Partnerships

• Author: Jack Zuckerman
• Pages: 25-57

¾FACT PATTERN FOR REAL

ESTAT E PARTNERS HIP

Hudson Grey Propertie s, L.P. is a general partner-

ship consisting of two partners, Mr. Hudson and

Mr. Grey. The partnership invested in an apart-

ment building in 1995 and has operated it for the

last 19 years.

¾FACT PATTERN FOR A

PROFESSIONAL PR ACTICE

PA RT N E R S H I P

Dealmaker & Codehead, a law rm operating as

a general partnership, consists of three partners,

Mr. Dealmaker, Ms. Codehead, and a new p artner,

Grant A. Herring, P.C.

¾OVERVIEW OF PARTNERSHIP

TAXATION

Persons who share prots and losses from unin-

corporated busi nesses are required to rep ort their

income on a partnership tax return, 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 tax return, Schedule E, page 2.

The partnership tax return is a combination

income statement, balance sheet, and informa-

tion report for the partnership. A reconciliation

format within the return is used to denote dif-

ferences between taxable income and nancial

statement income (also known as Book Income).

As a result, a very thorough nancial overview

of a business or practice is usually available from

the tax return 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 consist of Section B

25

PART TWO:

PARTNERSHIPS

Form 1065:

U.S. Partnership

Return of Income

in which 20 questions concerning the attributes

of the partnership are contained. Page 4 requires

reporting a summary of the amounts 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 requires

special tr eatment for those items. Page 5 contains

comparative balance sheets for the current and

prior year-ends. Also reported on page 5 are the

reconciliation of taxable income to book income,

and the analysis of partners’ capital accounts.

The capital account analysis reconciles the prior

year-end partners’ capital balances with the cur-

rent year-end balances.

Additional supporting schedules are required

to report other partnership activity. Examples of

such schedules are Form 1125-A, used to report

cost of goods sold, Form 8825, where real estate

rental activity is reported, and Form 4562, the

depreciation detail summary. Examples of sup-

porting partnership tax forms are presented in

the hypothetical tax returns included at the end

of this section.

Page 1—U.S. Partnership Return of Income

Generally a par tnership of individuals report s on

a calendar year basis because, as 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 because the alternative year-end

coincides with the partnership’s business cycle.

Form 8716 is used to elect a scal year other than

the required tax year.

Greater complexity in the preparation of

income available for child support and spousal

support (which the IRS and many states call “ali-

mony”) is more likely to exist where substantial

income, loss, or cash ow is derived from activi-

ties of a partnership that reports on a scal year

other than December 31. The complexity arises

because income from a partnership is reected

on the personal income tax return based on the

results of operation for the partnership’s scal

year-end. To illustrate, a partnership with a

November 30, 2014, year-end reects income for

eleven months of 2014 and one month of 2013.

When that income is reported on the personal

income tax return for 2013, the taxable income

shown on the personal income tax return will

not only report income earned in 2013 but also

contain 2014 earnings. Similarly, partnership

distributions for 2013 cannot be obtained with

reference to the 2013 partnership tax return with

a November 30 scal year-end because some or

all of the withdrawals indicated on the par tner’s

K-1 may have substantially or entirely occurred

in 2014. Careful analysis of underlying nancial

information is necessary in order to avoid mis-

stating income for a specic period. An error

resulting from overlooking the timing problems

associated w ith non-calenda r scal years will dis-

tort perceived earnings and cash ow.

L

INES

A

AND

B:Examples of how these boxes

for Principal Business Activity and Principal

Product or Service are completed appear in the

tax returns at the end of this section. For exam-

ple, the hypothetical tax return of Dealmaker

& Codehead indicates their principal business

activity is “Legal” and that they are a “Services”

partnership.

L

INE

C:Business code numbers are used by the

government to compile stati stical economic infor-

mation. A listing of such codes can be accessed

through the IRS website containing the instruc-

tions for Form 1065 at (www .IRS .gov. /instr uctions

/i1065 /ar03).

LINE D:A partnership obtains an Employer ID

Number by ling Form SS-4. The ID number is

reected on all payroll tax forms the partnership

is required to le.

L

INE

F:Total Assets shown h ere should be exactly

the same as the total assets on page 5, Schedule

L, line 14.A quick idea of the size of the busi ness

can be gleaned from this number.

 26 / THE BUSINESS TAX RETURN HA NDBOOK, FOURTH EDITION

LINE G:The Initial Return and Final Return

boxes alert the reader to important basic infor-

mation. If the business or practice was started or

terminated in 2013, the net prot or loss shown

may not be indicative of the tru e income potential

of the business because only the results for a par-

tial year are reec ted. Furthermore, the expense s

for the business may be greater than will be expe-

rienced in future years because of start-up costs

generally associated with the rst year of oper-

ations. Other considerations apply if a business

was terminated during the year. Inquiry should

be made whether the business has continued to

operate as a dif ferent legal entity or whether it has

ceased operations. If the business was incorpo-

rated during th e year, the partial i ncome and cash

ow for the partnership’s nal year must be added

to the partial corporate income and cash ow to

arrive at representative earnings. As mentioned

throughout this book, representative, or “true”

earnings, is a critical factor in appraising busi-

nesses and providi ng meaningful income ana lyses.

L

INE

H:The two most common accounting meth-

ods are the “cash basis” and “ac crual basis.” Both

of the hypothetical partnership tax returns pre-

sented at the end of the se ction use the cash basis.

When a partnership is on a cash basis, revenue

is reported in the year in which it is actually or

constructively re ceived in the form of cash. Deduc-

tions are taken only for expenses actually paid

during the year. In contrast, a ccrual basis part ner-

ships report revenue when it is earned (when the

right to receive it oc curs). T hus, if a customer was

billed for an item shipped on December 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 record the income in 2013 even

though the merchandise was paid for in the sub-

sequent year. On the accrual basis, expenses may

be deducted when incurred, whether or not the

expense is paid in 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 whose business activity includes

the sale of inventory must use the accrual basis

of accounting unless their average annual 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 partnerships, such as

professional practices, 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 obtain this information from

the partnership’s accounting records. Discovery

of the net realizable value of accounts receivable

is important for valuation purposes as it is often

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 with

the receivables will also be required to pay child

or spousal support based on cash basis income

derived from the collection of some or all of the

accounts receivable that existed at the date the

business or prac tice was appraised. The perc eived

“double dip” may appear particularly inequitable

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. Nevertheless, California law sup-

ports the proposition that it is proper to include

earnings as 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

accrual basis earn ings. This can be illustrate d by

a hypothetical in which it is assumed that the

business or practice is terminated at date of sepa-

ration and the partner/spouse nds a job as an

PART TWO: PARTNER SHIPS / 27