This article is continuation of my June 2017 article “Best Practices for Reading Personal Tax Returns.” As with personal tax returns, business tax returns can be challenging for an attorney to understand and navigate in the context of family court litigation. Thus, the goal of this Practice Point is to provide you with an overview of the following business tax returns, so that you can (a) understand the forms; (b) identify pertinent financial information; and (c) enable you to ask targeted questions and prepare a proper, detailed information request: Form 1120S, Form 1065, and Form 1120.
Initial Request
Similar to the personal tax returns, in order to develop an understanding of the business’ reported income and trends, generally three to five years of the income tax returns should be obtained.
Overview. Businesses and professional practices are formed under various legal entities including S corporation, partnership, liability partnership, limited liability corporation, and C corporation. Important information can be gleaned from the reporting entity’s tax returns, including the following:
- Name of business or practice
- Business address
- Employer ID number
- Date of incorporation/formation
- Industry or practice area
- Compensation of officers
- Revenues, expenses, and profit
- Assets and Liabilities
Form 1120S—S Corporation Tax Return (“Pass-Through Entity”)
S corporations do not incur federal income taxes; rather the profit reported on the S corporation tax return is passed through to the shareholders, based on their ownership percentages, and reported on their individual income tax returns within Schedule E of Form 1040. As an example, if an individual has a 50 percent ownership in an S corporation and the S corporation has $100,000 profit, the individual would report $50,000 of income received from S corporation on Schedule E within their personal income tax return.
Page 1. The top of page one of Form 1120S presents the following: name and address of business; employer ID number; date of incorporation; and date of S corporation election (which may be different). The dates of incorporation should be considered when deciding what valuation date may be required. Also reported at the top of page 1 is the business code (formerly SIC code). Line items that should be looked at in the first instance:
- Line 1, which reports the gross receipts of the business.
- Line 7, which reports the total compensation paid to officer(s).
- Line 17, which reports whether there are any pension or profit-sharing plans.
- Line 20, which reports “other expenses.” If there is an amount here, make sure there is a corresponding schedule or statement in the back of the return that details what these “other expenses” comprise.
- Line 21, which reports the profit or (loss) of the business.
Page 2. The top of Schedule B on page 2 of Form 1120S reports the business activity and product/service, as well the accounting method (i.e., cash versus accrual). The method of accounting is important to know, and you should discuss how it affects income and net assets with the accountant or financial expert you are working with.
Page 3. Schedule K reports shareholders’ aggregate share of income, deductions, credits, and so on (and mirrors the individual shareholder’s Form K-1, which is discussed below).
Page 4. Schedule L of Form 1120S reports the business’ balance sheet (at the beginning and end of the year), often with supporting statements presented in the back of the tax return showing further breakout of balances, such as current assets, current liabilities, and other liabilities. Notable line items of the balance sheet include the following:
- Line 2, which reports accounts receivable if the business reports its income under the accrual method of accounting. If the business reports its income under the cash basis of accounting, it is important to ask if there are amounts due to the business from its customers. If yes, request a detailed accounts receivable report.
- Line 6, which reports other assets. If there is not a detailed statement in the back of the tax return, request one to identify what these “other assets” consist of.
- Line 7, which reports loans to shareholders that are a receivable of the business.
- Line 10, which reports the property, equipment and other assets (i.e., intangible assets such as goodwill) the business acquired—at their original cost. Request a fixed asset detail listing to determine if appraisals are needed.
- Line 19, which reports loans from the shareholders that are payable to them by the business.
- Line 24, which reports the retained earnings in an S corporation that can be distributed tax free (as taxes have already been paid on these monies by the shareholders in prior years).
- Line 26, which reports treasury stock that represents redemptions of company stock and may provide a reliable indication of value.
Page 5. Schedule M-1 is a reconciliation of income and/or loss per books to the income and/or loss per the tax return. This schedule shows the items that explain the difference between “book” income and Schedule K tax income (i.e., differences in tax and non-tax reporting, such as portion of non-deductible travel and entertainment expense).
Schedule M-2 reports the beginning and end-year “equity” and any distributions to the shareholders in cash or property. Make sure you compare schedule M-1 with Form K and K-1 to ensure they report the same distributions. Distributions to shareholders should be based on their ownership percentages and can be important to the tracing of monies during a marital dissolution.
