Business Income Tax Returns Questions and Answers
In the Question and Answer segment of Webcast on Business Income Tax Returns on March 26th, we responded to the questions submitted. However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.
Q: What is the difference between guaranteed payments to partners and distributions?
A: Guaranteed payments are treated like salary and reduce reported income for a partnership by the amount of the guaranteed payment. The partner receiving a guaranteed payment must declare the amount as taxable income on his or her personal income tax returns. Distributions are not tax-deductible expenses and do not reduce reported profit. Further, a partner receiving a distribution does not report that amount as taxable income on his or her personal income tax returns.
Q: What would be a common reason for significant differences in taxable receipts and accrual revenue?
A: Contractors customarily use the percentage of completion method of accounting. As such they will record amounts on the asset side of the balance sheet that represents costs in excess of billings to clients. On the liability side of the balance sheet, they will record amounts that represent billings in excess of costs and profit. The costs in excess of billings are not recognized as accrual expenses but, rather, are recorded on the balance sheet. By the same token, billings in excess of costs and profit are not recognized as accrual income but, again, are recorded on the balance sheet.
The rules change for income tax purposes. The same contractor may consider costs in excess of billings as a tax deductible expense. The same contractor, however, must report billings in excess of costs and profit as taxable revenue. Consequently, the difference in accrual and income tax revenue and expense amounts can frequently be quite significant.
Q: Where did the $112,115 come from?
A: The $112,115 is the ordinary income for Information Access, Inc. reported on the first page of Form 1120S. That amount does not include additional income earned by the company, such as interest income. Further, it will not include certain deductions that are separated from the expense stream and may be claimed by the owner as a tax deduction on his or her personal income tax return.
Q: Are the distributions of $581,746 only applicable to Subchapter S corporations?
A: Distributions are facts of life for Subchapter S corporations, partnerships, limited liability companies (LLCs), and sole proprietorships. For sole proprietorships it’s customary to refer to distributions as withdrawals. Both are identical in purpose and intent. And neither distributions nor withdrawals are classified as expenses and, therefore, do not reduce reported company profit. In addition, neither distributions nor withdrawals are reported by the recipients as taxable income on their personal income tax returns.
Q: Is there any specific benefit/detrimental affect to accelerating depreciation?
A: Accelerated depreciation drives down taxable profit, so long as the assets in question are not fully depreciated. Once they are fully depreciated, then no further amount of depreciation may be claimed as an expense to reduce taxable profit.
So long as a company continues to add depreciable assets at a fairly healthy rate, it can offset some of the acquisition cost by reducing its tax burden via accelerated depreciation. But it must maintain its asset acquisition appetite in order to reap the benefits from accelerated depreciation. It can be an interesting surprise to a company if and when it exhausts its depreciable assets and has no further depreciation expense at its disposal to drive down taxable profit.
Q: So, for 2008 Schedules K-1 it will be at the accountants' discretion whether or not they include owners' distributions?
A: Yes. Actually, I think the change in the format goes back to at least 2006. But it is at the discretion of the accountant. In most instances, the accountant will list the amount of an item that affects base. As a precaution, always check Schedule K, which should invariably report the full amount of distributions for the year. Using information about an individual’s percent of ownership from Schedule K-1, you can then work out the likely distribution to the individual (assuming more than one owner) in the absence of specific information on Schedule K-1. And, at a minimum, it might be helpful to ask the accountant specifically about the existence and size of a distribution.
Q: Recently heard of a limited liability limited partnership (LLLP). Any special tax consequences to that type of entity?
A: A tax accountant would be the best source of information about an issue such as this. However, any type of business organization that uses the term “limited” usually refers, at least in the first instance, to protection against responsibility for satisfying the organization’s debt obligations. “Limited liability” and “limited partnership” together may apply to the conditions that determine ownership, e.g., minimum dollar investment, minimum number of owners, and so on, which also protects the limited partner from responsibility for partnership debt obligations.
Q: Who pays taxes on the $581M distribution?
A: The $581,746 distribution to Peter Keys is tax-free. No one pays taxes on that amount of cash provided by Information Access, Inc. to Peter Keys. According to the income tax regulations and the associated accounting standards that mirror those regulations, distributions are not an expense for the business, i.e., they do not reduce taxable profit, nor are they taxable income to the recipient, i.e., Peter Keys does not report $581,746 of cash inflow to him on his personal income tax returns.
