Net Income (Loss) Reconciliation for Certain Partnerships

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Instructions for Schedule M-3 (Form 1065)

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2006

Department of the Treasury
Internal Revenue Service

Instructions for Schedule
M-3 (Form 1065)
Net Income (Loss) Reconciliation for Certain Partnerships
Section references are to the Internal
Revenue Code unless otherwise noted.
Form 1065-B. All references to Form
1065 in these instructions shall be
deemed to include Form 1065-B except
as otherwise noted.

General Instructions
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)).

Who Must File
Note. 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 Large
Electing 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:
1. 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.
2. 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).
3. The amount of total receipts (as
defined on page 20 of the instructions to
Form 1065, Schedule B, question 5), for
the taxable year, is equal to $35 million or
more. Total receipts is defined on page
33 of the Instructions for Form 1065-B.
4. 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.
Note. 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
Cat. No. 38800Y

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.

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Instructions for Schedule M-3 (Form 1065)

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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.
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 under these
instructions). 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
2. Same facts as in Example 1A
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.
3. 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.
4. 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.
5. 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.
1. 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 (under these instructions) 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, (under these instructions) all

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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,
(under these instructions) 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 (under these
instructions) 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.
2. 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.
3. Same ownership facts as in
Example 2B 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

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Instructions for Schedule M-3 (Form 1065)

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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.
4. Same ownership facts as in
Example 2B 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.

Specific Instructions
Item D. Reportable Entity
Partner
On Schedule M-3, page 1, if the
partnership has any reportable entity
partner’s (defined on page 1) for the year,
check checkbox D. A partnership must
report the name, EIN or TIN if applicable,
and maximum percentage of deemed
ownership of each reportable entity
partner if there are one or two reportable

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entity partners for the tax year of the
partnership, and, if there are more than
two reportable entity partners for the tax
year of the partnership, the two reportable
entity partners with the largest maximum
percentage of deemed ownership for the
tax year of the partnership. The maximum
percentage of deemed ownership for a
reportable entity partner for a tax year of
the partnership is the maximum
percentage interest deemed owned under
these instructions by the reportable entity
partner in the partnership’s capital, profit,
or loss on any day during the tax year of
the partnership.

Part I. Financial
Information and Net
Income (Loss)
Reconciliation
When To Complete Part I
Part I must be completed for any tax year
for which the partnership files Schedule
M-3.

Line 1. Questions Regarding
the Type of Income Statement
Prepared
For lines 1 through 11, use only the
financial statements of the U.S.
partnership filing the Form 1065. If the
U.S. partnership filing the Form 1065 is
controlled by another entity, the U.S.
partnership must not use the financial
statements of the controlling entity for its
Schedule M-3, Part I.
If no financial statements are prepared
for the U.S. partnership filing Schedule
M-3, the U.S. partnership must enter “No”
on questions 1a, 1b, and 1c, skip lines 2a
through 3b, and enter the net income
(loss) per the books and records of the
U.S. partnership on line 4.
If a partnership filing a Schedule M-3
(a) is included in the consolidated
financial statements of a group
(consolidated financial statement group)
with an entity parent filing a U.S tax return
and Schedule M-3, (b) has its income
(loss) included and removed by the entity
parent on that entity parent’s Schedule
M-3, Part I, and (c) does not have a
separate financial statement (certified or
otherwise) of its own, the partnership
must answer questions 1a, 1b, and 1c as
appropriate for its own tax return and
must report on its own Schedule M-3, as
appropriate, the amount for the
partnership’s net income (loss) that is
equal to the amount included and
removed in the entity parent’s Schedule
M-3, Part I . However, if in the
circumstances described immediately
above, the partnership does have
separate financial statements (certified or
otherwise) of its own, independent of the
amount of the partnership’s net income
included in the consolidated financial
statements with the entity parent, the

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Instructions for Schedule M-3 (Form 1065)

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partnership must answer questions 1a,
1b, and 1c, as appropriate, for its own tax
return, based on its own separate income
statement, and must report on line 4, the
net income amounts shown on its
separate income statement.

Line 2 and 3. Questions
Regarding Income Statement
Period and Restatements
Line 2 and 3. Questions Regarding
Income Statement Period and
Restatements
The questions on lines 3a and 3b,
regarding income statement
restatements, refer to the worldwide
consolidated income statement issued by
the partnership filing Form 1065. Answer
“Yes” on lines 3a and/or 3b if the
partnership’s annual income statement
has been restated for any reason. Attach
a short explanation of the reasons for the
restatement in net income for each
annual income statement period that is
restated, including the original amount
and restated amount of each annual
statement period’s net income. The
attached schedule is not required to
report restatements on an entity-by-entity
basis.

Line 4. Worldwide Consolidated
Net Income (Loss) per Income
Statement
Report on Part I, line 4, the worldwide
consolidated net income (loss) per the
income statement (or books and records,
if applicable) of the partnership.
In completing Schedule M-3, the
partnership must use financial statement
amounts from the financial statement type
checked “Yes” on line 1 or from its books
and records if line 1c is checked “No”. If
line 1a is checked “Yes”, report on line 4
the net income amount reported in the
income statement presented to the SEC
on the partnership’s Form 10-K.
If a partnership prepares financial
statements, the amount on line 4 must
equal the financial statement net income
(loss) for the income statement period
ending with or within the tax year as
indicated on line 2.
If the partnership prepares financial
statements and the income statement
period differs from the partnership’s tax
year, the income statement period
indicated on line 2 applies for purposes of
lines 4 through 8.
If the partnership does not prepare
financial statements, check “No” on line
1c and enter the net income (loss) per the
books and records of the partnership on
line 4.
Report on lines 5a through 10, as
instructed below, all adjustment amounts
required to adjust worldwide net income
(loss) reported on line 4 (whether from
financial statements or books and
records) to net income (loss) of the
partnership that must be reported on line
11.

Line 5. Net Income (Loss) of
Nonincludible Foreign Entities
Remove the financial statement net
income (line 5a) or loss (line 5b) of each
foreign entity that is included in the
consolidated financial statement group
but is not the partnership (nonincludible
foreign entity). In addition, on line 8,
adjust for consolidation eliminations and
correct for minority interest and
intercompany dividends between any
nonincludible foreign entity and the
partnership filing Form 1065. Do not
remove in Part I the financial statement
net income (loss) of any nonincludible
foreign entity accounted for in the
financial statements on the equity
method.
Attach a supporting schedule that
provides the name, EIN (if applicable),
and net income (loss) per the financial
statement or books and records included
on line 4 that is removed on this line 5 for
each separate nonincludible foreign
entity. The amounts of income (loss)
detailed on the supporting schedule
should be reported for each separate
nonincludible foreign entity without regard
to the effect of consolidation or
elimination entries. If there are
consolidation or elimination entries
relating to nonincludible foreign entities
whose income (loss) is reported on the
attached schedule that are not reportable
on line 8, the net amounts of all such
consolidation and elimination entries must
be reported on a separate line on the
attached schedule, so that the separate
financial accounting income (loss) of each
nonincludible foreign entity remains
separately stated. For example, if the net
income (after consolidation and
elimination entries) of a nonincludible
foreign sub-consolidated group is being
reported on line 5a, the attached
supporting schedule should report the
income (loss) of each separate
nonincludible foreign legal entity from
each such entity’s own financial
accounting net income statement or
books and records, and any consolidation
or elimination entries (for intercompany
dividends, minority interests, etc.) not
reportable on line 8 should be reported on
the attached supporting schedule as a net
amount on a line separate and apart from
lines that report each nonincludible
foreign entity’s separate net income
(loss).

Line 6. Net Income (Loss) of
Nonincludible U.S. Entities
Remove the financial statement net
income (line 6a) or loss (line 6b) of each
U.S. entity that is included in the
consolidated financial statement group
but is not an includible entity in the
partnership return (nonincludible U.S.
entity). In addition, on line 8, adjust for
consolidation eliminations and correct for
minority interest and intercompany
dividends between any nonincludible U.S.
entity and any includible entity. Do not
remove in Part I the financial statement

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net income (loss) of any nonincludible
U.S. entity accounted for in the financial
statements on the equity method.
Attach a supporting schedule that
provides the name, EIN (if applicable),
and net income (loss) per the financial
statement or books and records included
on line 4 that is removed on line 6 for
each separate nonincludible U.S. entity.
The amounts of income (loss) detailed on
the supporting schedule should be
reported for each separate nonincludible
U.S. entity without regard to the effect of
consolidation or elimination entries. If
there are consolidation or elimination
entries relating to nonincludible U.S.
entities whose income (loss) is reported
on the attached schedule that are not
reportable on line 8, the net amounts of
all such consolidation and elimination
entries must be reported on a separate
line on the attached schedule, so that the
separate financial accounting income
(loss) of each nonincludible U.S. entity
remains separately stated. For example, if
the net income (after consolidation and
elimination entries) of a nonincludible
U.S. sub-consolidated group is being
reported on line 6a, the attached
supporting schedule should report the
income (loss) of each separate
nonincludible U.S. legal entity from each
such entity’s own financial accounting net
income statement or books and records,
and any consolidation or elimination
entries (for intercompany dividends,
minority interests, etc.) not reportable on
line 8 should be reported on the attached
supporting schedule as a net amount on a
line separate and apart from lines that
report each nonincludible U.S. entity’s
separate net income (loss).

Line 7. Net Income (Loss) of
Other Includible Entities
Include the financial statement net
income (line 7a) or loss (line 7b) of each
includible entity in the U.S. tax return that
is not included in the consolidated
financial statement group and therefore
not included in the income reported on
line 4. Also include on line 7 the financial
statement income of any disregarded
entity that is not included in the income
reported on line 4 , but is included on line
10 (other includible entities). In addition,
on line 8, adjust for consolidation
eliminations and correct for minority
interest and intercompany dividends for
any other includible entity.
Attach a supporting schedule that
provides the name, EIN, and net income
(loss) per the financial statement or books
and records included on line 7 for each
separate other includible entity. The
amounts of income (loss) detailed on the
supporting schedule should be reported
for each separate other includible entity
without regard to the effect of
consolidation or elimination entries solely
between or among the entities listed. If
there are consolidation or elimination
entries relating to such other includible
entities whose income (loss) is reported

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on the attached schedule that are not
reportable on line 8, the net amounts of
all such consolidation and elimination
entries must be reported on a separate
line on the attached schedule, so that the
separate financial accounting income
(loss) of each other includible entity
remains separately stated. For example, if
the net income (after consolidation and
elimination entries) of a sub-consolidated
U.S. group of other includible entities is
being reported on line 7a, the attached
supporting schedule should report the
income (loss) of each separate other
includible entity from each entity’s own
financial accounting net income statement
or books and records, and any
consolidation or elimination entries (for
intercompany dividends, minority
interests, etc.) not reportable on line 8
should be reported on the attached
supporting schedule as a net amount on a
line separate and apart from lines that
report each other includible entity’s
separate net income (loss).

