Capital account balance and percentage

Hi all, hope everyone, their families, and loved ones are well and continue to remain safe.

Need some comments /advise regarding a 1065 return. I have been presented with a 2018 return for review and i came across this situation. Please note the facts:

Partnership owns a commercial strip for rental income;
There are 6 partners:

1) Partner A, partnership (general partner) with 1% interest in profits, losses, and capital;
2) Partner B, individual - 44.90 % interest in profits and losses; 35% capital;
3) Partner C (spouse of partner B) - 44.20 interest in profits and losses; 34.3 % capital;
4) Partner D (son of partner B & C) - 0% interest in profits and losses; 9.9 % capital;
5) Partner E (son of partner B & C) - 0% interest in profits and losses; 9.9 % capital;
6) Partner F (son of partner B & C) - 9.9% interest in profits and losses; 9.9 % capital;

Partners Capital account on Schedule L = $ 1,687,236 and this is how it is shows on their K1's

Partner A: $ 4,542 - equals 0.27% of total capital on schedule L, however, K1 shows ending capital as 1.00%
Partner B: $ 934,338 - equals 55.38 % of total capital on schedule L, however, K1 shows ending capital as 35%
Partner C: $ 693,246 - equals 41.09% of total capital on schedule L, however, K1 shows ending capital as 34.40 %
Partner D: $ 0.00 - equals 0% of total capital on schedule L, however, K1 shows ending capital as 9.9%
Partner E: $ 0.00 - equals 0 % of total capital on schedule L, however, K1 shows ending capital as 9.9 %
Partner F: $ 55,110 - equals 3.27% of total capital on schedule L, however, K1 shows ending capital as 9.9%

Should we not be allocating the partners capital account on schedule L as per the percentages on the K1. The beginning capital for 2019 would be the ending capital per 2018 return. In 2019 can we use the other increases /decreases on k1 to properly allocate the capital as per the percentages, OR

we keep the $ allocation as is and report the ending capital percentage that corresponds to the $. In this event Partners D and E would show ending capital as 0% and 0% for profits and losses. What would be the point in being a partner then.

Taxpayer confirmed the percentages shown on the K1s for profit loss and capital are per the partnership agreement.

Please share your thoughts and comments on the above.

Be safe everyone.. Thank you

Regards,
A

On top there was an investment property bought in 2018 which does not show on the balance sheet. Significant cash buy. Can we restate the beginning schedule L or the preferred method would be adjusting the equity /capital in 2019. Suggestions ...

Anyone?? my apologies for trying to get someone look and suggest. I got to prepare and submit the return latest by Monday

Would highlyyyy appreciate comments..

Thanks

So here is the thing...you have posted a lot of detail and asked important questions about a complicated area. Partnerships are easy when everything is kept proportional. Beyond that, there are degrees of complexity.

You will have a better chance of getting responses if you streamline your question so that someone can digest it without having to set up an Excel schedule. Simplify your assumptions, suggest what you think should happen and perhaps explain why, and then ask for thoughts.

Your facts touch on these issues:

6 partners with different ownership interests in capital and profits,
related parties,
capital account amounts seem to indicate ownership interests different from interests noted in facts,
you ask how the capital accounts should be shown, but why aren't they shown that way to begin with? Disproportionate distributions? Something else? How can you answer the question about how they should be shown without understanding how they became what they are?
It seems that you have not seen the partnership agreement since you say that taxpayer confirmed that %s tie to the partnership agreement - you need to see it.
And then...there's an investment property from 2018??? Who owns it? If the partnership owns it, then how was it purchased? Please tell me that there is a balance sheet. If so, in 2018, cash should have decreased and debt increased. If that didn't happened, then who funded this purchase? And how do you propose accounting for it if it really is an asset of the partnerships?

If it were me...

I would not touch this with a 10 foot pole unless I had a copy of the partnership agreement, tax returns since inception, contact information of the attorney, and a retainer.

