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 – 2nd 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.