Line 8. Adjustment to
Eliminations of Transactions
Between Includible Entities and
Nonincludible Entities
Adjustments on line 8 to reverse certain
financial accounting consolidation or
elimination entries are necessary to
ensure that transactions between
includible entities and nonincludible U.S.
or foreign entities are not eliminated, in
order to report the correct total amount on
line 11. Also, additional consolidation
entries and eliminations entries may be
necessary on line 8 related to
transactions between includible entities
that are in the consolidated financial
statement group and other includible
entities that are not in the consolidated
financial statement group but that are
reported on line 7 in order to report the
correct total amount on line 11.
Include on line 8 the total of the
following: (i) amounts of any adjustments
to consolidation entries and elimination
entries that are contained in the amount
reported on line 4, required as a result of
removing amounts on line 5 or 6; and (ii)
amounts of any additional consolidation
entries and elimination entries that are
required as a result of including amounts
on line 7. This is necessary in order that
the consolidation entries and
intercompany eliminations entries
included in the amount reported on line
11 are only those applicable to the
financial net income (loss) of includible
entities for the financial statement period.
For example, adjustments must be
reported on line 8 to remove minority
interest and to reverse the elimination of
intercompany dividends included on line 4
that relate to the net income of entities
removed on line 5 or 6 because the
income to which the consolidation or
elimination entries relate has been
removed. Also, for example, consolidation
or elimination entries must be reported on
line 8 to eliminate any intercompany

dividends between entities whose income
is included on line 7 and other entities
included in the U.S. federal income tax
return.
If a an entity owner of an interest in
another entity: (1) accounts for the
interest in the other entity in the owner’s
separate general ledger on the equity
method, and (2) fully consolidates the
other entity in the owner’s consolidated
financial statements, but that entity is not
includible in the owner’s Form 1065, then,
as part of reversing all consolidation and
elimination entries for the nonincludible
entity, the owner must reverse on line 8
the elimination of the equity income
inclusion from the other entity. If the
owner does not account for the other
entity on the equity method on its own
general ledger, it will not have eliminated
the equity income for consolidated
financial statement purposes, and
therefore will have no elimination of equity
income to reverse.
The attached supporting schedule for
line 8 must identify the type (e.g., minority
interest, intercompany dividends, etc.)
and amount of consolidation or
elimination entries reported, as well as
the names of the entities to which they
pertain. It is not necessary, but it is
permitted, to report intercompany
eliminations that net to zero on line 8,
such as intercompany interest income
and expense.

Line 9. Adjustment to Reconcile
Income Statement Period to Tax
Year
Include on line 9 any adjustments
necessary to the income (loss) of the
partnership to reconcile differences
between the partnership’s income
statement period reported on line 2 and
the partnership’s tax year. Attach a
schedule describing the adjustment.

Line 10. Other Adjustments
Required To Reconcile to
Amount on Line 11
Include on line 10 any other adjustments
to reconcile net income (loss) on line 4,
with net income (loss) of the partnership
reported on line 11.
For any adjustment reported on line
10, attach a supporting schedule with an
explanation of each net adjustment
included on line 10.

Line 11. Net Income (Loss) per
Income Statement of the
Partnership.
Report on line 11 the net income (loss)
per the income statement (or books and
records, if applicable) of the partnership.
Amounts reported in column (a) of Parts II
and III (see instructions below) must be
reported on the same accounting method
as is used to report the amount of net
income (loss) per income statement of the
partnership on Part I, line 11.
Do not, in any event, report on line 11
the net income of entities other than the

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partnership filing Form 1065 for the tax
year. For example, it is not permissible to
remove the income of non-includible
entities on lines 5 and/or 6, above, then to
add back such income on lines 7 through
10, such that the amount reported at line
11 includes the net income of entities not
includible in the U.S. federal income tax
return. A principal purpose of Schedule
M-3 is to report on line 11 only the
financial accounting net income of only
the partnership (including any other
includible entities) filing the U.S. Return of
Partnership Income.
Whether or not the partnership
prepares financial statements, Line 11
must include all items that impact the net
income (loss) of the partnership even if
they are not recorded in the profit and
loss accounts in the partnership’s general
ledger, including, for example, all
post-closing adjusting entries (including
workpaper adjustments) and dividend
income or other income received from
non-includible entities.
Example 3.
1. U.S. partnership P owns 60% of
corporation DS1 which is fully
consolidated in P’s financial statements.
P does not account for DS1 in P’s
separate general ledger on the equity
method. DS1 has net income of $100
(before minority interests) and pays
dividends of $50, of which P receives
$30. The dividend is eliminated in the
consolidated financial statements. In its
financial statements, P consolidates DS1
and includes $60 of net income ($100
less the minority interest of $40) on Part I,
line 4.
P must remove the $100 net income of
DS1 on Part I, line 6a. P must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of DS1. In
addition, P reverses its elimination of the
$30 intercompany dividend in its financial
statements on Part I, line 8. The net result
is that P includes the $30 dividend from
DS1 at Part I, line 11, and on Part II, line
6, column (a). P’s taxable dividend
income from DS1 must be reported on
Part II, line 6, column (d).
2. U.S. partnership C owns 60% of
the capital and profits interests in U.S.
LLC N. C does not account for N in P’s
separate general ledger on the equity
method. N has net income of $100
(before minority interests) and makes no
distributions during the tax year. C treats
N as a corporation for financial statement
purposes and as a partnership for U.S.
federal income tax purposes. In its
financial statements, C consolidates N
and includes $60 of net income ($100
less the minority interest of $40) on Part I,
line 4.
C must remove the $100 net income of
N on Part I, line 6a. C must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of N. The
result is that C includes no income for N
either on Part I, line 11, or on Part II, line
7, column (a). C’s taxable income from N

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must be reported by C on Part II, line 7,
column (d)
3. U.S. partnership P owns 60% of
corporation DS1, which is fully
consolidated in P’s financial statements.
P accounts for DS1 in P’s separate
general ledger on the equity method. DS1
has net income of $100 (before minority
interests) and pays dividends of $50, of
which P receives $30. The dividend
reduces P’s investment in DS1 for equity
method reporting on P’s separate general
ledger where P includes its 60% equity
share of DS1 income, which is $60. In its
financial statements, P eliminates the
DS1 equity method income of $60 and
consolidates DS1, including $60 of net
income ($100 less the minority interest of
$40) on Part I, line 4.
P must remove the $100 net income of
DS1 on Part I, line 6a. P must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of DS1 and
the elimination of the $60 of DS1 equity
income. The net result is that P includes
the $60 of equity method income from
DS1 at Part I, line 11, and on Part II, line
5, column (a). P’s taxable dividend
income from its investment in DS1 must
be reported on Part II, line 6, column (d).
4. U.S. partnership C owns 60% of
the capital and profits interests in U.S.
LLC N. C accounts for N in C’s separate
general ledger on the equity method. N
has net income of $100 (before minority
interests) and makes no distributions
during the tax year. C treats N as a
corporation for financial statement
purposes and as a partnership for U.S.
federal income tax purposes. For equity
method reporting on C’s separate general
ledger, C includes its 60% equity share of
N income, which is $60. In its financial
statements, C eliminates the $60 of N
equity method income and consolidates N
including $60 of net income ($100 less
the minority interest of $40) on Part I, line
4.
C must remove the $100 net income of
N on Part I, line 6a. C must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of N and the
elimination of the $60 of N equity method
income. The result is that C includes the
$60 of equity method income for N on
Part I, line 11, and on Part II, line 7,
column (a). C’s taxable income from N
must be reported by C on Part II, line 7,
column (d).
5. U.S. partnership C owns 60% of
the capital and profits interests in U.S.
LLC N. C accounts for N in C’s separate
general ledger on the equity method. N
has net income of $100 (before minority
interests) and pays a $50 cash
distribution, of which C receives $30. The
dividend reduces C’s investment in N for
equity method reporting on C’s separate
general ledger. C treats N as a
corporation for financial statement
purposes and as a partnership for U.S.
federal income tax purposes. For equity
method reporting on C’s separate general
ledger, C includes its 60% equity share of

N income, which is $60. In its financial
statements, C eliminates the $60 of N
equity method income and consolidates N
and includes $60 of net income ($100
less the minority interest of $40) on Part I,
line 4.
C must remove the $100 net income of
N on Part I, line 6a. C must reverse on
Part I, line 8, the elimination of the $40
minority interest net income of N and the
elimination of the $60 of N equity method
income. The result is that C includes the
$60 of equity method income for N on
Part I, line 11, and on Part II, line 7,
column (a). C’s taxable income from N
must be reported by C on Part II, line 7,
column (d).
6. U.S. partnership P owns 100% of
the stock of U.S. LLC Q, a disregarded
entity. Q is included in P’s federal income
tax return, even though DS is not included
in P’s consolidated financial statements
on either a consolidated basis or on the
equity method. Q has current year net
income of $100 after taking into account
its $40 interest payment to P. P has net
income of $1,040 after recognition of the
interest income from Q. Because Q is an
includible entity, 100% of the net income
of both P and Q must be reported on
Form 1065 of P’s U.S. Return of
Partnership Income, and the
intercompany interest income and
expense must be removed by
consolidation elimination entries.
P must report its financial statement
net income of $1,040 on Part I, line 4, and
reports Q’s net income of $100 on Part I,
line 7. Then, in order to reflect the full
consolidation of the financial accounting
net income of P and Q at Part I, line 11,
Net income (loss) per income statement
of the partnership, the following
consolidation and elimination entry is
reported on Part I, line 8: offsetting entries
to remove the $40 of interest income
received from Q included by P on line 4,
and to remove the $40 of interest
expense of Q included in line 76 for a net
change of zero. The result is that Part I,
line 11, reports $1,140: $1,040 from line
4, and $100 from line 7. Stated another
way, Part I, line 11, includes the entire
$1,000 net income of P, measured before
recognition of the intercompany interest
income from Q and the consolidation of Q
operations, plus the entire $140 net
income of Q, measured before interest
expense to P. P is not required to include
on the attached supporting schedule for
Part I, line 8 the offsetting adjustment to
the intercompany elimination of interest
income and interest expense (though it is
permitted to do so).

included in taxable income on Form 1065,
page 4, Analysis of Net Income (Loss),
line 1.
Note. A schedule or explanation may be
attached to any line even if none is
required.