Q: What is the difference between the $581K distribution in the K-1 schedule and the $37.7K listed in schedule M-2?
A: In this instance, there is no relationship. The amount at Line 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796. The accountant failed to enter the beginning balance, so we have no way of knowing the final balance. However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute.
The $581,746 distribution reported on Schedule K-1 is a different issue. It is the amount of cash actually distributed by the company to Peter Keys in 2001, regardless of the amount of retained, taxable profit available for distribution. Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, Keys will not be subject to income tax on the distribution, since he has likely guaranteed company debt. By doing so, he increases his equity base, in effect. Therefore, if Keys provides a guarantee for the short-term credit line of $2,000,000, his equity base increases by $2,000,000. So long as distributions do not exceed the sum of his combined business and guaranteed base, they are tax-free to Keys.
Q: How do we determine principals' contributions to the entity on the new Schedule K-1 forms?
A: On the Schedule K-1 (Form 1065) for partnerships, the information about contributions is captured in box L. On the Schedule K-1 (Form 1120S) for Subchapter S corporations, the information is not captured. You’ll need to review Line 25 on Schedule L and any attachment that would provide information about capital contributions by owners.
Q: Could you discuss deferred revenue?
A: Deferred revenue occurs when a company has either invoiced a client for goods and services it has yet to provide or receives cash from a client for goods or services it has yet to provide. For example, if Information Access, Inc. billed a client $100,000 for a software system it will deliver in 60 days, it would post a $100,000 debit to accounts receivable, thereby increasing that asset account by $100,000, and it would post a $100,000 credit entry to deferred revenue, thereby increasing that liability account by $100,000. These entries affect only the balance sheet. The company cannot properly recognize revenue until it ships the product or service. When it does so in 60 days, it will post a $100,000 debit entry to deferred revenue, thereby decreasing the account by $100,000, and it will post a $100,000 credit entry to revenue, thereby recognizing revenue and increasing that account by $100,000. In effect, the company moves $100,000 from the balance sheet to the income statement.
Q: How do you reconcile differences in M-2 distributions to Schedule K and Schedule K-1 distributions?
A: There is no reconciliation. The amount recorded at Line 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796. The accountant failed to enter the beginning balance, so we have no way of knowing the final balance. However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute.
The $581,746 distribution reported on Schedule K-1 is a different issue. It is the amount of cash actually distributed by the company to Peter Keys in 2001, regardless of the amount of retained, taxable profit available for distribution. Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, Keys will not be subject to income tax on the distribution, since he has likely guaranteed company debt. By doing so, he increases his equity base, in effect. Therefore, if Keys provides a guarantee for the short-term credit line of $2,000,000, his equity base increases by $2,000,000. So long as distributions do not exceed the sum of his combined business and guaranteed base, they are tax-free to Keys.
Q: Why are the distributions on Schedule K different from the distributions on Schedule M-2?
A: The amount recorded at Lines 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796. The accountant failed to enter the beginning balance, so we have no way of knowing the final balance. However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute – listed at both Lines 6 and 7.
The $709,446 distribution reported on Schedule K is a different issue. It is the amount of cash actually distributed by the company to the owners, regardless of the amount of retained, taxable profit available for distribution. Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, the owners will not be subject to income tax on the distribution, since they likely guaranteed company debt. By doing so, they increase their equity base, in effect. Therefore, if the two owners provide a guarantee for the short-term credit line of $2,000,000, their equity base increases by $2,000,000. So long as distributions do not exceed the sum of the combined business and guaranteed base, those distributions are tax-free to the owners.
Q: If the customer is taking more in distributions than income earned, where does the difference come from?
A: It all depends on the cash resources available to the company. For example, I
reviewed a rather fascinating credit a couple of years ago in which a borrower lost roughly $800,000. It was a Subchapter S corporation with a single owner. The owner reported the $800,000 loss on Schedule E and again at Line 17 on his Form 1040. It had the effect of driving his adjusted gross income into negative territory – more than offsetting salaries, bonuses, and other sources of taxable income – and eliminating any personal income tax obligation for the year.
