Schedule M-2 on Form 1065: Instructions and Reconciliation

Schedule M-2 on Form 1065 reconciles the total of all partners’ capital accounts from the beginning of the tax year to the end. You work through it in a fixed order: start with last year’s ending balance on Line 1, add contributions and net income on Lines 2 through 4, subtract distributions, losses, and nondeductible items on Lines 5 through 7, and finish with an ending balance on Line 9 that must equal the sum of every partner’s ending tax-basis capital account reported in Item L of the Schedules K-1. The arithmetic is simple. The trouble is knowing which figures belong on which line, and that is where these instructions focus.

Do You Even Have to File Schedule M-2

Not every partnership completes it. You can skip Schedules L, M-1, and M-2 if you answer “Yes” to question 4 on Schedule B of Form 1065, which requires meeting all four of these tests:¹

Total receipts under $250,000, counting gross receipts or sales plus all other income reported on page 1 and Schedule K.
Total assets under $1 million, based on the amount reported in Item F on page 1 of Form 1065.
All Schedules K-1 were filed with the return and furnished to partners on or before the due date, including extensions.
The partnership is not filing and is not required to file Schedule M-3.

Fail any one, and Schedule M-2 is required. Most partnerships with meaningful size or complexity end up filing it.

Tax-Basis Reporting Is Mandatory Before You Start

Before entering any numbers, confirm you are working in tax basis. Beginning with tax year 2020, the IRS ended the option to report partner capital on Schedule K-1 using GAAP, Section 704(b) book value, or an undefined “Other” method.² Each partner’s beginning and ending capital account must now be reported using the tax-basis method.³

Under that method, each partner’s capital account reflects capital contributed, their share of current-year net income or loss computed for tax purposes, withdrawals and distributions, and other increases or decreases determined consistently with computing the partner’s adjusted tax basis in their partnership interest, ignoring partnership liabilities.³ Schedule M-2 follows the same framework, so Line 1 must match the aggregate of all partners’ beginning tax-basis capital accounts from Item L of Schedule K-1.¹

If your partnership has been keeping capital accounts internally under GAAP or Section 704(b), those numbers will not necessarily match what belongs on the return. You need a separate tax-basis computation, which often means maintaining two sets of capital account records.

Line-by-Line Instructions

Schedule M-2 has nine lines. Line 1 sets the starting point. Lines 2 through 4 record increases. Lines 5 through 7 record decreases. Lines 8 and 9 produce the ending balance.

Line 1: Balance at Beginning of Year

Enter the total of all partners’ beginning tax-basis capital accounts as reported in Item L of every Schedule K-1. For most partnerships this figure simply carries forward from last year’s Schedule M-2, Line 9. If it does not match the aggregate of the beginning K-1 balances, the IRS instructions require you to attach an explanation of the difference.¹ Getting Line 1 right matters because every other line builds on it.

Line 2: Capital Contributed During the Year

Line 2 is split in two. Line 2a is cash contributed by partners. Line 2b is the adjusted tax basis of property contributed by partners, net of any liabilities attached to that property.¹

Contributed property goes in at adjusted tax basis, not fair market value. A partner who contributes a building worth $500,000 with an adjusted tax basis of $200,000 adds $200,000 to Line 2b. Fair market value matters for other purposes, like determining each partner’s share of built-in gain under Section 704(c), but it does not belong on Schedule M-2.

Line 3: Net Income (Loss) Per Books

Enter the amount from the Analysis of Net Income (Loss) per Return, line 1. This figure generally matches Schedule M-1, line 9 (if required), or Schedule M-3, Part II, line 26.¹

One wrinkle: Section 743(b) basis adjustments and guaranteed payment income are not part of partners’ tax-basis capital accounts, so you may need to remove their effects here and account for them on Line 4 or Line 7 instead.

Line 4: Other Increases

Line 4 captures increases not reflected on Lines 2 or 3. Tax-exempt interest income is the most common item, because it increases the partners’ economic stake without producing taxable income. Use Line 4 as well to add back any net negative income from Section 743(b) adjustments that was included as a decrease to net income on Line 3.

Line 5: Distributions

Line 5a records cash distributions to partners. Line 5b records the adjusted tax basis of property distributed. Distributed property, like contributed property, goes on the schedule at tax basis rather than fair market value.

Line 6: Net Loss

If the partnership had a loss year, enter the amount from the same Analysis of Net Income (Loss) per Return that feeds Line 3. You use Line 3 or Line 6 depending on whether the year produced net income or a net loss.

Line 7: Other Decreases

The most common items on Line 7 are nondeductible expenses: penalties, fines, 50% of meals expenses, political contributions, and the nondeductible portion of charitable contributions. Guaranteed payment income removed from Line 3 also gets reported here. These items reduce partners’ capital without producing a corresponding tax deduction, which is why they need their own line.

Lines 8 and 9: The Ending Balance

Line 8 is the net total of all increases and decreases on Lines 2 through 7. Line 9 adds Line 8 to Line 1 to produce the ending capital account balance. Line 9 must equal the sum of every partner’s ending capital account reported in Item L of the Schedules K-1. If those two totals do not match, the return is internally inconsistent, and the IRS will follow up.

Reconciling Schedule M-2 to the Schedules K-1

The relationship between Schedule M-2 and the individual K-1s is where errors most commonly surface. Each K-1 has an Item L that reconciles that partner’s capital account from beginning to end of year. Aggregate every partner’s ending capital across the K-1s, and the total must equal Schedule M-2, Line 9.

Numbers can drift when a partner joined or left mid-year, when the partnership made a special allocation, or when a partner contributed property with a tax basis different from its book value. Reconcile before filing rather than discovering the mismatch after the IRS flags it. The reconciliation is mechanical: compare the totals column by column (beginning balance, contributions, income or loss, distributions, other items, ending balance) and locate exactly where any discrepancy originates.

Schedule M-1, if required, sits alongside M-2 but answers a different question. M-1 reconciles book income to tax-return income. M-2 then takes the tax-return income figure as one input to the capital account reconciliation.

Mistakes That Break the Reconciliation

Recording Contributions at Fair Market Value

Schedule M-2 tracks tax-basis capital. Contributed property goes on Line 2b at adjusted tax basis. Using fair market value inflates capital and guarantees a mismatch with the K-1s.

Leaving Guaranteed Payments in Net Income

Guaranteed payments to partners for services or use of capital are deductible by the partnership and included in the ordinary income calculation, but they are not part of partners’ tax-basis capital accounts. If Line 3 includes guaranteed payment income, back it out on Line 7. Missing this step is one of the most common reasons Schedule M-2 will not reconcile to the K-1 capital accounts.

Ignoring Section 743(b) Adjustments

When a partnership interest changes hands and a Section 754 election is in effect, Section 743(b) creates a basis adjustment for the buying partner. That adjustment affects the buyer’s individual tax computations but does not flow through the aggregate capital accounts on Schedule M-2. If Line 3 includes the effect of 743(b) adjustments, reverse them using Lines 4 and 7.¹

Line 1 That Does Not Match Prior Year’s Line 9

The beginning balance on Line 1 should equal last year’s ending balance. When it does not, usually because of a prior-year amendment, an error carried forward, or a transition from a different reporting method to tax basis, attach an explanation. Do not force the numbers to match. The IRS specifically flags this discrepancy, and an unexplained difference invites scrutiny of the entire return.

1
Internal Revenue Service. Instructions for Form 1065 (2025)
2
Internal Revenue Service. Notice 2020-43 – Tax Capital Reporting – Notice Requesting Comments
3
Internal Revenue Service. Partner’s Instructions for Schedule K-1 (2025)