Parts II and III

Columns (b) and (c) of Parts II and III
must be completed for any tax year for
which the partnership files Schedule M-3.
For any item of income, gain, loss,
expense, or deduction for which there is a
difference between columns (a) and (d),
the portion of the difference that is
temporary must be entered in column (b)

General Reporting Information
For each line item in Parts II and III,
report in column (a) the amount of net
income (loss) included in Part I, line 11,
and report in column (d) the amount

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When To Complete Columns (a)
and (d)
A partnership is not required to complete
columns (a) and (d) of Parts II and III for
the first tax year the partnership is
required to file Schedule M-3, and for all
subsequent years the partnership is
required to file Schedule M-3, the
partnership must complete Schedule M-3
in its entirety. Accordingly, the partnership
must complete columns (a) through (d) of
Parts II and III for all tax years
subsequent to the first tax year the
partnership is required to file Schedule
M-3.
If, for any tax year (or tax years) prior
to the first tax year a partnership is
required to file Schedule M-3, a
partnership voluntarily files Schedule M-3
in lieu of Schedule M-1, then in those
voluntary filing years the partnership is
not required to complete columns (a) and
(d) of Parts II and III. In addition, in the
first tax year the partnership is required to
file Schedule M-3 the partnership is not
required to complete columns (a) and (d)
of Parts II and III.
If a partnership chooses not to
complete columns (a) and (d) of Parts II
and III in the first tax year the partnership
is required to file Schedule M-3 (or in any
year in which the partnership voluntarily
files Schedule M-3), then Part II, line 26,
is reconciled by the partnership in the
following manner:
1. Report the amount from Part I, line
11, on Part II, line 26, column (a);
2. Leave blank Part II, lines 1 through
25, columns (a) and (d);
3. Leave blank Part III, columns (a)
and (d); and
4. Report on Part II, line 26, column
(d), the sum of Part II, line 26, columns
(a), (b), and (c).
Note. Part II, line 26, column (d), must
equal the amount on Form 1065, page 4,
Analysis of Net Income (Loss), line 1.
Thus, column (d) on Part II and Part III
must include not only items contributing to
the ordinary income (loss) from trade or
business activities on Form 1065, page 1,
line 22 (line 25 for Form 1065-B), but also
certain of the separately stated items on
Form 1065, Schedule K.

When To Complete Columns (b)
and (c)

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and the portion of the difference that is
permanent must be entered in column (c).
If financial statements are prepared by
the partnership in accordance with
generally accepted accounting principles
(GAAP), differences that are treated as
temporary for GAAP must be reported in
column (b) and differences that are
permanent (that is, not temporary for
GAAP) must be reported in column (c).
Generally, pursuant to GAAP, a
temporary difference affects (creates,
increases, or decreases) a deferred tax
asset or liability.
If the partnership does not prepare
financial statements, or the financial
statements are not prepared in
accordance with GAAP, report in column
(b) any difference that the partnership
believes will reverse in a future tax year
(that is, have an opposite effect on
taxable income in a future tax year (or
years) due to the difference in timing of
recognition for financial accounting and
U.S. federal income tax purposes) or is
the reversal of such a difference that
arose in a prior tax year. Report in column
(c) any difference that the partnership
believes will not reverse in a future tax
year (and is not the reversal of such a
difference that arose in a prior tax year).
If the partnership is unable to
determine whether a difference between
column (a) and column (d) for an item will
reverse in a future tax year or is the
reversal of a difference that arose in a
prior tax year, report the difference for
that item in column (c).
Example 4. For the 2006, 2007, and
2008 tax years, partnership A has
adjusted total assets (under these
instructions) of $8 million, $11 million, and
$12 million, respectively. Based on the
amount of its adjusted total assets, A is
required to file Schedule M-3 for its 2007
and 2008 tax years, but not for its 2006
tax year. Further, for its 2006, 2007, and
2008 tax years, A is not required to file
Schedule M-3 based on any of the other
required tests.
For its 2006 tax year, A voluntarily files
Schedule M-3 in lieu of Schedule M-1 and
does not complete columns (a) and (d) of
Parts II and III.
For A’s 2007 tax year, the first tax year
that A is required to file Schedule M-3, A
is only required to complete Part I and
columns (b) and (c) of Parts II and III.
For A’s 2008 tax year, A is required to
complete Schedule M-3 in its entirety.

Reporting Requirements for
Parts II and III
Note. The following requirements for
columns (a) and (d) do not apply to
partnerships for the 2006 tax year. See
When To Complete Columns (a) and (d),
above.

General Reporting Requirements
If an amount is attributable to a reportable
transaction described in Regulations
section 1.6011-4(b), the amount must be

reported in columns (a), (b), (c), and (d),
as applicable, of Part II, line 10, Items
relating to reportable transactions,
regardless of whether the amount would
otherwise be reported on Part II or Part III
of Schedule M-3. Thus, if a taxpayer files
Form 8886, Reportable Transaction
Disclosure Statement, the amounts
attributable to that reportable transaction
must be reported on Part II, line 10.
A partnership is required to report in
column (a) of Parts II and III the amount
of any item specifically listed on Schedule
M-3 that is in any manner included in the
partnership’s current year financial
statement net income (loss) or in an
income or expense account maintained in
the partnership’s books and records, even
if there is no difference between that
amount and the amount included in net
income (loss) for tax purposes unless (a)
otherwise provided in these instructions
or (b) the amount is attributable to a
reportable transaction described in
Regulations section 1.6011-4(b) and is
therefore reported on Part II, line 10. For
example, with the exception of interest
income reflected on a Schedule K-1
received by the partnership as a result of
the partnership’s investment in a
partnership or other pass-through entity,
all interest income included on Part I, Line
11 , whether from unconsolidated
affiliated entities, third parties, banks, or
other entities, whether from foreign or
domestic sources, whether taxable or
exempt from tax and whether classified
as some other type of income for U.S.
federal income tax purposes (such as
dividends), must be included on Part II,
line 11, column (a). Likewise, all fines and
penalties included in Part I, Line 11, paid
to a government or other authority for the
violation of any law for which fines or
penalties are assessed must be included
on Part III, line 7, column (a), regardless
of the government authority that imposed
the fines or penalties, regardless of
whether the fines or penalties are civil or
criminal, regardless of the classification,
nomenclature, or terminology attached to
the fines or penalties by the imposing
authority in its actions or documents.
If a partnership would be required to
report in column (a) of Parts II and III the
amount of any item specifically listed on
Schedule M-3 in accordance with the
preceding paragraph, except that the
partnership has capitalized the item of
income or expense and reports the
amount in its financial statement balance
sheet or in asset and liability accounts
maintained in the partnership’s books and
records, the partnership must report the
proper tax treatment of the item in
columns (b), (c), and (d), as applicable.
Furthermore, in applying the two
preceding paragraphs, a partnership is
required to report in column (a) of Parts II
and III the amount of any item specifically
listed on Schedule M-3 that is included in
the partnership’s financial statements or
exists in the partnership’s books and
records, regardless of the nomenclature

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associated with that item in the financial
statements or books and records.
Accurate completion of Schedule M-3
requires reporting amounts according to
the substantive nature of the specific line
items included in Schedule M-3 and
consistent reporting of all transactions of
like substantive nature that occurred
during the tax year. For example, all
expense amounts that are included in the
financial statements or exist in the books
and records that represent some form of
“Bad debt expense”, must be reported on
Part III, line 26, in column (a), regardless
of whether the amounts are recorded or
stated under different nomenclature in the
financial statements or the books and
records such as: “Provision for doubtful
accounts”; “Expense for uncollectible
notes receivable”; or “Impairment of trade
accounts receivable”. Likewise, as stated
in the preceding paragraph, all fines and
penalties must be included on Part III, line
7, column (a), regardless of the
terminology or nomenclature attached to
them by the partnership in its books and
records or financial statements.
With limited exceptions, Part II
includes lines for specific items of income,
gain, or loss (income items). (See Part II,
lines 1 through 21.) If an income item is
described in Part II, lines 1 through 21,
report the amount of the item on the
applicable line, regardless of whether
there is a difference for the item. If there
is a difference for the income item, or only
a portion of the income item has a
difference and a portion of the item does
not have a difference, and the item is not
described in Part II, lines 1 through 21,
report and describe the entire amount of
the item on Part II, line 22.
With limited exceptions, Part III
includes lines for specific items of
expense or deduction (expense items).
(See Part III, lines 1 through 28.) If an
expense item is described on Part III,
lines 1 through 28, report the amount of
the item on the applicable line, regardless
of whether there is a difference for the
item. If there is a difference for the
expense item, or only a portion of the
expense item has a difference and a
portion of the item does not have a
difference and the item is not described in
Part III, lines 1 through 28, report and
describe the entire amount of the item on
Part III, line 29.
If there is no difference between the
financial accounting amount and the
amount reported for tax purposes of an
entire item of income, loss, expense, or
deduction and the item is not described or
included in Part II, lines 1 through 22, or
Part III, lines 1 through 29, report the
entire amount of the item in column (a)
and (d) of Part II, line 25,.
Separately stated and adequately
disclosed. Each difference reported in
Parts II and III must be separately stated
and adequately disclosed. In general, a
difference is adequately disclosed if the
difference is labeled in a manner that
clearly identifies the item or transaction