Thank you, JAD. the original post is indeed all over and lengthy. I would certainly be careful in drafting posts next time as advised. I will try to make this one as meaningful as possible and brief.

Received tax returns and partnership agreement this morning. He does not have returns prior 2016. The percent share of profit, loss, and capital on the K1's is as per the agreement.

Partnership agreement amended in 2018: Two of the three sons got employed and moved out of state. Since they were not taking part in the business the agreement was amended such that they would not get a share of any profits or loss but their capital would remain at 9.9%.

2018 K1's shows profit and loss as 0% for those two and capital at 9.9% each. However the K1's for these two do not carry a beginning capital account dollar value from 2017. Item L on 2018 K1 is blank. The ending balances for these two from 2017 were added to the other partners beginning balances in 2018

The dollar value of capital account for each partner for Item L on the K1 does not equal as per the capital percentages in the agreement due to unequal distributions and contributions being made by partners over the years. The previous preparer did not report the correct percentages as per each partners capital account balance and individual partner accounts were not maintained.

I also have the buyers settlement statement for the property. The title is in the name of the partnership. It is a vacant investment land that was funded from the dad's personal account in full (no mortgage). The purchase was brought to the attention of the previous preparer and the taxpayer was advised to treat it as investment property and will be reported on his personal 1040 when he sells it. That is the reason it does not show on the balance sheet of the partnership.

My thoughts:
1) Take 2018 ending capital balances as 2019 beginning; Use M2 other increases /decreases to adjust capital amongst partners as per the percentages in the operating agreement. Call it "capital allocation per agreement" (individual partner accounts have not been maintained and the taxpayer is ok to allocate capital as per the agreement)
2) Record the purchase of land on the partnership's books and allocate the purchase to each partners capital account as per the agreement. Also use M2 and call it "Prior period contribution to purchase land"

My advice: Take your time. Why must this be filed by Monday? If that is a state deadline, extend.

Received tax returns and partnership agreement this morning. He does not have returns prior 2016. The percent share of profit, loss, and capital on the K1's is as per the agreement.

Not good enough. You are now responsible for preparing a return that reports tax basis capital accounts – the 2019 requirement was delayed until 2020, but there is no time like the present to get your hands around this issue. If you address all issues now, then you can blame a lot of the substantial fee that you are going to charge on poor work in prior years. Leave nothing unresolved – now is your chance to get it right. Get returns since inception, and if taxpayer doesn’t have them, get copies from IRS.


Partnership agreement amended in 2018: Two of the three sons got employed and moved out of state. Since they were not taking part in the business the agreement was amended such that they would not get a share of any profits or loss but their capital would remain at 9.9%.

2018 K1's shows profit and loss as 0% for those two and capital at 9.9% each. However the K1's for these two do not carry a beginning capital account dollar value from 2017. Item L on 2018 K1 is blank. The ending balances for these two from 2017 were added to the other partners beginning balances in 2018

This is important. What was everyone’s intention? The partnership agreement was amended, so perhaps a conversation with the attorney is in order. Capital account balances were added to other partners’ beginning balances. Great. Sounds like a gift. What was the FMV of the capital account interests transferred? If FMV did not equal basis, then that transaction could have triggered the application of other complicated code sections. Was that simply a mistake that could be reversed? This is a legal question that again gets to their intention, and you cannot provide legal advice, so get with the attorney.

The dollar value of capital account for each partner for Item L on the K1 does not equal as per the capital percentages in the agreement due to unequal distributions and contributions being made by partners over the years. The previous preparer did not report the correct percentages as per each partners capital account balance and individual partner accounts were not maintained.

And you are now responsible for knowing and reporting each partner’s tax basis capital account. Again, you need returns since inception so you can figure this out. As for disproportionate distributions, that triggers other complexities. Unequal contributions….was the contribution in excess of ownership % a loan? Did it change ownership %? Again, legal issue.