However, his Schedule K-1 recorded a $1,000,000 distribution from the company to this single owner – tax free, of course, to the owner. So where did the cash come from? As it turned out, the company maxed out its short-term working capital line, which it did not need to support receivable and inventory as it turned out, and used the proceeds to provide the $1,000,000 distribution to the owner.
So, in the final analysis, excessive distributions always depend on available cash, which can come from many sources. In the above instance, the lender thought it was financing receivables and inventory. In fact, it was financing the owner’s lifestyle.
Q: Has the corporation distributed more than its accumulated profits? If so, is the excess amount taxable to the individual?
A: Not necessarily and usually not at all. Even though distributions exceed the amount of 2001 taxable profit available for distribution, the owners will not be subject to income tax on the distribution, since they likely guaranteed company debt. By doing so, they increase their equity base, in effect. Therefore, if the two owners provide a guarantee for the short-term credit line of $2,000,000, their equity base increases by $2,000,000. So long as distributions do not exceed the sum of the combined business and guaranteed base, those distributions are tax-free to the owners.
Q: What about line 21 on Schedule K-1. They show loan from shareholders of $200,000. However, line 19 on Schedule L shows an increase of 230,000.
A: I think the amount at Line 21 on Schedule K-1 (Form 1120S) for Peter Keys is $160,000. The amounts at Line 19 on Schedule L – $363,164 in 2000 and $131,164 in 2001 – reflect a decrease in loans to shareholders of $232,000. Of that payback amount of $232,000, $160,000 went to Peter Keys in 2001. The remaining $72,000 of debt reduction must have gone to his co-owner.
Q: If an LLC is owned by another LLC, are both required to file a tax return even though the income and expenses are passed through one entity into the other or only the one LLC that is the owner of the other LLC?
A: All LLCs are required to file Form 1065. The LLC at the bottom of the chain files its information-only income tax return – its Form 1065 – indicating the amount of profit its parent LLC must report on the income tax return it files – its own Form 1065. If the parent LLC is owned by two private individuals, for example, each must report their pro-rata share of LLC income on their Form 1040. So, in effect, the LLC at the bottom of the chain passes its taxable profit all the way up the chain to the ultimate taxpayers.
Q: What is the difference between guaranteed payments to partners and distributions?
A: Guaranteed payments are treated like salary and reduce reported income for a partnership by the amount of the guaranteed payment. The partner receiving a guaranteed payment must declare the amount as taxable income on his or her personal income tax returns. Distributions are not tax-deductible expenses and do not reduce reported profit. Further, a partner receiving a distribution does not report that amount as taxable income on his or her personal income tax returns.
Q: What would be a common reason for significant differences in taxable receipts and accrual revenue?
A: Contractors customarily use the percentage of completion method of accounting. As such they will record amounts on the asset side of the balance sheet that represents costs in excess of billings to clients. On the liability side of the balance sheet, they will record amounts that represent billings in excess of costs and profit. The costs in excess of billings are not recognized as accrual expenses but, rather, are recorded on the balance sheet. By the same token, billings in excess of costs and profit are not recognized as accrual income but, again, are recorded on the balance sheet.
The rules change for income tax purposes. The same contractor may consider costs in excess of billings as a tax deductible expense. The same contractor, however, must report billings in excess of costs and profit as taxable revenue. Consequently, the difference in accrual and income tax revenue and expense amounts can frequently be quite significant.
Q: Where did the $112,115 come from?
A: The $112,115 is the ordinary income for Information Access, Inc. reported on the first page of Form 1120S. That amount does not include additional income earned by the company, such as interest income. Further, it will not include certain deductions that are separated from the expense stream and may be claimed by the owner as a tax deduction on his or her personal income tax return.
Q: Are the distributions of $581,746 only applicable to Subchapter S corporations?
A: Distributions are facts of life for Subchapter S corporations, partnerships, limited liability companies (LLCs), and sole proprietorships. For sole proprietorships it’s customary to refer to distributions as withdrawals. Both are identical in purpose and intent. And neither distributions nor withdrawals are classified as expenses and, therefore, do not reduce reported company profit. In addition, neither distributions nor withdrawals are reported by the recipients as taxable income on their personal income tax returns.
