Understanding Your
Law Firm K-1
Institute of Continuing Legal Education in Georgia
September 2010
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 (write- up or write-down).
– When bill paid receivable adjustment made (bad debt).
• Expense recognized when vendor bill received.
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
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
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
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)
Key to Understanding
C/Y Increase: You should be
able to calculate this figure
from data presented in Part
Dummied-up
BB&B K-1
Dummied-up
BB&B K-1
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
Box 5
Box 10 Net
section 1231
Box 13 Other
deductions
Box 18 Tax-exempt income and
nondeductible expenses
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 14
Self-employment
earnings (loss)
Box 17
Alternative
minimum tax
Box 20A
Other
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 – 2nd states without citation.
• Prep software has “SBE” linking to K-1’s and flowing to Form 1040, Schedule E.
Statement
SBE
(In lieu of
Form 2106,
“Employee
Business
Expenses”)
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
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
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.
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.
This figure is added to ending capital account for partner’s tax investment in partnership. Very important in negative capital account situations.