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from which the difference arises. For
further guidance about adequate
disclosure, see Regulations section
1.6662-4(f), Rev. Proc. 2004-45, 2004-31
I.R.B. 140 and Rev. Proc. 2005-75,
2005-50 I.R.B. 1137. If a specific item of
income, gain, loss, expense, or deduction
is described on Part II, lines 7 through 21,
or Part III, lines 1 through 28, and the line
does not indicate to “attach schedule” or
“attach details”, and the specific
instructions for the line do not call for an
attachment of a schedule or statement,
then the item is considered separately
stated and adequately disclosed if the
item is reported on the applicable line and
the amount(s) of the item(s) are reported
in the applicable columns of the
applicable line. See the instructions
beginning on page 9 for specific
additional information required to be
provided for amounts reported on Part II,
lines 1 through 6.
Note. A schedule or explanation may be
attached to any line even if none is
required.
Except as otherwise provided,
differences for the same item must be
combined or netted together and reported
as one amount on the applicable line of
Schedule M-3. However, differences for
separate items must not be combined or
netted together. Each item (and
corresponding amount attributable to that
item) must be separately stated and
adequately disclosed on the applicable
line of Schedule M-3 or any schedule
required to be separately stated and
adequately disclosed on the applicable
line of Schedule M-3, or any schedule
required to be attached, even if the
amounts are below a certain dollar
amount.
Example 5. Partnership B prepares
GAAP financial statements. In prior years,
B acquired intellectual property (IP) and
goodwill through several corporate
acquisitions. The IP is amortizable for
both U.S. federal income tax and financial
statement purposes. In the current year,
B’s annual amortization expense for IP is
$9,000 for U.S. federal income tax
purposes and $6,000 for financial
statement purposes. The goodwill is not
amortizable for U.S. federal income tax
purposes and is subject to impairment for
financial statement purposes. In the
current year, B records an impairment
charge on the goodwill of $5,000. B must
report the amortization attributable to the
IP on Part III, line 21, and report $6,000 in
column (a), a temporary difference of
$3,000 in column (b), and $9,000 in
column (d). B must report the goodwill
impairment on Part III, line 19, and report
$5,000 in column (a), a permanent
difference of ($5,000) in column (c), and
$0 in column (d).
Example 6. Partnership C is a
calendar year taxpayer that placed in
service ten depreciable fixed assets in
2002. C was required to file Schedule M-3
for its 2006 tax year and is required to file
Schedule M-3 for its 2007 tax year. C’s

total depreciation expense for its 2007 tax
year for five of the assets is $50,000 for
income statement purposes and $70,000
for U.S. federal income tax purposes. C’s
total annual depreciation expense for its
2007 tax year for the other five assets is
$40,000 for income statement purposes
and $30,000 for U.S. federal income tax
purposes, giving rise to temporary
differences that will reverse in future
years. C must combine all of its
depreciation adjustments. Accordingly, C
must report on Part III, line 25, for its
2007 tax year income statement
depreciation expense of $90,000 in
column (a), a temporary difference of
$10,000 in column (b), and U.S. federal
income tax depreciation expense of
$100,000 in column (d).
Example 7. Partnership D is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. On December 31, 2007, D
establishes three reserve accounts in the
amount of $100,000 for each account.
One reserve account is an allowance for
accounts receivable that are estimated to
be uncollectible. The second reserve is
an estimate of coupons outstanding that
may have to be paid. The third reserve is
an estimate of future warranty expenses.
The three reserve accounts give rise to
temporary differences that will reverse in
future years. The three reserves are
expenses in D’s 2007 financial
statements but are not deductions for
U.S. federal income tax purposes in 2007.
D must not combine the Schedule M-3
differences for the three reserve
accounts. D must report the amounts
attributable to the allowance for
uncollectible accounts receivable on Part
III, line 26, and must separately state and
adequately disclose the amounts
attributable to each of the other two
reserves, coupons outstanding and
warranty costs, on a required, attached
schedule that supports the amounts at
Part III, line 29.
Example 8. Partnership E is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. On January 2, 2007, E
establishes an allowance for uncollectible
accounts receivable (bad debt reserve) of
$100,000. During 2007, E increased the
reserve by $250,000 for additional
accounts receivable that may become
uncollectible. Additionally, during 2007 E
decreases the reserve by $75,000 for
accounts receivable that were discharged
in bankruptcy during 2007. The balance in
the reserve account on December 31,
2007, is $275,000. The $100,000 amount
to establish the reserve account and the
$250,000 to increase the reserve account
are expenses on E’s 2007 financial
statements but are not deductible for U.S.
federal income tax purposes in 2007.
However, the $75,000 decrease to the
reserve is deductible for U.S. federal
income tax purposes in 2007. The

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reserve account gives rise to a temporary
difference that will reverse in future tax
years. E must report on Part III, line 26,
for its 2007 tax year income statement
bad debt expense of $350,000 in column
(a), a temporary difference of ($275,000)
in column (b), and U.S. federal income
tax bad debt expense of $75,000 in
column (d).
Example 9. Partnership F is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. During 2007, F incurs
$200 of meals and entertainment
expenses that F deducts in computing net
income per the income statement. Fifty
dollars ($50) of the $200 is subject to the
$50% limitation under section 274(n). The
limitation on deductions for meals and
entertainment is a permanent difference.
Because meals and entertainment
expenses are specifically described in
Part III, line 6, F must report all of its
meals and entertainment expenses on
this line, regardless of whether there is a
difference. Accordingly, F must report
$200 in column (a), $25 in column (c),
and $175 in column (d). F must not report
the $150 of meals and entertainment
expenses that are deducted in F’s
financial statement net income and are
fully deductible for U.S. federal income
tax purposes on Part II, line 26, Other
items with no differences, and the $50
subject to the limitation under section
274(n) on Part III, line 6,

Part II. Reconciliation of
Net Income (Loss) per
Income Statement of
Partnership With Income
(Loss) per Return
Lines 1 Through 6. Additional
Information for Each Entity
For any item reported on lines 1 or 3
through 5, attach a supporting schedule
that provides the name of the entity for
which the item is reported, the type of
entity (corporation, partnership, etc.), the
entity’s EIN (if applicable), and the item
amounts for columns (a) through (d). See
the instructions for lines 2 and 6, for the
specific information required for those
particular lines.

Line 1. Income (Loss) From
Equity Method Foreign
Corporations
Report on line 1, column (a), the income
statement income (loss) included in Part I,
line 11 for any foreign corporation
accounted for on the equity method and
remove such amount in column (b) or (c),
as applicable. Report the amount of
dividends received and other taxable
amounts received or includible from
foreign corporations on Part II, lines 2
through 4, as applicable.

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Line 2. Gross Foreign
Dividends Not Previously Taxed
Except as otherwise provided in this
paragraph, report on line 2, column (d),
the amount (before any withholding tax)
of any foreign dividends included in Form
1065, page 4, Analysis of Net Income
(Loss), line 1, and report on line 2,
column (a), the amount of dividends from
any foreign corporation included in Part I,
line 11. Do not report on line 2 any
amounts that must be reported on line 3
or dividends that were previously taxed
and must be reported on line 4. (See the
instructions below for lines 3 and 4).
Report withholding taxes on Part III, line
29, Other expense/deduction items with
differences, or Part II, line 25, Other items
with no differences, as applicable.
For any dividends reported on line 2
that are received on a class of voting
stock of which the partnership directly or
indirectly owned 10% or more of the
outstanding shares of that class at any
time during the tax year, report on an
attached supporting schedule (1) the
name of the dividend payer, (2) the
payer’s EIN (if applicable), (3) the class of
voting stock on which the dividend was
paid, (4) the percentage of the class
directly or indirectly owned, and (5) to (8)
the item amounts for columns (a) through
(d).

Line 3. Subpart F, QEF, and
Similar Income Inclusions
Report on line 3, column (d), the amount
included in taxable income under section
951 (relating to Subpart F), gains or other
income inclusions resulting from elections
under sections 1291(d)(2) and 1298(b)(1),
and any amount included in taxable
income pursuant to section 1293 (relating
to qualified electing funds). The amount of
Subpart F income corresponds to the total
of the amounts reported by the
partnership on line 6, Schedule I, of all
Forms 5471, Information Return of U.S.
Persons With Respect to Certain Foreign
Corporations. The amount of qualified
electing fund income corresponds to the
total of the amounts reported by the
partnership on line 3(a), Part II, of all
Forms 8621, Return by a Shareholder of
a Passive Foreign Investment Company
or Qualified Electing Fund.
Also include on line 3 PFIC
mark-to-market gains and losses under
section 1296. Do not report such gains
and losses on line 14.

Line 4. Gross Foreign
Distributions Previously Taxed
Report on line 4, column (a), any
distributions received from foreign
corporations that were included in Part I,
line 11, that were previously taxed for U.S
federal income tax purposes. For
example, include in column (a) amounts
that are excluded from taxable income
under sections 959 and 1293(c). Remove
such amount in column (b) or (c), as
applicable. Report the full amount of the
distribution before any withholding tax.

Report withholding taxes on Part III, line
29, Other expense/deduction items with
differences, or Part II, line 25, as
applicable. Since previously taxed foreign
distributions are not currently taxable, line
4, column (d) is shaded. (Also, see
instructions above for line 2.)

Line 5. Income (Loss) From
Equity Method U.S.
Corporations
Report on line 5, column (a), the income
statement income (loss) included in Part I,
line 11 for any U.S. corporation
accounted for on the equity method and
remove such amount in column (b) or (c),
as applicable. Report the amount of
dividends received from any U.S.
corporations on line 6.

Line 6. U.S. Dividends
Report on line 6, column (a), the amount
of dividends included in Part I, line 11,
received from any U.S. corporation.
Report on line 6, column (d), the amount
of any U.S. dividends included in taxable
income on Form 1065, page 4, Analysis
of Net Income (Loss), line 1.
For any dividends reported on line 6
that are received on classes of voting
stock in which the partnership directly or
indirectly owned 10% or more of the
outstanding shares of that class at any
time during the tax year, report on an
attached supporting schedule for line 6
(1) the name of the dividend payer, (2)
the payer’s EIN (if applicable), (3) the
class of voting stock on which the
dividend was paid, (4) the percentage of
the class directly or indirectly owned, and
(5) to (8) the item amounts for columns
(a) through (d).