Q: Is there any specific benefit/detrimental affect to accelerating depreciation?
A: Accelerated depreciation drives down taxable profit, so long as the assets in question are not fully depreciated. Once they are fully depreciated, then no further amount of depreciation may be claimed as an expense to reduce taxable profit.
So long as a company continues to add depreciable assets at a fairly healthy rate, it can offset some of the acquisition cost by reducing its tax burden via accelerated depreciation. But it must maintain its asset acquisition appetite in order to reap the benefits from accelerated depreciation. It can be an interesting surprise to a company if and when it exhausts its depreciable assets and has no further depreciation expense at its disposal to drive down taxable profit.
Q: So, for 2008 Schedules K-1 it will be at the accountants' discretion whether or not they include owners' distributions?
A: Yes. Actually, I think the change in the format goes back to at least 2006. But it is at the discretion of the accountant. In most instances, the accountant will list the amount of an item that affects base. As a precaution, always check Schedule K, which should invariably report the full amount of distributions for the year. Using information about an individual’s percent of ownership from Schedule K-1, you can then work out the likely distribution to the individual (assuming more than one owner) in the absence of specific information on Schedule K-1. And, at a minimum, it might be helpful to ask the accountant specifically about the existence and size of a distribution.
Q: Recently heard of a limited liability limited partnership (LLLP). Any special tax consequences to that type of entity?
A: A tax accountant would be the best source of information about an issue such as this. However, any type of business organization that uses the term “limited” usually refers, at least in the first instance, to protection against responsibility for satisfying the organization’s debt obligations. “Limited liability” and “limited partnership” together may apply to the conditions that determine ownership, e.g., minimum dollar investment, minimum number of owners, and so on, which also protects the limited partner from responsibility for partnership debt obligations.
Q: Who pays taxes on the $581M distribution?
A: The $581,746 distribution to Peter Keys is tax-free. No one pays taxes on that amount of cash provided by Information Access, Inc. to Peter Keys. According to the income tax regulations and the associated accounting standards that mirror those regulations, distributions are not an expense for the business, i.e., they do not reduce taxable profit, nor are they taxable income to the recipient, i.e., Peter Keys does not report $581,746 of cash inflow to him on his personal income tax returns.
Q: What is the difference between the $581K distribution in the K-1 schedule and the $37.7K listed in schedule M-2?
A: In this instance, there is no relationship. The amount at Line 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796. The accountant failed to enter the beginning balance, so we have no way of knowing the final balance. However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute.
The $581,746 distribution reported on Schedule K-1 is a different issue. It is the amount of cash actually distributed by the company to Peter Keys in 2001, regardless of the amount of retained, taxable profit available for distribution. Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, Keys will not be subject to income tax on the distribution, since he has likely guaranteed company debt. By doing so, he increases his equity base, in effect. Therefore, if Keys provides a guarantee for the short-term credit line of $2,000,000, his equity base increases by $2,000,000. So long as distributions do not exceed the sum of his combined business and guaranteed base, they are tax-free to Keys.
Q: How do we determine principals' contributions to the entity on the new Schedule K-1 forms?
A: On the Schedule K-1 (Form 1065) for partnerships, the information about contributions is captured in box L. On the Schedule K-1 (Form 1120S) for Subchapter S corporations, the information is not captured. You’ll need to review Line 25 on Schedule L and any attachment that would provide information about capital contributions by owners.
Q: Could you discuss deferred revenue?
A: Deferred revenue occurs when a company has either invoiced a client for goods and services it has yet to provide or receives cash from a client for goods or services it has yet to provide. For example, if Information Access, Inc. billed a client $100,000 for a software system it will deliver in 60 days, it would post a $100,000 debit to accounts receivable, thereby increasing that asset account by $100,000, and it would post a $100,000 credit entry to deferred revenue, thereby increasing that liability account by $100,000. These entries affect only the balance sheet. The company cannot properly recognize revenue until it ships the product or service. When it does so in 60 days, it will post a $100,000 debit entry to deferred revenue, thereby decreasing the account by $100,000, and it will post a $100,000 credit entry to revenue, thereby recognizing revenue and increasing that account by $100,000. In effect, the company moves $100,000 from the balance sheet to the income statement.
