Understanding Your Law Firm K-1 Institute of Continuing Legal Education in Georgia September 2010 Copyright 2010 Kelley Boshell Toole & Ellison, LLP. All Rights Reserved
Overview Firm accounts for operations annually Annual results are converted to tax basis Ownership interests are tracked through maintenance of capital accounts
Firm Accounts For Operations Annually Revenue recognized when time charged to client. When bill sent billing adjustment made (writeup or write-down). When bill paid receivable adjustment made (bad debt). Expense recognized when vendor bill received. This is accrual accounting.
Annual Results Are Converted To Tax Basis Revenue recognized when client pays. Expense recognized when payments made. Cash accounting is used by legal profession because receivables exceed payables in high margin businesses, meaning book income should always exceed taxed income on cumulative basis.
Ownership Interests Tracked Through Maintenance of Capital Accounts Each partner has own cash (tax) basis capital account. Capital accounts adjust upward for partner s share of firm income. Capital accounts adjust downward for disbursements made to partner or to others on partner s behalf.
Form 1065 Schedule K-1
Section L Overview Beginning and Ending capital simple math. Capital contributed during the year is partner s annual cash investment. C/Y increase is partner s allocation of tax basis income. W/D & distributions is sum of disbursements made to the partner and to others on the partner s behalf (draw account).
C/Y Increase Current year increase is the partner s share of tax basis income in normal years. Calculation can be as simple as partnership income multiplied by partner s share (points). Different profit centers are sometimes split based on differing shares. Allocation of partnership s profits is only limited by one s imagination. Agreed draws with residual income split on points Bonus pool (formula or discretionary) Commission off the top
Key to Understanding C/Y Increase: You should be able to calculate this figure from data presented in Part III of your K-1.
Dummied-up BB&B K-1 Page 1
Dummied-up BB&B K-1 Page 2
IRC 702(a) Separate Statement Requirement Prohibits one bottom-line number for each partner. Separate disclosure of items which could result in different tax liabilities for different partners. Example: State income tax paid by disrespected partnership.
BB&B K-1, Part III Items flowing to C/Y increase Box 1 Ordinary business income (loss) Box 5 Interest Income Box 10 Net Section 1231 gain (loss) Box 13 Other deductions Box 18 Tax-exempt income and nondeductible expenses
Box 1 Ordinary business income (loss)
Box 5 Interest income
Box 10 Net section 1231 gain (loss)
Box 13 Other deductions
Box 18 Tax-exempt income and nondeductible expenses Not deducted due to public policy logic.
BB&B K-1, Part III Items not flowing to C/Y increase. Box 14 Self-employment earnings (loss) Box 15 Credits Box 17 Alternative minimum tax (AMT) items Box 20A Other Information
Box 14 Self-employment earnings (loss)
Box 15 Credits
Box 17 Alternative minimum tax (AMT) items
Box 20A Other information
Part III Items of Interest Box 20A is Box 5. Items not in C/Y increase originate from items in C/Y increase.
Partner Expense Not on K-1: Big Secret Expenses you pay in furtherance of firm business are deductible on Form 1040, Schedule E without Employee Business Expense limit if not reimbursable by firm.
Form 1040 Schedule A
Authority For Position None found I have done for years, including examined returns. BNA 519 2 nd states without citation. Prep software has SBE linking to K-1 s and flowing to Form 1040, Schedule E. Self-employment tax ramifications.
Statement SBE (In lieu of Form 2106, Employee Business Expenses )
Withdrawals & Distributions An individual accounting of funds disbursed to you or to others on your behalf.
Dummied-up BB&B Draw Account Analysis
Tax Items Embedded in Withdrawals & Distributions Retirement plan contribution Composite tax payments SE health insurance
Retirement plan contribution (K-1 Box 13 Code W)
Composite tax payments (Georgia credit based on year taxed, Federal deduction based on year paid)
SE health insurance (K-1 Box 13 Code W)
Draw account analysis is a practical guide to minimizing penalties for underpaying estimated income taxes.
Technical Method Firm determines actual tax basis income for four periods. Allocate each partner a share of period income.
Practical Application Few firms make this calculation, so partner draw account is used to approximate flow of firm taxable income through year. Imperfect if cash is horded or if borrowings are incurred to pay draws. Never had issue raised on IRS audit.
Partners Share of Liabilities This figure is added to ending capital account for partner s tax investment in partnership. Very important in negative capital account situations.