered as a permanent difference in column (c). This adjustment increases taxable income relative to book income, and the final tax-deductible amount is reported in column (d).