AuthorJack Zuckerman
Hudson Grey Propertie s, L.P. is a general partner-
ship consisting of two par tners, Mr. Hudson and
Mr. Grey. The partnership investe d in an apart-
ment building in 1995 and has operate d it for the
last 19 years.
Dealmaker & Codehead, a law rm operating as
a general part nership, consists of th ree partners,
Mr. Dealmaker, Ms. Codehead, and a new p artner,
Grant A. Herring, P.C.
Persons who share prots and losses from un in-
corporated busi nesses are required to rep ort their
income on a part nership tax retu rn, IRS Form
1065. The partnership itself is not subje ct to income
taxes. Rather the inc ome of the partnership ows
through to the indiv idual partners who must report
their share of par tnership income on their indiv id-
ual income ta x return, Schedule E, page 2.
The partnership tax retur n is a combination
income statement, ba lance sheet, and i nforma-
tion report for the partner ship. A reconcil iation
format within the ret urn is use d to denote dif-
ferences betwe en taxable income and nancial
statement income (also known a s Book Income).
As a result, a very thorough n ancial overview
of a business or practi ce is usually available from
the tax retur n itself.
The 2013 Form 1065 contains ve pages plus
as many K-1s as there are partners. Prior to 2013,
Form 1065 contained only four pages. The K-1
Form is titled “Partner’s Share of Income, Cre dits,
Deductions, Etc.” and reects the t axable income
and deductible expens es allocable to each partner.
Income from a trade or busin ess is reported on
the rst page. Pages 2 and 3 con sist of Section B
Form 1065:
U.S. Partnership
Return of Income
in which 20 questions c oncerni ng the attributes
of the partnersh ip are contained. Page 4 requires
reporting a summary of the a mounts shown on
all of the partnership K-1s. Page 4 generally con-
tains additional income or expense items that do
not appear on page 1 because tax law requir es
special tr eatment for those items. Page 5 contains
comparative balance she ets for the current and
prior year-ends. Also reported on page 5 are the
reconcil iation of taxable income to book income,
and the analysis of partners’ capital accounts.
The capital acc ount analysis reconc iles the prior
year-end partners’ capital balance s with the cur-
rent year-end balances.
Additional supporting schedules are required
to report other par tnership activ ity. Examples of
such schedules a re Form 1125-A, used to repor t
cost of goods sold, Form 8825, where real estate
rental activity is r eported, and Form 4562, the
depreciation deta il summary. Examples of sup-
porting part nership tax forms a re presented in
the hypothetical t ax returns included at the end
of this section.
Page 1—U.S. Partnershi p Return of Income
Generally a par tnership of individuals report s on
a calendar year ba sis because, a s a rule, it must
conform to the tax yea r of the majority of its part-
ners unles s the partnership can establi sh a business
purpose for adopting another s cal year. Certain
partnersh ips may elect a scal year-end other than
a December 31 becaus e the alternative year-end
coincides with t he partnersh ip’s business cycle.
Form 8716 is used to elect a scal year other tha n
the required t ax year.
Greater complexity in the preparation of
income available for child support and spousal
support (which the IRS and many states c all “ali-
mony”) is more likely to exist where substantial
income, loss, or cash ow is der ived from activi-
ties of a partner ship that reports on a s cal year
other than Dece mber 31. The complexity arises
because income from a partner ship is reecte d
on the personal inc ome tax retur n based on the
results of operation for the par tnership’s scal
year-end. To illustrate, a partnersh ip with a
November 30, 2014, year-end reects income for
eleven months of 2014 and one month of 2013.
When that income i s reported on the p ersonal
income tax return for 2013, the taxable income
shown on the personal inc ome tax retur n will
not only report income ea rned in 2013 but also
contain 2014 earnings. Similarly, partnership
distributions for 2013 cannot be obtained with
reference to the 2013 partnership tax return w ith
a November 30 scal year-end bec ause some or
all of the withdrawals i ndicated on the par tner’s
K-1 may have substantially or entirely oc curred
in 2014. Careful analysis of underlying nan cial
information is nec essary i n order to avoid mis-
stating income for a spe cic period. An error
resulting from overlooking the ti ming problems
associated w ith non-calenda r scal years will dis-
tort perceived e arnings a nd cash ow.
B: Example s of how these boxes
for Principal Business Activity and Pr incipal
Product or Servi ce are completed app ear in the
tax retur ns at the end of this se ction. For exam-
ple, the hypothetical t ax return of De almaker
& Codehead indic ates their principal busine ss
activity is “Legal” and t hat they are a “Serv ices”
part ners hip.