Q: How do you reconcile differences in M-2 distributions to Schedule K and Schedule K-1 distributions?
A: There is no reconciliation. The amount recorded at Line 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796. The accountant failed to enter the beginning balance, so we have no way of knowing the final balance. However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute.
The $581,746 distribution reported on Schedule K-1 is a different issue. It is the amount of cash actually distributed by the company to Peter Keys in 2001, regardless of the amount of retained, taxable profit available for distribution. Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, Keys will not be subject to income tax on the distribution, since he has likely guaranteed company debt. By doing so, he increases his equity base, in effect. Therefore, if Keys provides a guarantee for the short-term credit line of $2,000,000, his equity base increases by $2,000,000. So long as distributions do not exceed the sum of his combined business and guaranteed base, they are tax-free to Keys.
Q: Why are the distributions on Schedule K different from the distributions on Schedule M-2?
A: The amount recorded at Lines 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796. The accountant failed to enter the beginning balance, so we have no way of knowing the final balance. However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute – listed at both Lines 6 and 7.
The $709,446 distribution reported on Schedule K is a different issue. It is the amount of cash actually distributed by the company to the owners, regardless of the amount of retained, taxable profit available for distribution. Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, the owners will not be subject to income tax on the distribution, since they likely guaranteed company debt. By doing so, they increase their equity base, in effect. Therefore, if the two owners provide a guarantee for the short-term credit line of $2,000,000, their equity base increases by $2,000,000. So long as distributions do not exceed the sum of the combined business and guaranteed base, those distributions are tax-free to the owners.
Q: If the customer is taking more in distributions than income earned, where does the difference come from?
A: It all depends on the cash resources available to the company. For example, I
reviewed a rather fascinating credit a couple of years ago in which a borrower lost roughly $800,000. It was a Subchapter S corporation with a single owner. The owner reported the $800,000 loss on Schedule E and again at Line 17 on his Form 1040. It had the effect of driving his adjusted gross income into negative territory – more than offsetting salaries, bonuses, and other sources of taxable income – and eliminating any personal income tax obligation for the year.
However, his Schedule K-1 recorded a $1,000,000 distribution from the company to this single owner – tax free, of course, to the owner. So where did the cash come from? As it turned out, the company maxed out its short-term working capital line, which it did not need to support receivable and inventory as it turned out, and used the proceeds to provide the $1,000,000 distribution to the owner.
So, in the final analysis, excessive distributions always depend on available cash, which can come from many sources. In the above instance, the lender thought it was financing receivables and inventory. In fact, it was financing the owner’s lifestyle.
Q: Has the corporation distributed more than its accumulated profits? If so, is the excess amount taxable to the individual?
A: Not necessarily and usually not at all. Even though distributions exceed the amount of 2001 taxable profit available for distribution, the owners will not be subject to income tax on the distribution, since they likely guaranteed company debt. By doing so, they increase their equity base, in effect. Therefore, if the two owners provide a guarantee for the short-term credit line of $2,000,000, their equity base increases by $2,000,000. So long as distributions do not exceed the sum of the combined business and guaranteed base, those distributions are tax-free to the owners.
Q: What about line 21 on Schedule K-1. They show loan from shareholders of $200,000. However, line 19 on Schedule L shows an increase of 230,000.
A: I think the amount at Line 21 on Schedule K-1 (Form 1120S) for Peter Keys is $160,000. The amounts at Line 19 on Schedule L – $363,164 in 2000 and $131,164 in 2001 – reflect a decrease in loans to shareholders of $232,000. Of that payback amount of $232,000, $160,000 went to Peter Keys in 2001. The remaining $72,000 of debt reduction must have gone to his co-owner.
Q: If an LLC is owned by another LLC, are both required to file a tax return even though the income and expenses are passed through one entity into the other or only the one LLC that is the owner of the other LLC?
A: All LLCs are required to file Form 1065. The LLC at the bottom of the chain files its information-only income tax return – its Form 1065 – indicating the amount of profit its parent LLC must report on the income tax return it files – its own Form 1065. If the parent LLC is owned by two private individuals, for example, each must report their pro-rata share of LLC income on their Form 1040. So, in effect, the LLC at the bottom of the chain passes its taxable profit all the way up the chain to the ultimate taxpayers.