Line 7. Income (Loss) From U.S.
Partnerships and
Line 8. Income (Loss) From
Foreign Partnerships
For any interest owned by the partnership
that is treated as an investment in a
partnership for U.S. federal income tax
purposes (other than an interest in a
disregarded entity), report amounts on
line 7 or 8 as described below:
1. In column (a), the sum of the
partnership’s distributive share of income
or loss from a U.S. or foreign partnership
that is included in Part I, line 11;
2. In column (b) or (c), as applicable,
the sum of all differences, if any,
attributable to the partnership’s
distributive share of income or loss from a
U.S. or foreign partnership; and
3. In column (d), the sum of all
amounts of income, gain, loss, or
deduction attributable to the partnership’s
distributive share of income or loss from a
U.S. or foreign partnership (i.e., the sum
of all amounts reportable on the
partnership’s Schedule(s) K-1 received
from the partnership (if applicable)),
without regard to any limitations
computed at the partner level.

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For each partnership reported on line 7
or 8, attach a supporting schedule that
provides the name, EIN (if applicable),
end-of-year profit-sharing percentage (if
applicable), end – of-year loss-sharing
percentage (if applicable), and the
amount reported in column (a), (b), (c), or
(d) of lines 7 or 8, as applicable.
Example 10. U.S. partnership H is a
calendar year partnership that was
required to file Schedule M-3 for its 2006
tax year and is required to file Schedule
M-3 for its 2007 tax year. H has an
investment in a U.S. partnership USP. H
prepares financial statements in
accordance with GAAP. For its 2007 tax
year, H’s financial statement net income
includes $10,000 of income attributable to
its share of USP’s net income. H’s
Schedule K-1 from USP reports $5,000 of
ordinary income, $7,000 of long-term
capital gains, $4,000 of charitable
contributions, and $200 of section 179
expense. H must report on Part II, line 7,
$10,000 in column (a), a permanent
difference of ($2,200) in column (c), and
$7,800 in column (d).

Line 9. Income (Loss) From
Other Pass-Through Entities
For any interest in a pass-through entity
(other than an interest in a partnership
reportable on line 7 or 8, as applicable)
owned by the U.S. partnership (other than
an interest in a disregarded entity), report
the following on line 9:
1. In column (a), the sum of the
partnership’s distributive share of income
or loss from the pass-through entity that is
included in Part I, line 11;
2. In column (b) or (c), as applicable,
the sum of all differences, if any,
attributable to the pass-through entity;
and
3. In column (d), the sum of all taxable
amounts of income, gain, loss, or
deduction reportable on the partnership’s
Schedules K-1 received from the
pass-through entity (if applicable).
For each pass-through entity reported
on line 9, attach a supporting schedule
that provides that entity’s name, EIN (if
applicable), the partnership’s end-of-year
profit-sharing percentage (if applicable),
the partnership’s end-of-year loss-sharing
percentage (if applicable), and the
amounts reported by the partnership in
column (a), (b), (c), or (d), of line 9, as
applicable.

Line 10. Items Relating to
Reportable Transactions
Any amounts attributable to any
reportable transactions (as described in
Regulations section 1.6011-4) must be
included on line 10 regardless of whether
the difference, or differences, would
otherwise be reported elsewhere in Part II
or Part III. Thus, if a taxpayer files Form
8886 for any reportable transaction
described in Regulations section 1.6011-4
the amounts attributable to that reportable
transaction must be reported on line 10.
In addition, all income and expense

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amounts attributable to a reportable
transaction must be reported on line 10,
columns (a) and (d) even if there is no
difference between the financial
statement amounts and the taxable
amounts.
Each difference attributable to a
reportable transaction must be separately
stated and adequately disclosed. A
partnership will be considered to have
separately stated and adequately
disclosed a reportable transaction on line
10 if the partnership sequentially numbers
each Form 8886 and lists by identifying
number on the supporting schedule for
line 10 each sequentially numbered
reportable transaction and the amounts
required for line 10, columns (a) through
(d).
In lieu of the requirements of the
preceding paragraph, a partnership will
be considered to have separately stated
and adequately disclosed a reportable
transaction if the partnership attaches a
supporting schedule that provides the
following for each reportable transaction:
1. A description of the reportable
transaction disclosed on Form 8886 for
which amounts are reported on line 10;
2. The name and tax shelter
registration number, if applicable, as
reported on lines 1a and 1b, respectively,
of Form 8886; and
3. The type of reportable transaction
(i.e., listed transaction, confidential
transaction, transaction with contractual
protection, etc.) as reported on line 2 of
Form 8886.
If a transaction is a listed transaction
described in Regulations section
1.6011-4(b)(2), the description also must
include the description provided on line 3
of Form 8886. In addition, if the reportable
transaction involves an investment in the
transaction through another entity such as
a partnership, the description must
include the name and EIN (if applicable)
of that entity as reported on line 5 of Form
8886.
Example 11. Partnership J is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. J incurred seven different
abandonment losses during its 2007 tax
year. One loss of $12 million results from
a reportable transaction described in
Regulations section 1.6011-4(b)(5),
another loss of $5 million results from a
reportable transaction described in
Regulations section 1.6011-4(b)(4), and
the remaining five abandonment losses
are not reportable transactions. J
discloses the reportable transactions
giving rise to the $12 million and $5
million losses on separate Forms 8886
and sequentially numbers them X1 and
X2, respectively. J must separately state
and adequately disclose the $12 million
and $5 million losses on Part II, line 10.
The $12 million loss and the $5 million
loss will be adequately disclosed if J
attaches a supporting schedule for line 10

that lists each of the sequentially
numbered forms, Form 8886-X1 and
Form 8886-X2, and with respect to each
reportable transaction reports the
appropriate amounts required for Part II,
line 10, columns (a) through (d).
Alternatively, J’s disclosures will be
adequate if the description provided for
each loss on the supporting schedule
includes the names and tax shelter
registration numbers, if any, disclosed on
the applicable Form 8886, identifies the
type of reportable transaction for the loss,
and reports the appropriate amounts
required for Part II, line 10, columns (a)
through (d). J must report the losses
attributable to the other five abandonment
losses on Part II, line 21e, regardless of
whether a difference exists for any or all
of those abandonment losses.
Example 12. Partnership K is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. K enters into a transaction
with contractual protection that is a
reportable transaction described in
Regulations section 1.6011-4(b)(4). This
reportable transaction is the only
reportable transaction for K’s 2007 tax
year and results in a $7 million capital
loss for both financial statement purposes
and U.S. federal income tax purposes.
Although the transaction does not result
in a difference, K is required to report on
Part II, line 10, the following amounts: ($7
million) in column (a), zero in columns (b)
and (c), and ($7 million) in column (d).
The transaction will be adequately
disclosed if K attaches a supporting
schedule for line 10 that (a) sequentially
numbers the Form 8886 and refers to the
sequentially-numbered Form 8886-X1
and (b) reports the applicable amounts
required for line 10, columns (a) through
(d). Alternatively, the transaction will be
adequately disclosed if the supporting
statement for line 10 includes a
description of the transaction, the name
and tax shelter registration number, if
any, and the type of reportable
transaction disclosed on Form 8886.

Line 11. Interest income
Report on line 11, column (a), the total
amount of interest income included on
Part I, line 11, and report on line 11,
column (d), the total amount of interest
income included on Form 1065, page 4
Analysis of Net Income (Loss), line 1, that
is not required to be reported elsewhere
on Schedule M-3. In columns (b) or (c),
as applicable, adjust for any amounts
treated for U.S. federal income tax
purposes as interest income that are
treated as some other form of income in
the financial statements, or vice versa.
For example, adjustments to interest
income resulting from adjustments made
in accordance with instructions for line 16,
should be made in columns (b) and (c) of
line 11.

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Do not report on line 11 amounts
reported in accordance with instructions
for lines 7, 8, 9, 10 and 20.

Line 12. Total Accrual to Cash
Adjustment
This line is completed by a partnership
that prepares financial statements (or
books and records, if permitted) using an
overall accrual method of accounting and
uses an overall cash method of
accounting for U.S. federal income tax
purposes (or vice-versa). With the
exception of amounts required to be
reported on line 10, the partnership must
report on line 12 a single amount net of all
adjustments attributable solely to the use
of the different overall methods of
accounting (e.g., adjustments related to
accounts receivable, accounts payable,
compensation, accrued liabilities, etc.),
regardless of whether a separate line on
Schedule M-3 corresponds to an item
within the accrual to cash reconciliation.
Differences not attributable to the use of
the different overall methods of
accounting must be reported on the
appropriate lines of Schedule M-3 (e.g., a
depreciation difference must be reported
on Part III, line 25).
Example 13. Partnership L is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. L prepares financial
statements in accordance with GAAP
using an overall accrual method of
accounting. L uses an overall cash
method of accounting for U.S. federal
income tax purposes. L’s financial
statements for the year ending December
31, 2007, report accounts receivable of
$35,000, an allowance for bad debts of
$10,000, and accounts payable of
$17,000 related to current year
acquisition and reorganization legal and
accounting fees. In addition, for L’s year
ending December 31, 2007, L reported
financial statement depreciation expense
of $15,000 and depreciation for U.S.
federal income tax purposes of $25,000.
For L’s 2007 tax year using an overall
cash method of accounting, L does not
recognize the $35,000 of revenue
attributable to the accounts receivable,
cannot deduct the $10,000 allowance for
bad debt, and cannot deduct the $17,000
of accounts payable. Both the difference
in overall accounting methods used for
financial statement and U.S. federal
income tax purposes and the difference in
depreciation expense are temporary
differences. L must combine all
adjustments attributable to the differences
related to the overall accounting methods
on Part II, line 12. As a result, L must
report on Part II, line 12, $8,000 in column
(a) ($35,000 - $10,000 - $17,000),
($8,000) in column (b), and zero in
column (d). L must not report the accrual
to cash adjustment attributable to the
legal and accounting fees on Part III, line
18, Current year acquisition/
reorganization legal and accounting fees.
Because the difference in depreciation

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expense does not relate to the use of the
cash or accrual method of accounting, L
must report the depreciation difference on
Part III, line 25, and report $15,000 in
column (a), $10,000 in column (b), and
$25,000 in column (d).

