Instructions for Schedule M-3 (Form 1065) (2006)

General Instructions

This is archived information that pertains only to the 2006 Tax Year. If you
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Table of Contents

Purpose of Schedule

Schedule M-3 Part I asks certain questions about the partnership's financial statements and reconciles financial statement net income (loss) for the consolidated financial statement group to income (loss) per the income statement for the partnership.

Schedule M-3 Parts II and III reconcile financial statement net income (loss) for the partnership (per Schedule M-3, Part I, line 11) to income (loss) per return on Form 1065 and Form 1065-B, page 4, Analysis of Net Income (Loss), line 1.

Schedule M-3 is effective for any tax year ending on or after December 31, 2006. For purposes of determining whether a partnership with a 52-53 week tax year must file Schedule M-3, such partnership's tax year is deemed to end or close on the last day of the calendar month nearest to the last day of the 52-53 week tax year. (For further guidance on 52-53 week tax years, see Regulations section 1.441-2(c)(1)).

Where To File

If the partnership is required to file (or voluntarily files) Schedule M-3 (Form 1065), the partnership must file Form 1065 and all attachments and schedules, including Schedule M-3 (Form 1065), with the Internal Revenue Service Center, Ogden, UT 84201-0011.

Who Must File

A U.S. partnership filing Form 1065 or Form 1065-B that is not required to file Schedule M-3 may voluntarily file Schedule M-3 in place of Schedule M-1.

Any entity which files Form 1065, U.S. Return of Partnership Income, or Form 1065-B, U.S. Return of Income for Electing Large Partnerships, must complete and file Schedule M-3 in lieu of Schedule M-1, Reconciliation of Income (Loss) per Books With Income (Loss) per Return, if any of the following is true:

The amount of total assets at the end of the tax year reported on Form 1065, Schedule L, line 14, column (d), is equal to $10 million or more.
The amount of adjusted total assets for the year is equal to $10 million or more. For these purposes, the amount of adjusted total assets is total assets at the end of the tax year before capital distributions, losses, and adjustments that reduce total capital, and is calculated as the sum of (1) the amount of total assets at the end of the tax year reported on Form 1065, Schedule L, line 14, column (d), plus (2) the amounts of capital distribution reported on Schedule M-2 line 6a and line 6b (stated as positive amounts), plus (3) the amount of any loss reported on Schedule M-2, line 3 (stated as a positive amount), plus (4) the amount of any positive adjustment on Schedule M-2, line 7, plus (5) the amount of any negative adjustment on Schedule M-2, line 4 (stated as a positive amount).
The amount of total receipts (as defined on page 21 of the Instructions for Form 1065, Schedule B, question 5), for the taxable year, is equal to $35 million or more. Total receipts is defined in the instructions for Codes for Principal Business Activity and Principle Product or Service in the Instructions for Form 1065-B.
An entity that is a reportable entity partner with respect to the partnership (as defined under these instructions) owns or is deemed to own, directly or indirectly, an interest of 50 percent or more in the partnership's capital, profit, or loss, on any day during the tax year of the partnership.

A common trust fund or foreign partnership filing Form 1065 is subject to Schedule M-3 if it meets any of the tests.

Reportable Entity Partner Reporting Responsibilities

For the purposes of these instructions, a reportable entity partner with respect to a partnership filing Form 1065 is an entity that (1) owns or is deemed to own, directly or indirectly, under these instructions a 50 percent or greater interest in the income, loss or capital of the partnership on any day of the tax year on or after June 30, 2006, and (2) was required to complete Schedule M-3 on its most recently filed US federal income tax return or return of income filed prior to that day.

For the purposes of these instructions: (1) the parent corporation of a consolidated tax group is deemed to own all corporate and partnership interests owned or deemed to be owned under these instructions by any member of the tax consolidated group; (2) the owner of a disregarded entity is deemed to own all corporate and partnership interests owned or deemed to be owned under these instructions by the disregarded entity; (3) the owner of 50 percent or more of a corporation by vote on any day of the corporation tax year is deemed to own all corporate and partnership interests owned or deemed to be owned under these instructions by the corporation during the corporation tax year; (4) the owner of 50 percent or more of partnership income, loss, or capital on any day of the partnership tax year is deemed to own all corporate and partnership interests owned or deemed to be owned under these instructions by the partnership during the partnership tax year; and (5) the beneficial owner of 50 percent or more of the beneficial interest of a trust or nominee arrangement on any day of the trust or nominee arrangement tax year is deemed to own all corporate and partnership interests owned or deemed to be owned under these instructions by the trust or nominee arrangement.