I also have the buyers settlement statement for the property. The title is in the name of the partnership. It is a vacant investment land that was funded from the dad's personal account in full (no mortgage). The purchase was brought to the attention of the previous preparer and the taxpayer was advised to treat it as investment property and will be reported on his personal 1040 when he sells it. That is the reason it does not show on the balance sheet of the partnership.

Then how about if you ask the lawyer to correct the title?

Your thoughts – look, these ideas might work mathematically, but if you are unlucky to have anyone coming behind you (another preparer or an auditor), you will have simply compounded problems. It’s not your fault that Subchapter K is so complicated, that your partners and their attorney made this so complicated, and that the prior preparer didn’t do his/her job. If you take short-cuts, you are getting in bed with all of them.

Sorry some of my answers above are vague. I’d have to do a fair amount of research to refresh my memory on these issues. I really don’t deal with them much. When people want to get fancy, I tell them that they will wind up paying me way too much to address the tax ramifications. That generally scares them into keeping it simple.

"If you address all issues now, then you can blame a lot of the substantial fee that you are going to charge on poor work in prior years. Leave nothing unresolved – now is your chance to get it right. Get returns since inception..."

Completely agree. Anything you don't resolve now will be on you to fix later. Unless, they haven't told you about it.
Be honest and candid with the client, your job and responsibility is to prepare a correct return and every question seems to beg more questions at this point.
It won't be easy and it won't be cheap, but it will be correct.
Get the retainer or pass. Clients routinely don't appreciate the difficulty in getting partnership returns correct.

Thank you, Jad and Captcook. much much appreciated.

Let me setup a meeting with the taxpayer (TP) and try to get as much information as possible.

As far as the capital account is concerned, it is tax basis but not allocated properly to individual partners. Getting returns since inception would not solve this due to the fact that proper accounting was never done to maintain individual accounts. As i see in the returns for eg. a 100k distribution to DAD was split as per respective percentages to everyone. It would be a hell of a time consuming task to reconstruct the books since inception..

The idea of getting the title changed to his personal name would fix the property issue. For the capital accounts, let me meet with the taxpayer and disclose the complexity of the issue and ask him all the questions and for his attorney. From what i can tell from recent meetings and calls, the TP is going to stick with the only response he always gives me - percentages as per the agreement and just allocate them accordingly.

The capital account balances that were added to other partners is about 25k each from the two sons. Since the partnership owns one rental property, we could possibly take county appraised values for the property for 2017 and add cash from Sch L to come up with the FMV if there was a gift in the first place. There are no liabilities on schedule L. If it wasnt a gift and a mistake we would need to report correct tax basis capital accounts for each partner, and to the best of my knowledge that would be an adjustment on the M2 after reconstructing the books since inception, with an explanation. Please correct me if am wrong.

Thank you once again. I shall keep the gurus posted.

Above posts are offering good advice.

Here's just one example of vagueness. Two of the three sons got employed and moved out of state. Since they were not taking part in he business the agreement was amended such that they would not get a share of any profits or loss but their capital would remain at 9.9%. . 9.9% of what and when? Total capital, as of when they left? It can't stay at 9.9% unless capital never changes. But it can stay at a fixed amount (possibly plus interest in the form of a GP). Or is it, as I assume, 9.9% of total capital measured when they get redeemed. What if the other partners leave some capital in rather than taking each year's earnings. or if others add more capital but the two sons don't. Etc.

Exactly. it can only stay at 9.9% if the other partners took distributions of the exact amount of earnings allocated to them each year as these two were not being allocated any profits. Assuming the other partners take less distributions than earnings allocated, the 9.9% would start to shrink as the other partners capital accounts increase.

I guess to keep it at 9.9% the other partners would gift 9.9% of earnings to these two and not take distributions themselves or keep distributions propotionate amongst all per their percentages. Btw total net income from the property is about 80k. so 9.9% of that is well below the annual gift tax exclusion of $15k each. but in the event of a loss, the other partners would need to contribute by the amount of loss to keep their percentages the same. lol

Looking forward to meeting the taxpayer for a lot of clarifications. One thing he needs to understand is that capital account percentages will fluctuate each year with dispropotionate contributions and distributions.