Line 13. Hedging Transactions
Report on line 13, column (a), the net
gain or loss from hedging transactions
included in net income per the income
statement. Report in column (d) the
amount of taxable income from hedging
transactions as defined in section 1221
(b)(2). Use columns (b) and (c) to report
all differences caused by treating hedging
transactions differently for financial
accounting purposes and for U.S. federal
income tax purposes. For example, if a
portion of a hedge is considered
ineffective under GAAP but still is a valid
hedge under section 1221(b)(2), the
difference must be reported on line 13.
The hedge of a capital asset, which is not
a valid hedge for U.S. federal income tax
purposes but may be considered a hedge
for GAAP purposes, must also be
reported here.
Report hedging gains and losses
computed under the mark-to-market
method of accounting on line 13 and not
on line 14.
Report any gain or loss from inventory
hedging transactions on line 13 and not
on line 15.

Line 14. Mark-to-Market Income
(Loss)
Report on line 14 any amount
representing the mark-to-market income
or loss for any securities held by a dealer
in securities, a dealer in commodities
having made a valid election under
section 475(e), or a trader in securities or
commodities having made a valid election
under section 475(f). “Securities” for
these purposes are securities described
in section 475(c)(2) and section 475(e)(2).
“Securities” do not include any items
specifically excluded from sections
475(c)(2) and 475(e)(2), such as certain
contracts to which section 1256(a)
applies.
Report hedging gains and losses
computed under the mark-to-market
method of accounting on Part II, line 13,
and not on line 14.

Line 15. Cost of Goods Sold
Report on line 15 any amounts deducted
as part of cost of goods sold during the
tax year, regardless of whether the
amounts would otherwise be reported
elsewhere in Part II or Part III. However,
do not report the items mentioned in the
next paragraph on line 15. Examples of
amounts that must be included on line 15
are amounts attributable to inventory
valuation, such as amounts attributable to
cost-flow assumptions, additional costs
required to be capitalized (including
depreciation) such as section 263A costs,
inventory shrinkage accruals, inventory

obsolescence reserves, and lower of cost
or market (LCM) write-downs.
Do not report the following on line 15:
• Amounts reportable on line 10;
• Any gain or loss from inventory hedging
transactions reportable on line 13;
• Mark-to-market income or (loss)
associated with the inventories of dealers
in securities under section 475 reportable
on line 14;
• Section 481(a) adjustments related to
cost of goods sold or inventory valuation
reportable on line 17;
• Fines and penalties reportable on Part
III, line 7; and
• Judgments, damages, awards and
similar costs, reportable on Part III, line 8.
For the amount reported on Part II, line
15, attach Form 8916-A and report
amounts for each item listed on Form
8916-A in columns (a) through (d).
Example 14. Partnership C is a
calendar year partnership that placed in
service ten depreciable fixed assets in
2000. C is required to file Schedule M-3
for its 2006 tax year. C’s total
depreciation expense for its 2006 tax year
for five of the assets is $50,000 for
income statement purposes and $70,000
for U.S. federal income tax purposes. C’s
total annual depreciation expense for its
2006 tax year for the other five assets is
$40,000 for income statement purposes
and $30,000 for U.S. federal income tax
purposes. In addition, C incurs $200 of
meals and entertainment expenses that C
deducts in computing net income per the
income statement. All $200 of is subject
to the $50% limitation under section
274(n). In its financial statements, C
treats the $50,000 depreciation and $100
of the meals and entertainment as other
costs in computing Cost of Goods Sold.
Accordingly, C must include on Part II,
line 15, in column (a), the $50,000 of
depreciation and $100 of meals and
entertainment. C must also include a
temporary difference of $20,000 in
column (b) a permanent difference of
$(50) in column (c) and $70,050 in
column (d) [$70,000 depreciation and $50
meals]. In addition, C must report: on Part
III, line 25, for its 2006 tax year income
statement, depreciation expense of
$40,000 in column (a), a temporary
difference of $(10,000) in column (b) and
$30,000 in column (d); and on Part III, line
6, meals and entertainment expense of
$100 in column (a), a permanent
difference of $(50) in column (c), and $50
in column (d). All other COGS items
would be added to the amounts included
on Part II, line 15 detailed in this example
and reported on Part II, line 15, in the
appropriate columns.

Line 16. Sale Versus Lease (for
Sellers and/or Lessors)
(Also see the instructions at Part III, line
28 for purchasers and/or lessees.)
Asset transfer transactions with
periodic payments characterized for
financial accounting purposes as either a
sale or a lease may, under some

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circumstances, be characterized as the
opposite for tax purposes. If the
transaction is treated as a lease, the
seller/lessor reports the periodic
payments as gross rental income and
also reports depreciation expense or
deduction. If the transaction is treated as
a sale, the seller/lessor reports gross
profit (sale price less cost of goods sold)
from the sale of assets and reports the
periodic payments as payments of
principal and interest income.
On line 16, column (a), report the
gross profit or gross rental income for
financial income purposes for all sale or
lease transactions that must be given the
opposite characterization for U.S. federal
income tax purposes. On line 16, column
(d), report the gross profit or gross rental
income for federal income tax purposes.
Interest income amounts for such
transactions must be reported on line 11,
Interest income, in column (a) or (d), as
applicable. Depreciation expense for such
transactions must be reported on Part III,
line 25, Depreciation, in column (a) or (d),
as applicable. Use columns (b) and (c) of
lines 11 and 16, and Part III, line 25, as
applicable to report the differences
between column (a) and (d).
Example 15. Partnership M sells and
leases property to customers. M is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. For financial accounting
purposes, M accounts for each
transaction as a sale. For U.S. federal
income tax purposes, each of M’s
transactions must be treated as a lease.
The difference in the financial accounting
and the U.S. federal income tax treatment
of these transactions is temporary. During
2007, M reports in its financial statements
$1,000 of sales and $700 of cost of goods
sold with respect to 2007 lease
transactions. M receives periodic
payments of $500 in 2007 with respect to
these 2007 transactions and similar
transactions from prior years and treats
$400 as principal and $100 as interest
income. For financial income purposes, M
reports gross profit of $300 ($1,000 $700) and interest income of $100 from
these transactions. For U.S. federal
income tax purposes, M reports $500 of
gross rental income (the periodic
payments) and (based on other facts)
$200 of depreciation deduction on the
property. On its 2007 Schedule M-3, M
must report on Part II, line 11, $100 in
column (a), ($100) in column (b), and
zero in column (d). In addition, M must
report on Part II, line 16, $300 of gross
profit in column (a), $200 in column (b),
and $500 of gross rental income in
column (d). Lastly, M must report on Part
III, line 25, $200 in column (b) and (d).

Line 17. Section 481(a)
Adjustments
With the exception of a section 481(a)
adjustment that is required to be reported
on line 10 for reportable transactions, any

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difference between an income or expense
item attributable to an authorized (or
unauthorized) change in method of
accounting made for U.S. federal income
tax purposes that results in a section
481(a) adjustment must be reported on
line 17, regardless of whether a separate
line for that income or expense item
exists in Part II or Part III.
Example 16. Partnership N is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its
2007 tax year. N was depreciating certain
fixed assets over an erroneous recovery
period and, effective for its 2007 tax year,
N receives IRS consent to change its
method of accounting for the depreciable
fixed assets and begins using the proper
recovery period. The change in method of
accounting results in a positive section
481(a) adjustment of $100,000 that is
required to be spread over four tax years,
beginning with the 2007 tax year. The
section 481(a) adjustment is a temporary
difference. N must report on Part II, line
17, $25,000 in columns (b) and (d) for its
2007 tax year and each of the
subsequent three tax years (unless N is
otherwise required to recognize the
remainder of the 481(a) adjustment
earlier). N must not report the section
481(a) adjustment on Part III, line 25.

Line 18. Unearned/Deferred
Revenue
Report on line 18, column (a), amounts of
revenues included in Part I, line 11, that
were deferred from a prior financial
accounting year. Report on line 18,
column (d), amounts of revenues
recognizable for U.S. federal income tax
purposes in the current tax year that are
recognized for financial accounting
purposes in a different year. Also report
on line 18, column (d), any amount of
revenues reported on line 18, column (a),
that are recognizable for U.S. federal
income tax purposes in the current tax
year. Use columns (b) and (c) of line 18,
as applicable, to report differences
between column (a) and (d).
Line 18 must not be used to report
income recognized from long-term
contracts. Instead, use line 19.

Line 19. Income Recognition
From Long-Term Contracts
Report on line 19 the amount of net
income or loss for financial statement
purposes (or books and records, if
applicable) or U.S. federal income tax
purposes for any contract accounted for
under a long-term contract method of
accounting.

1. The difference between issue price
and the stated redemption price at
maturity of a debt instrument, which may
be wholly or partially realized on the
disposition of a debt instrument under
section 1273;
2. Amounts that are imputed interest
on a deferred sales contract under
section 483;
3. Amounts treated as interest or OID
under the stripped bond rules under
Section 1286; and
4. Amounts treated as OID under the
below-market interest rate rules under
Section 7872.

Line 21a. Income Statement
Gain/loss on Sale, Exchange,
Abandonment, Worthlessness,
or Other Disposition of Assets
Other Than Inventory and
Pass-Through Entities
Report on line 21a, column (a) all gains
and losses on the disposition of assets
except for (a) gains and losses on the
disposition of inventory, and (b) gains and
losses allocated to the partnership from a
pass-through entity (e.g., on Schedule
K-1) that are included in the net income
(loss) per income statement of the
partnership reported on Part I, line 11.
Reverse the amount reported in column
(a) in column (b) or (c), as applicable. The
corresponding gains and losses for U.S.
federal income tax purposes are reported
on lines 21b through 21g, as applicable.

Line 21b. Gross Capital Gains
From Schedule D, Excluding
Amounts From Pass-Through
Entities
Report on line 21b, gross capital gains
reported on Schedule D, excluding capital
gains from pass-through entities, which
must be reported on lines 7, 8, or 9, as
applicable.