A reportable entity partner with respect to a partnership (as defined above) must report the following to the partnership on September 15, 2006, or if later, within 30 days of first becoming a reportable entity partner and, after first reporting to the partnership under these instructions, thereafter within 30 days of the date of any change in the interest it owns or is deemed to own, directly or indirectly, under these instructions, in the partnership: (1) its name, (2) its mailing address, (3) its taxpayer identification number (TIN or EIN) if applicable, (4) its entity or organization type, (5) the state or country in which it is organized, (6) the date on which it first became a reportable entity partner on or after June 30, 2006, (7) the date with respect to which it is reporting a change in its ownership interest in the partnership, if applicable, (8) the interest in the partnership it owns or is deemed to own in the partnership, directly or indirectly (as defined under these instructions) as of the date with respect to which it is reporting, and (9) any change in that interest as of the date with respect to which it is reporting.

For more information, see Item D. Reportable Entity Partner on page 3.

Other Issues Affecting Schedule M-3 Filing Requirements

For purposes of determining for Schedule M-3 whether the partnership's adjusted total assets (under these instructions) equal $10 million or more, the partnership's total assets at the end-of-year must be determined on an overall accrual method of accounting unless both of the following apply: (a) the tax return of the partnership is prepared using an overall cash method of accounting, and (b) the partnership does not prepare and is not included in financial statements prepared on an accrual basis.

In the case of a partnership year ending because of a section 708 termination (sale or exchange within a 12 month period of 50 percent or more of the partnership interest in income and capital), total end-of-year assets of the partnership for determining the requirement to file Schedule M-3 shall be determined immediately before the section 708 termination and any actual or deemed contribution or distribution of the partnership assets under the provisions of section 708.

Example 1.

U.S. partnership A owns 80 percent of the income and capital of U.S. partnership B. For its 2006 tax year ending December 31, 2006, A prepares consolidated financial statements with B that report total assets at end-of-year of $12 million. A files a Form 1065 and reports on Schedule L total assets at end-of-year of $7 million. The amount of A's adjusted total assets (under these instructions) is $8 million for the 2006 tax year. A has total receipts for the 2006 tax year of $15 million. A has no reportable entity partners (as defined on page 1). A is not required to file Schedule M-3 for the 2006 tax year based on its total assets or adjusted total assets. A is not required to file Schedule M-3 for the 2006 tax year based on its total receipts. A is not required to file Schedule M-3 for the 2006 tax year based on reportable entity partners. A is not required to file Schedule M-3 under any of the four tests and therefore is not required to file Schedule M-3 for the 2006 tax year. A may voluntarily file Schedule M-3 for the 2006 tax year. If A does not file Schedule M-3, it must file Schedule M-1.
Same facts as in Example 1.1 except that U.S. partnership A has total receipts for 2006 of $40 million. Because A has total receipts of $35 million or more for its tax year ending December 31, 2006, A must complete Schedule M-3 for 2006.
R, a U.S. partnership, files a Form 1065 for the tax year ending December 31, 2006. R has total assets at the end of 2006 reported on Schedule L, line 14, column (d), of $7.5 million. R made distributions of $3.0 million during 2006 reflected on Schedule M-2, line 6. R did not report a loss for 2006 on Schedule M-2, line 3. R did not report adjustments to capital on Schedule M-2, lines 4 or 7. R has adjusted total assets for 2006 of $10.5 million, the sum of $7.5 million plus $3.0 million (the amount of distributions that must be added back to determine adjusted total assets for 2006). Because R has adjusted total assets of $10 million or more for its tax year ending December 31, 2006, R must file Schedule M-3 for 2006.
S, a U.S. partnership, files a Form 1065 for the tax year ending December 31, 2006. S has total assets at the end of 2006 reported on Schedule L, line 14, column (d), of $7.5 million. S made no distributions during 2006 reflected on Schedule M-2, line 6. S reported a loss of ($3.0 million) for 2006 on Schedule M-2, line 3. S did not report adjustments to capital on Schedule M-2, lines 4 or 7. S has adjusted total assets for 2006 of $10.5 million, the sum of $7.5 million plus $3.0 million (the amount of the loss stated as a positive amount that must be added back to determine adjusted total assets for 2006). Because S has adjusted total assets of $10 million or more for its tax year ending December 31, 2006, S must file Schedule M-3 for 2006.
T, a U.S. partnership, files a Form 1065 for the tax year ending December 31, 2006. T has total assets at the end of 2006 reported on Schedule L, line 14, column (d), of $7.5 million. T made no distributions during 2006 reflected on Schedule M-2, line 6. T did not report a loss for 2006 on Schedule M-2, line 3. T did not report adjustments to capital on Schedule M-2, line 7, but did report a negative adjustment of ($3.0 million) on Schedule M-2, line 4. T has adjusted total assets for 2006 of $10.5 million, the sum of $7.5 million plus $3.0 million (the amount of the negative adjustment stated as a positive amount that must be added back to determine adjusted total assets for 2006). Because T has adjusted total assets of $10 million or more for its tax year ending December 31, 2006, T must file Schedule M-3 for 2006.

