Partnerships do not pay taxes on their profits, their partners do. Partnerships are pass-through entities that report their income, deductions, credits and other items to partners so that partners can then enter their share of this information on their personal tax returns.
The partnership, as well as an entity treated as a partnership for federal income tax purposes, uses Form 1065, U.S. Return of Partnership Income, to list this information. An allocation of the items is made to each partner on a Schedule K-1, Partner’s Share of Income, Deductions, Credits, Etc., based on their ownership interests.
What the Form Reports
Form 1065 is five pages.
Page One: Basic information about the partnership (name, address, employer identification number, business activity, date that the business started) is shown at the top of the form. Then the partnership indicates whether the return is special (e.g., amended, final, reflecting change of name or address), the method of accounting and the number of Schedule K-1s that are attached.
The income section lists various income items from the partnership’s trade or business, such as gross receipts from sales and net gain or loss from the sale of business assets (a figure that is taken from Form 4797). Some items require special treatment on shareholders' (partners') own returns; these are referred to as separately stated items and do not appear on page one of Form 1040. For example, because of special rules for rental real estate income and deductions, you won’t see an entry of these rents in the income section of the Form 1065 return.
Similarly, while some of a partnership’s trade or business deductions are listed on page one of Form 1065, some are reported elsewhere (e.g., charitable contributions, Sec. 179 deduction) so that partners can apply their own limitations for these write-offs. Deductions on page one of Form 1065 include salaries and wages to employees (but partners are not employees so payments to them are not listed here); any guaranteed payments to partners are listed.
The difference between the partnership’s total income and its total deductions is ordinary business income profit or loss. This net amount, along with other items, is allocated to partners.
The bottom of page one is used for signing and dating the form if the return is filed on paper (electronic signatures are used for e-filed returns) and noting information about a paid preparer, if any.
Pages Two and Three: Schedule B, Other Information, is a series of yes-no questions about the partnership. For example, check the box for question one regarding the type of partnership or other entity filing the return, such as a limited liability company (LLC) with two or more partners and a limited liability partnership (LLP). Schedule B is also used to provide information about the Tax Matters Partner: someone designated by the partnership to sign the return and interface with the IRS on matters concerning the return. (If there are more than 10 partners, any audits must be conducted at the partnership level to save the IRS the trouble of auditing each individual partner about the treatment of a partnership item.)
Page Four: Schedule K lists the partners’ distributive share of items. It is from this schedule that allocations are made to individual partners of each of these items; the allocated amounts are reported on Schedule K-1, which has sections for:
- income (loss)
- foreign transactions
- alternative minimum tax items
- other information
Page Five: This page is made up of a number of different schedules:
Schedule K’s analysis of net income (loss) is a breakdown of the income or loss according to the nature of the partnership (corporate, individual (active), individual (passive), etc.). It further segregates the income and loss among general partners and limited partners.
Schedule L is the balance sheet. Its entries for assets and liabilities are populated according to the books of the partnership. As with any balance sheet, the difference between the assets and liabilities effectively reflects the partner’s capital accounts (i.e., equity in the partnership).
Schedule M-1 is a reconciliation of income or loss per the books, with income or loss per return. Because tax rules don’t necessarily follow the economic reality of partnership activities, this reconciliation is necessary. For example, while a partnership may deduct the full cost of meal and entertainment on its books, for tax purposes only 50% of these costs are deductible; the reconciliation is made on Schedule M-1.
Schedule M-2 is an analysis of the partners’ capital accounts. This equity interest adjusts each year to reflect contributions made by partners, the partnership’s profit or loss, distributions from the partnership to partners and other activities.
Note: Schedule M-3, which is a statement required only for large partnerships ($50 million or more in total assets), is not part of the five pages of Form 1065. If a partnership is required to attach this schedule to the return it is noted on line J on page one of the return.
As explained earlier, this form allocates partnership items as well as separately stated items to shareholders so they can report them on their personal returns. Page two of this schedule directs partners who are individuals filing Form 1040 where to report the items. For example, a partner’s share of profit or loss (the ordinary income or loss from page one of Form 1065) is reported on Schedule E of an individual’s Form 1040. A partner’s share of net long-term capital gains is reported on Schedule D of Form 1040 (and may have to be entered on Form 8949 as well).
Filing the Return
Form 1065 has a due date on the 15th day of the third month after the end of the entity's tax year. March 15 for a calendar year entity. A partnership currently can obtain an automatic six-month filing extension to September 15. Partnerships that fail to file their returns on time are subject to a penalty of $195 per partner for each month they delay.
(For further reading on partnerships, see: How Are Business Decisions Made in a Partnership? and Silent Partner vs. General Partner: What's the Difference?)
Provisions were made in the Coronavirus Aid, Relief, and Economic Security (CARES) Act to allow registered partnerships to claim certain benefits retroactively for the 2018 and 2019 tax years using Form 1065. The change applies to partnerships that are subject to audit regimes under the Bipartisan Budget Act of 2015.
Partnerships using the form are able to deduct additional interest expense and full depreciation on improvements made to a building's interior, as long as it's made to non-residential property. Those using the form to claim these retroactive benefits must indicate that they're filing an amended return by checking off the appropriate box.
The Bottom Line
Even though no tax is due on a partnership return, it is a vital piece of information for the IRS to use in checking that partners pay their taxes on partnership items. Completion of the form can be confusing and complex, so it is advisable to work with a knowledgeable tax professional.