When preparing your business tax return—especially Form 1065 (for partnerships) or Form 1120 (for corporations)—you’ll encounter Schedule L, the balance sheet section. A common question among business owners, accountants, and students is: Does Schedule L need to be on a tax basis?
The Short Answer to Does Schedule L Need to Be on Tax Basis?
Yes—Schedule L should generally be prepared on a tax basis to align with the rest of the tax return. However, there are exceptions, and consistency is key.
What Is “Tax Basis” Accounting?
Tax basis accounting refers to financial reporting that follows IRS tax rules rather than generally accepted accounting principles (GAAP). Under the tax basis:
- Only deductible expenses are recorded
- Capitalized assets are depreciated using IRS-approved methods
- Revenue recognition follows IRS timing rules (which may differ from GAAP or accrual-based books)
This basis is what the IRS uses to determine your business’s taxable income.
How Schedule L Should Be Prepared
The IRS expects the figures reported on Schedule L to be consistent with the rest of the return, especially when reconciling with Schedules M-1 and M-2. If your business keeps financial statements on a tax basis, Schedule L should reflect that.
However, if you maintain GAAP or book-basis financials, and you use those numbers to complete Schedule L, you must:
- Indicate this choice clearly
- Ensure that Schedule M-1 properly reconciles book income to taxable income
- Make any necessary adjustments to show how the balance sheet connects to reported taxable results
Why It Matters
Inconsistency between Schedule L and the rest of your return can raise red flags with the IRS. For example, if Schedule L shows retained earnings that don’t align with reported net income or distributions, it may prompt questions or even an audit.
Final Thoughts
While Schedule L does not always have to be on a strict tax basis, it must match the method used in the return overall. The key is consistency, transparency, and accurate reconciliation. If in doubt, reach out to us. Our dedicated team at Dimov Tax is ready to present professional support in terms of Schedule L.