Example 2.

P, a US corporation, is the parent of a financial consolidation group with 50 domestic subsidiaries DS1 through DS50 and 50 foreign subsidiaries FS1 through FS50, all 100 percent owned on June 30, 2006. On September 15, 2005, P filed a consolidated tax return on Form 1120 and was required to complete Schedule M-3 for the tax year ending December 31, 2004. On June 30, 2006, DS1, DS2, DS3, FS1, and FS2 are each 10 percent partners in partnership K which files Form 1065 for the tax year ending December 31, 2006. P is deemed to own, directly or indirectly, all corporate and partnership interests of DS1, DS2, DS3, as the parent of the tax consolidation group and therefore is deemed to own 30 percent of K on June 30, 2006. P is deemed to own, directly or indirectly, all corporate and partnership interests of FS1 and FS2 as the owner of 50 percent or more of each corporation by vote and therefore is deemed to own 20 percent of K on June 30, 2006. P is therefore deemed to own 50 percent of K on June 30, 2006. P was required to complete Schedule M-3 on its 2004 Form 1120 filed September 15, 2005, its most recently filed U.S. federal income tax return filed prior to June 30, 2006. P owns or is deemed to own, directly or indirectly, 50 percent or more of K on June 30, 2006, and was required to complete Schedule M-3 on its most recently filed U.S. income tax return filed prior to that date. Therefore, P is a reportable entity partner of K as of June 30, 2006. On September 15, 2006, P reports to K, as it is required to do, that P is a reportable entity partner as of June 30, 2006, deemed to own a 50 percent interest in K. K is therefore required to complete Schedule M-3 when it files its Form 1065 for its tax year ending December 31, 2006.
Throughout 2006, A, a limited liability company (LLC) filing a Form 1065 for calendar year 2006, owns, as its only asset, 50 percent of each of B, C, D, and E, each also an LLC filing a Form 1065 for calendar year 2006. A is owned by individuals and S corporations not required to complete Schedule M-3 for 2005, 2006, or 2007. B, C, D, and E are owned by A and by individuals and S corporations not required to complete Schedule M-3 for 2005, 2006, or 2007. For the partnership tax years ending December 31, 2006, each of B, C, D, and E has no end-of-year liabilities, $3 million in total assets and $6 million in adjusted total assets (the difference equal to the distributions by each in 2006), and 2006 total receipts of $20 million. As of December 31, 2006, no owner, direct or indirect, of B, C, D, or E was required to complete Schedule M-3 on its most recently filed U.S. federal income tax return or return of income. None of B, C, D, or E is required to complete Schedule M-3 for 2006. For the partnership tax years ending December 31, 2006, A has no end-of-year liabilities, $6 million in total assets and $12 million in adjusted total assets (the difference equal to the distributions in 2006), and 2006 total receipts of $6 million. As of December 31, 2006, no owner, direct or indirect, of A was required to complete Schedule M-3 on its most recently filed U.S. federal income tax return. A must complete Form 1065 Schedule M-3 when it completes its Form 1065 for 2006 because A has adjusted total assets of $10 million or more.
Same ownership facts as in Example 2.2 continued to calendar year 2007. On March 1, 2007, A files its Form 1065 with Schedule M-3 for the partnership tax year ended December 31, 2006. As of March 2, 2007, A becomes a reportable entity partner with respect to any partnership in which it owns or is deemed to own, directly or indirectly, (under these instructions) a 50 percent or greater interest in the income, loss, or capital of the partnership. A owns 50 percent of each of B, C, D, and E and is therefore a reportable entity partner with respect to each as of March 2, 2007, the day after it filed its 2006 Form 1065 with a required Schedule M-3. On March 20, 2007, A reports to B, C, D, and E, as it is required to do within 30 days of March 2, that it is a reportable entity partner owning a 50 percent interest. Each of B, C, D, and E is required to complete Schedule M-3 for 2007 because each has a reportable entity partner. A will determine if it must complete Schedule M-3 for 2007 based on its separate facts for 2007.
Same ownership facts as in Example 2.2 for calendar year 2006 except that A is owned 50 percent by corporation Z that was first required to complete Schedule M-3 for its corporate tax year ended December 31, 2005, and that filed its Form 1120 with Schedule M-3 for 2005 on September 15, 2006. As of September 16, 2006, Z was a reportable entity partner with respect to A and, through A, with respect to B, C, D, and E. On October 5, 2006, Z reports to A, B, C, D, and E, as it is required to do within 30 days of September 16, that Z is a reportable entity partner directly owning (with respect to A) or deemed to own indirectly (with respect to B, C, D, and E) a 50 percent interest. Therefore, because Z was a reportable entity partner for 2006, each of A, B, C, D, and E is required to complete Form 1065 Schedule M-3 for 2006, regardless of whether they would otherwise be required to complete Schedule M-3 for that year.