Form K-1
Form K-1 reports the individual shareholder’s share of income and/or loss, as well as various “flow-through” items of income and expense. Unlike the Form K-1 for partnerships (Form 1065 discussed below), the S corporation K-1 does not present capital balances at the beginning and end of each year. Look at Box F of the Form K-1 and notice if the percentage of ownership has changed compared to previous years. If it has, request all agreements regarding change of ownership. Box 16 of the Form K-1 reports distributions to the shareholder.
Form 1065—Partnership Tax Return (“Pass-Through Entity”)
Form 1065 is used for a general partnership, limited partnership, limited liability corporation, and limited liability partnership. Similar to the S corporation, partnership tax returns represents tax reporting for a “pass-through entity.”
Page 1. The top of page 1 presents the name, business address, employer ID number, the date the partnership started, and business activity and code.
Page 1 also sets forth whether the partnership reports its income under the cash or accrual method of accounting (most often cash basis, for professional practices). Line items that should be looked at in the first instance are as follows:
- Line 1, which reports the gross receipts received from customers.
- Line 10, which reports guaranteed payments to partners. A partnership does not pay wages to its partners; rather they may have “guaranteed payments.”
- Line 20, which reports “other deductions” and should be supported by a detailed statement in the back of the tax returns. These “other expenses” present a good starting point for identifying non-essential expenses or perks.
- Line 22, which reports the income and/or (loss) of the partnership.
Pages 2 and 3: Schedule B reports whether or not there are other partners who are partnerships (i.e., foreign business partners).
Page 4: Schedule K reports the partners’ aggregate of income, deductions, credits, etc. (and mirrors individual Form K-1’s for each partner).
Page 5: Schedule L of the Form 1065 presents the balance sheet. Similar to the Form 1120S, notable line items for the partnership balance sheet are as follows:
- Line 2, which reports accounts receivable if the partnership reports its income under the accrual method of accounting. If the partnership reports its income under the cash basis of accounting, it is important to ask if there are amounts due to the partnership from its customers. If yes, request a detailed accounts receivable report.
- Line 6, which reports other assets. If there is not a detailed statement in the back of the tax return, request one to identify what these “other assets” consist of.
- Line 9, which reports the fixed assets at their cost. Request a detailed fixed asset list and determine if appraisals are needed.
- Line 21, which reports the partners’ capital balances based on the method of accounting utilized, (i.e., accrual vs. cash).
Form K-1: Unlike the individual Form K-1 of the S Corporation, the partnership Form K-1 presents beginning and end-of-year capital balances, as well as capital contributions and withdrawals (See Line J on the left hand side of each Form K-1).
- Box L presents the beginning and ending capital account balance.
- Box 19 reports any distributions.
Form 1120—C Corporation Tax Return
C corporations are taxed on the income they report. Dividends paid to stockholders are not deductible by the corporation and are reported as income to the stockholder when received. This is what is meant by “double taxation”—the corporation pays taxes on the income, and when the income is paid to the stockholder as a dividend, the stock holder pays taxes on the dividend.
Page 1. As with the other types of business tax returns the top of page one presents: business name, address, and date incorporated. The income and expense line items (lines 1a through 30) are self-explanatory. Line 31 reports the amount of total tax the corporation is responsible for; Line 32 reports total tax payments made throughout the year; and Line 34 reports the total tax due. If there was an overpayment of estimated taxes, Line 35 reports the amount of the overpayment.
Page 3. At the bottom of page 3, within Schedule K, the type of accounting method (cash or accrual), business code, and business activity are listed.
Page 5. On this page, the balance sheet for the corporation is reported within Schedule L. See the discussion on the balance sheet for S corporations and partnerships above.
Schedule 1125-E
This schedule is unique to the corporation tax return and reports the officer’s names, social security numbers, percentage of stock owned (if any), and their individual compensation.
In summary, the business tax returns contain useful financial information if you know how to read them. This Practice Point was written to take you through a high level guided tour of the information reported to the IRS and how you can use that information in your discovery process.
David L. Gresen is a member of Klein Liebman & Gresen, LLC, in Syosset, New York.