C: Business code numbers are used by the
government to compile stati stical economic infor-
mation. A listing of such code s can be acc essed
through the IRS website conta ining the instruc-
tions for Form 1065 at (www .IRS .gov . /instr uctions
/i1065 /ar 03).
LINE D: A par tnership obtains an Employer ID
Number by ling Form SS- 4. The ID number is
reected on al l payroll tax forms the partnership
is required to  le.
F: Total Assets shown h ere should be exactly
the same as the total a ssets on page 5, Schedule
L, line 14. A quick idea of the size of the busi ness
can be gleaned from this number.
LINE G : The Initial Return and Final Retu rn
boxes alert the reader to important basic i nfor-
mation. If the business or pr actice was sta rted or
termin ated in 2013, the net prot or loss shown
may not be indicative of the tru e income potential
of the business be cause only the re sults for a par-
tial year are reec ted. Furthermore, the expense s
for the business may be greater than wil l be expe-
rienced i n future years be cause of start-up costs
generally asso ciated with the  rst year of oper-
ations. Other considerations apply if a bu siness
was termi nated during the year. Inquiry should
be made whether the busi ness has continue d to
operate as a dif ferent legal entity or whether it has
ceased op erations. If the busine ss was incor po-
rated during th e year, the partial i ncome and cash
ow for the partnership’s nal year must be added
to the partial c orporate incom e and cash ow to
arrive at represe ntative earnings. A s mentioned
throughout this book, representative, or “true”
earnings, is a critical factor in appraising busi-
nesses and providi ng meaningful income ana lyses.
H: The two most common accounting meth-
ods are the “cash basis” and “ac crual basis.” Both
of the hypothetical par tnership ta x returns pre -
sented at the end of the se ction use the cash basis.
When a partnership is on a cash basi s, revenue
is reported i n the year in which it is a ctually or
constructively re ceived in the form of cash. Deduc-
tions are taken only for expens es actual ly paid
during the year. In contrast, a ccrual basis part ner-
ships report revenue when it is ea rned (when the
right to receive it oc curs). T hus, if a customer was
billed for an item shipp ed on Dece mber 31, 2013,
but the customer did not pay for the item until Feb-
ruary 1, 2014, the business reporting on a n accrual
basis would still re cord the income i n 2013 even
though the merchandise was paid for in the sub-
sequent year. On the accr ual basis, exp enses may
be deducted when i ncurred, whether or not the
expense is paid i n that tax year.
If the accounting method changes from cash to
accrual or vice versa between two tax years, adjust-
ments to taxable income resulting from the change
should have no effect on income available for sup-
port. The accounting transition is merely a change
in form that does not change the underlying eco-
nomic reality.
Partnerships whos e business activity includes
the sale of inventory must use t he accru al basis
of accounting un less their average an nual gross
receipts do not exceed $1 mil lion or not more than
$10 million for Qualifying Smal l Business Taxpay-
ers as dened i n IRS Publication 538 and Revenue
Procedure 2002-28. Service part nerships, such as
professional practic es, generally are on a cash
basis. A cash basis p artnership generally does not
report accou nts receivable on its Sche dule L. As a
result, for purpose s of business appra isal, forensic
accountants must obtai n this in formation from
the partnersh ip’s accounting records. Disc overy
of the net realiz able value of accounts rec eivable
is important for valuation pur poses as it is ofte n
one of the largest asset s of the business or practice.
Accounts receivable pre sent an interesting prob-
lem when cash basis partnerships are valued in
family law matters if the spouse charged w ith
the receivables wi ll also be required to pay child
or spousal support bas ed on cash basis i ncome
derived from the collection of some or all of the
accounts rec eivable that existed at the date the
business or prac tice was appraised. The perc eived
“double dip” may appear particularly ine quitable
in property div isions where one party is receivi ng
the partnersh ip interest and paying support while
assets of equal st ated value are apportioned to the
other spouse. Nevertheles s, California law sup -
ports the proposition that it is prope r to include
earnings a s income available for support even if
some of those same rec eivables the spouse received
in the property d ivision will be used to pay support.
The “double-dip” effect, while app earing inequi-
table, can be bett er understood in terms of ac crual
basis accounti ng. On an accr ual basis, the paying
spouse is actua lly providing support from current
accrua l basis earn ings. This can be illustrate d by
a hypothetical in wh ich it is assumed t hat the
business or pract ice is terminated at date of sepa-
ration and the partner/spouse  nds a job as an

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