Other Form 1065 Schedules Affected by Schedule M-3 Requirements

Schedule L

Total assets at the end of the tax year shown on Schedule L, line 14, column (d), must equal the total assets of the partnership as of the last day of the tax year, and must be the same total assets reported by the partnership in the financial statements, if any, used for Schedule M-3. If the partnership prepares financial statements, Schedule L must report the financial statement total assets. If the partnership does not prepare financial statements, Schedule L must be based on the partnership's books and records. The Schedule L balance sheet may show tax-basis balance sheet amounts if the partnership is allowed to use books and records for Schedule M-3 and the partnership's books and records reflect only tax-basis amounts.

For purposes of measuring total assets at the end of the year, assets may not be netted or offset against liabilities. In addition, total assets may not be reported as a negative amount.

Schedule M-2

The amount shown on Schedule M-2, line 3, Net income (loss) per books, must equal the amount shown on Schedule M-3, Part I, line 11.

Entity Considerations for Schedule M-3

For purposes of Schedule M-3, references to the classification of an entity (for example, as a corporation, a partnership, or a trust) are references to the treatment of the entity for U.S. federal income tax purposes. An entity that generally is disregarded as separate from its owner for U.S. federal income tax purposes (disregarded entity) must not be separately reported on Schedule M-3 except, if required, on Part I, line 7. On Schedule M-3, Parts II and III, any item of income, gain, loss, deduction, or credit of a disregarded entity must be reported as an item of its owner. In particular, the income or loss of a disregarded entity must not be reported on Part II, lines 7, 8, or 9 as a separate partnership or other pass-through. The financial statement income or loss of a disregarded entity is included on Part I, line 7, if and only if its financial statement income or loss is included on Part I, line 11, but not on Part I, line 4.

Completion of Schedule M-3

A partnership required to file Schedule M-3 must complete the schedule in its entirety. At the time the Form 1065 is filed, all applicable questions must be answered on Part I, all columns must be completed on Parts II and III, and all numerical data required by Schedule M-3 must be provided. Any schedule required to support a line item on Schedule M-3 must be attached at the time Form 1065 is filed and must provide the information required for that line item.

Any partnership required to file Schedule M-3 must check all boxes that apply on the top of page 1 above Part I of Schedule M-3 with respect to the reasons for which the Schedule M-3 is required to be filed. A partnership not required to file Schedule M-3, but that is doing so voluntarily, should check box E on page 1 of the Form 1065 Schedule M-3.