The Magic of M1 (Video)

Sometimes my clients ask me, why don’t my books equal my tax return? Here I have a sample partnership that sold something and had cost of goods sold, had some expenses, had some investment income, and so the net income for this sample partnership is $124,300. Why then does their tax return show only an income of $105,550 on the front page? Well, the front page first of all, isn’t the whole story. That’s just the ordinary business income. We also see that there is dividend income that goes not on the front page, but here on Schedule K and if we scroll all the way down here to the analysis of net income per return, in total, there’s $120,550 worth of taxable income on this tax return. How do we go from the $124,300 to $120,550? All the magic happens down here in Schedule M1. Notice that this is the reconciliation of the books to the tax return. So we start with the book Income of $124,300. We then have expenses that are on the books that we can’t deduct. In this case, it’s one half of my meals expense. So I’m adding that back. Then I have some income that’s on my books that isn’t taxable. All of my interest income is exempt interest. So I get to subtract that. So that’s where my $124,300 worth of book income turns into $120,550 of taxable income. If we go back to Schedule K, we see the taxable pieces up here, but it also lists them here at the tax exempt income and the nondeductible expenses. This is exactly what gets split amongst the partners. So I have a 75% partner here who gets some ordinary income, some dividends and it also reports the nondeductible and tax exempt pieces. Likewise, my 25% partner gets their pieces of those same things.