Line 21c. Gross Capital Losses
From Schedule D, Excluding
Amounts From Pass-Through
Entities, Abandonment Losses,
and Worthless Stock Losses
Report on line 21c, gross capital losses
reported on Schedule D, excluding capital
losses from (a) pass-through entities,
which must be reported on lines 7, 8, or 9,
as applicable; (b) abandonment losses,
which must be reported on line 21e; and
(c) worthless stock losses, which must be
reported on line 21f.

Line 20. Original Issue Discount
and Other Imputed Interest

Line 21d. Net Gain/Loss
Reported on Form 4797, Line
17, Excluding Amounts From
Pass-Through Entities,
Abandonment Losses, and
Worthless Stock Losses

Report on line 20 any amounts of original
issue discount (OID) and other imputed
interest. The term 00original issue
discount and other imputed interest’’
includes, but is not limited to:

Report on line 21d the net gain or loss
reported on line 17 of Form 4797, Sales
of Business Property, excluding amounts
from (a) pass-through entities, which must
be reported on lines 7, 8, or 9, as

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applicable; (b) abandonment losses,
which must be reported on line 21e; and
(c) worthless stock losses, which must be
reported on line 21f.

Line 21e. Abandonment Losses
Report on line 21e any abandonment
losses, regardless of whether the loss is
characterized as an ordinary loss or a
capital loss.

Line 21f. Worthless Stock
Losses
Report on line 21f any worthless stock
loss, regardless of whether the loss is
characterized as an ordinary loss or a
capital loss. Attach a schedule that
separately states and adequately
discloses each transaction that gives rise
to a worthless stock loss and the amount
of each loss.

Line 21g. Other Gain/Loss on
Disposition of Assets Other
Than Inventory
Report on line 21g any gains or losses
from the sale or exchange of property
other than inventory and that are not
reported on lines 21b through 21f.

Line 22. Other Income (Loss)
Items With Differences
Separately state and adequately disclose
on line 22, all items of income (loss) with
differences that are not otherwise listed
on lines 1 through 21. Attach a schedule
that itemizes the type of income (loss)
and the amount of each item.
If any “comprehensive income” as
defined by Statement of Financial
Accounting Standards (SFAS) No. 130 is
reported on this line, describe the item(s)
in detail. Examples of sufficiently detailed
descriptions include “Foreign currency
translation adjustments” and “gains and
losses on available-for-sale securities”.

Line 24. Total Expense/
Deduction Items
Report on line 24, columns (a) through
(d), as applicable, the negative of the
amounts reported on Part III, line 30,
columns (a) through (d). For example, if
Part III, line 30, column (a), reflects an
amount of $1 million then report on line
24, column (a), ($1 million). Similarly, if
Part III, line 30, column (b), reflects an
amount of ($50,000), then report on line
24, column (b), $50,000.

Line 25. Other Items With No
Differences
If there is no difference between the
financial accounting amount and the
taxable amount of an entire item of
income, gain, loss, expense, or deduction
and the item is not described or included
in Part II, lines 1 through 22, or Part III,
lines 1 through 29, report the entire
amount of the item in columns (a) and (d)
of line 25. If a portion of an item of
income, loss, expense, or deduction has
a difference and a portion of the item
does not have a difference, do not report
any portion of the item on line 25. Instead,

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report the entire amount of the item (i.e.,
both the portion with a difference and the
portion without a difference) on the
applicable line of Part II, lines 1 through
22, or Part III, lines 1 through 29. See
Example 9 on page 8.

Line 26. Reconciliation Totals.
Combine lines 23 through 25.
If a partnership chooses not to complete
columns (a) and (d) of Parts II and III in
the first tax year the partnership is
required to file Schedule M-3 (or for any
year in which the partnership voluntarily
files Schedule M-3), line 26 is reconciled
by the partnership in the following
manner:
1. Report the amount from Part I, line
11, on line 26, column (a);
2. Leave blank lines 1 through 25,
columns (a) and (d);
3. Leave blank Part III, columns (a)
and (d); and
4. Report on line 26, column (d), the
sum of Part II, line 26, columns (a), (b),
and (c).

Part III. Reconciliation of
Net Income (Loss) per
Income Statement of
Partnerships With Income
(Loss) per Return —
Expense/ Deduction Items
Lines 1 Through 4. Income Tax
Expense
If the partnership does not distinguish
between current and deferred income tax
expense in its financial statements (or its
books and records, if applicable), report
income tax expense as current income
tax expense using lines 1 and 3, as
applicable.

Line 5. Equity-Based
Compensation
Report on line 5 any amounts for
equity-based compensation or
consideration that are reflected as
expense in the financial statements
(column (a)) or deducted in the U.S.
federal income tax return (column (d))
other than amounts reportable elsewhere
on Schedule M-3, Parts II and III.
Examples of amounts reportable on line 5
include expense/deduction items
attributable to options to acquire capital
interest units, profits interest units, and
other rights to acquire partnership equity,
regardless of whether such payments are
made to employees or non-employees, or
as payment for property or compensation
for services.

Line 6. Meals and
Entertainment
Report on line 6, column (a), any amounts
paid or accrued by the partnership during
the tax year for meals, beverages, and

entertainment that are accounted for in
financial accounting income, regardless of
the classification, nomenclature, or
terminology used for such amounts, and
regardless of how or where such amounts
are classified in the partnership’s financial
income statement or the income and
expense accounts maintained in the
partnership’s books and records. Report
only amounts not otherwise reportable
elsewhere on Schedule M-3, Parts II and
III (e.g., Part II, line 15).

Line 7. Fines and Penalties
Report on line 7 any fines or similar
penalties paid to a government or other
authority for the violation of any law for
which fines or penalties are assessed. All
fines and penalties expensed in financial
accounting income (paid or accrued) must
be included on this line 7, column (a),
regardless of the government or other
authority that imposed the fines or
penalties, regardless of whether the fines
and penalties are civil or criminal,
regardless of the classification,
nomenclature, or terminology used for the
fines or penalties by the imposing
authority in its actions or documents, and
regardless of how or where the fines or
penalties are classified in the
partnership’s financial income statement
or the income and expense accounts
maintained in the partnership’s books and
records. Also report on line 7, column (a),
the reversal of any overaccrual of any
amount described in this paragraph. See
sections 162(f) and 162(g) for additional
guidance.
Report on line 7, column (d), any such
amounts as are described in the
preceding paragraph that are includible in
taxable income, regardless of the
financial accounting period in which such
amounts were or are included in financial
accounting net income. Complete
columns (b) and (c), as appropriate.
Do not report on this , line 7, amounts
required to be reported in accordance
with instructions for Part III, line 8.
Do not report on line 7, amounts
recovered from insurers or any other
indemnitors for any fines and penalties
described above.

Line 8. Judgments, Damages,
Awards, and Similar Costs
Report on line 8, column (a), the amount
of any estimated or actual judgments,
damages, awards, settlements, and
similar costs, however named or
classified, included in financial accounting
income, regardless of whether the
amount deducted was attributable to an
estimate of future anticipated payments or
actual payments. Also report on line 8,
column (a), the reversal of any
overaccrual of any amount described in
this paragraph.
Report on line 8, column (d), any such
amounts as are described in the
preceding paragraph that are includible in
taxable income, regardless of the
financial accounting period in which such

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amounts were or are included in financial
accounting net income. Complete
columns (b) and (c), as appropriate.
Do not report on this line 8 amounts
required to be reported in accordance
with instructions for line 7.
Do not report on line 8, amounts
recovered from insurers or any other
indemnitors for any judgments, damages,
awards, or similar costs described above.

Line 9. Guaranteed Payments
Include on line 9, column (a), the amount
of guaranteed payments expense that is
included on Part I, line 11. Report in
column (d) the amount of guaranteed
payments deduction included on Form
1065, page 4 Analysis of Net Income
(Loss), line 1,

Line 10. Pension and
Profit-Sharing
Report on line 10 any amounts
attributable to the partnership’s pension
plans, profit-sharing plans, and any other
retirement plans.

Line 11. Other Post-Retirement
Benefits
Report on line 11 any amounts
attributable to other post-retirement
benefits not otherwise includible on line
10, for example, retiree health and life
insurance coverage, dental coverage, etc.

Line 12. Deferred
Compensation
Report on line 12, column (a), any
deferred compensation expense included
in the net income (loss) amount reported
in Part I, line 11 that is not deductible for
U.S. federal income tax purposes in the
current tax year and that was not reported
elsewhere on Schedule M-3, column (a).
Report on line 12, column (d), any
deferred compensation deductible in the
current tax year that is not included in the
net income (loss) amount reported in Part
I, line 11, for the current tax year and that
is not reportable elsewhere on Schedule
M-3, including any compensation
deductions deferred in a prior tax year.
For example, report originations and
reversals of deferred compensation
subject to section 409A on line 12.

Line 14. Charitable Contribution
of Intangible Property
Report on line 14 any charitable
contribution of intangible property, for
example, contributions of:
• Intellectual property, patents (including
any amounts of additional contributions
allowable by virtue of income earned by
donees subsequent to the year of
donation), copyrights, trademarks;
• Securities (including stocks and their
derivatives, stock options, and bonds);
• Conservation easements (including
scenic easements or air rights);
• Railroad rights of way;
• Mineral rights; and
• Other intangible property.

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Line 15. Organizational
Expenses as per 1.709-2(a)
Include on line 15, column (a),
organizational expenses as defined in
Regulations 1.709-2(a). Include on line
15, column (d), the amount of
organizational expense deducted per
Section 709(b).

Line 16. Syndication Expenses
as per 1.709-2(b)
Include on line 16 syndication expenses
as defined in Regulations 1.709-2(b).

Line 17. Current Year
Acquisition/Reorganization
Investment Banking Fees
Report on line 17 any investment banking
fees paid or incurred in connection with a
taxable or tax-free acquisition of property
(e.g., ownership interests or assets) or a
tax-free reorganization not otherwise
reportable on Schedule M-3 (e.g., Part III,
line 15 or 16). Report on this line any
investment banking fees paid or incurred
at any stage of the acquisition or
reorganization process including, for
example, fees paid or incurred to evaluate
whether to investigate an acquisition, fees
to conduct an actual investigation, and
fees to consummate the acquisition or
reorganization.

