If you operate a multi-member US LLC taxed as a partnership, understanding Form 1065 Schedule M-2 is critical in 2026. The IRS continues to focus heavily on partner capital accounts, and incorrect reporting can trigger notices, delays, or audits.
For foreign-owned and domestic partnerships alike, Schedule M-2 plays a key role in explaining changes in partners’ capital during the year.
Let’s break it down clearly.
What Is Form 1065 Schedule M-2?
Form 1065 is the U.S. Return of Partnership Income.
Schedule M-2 is attached to Form 1065 and reconciles:
- Beginning capital accounts
- Net income (or loss)
- Contributions
- Distributions
- Other adjustments
- Ending capital accounts
In simple terms, Schedule M-2 explains how partner equity changed during the year.
Why Schedule M-2 Matters More in 2026
The IRS now requires partnerships to report capital accounts using the tax basis method (not GAAP or Section 704(b) methods).
That means:
- Capital must reflect tax-adjusted basis
- Book-to-tax differences must be tracked properly
- Distributions cannot reduce capital below tax basis incorrectly
- Loss allocations must follow basis and at-risk rules
For foreign partners, errors in capital reporting can also affect:
- Withholding under Section 1446
- Form 8805 allocations
- ECI (Effectively Connected Income) calculations
Structure of Schedule M-2 (Line-by-Line Overview)
Here’s how Schedule M-2 works:
1️⃣ Beginning Capital
Carries forward from prior year’s ending balance.
2️⃣ Capital Contributed During Year
Includes:
- Cash contributions
- Property contributions (at tax basis)
3️⃣ Net Income (Loss)
Pulled from:
-
Page 1, Line 22 of Form 1065
4️⃣ Other Increases
Examples:
- Tax-exempt income
- Certain adjustments
5️⃣ Distributions
Cash or property distributions reduce capital.
6️⃣ Other Decreases
Examples:
-
Nondeductible expenses
-
Adjustments reducing tax basis
7️⃣ Ending Capital
This must tie to:
-
Schedule K-1, Item L (for each partner)
Common Errors We See in US LLCs
Many partnerships—especially foreign-owned US LLCs—make these mistakes:
- Reporting capital using book method instead of tax basis
- Forgetting to include nondeductible expenses
- Mismatch between Schedule M-2 and K-1 capital accounts
- Not adjusting capital after amended returns
- Incorrect partner allocation percentages
These errors often trigger IRS CP notices.
Special Note for Foreign-Owned Partnerships
If your Wyoming or Delaware LLC has foreign partners:
- Capital reporting must align with withholding calculations
- Section 1446 tax payments impact partner equity
- Currency translation adjustments must be handled properly
- Incorrect capital can impact treaty position claims
For partnerships with two foreign partners (like many structures formed in 2024–2025), Schedule M-2 is closely reviewed when losses are allocated.
Example: Simple Capital Movement
Opening Capital (2 Partners) → $50,000
- Additional Contribution → $20,000
- Net Income → $30,000
– Distributions → ($40,000)
Ending Capital → $60,000
This total must reconcile across:
- Schedule M-2
- All partner K-1s
- Balance sheet (Schedule L)
If it doesn’t, the return is technically inconsistent.
Why Proper Capital Tracking Protects You
Correct Schedule M-2 reporting:
- Prevents IRS mismatch notices
- Ensures proper loss utilization
- Supports basis calculations
- Avoids partner-level audit risk
- Maintains compliance for foreign investors
For 2026 filings, capital accuracy is not optional—it is a compliance requirement.
Read more: Real Estate Professional Status: The Ultimate Tax Advantage in 2026
Final Thoughts
Form 1065 Schedule M-2 is not just a reconciliation schedule—it is the backbone of partnership capital reporting.
If your US LLC:
- Has multiple members
- Includes foreign partners
- Distributes profits regularly
- Reports losses
- Filed late or amended returns
You must ensure capital accounts are fully reconciled under tax basis rules.
Inaccurate capital reporting today can become an expensive IRS issue tomorrow.
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