Thanks for commenting, Nilodop.. Appreciated..

Met the TP and spoke to the previous preparer.

There was an error on the 2018 return: K1, Item L was left blank for the two partners (who were not to receive share of profits /losses). It was never the intention to transfer the capital.

Preparer confirmed that the capital accounts are tax basis, as marked on the 2018 K1s, and that she relied on the tax software to calculate the K1 capital account percentages as per the capital account balances, which did not happen.

As per her the beginning balances shown on 2018 K1's are correct individual accounts except for one partner which is increased by amounts missed and left blank in error on the two K1's - about 25k each, for a total of 50k overstated beginning balance.

TP does not have an attorney. The amendment was done by himself and the initial agreement is dated Jan 2005. I have requested from the preparer all returns since inception and she would not be able to get any past 2010. Requested a ledger of capital accounts and we should have that coming in on Monday - the books were prepared on tax-basis;

TP confirmed that profit and losses are not to be assigned to two sons for 2019 as well.

TP wants to retain the title of the investment land in the name of the partnership;

My takes:
1) Did my own excel worksheet for overall tax basis capital computation from 2016 - 2018. The allocation of income, distributions, and contributions all add up to the correct amount of total capital; will wait for returns prior 2016 and expand my worksheet to include those as well;

2) Since the intention was not to transfer the capital, the deemed sale of partnership interest for related parties issue no longer exists;

3) Will wait for the capital accounts ledger and if that matches with the beginning balances as shown on the 2018 K1's then i guess I would be comfortable and ok to keep it as backup basis and part of my due diligence;

4) If ledger matches, i can see two options. Either to restate beginning balances on the K1s as they should be or run the adjustment through current year on the M2. need advise which would be a better approach;

5) Investment land: Allocate the purchase between husband and wife equally as they were the ones to fund it. Again restate the beginning schedule L or as a current year M2 adjustment?

6) Will report beginning & ending capital account percentages in item J as a ratio of total capital to individual capital accounts;

Thanks and wish you all a great weekend!!

Got the ledger and it all ties up. Have the individual account balances. Only one partner account is overstated by the amount for the two k1's those were left blank in error.

Property will remain in the partnerships name. What would be preferred method:

1) restate beginning balance sheet and record land against capital for the husband and wife; or run it through current year on the m2 with an explanation?

2) restate beginning capital on k1 as per ledger balances or run this as a current year adjustment on the m2;

3) with either approach will be reporting correct capital percentages as a ratio of total capital to individual capital accounts;

Thanks everyone...

The difference existed in 2018. I would restate the opening balance sheet and credit M&D's capital for the contribution or record a loan from them.

An M-2 adjustment doesn't seem like the right approach.

Thanks Capt. Appreciate the response. I was always under the impression the sch L beginning balances have to match the prior year ending, else its a red flag and a notice from the IRS.

What do you think about the beginning capital on the K1's. Restate them as well?

Thanks Capt. Appreciate the response. I was always under the impression the sch L beginning balances have to match the prior year ending, else its a red flag and a notice from the IRS.

What do you think about the beginning capital on the K1's. Restate them as well?

Restate to the proper amounts. If they don't affect income or expense, there's no issue.

I've restated balance sheets a number of times. Especially when I get new clients with overly simplified cash basis balance sheets. I restate them to match their books (usually accrual) and then show the appropriate accrual to cash adjustments in Sch M-1. I make sure to tie out beginning tax basis in all cases.

In every audit I've ever been a part of, IRS has never tied out balance sheets year to year. They want to see support for the P&L items.

Thanks a bunch, Capt. Will restate the capital balances on the k1 as they should have been and restate the beginning and ending capital percentages as well.

The books are already cash/tax basis so no M1 adjustment required.

Thank you once again everyone for the valuable comments.