Line 18. Current Year
Acquisition/Reorganization
Legal and Accounting Fees
Report on line 18 any legal and
accounting fees paid or incurred in
connection with a taxable or tax-free
acquisition of property (e.g., ownership
interests or assets) or a tax-free
reorganization not otherwise reportable
on Schedule M-3 (e.g., Part III, line 15 or
16). Report on this line any legal and
accounting fees paid or incurred at any
stage of the acquisition or reorganization
process including, for example, fees paid
or incurred to evaluate whether to
investigate an acquisition, fees to conduct
an actual investigation, and fees to
consummate the acquisition or
reorganization.

Line 19. Amortization/
Impairment of Goodwill
Report on line 19 amortization of goodwill
or amounts attributable to the impairment
of goodwill.

Line 20. Amortization of
Acquisition, Reorganization,
and Start-Up Costs
Report on line 20 amortization of
acquisition, reorganization, and start-up
costs. For purposes of column (b), (c),
and (d), include amounts amortizable
under section 167 or 195.

Line 21. Other Amortization or
Impairment Write-Offs
Report on line 21 any amortization or
impairment write-offs not otherwise
includible on Schedule M-3.

Line 22. Section 198
Environmental Remediation
Costs
Report on line 22, column (a), any
amounts attributable to environmental
remediation costs included in the net
income per the income statement. Report
in columns (b), (c), and (d), as applicable,
any deductible amounts attributable to
environmental remediation costs
described in section 198 that are paid or
incurred during the current tax year.

Line 23a. Depletion – Oil & Gas
Report on line 23a, column (a), any oil
and gas depletion included in Part I, line
11.
Note. Form 1065-B must report oil and
gas depletion on Part III, line 23b.

form of expense in the financial
statements, or vice versa. For example,
adjustments to interest expense/
deduction resulting from adjustments
made in accordance with instructions for
line 28, Purchase versus lease (for
purchasers and/or lessors), should be
made in columns (b) and (c), as
applicable, of line 27.
Do not report on line 27 amounts
reported in accordance with instructions
for (i) Part II, lines 7, 8 and 9, Income
(loss) from U.S. partnerships, foreign
partnerships and other pass-through
entities, and (ii) Part II, line 10, Items
relating to reportable transactions.

Line 28. Purchase Versus Lease
(for Purchasers and/or
Lessees)

Line 23b. Depletion – Other
than Oil & Gas

Note: Also see the instructions at Part II,
line 16 for sellers and/or lessors.

Report on line 23b any depletion
expense/deduction other than oil and gas
that is not required to be reported
elsewhere on Schedule M-3 (e.g., on Part
II, lines, 7, 8, 9, or 15).
Note. Form 1065-B must report oil and
gas depletion on this line 23b.

Asset transfer transactions with
periodic payments characterized for
financial accounting purposes as either a
purchase or a lease may, under some
circumstances, be characterized as the
opposite for tax purposes.
If a transaction is treated as a lease,
the purchaser/lessee reports the periodic
payments as gross rental expense. If the
transaction is treated as a purchase, the
purchaser/lessee reports the periodic
payments as payments of principal and
interest and also reports depreciation
expense or deduction with respect to the
purchased asset.
Report on line 28, column (a), gross
rent expense for a transaction treated as
a lease for income statement purposes
but as a sale for U.S. federal income tax
return purposes. Report on line 28,
column (d), gross rental deductions for a
transaction treated as a lease for U.S.
federal income tax purposes but as a
purchase for income statement purposes.
Report interest expense or deduction
amounts for such transactions on line 27,
Interest expense in columns (a) and (d),
as applicable. Report depreciation
expense or deductions for such
transactions on line 25, Depreciation, in
column (a) or (d), as applicable. Use
columns (b) and (c) of lines 25, 27, and
28, as applicable, to report the differences
between column (a) and (d) for such
recharacterized transactions.
Example 17. U.S. partnership X
acquired property in a transaction that, for
financial accounting purposes, X treats as
a lease. X is a calendar year taxpayer
that was required to file Schedule M-3 for
its 2006 tax year and is required to file
Schedule M-3 for its 2007 tax year. For
U.S. federal income tax purposes,
because of its terms, the transaction is
treated for U.S. federal income tax
purposes as a purchase and X must treat
the periodic payments it makes partially
as payment of principal and partially as
payment of interest. In its financial
statements, X treats the difference
between the financial accounting and

Line 24 Intangible Drilling and
Development Costs (IDC)
Intangible Drilling and Development Costs
(IDC) are costs of developing oil, gas, or
geothermal wells. Report on line 24,
column (a), the total amount of intangible
drilling and development costs (or such
equivalent costs as classified in the
partnership’s financial statements)
included on Part I, line 11, and report on
line 24, column (d), the total amount of
IDC paid or incurred during the current
tax year under section 263(c) and
Regulations section 1.612-4.

Line 25. Depreciation
Report on line 25 any depreciation
expense/deduction that is not required to
be reported elsewhere on Schedule M-3
(e.g., on Part II, lines, 7, 8, 9, or 15).

Line 26 Bad Debt Expense
Report on line 26, column (a), any
amounts attributable to an allowance for
uncollectible accounts receivable or
actual write-offs of accounts receivable
included in net income per the income
statement. Report in column (d), the
amount of bad debt expense deducted for
federal income tax purposes in
accordance with section 166.

Line 27. Interest Expense
Report on line 27, column (a), the total
amount of interest expense included on
Part I, line 11, and report on line 27,
column (d), the total amount of interest
deduction included on Form 1065, page 4
Analysis of Net Income (Loss), line 1, that
is not reported elsewhere on Schedule
M-3. In columns (b) or (c), as applicable,
adjust for any amounts treated for U.S.
federal income tax purposes as interest
deduction that are treated as some other

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U.S. federal tax treatment of this
transaction as a temporary difference.
During 2007, X reports in its financial
statements $1,000 of gross rental
expense that, for U.S. federal income tax
purposes, is recharacterized as a $700
payment of principal and a $300 payment
of interest, accompanied by a
depreciation deduction of $1,200 (based
on other facts). On its 2007 Schedule
M-3, X must report on Part III, line 28,
column (a), $1,000, its financial
accounting gross rental expense; column
(b), ($1,000); and column (d), zero. On
Part III, line 27, X reports zero in column
(a), and $300 in columns (b) and (d), for
the interest deduction. On Part III, line 25,
X reports zero in column (a), and $1,200
in columns (b) and (d), for the
depreciation deduction.

Line 29. Other Expense/
Deduction Items With
Differences
Report on line 29 all items of expense/
deduction that are not otherwise listed on
Part III, lines 1 through 28.
Comprehensive income. If any
“comprehensive income” as defined by
SFAS No. 130 is reported on this line,
describe the item(s) in detail as, for
example, “Foreign currency translation
adjustments” and “Gains and losses on
available-for-sale securities”.
Reserves and contingent liabilities.
Report on line 29 each reserve or
contingent liability that is not reported
elsewhere on Schedule M-3 Report on
line 29, column (a), expenses included in
net income reported on Part I, line 11,
that are related to reserves and
contingent liabilities. Report on line 29,
column (d), amounts related to liabilities
for reserves and contingent liabilities that
are deductible in the current tax year for

U.S. federal income tax purposes.
Examples of items that must be reported
on line 29 include warranty reserves,
restructuring reserves, reserves for
discontinued operations, and reserves for
acquisitions and dispositions. Only report
on line 29 items that are not required to
be reported elsewhere on Schedule M-3,
Parts II and III. For example, the expense
for a reserve for inventory obsolescence
must be reported on Part II, line 15.
The schedule of details attached to the
return for line 29 must separately state
and adequately disclose the nature and
amount of the expense related to each
reserve and/or contingent liability. The
appropriate level of disclosure depends
upon each taxpayer’s operational activity
and the nature of its accounting records.
For example, if a partnership’s net income
amount reported in the income statement
includes anticipated expenses for a
discontinued operation as a single
amount, and its general ledger or other
books, records, and workpapers provide
details for the anticipated expenses under
more explanatory and defined categories
such as employee termination costs,
lease cancellation costs, loss on sale of
equipment, etc., a supporting schedule
that lists those categories of expenses
and their details will satisfy the
requirement to separately state and
adequately disclose. In order to
separately state and adequately disclose
the employee termination costs, it is not
required that an anticipated termination
cost amount be listed for each employee,
or that each asset (or category of asset)
be listed along with the anticipated loss
on disposition.
Example 18. Partnership Q is a
calendar year taxpayer that was required
to file Schedule M-3 for its 2006 tax year
and is required to file Schedule M-3 for its

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2007 tax year. On July 1 of each year, Q
has a fixed liability for its annual
insurance premiums that provides a
12-month coverage period beginning July
1 through June 30. In addition, Q
historically prepays 12 months of
advertising expense on July 1. On July 1,
2007, Q prepays its insurance premium of
$500,000 and advertising expenses of
$800,000. For financial statement
purposes, Q capitalizes and amortizes the
prepaid insurance and advertising over 12
months. For U.S. federal income tax
purposes, Q deducts the insurance
premium when paid and amortizes the
advertising over the 12-month period. The
differences attributable to the financial
statement treatment and U.S. federal
income tax treatment of the prepaid
insurance and advertising are temporary
differences. Q must separately state and
adequately disclose on Part III, line 29, its
prepaid insurance premium and report
$250,000 in column (a) ($500,000/12
months X 6 months), $250,000 in column
(b), and $500,000 in column (d). Q must
also separately state and adequately
disclose on Part II, line 22, Other items
with no differences, its prepaid advertising
and report $400,000 in column (a) and
(d).

Line 30. Total Expense/
Deduction Items
Report on Part II, line 24, columns (a)
though (d), as applicable, the negative of
the amounts reported on line 30, column
(a) through (d), as applicable. For
example, if line 30, column (a), reflects an
amount of $1 million, then report on Part
II, line 24, column (a), ($1 million).
Similarly, if line 30, column (b), reflects an
amount of ($50,000), then report on Part
II, line 24, column (b), $50,000.