The Taxing Side of Divorce: Partnership Tax Returns as Discovery Tools

September 01, 2013

The Partnership Tax Return – Form 1065

Returns and return information of a partnership or LLC may be disclosed to any person who was a member of the partnership during any part of the period covered by the return. Both general and limited partners are entitled to request and receive partnership returns and return information. On December 20, 2007, IRC §6103(e)(10) was enacted, limiting the disclosure of certain information attached to partnership returns. The information to be disclosed cannot include any supporting schedule, attachment, or list of a person other than the individual making the request for access. A requesting partner can no longer receive any Forms K-1 or other attachments that include identifying information of other partners or other individuals. He or she can receive only the Form K-1 for his or her interest in the partnership.

Special attention should be paid to the information reported on partnership returns when the divorcing partner owns a significant or controlling interest in the partnership. A controlling partner will presumably have the ability to dictate how income and expense items are classified and reported on the return. A minority partner, especially one with a very small percentage interest, usually has little or no input in the financial reporting process.

Page 1 Form 1065 – Beyond the Numbers

There is important information to be gleaned before looking at the numbers.

  • Boxes A & B identify the business activity of the partnership and the product or service provided.
  • Box E provides the date the partnership was formed. If it is a new partnership, you may want to inquire as to the original capital required of the divorcing partner.
  • Box H identifies the method of accounting. Accrual-based accounting is considered to provide the most accurate picture of the partnership’s financial results. If the partnership reports on a cash basis, does the divorcing partner have the ability to defer receipt of income or accelerate payment of expenses resulting in decreased earnings in the year of divorce?
  • Box J provides the number of partners holding ownership interests at any time during the year. Changes in the number of partners may allow for the discovery of partner interest valuations or other partnership agreements.

Page 1 Form 1065 – Numbers Worth a Second Look

Ordinary income or loss from other partnerships, estates, and trusts is reported on Line 4. An entry on this line indicates that the partnership owns an interest in another entity. Inquire as to the nature and purpose of the ownership. You may want to request a copy of the other entity’s tax returns.

Other income is reported on Line 7. There should be a statement attached to the return that identifies the source of this income. Compare the entries year by year to determine if this is recurring income or a one-time occurrence.

Salaries and wages reported on Line 9 should not include any payments to partners. Are the amounts paid commensurate with the nature and volume of the partnership? If not, further investigation may be warranted. Inquire as to the reason and determine if there are family members receiving wages.

Guaranteed payments on Line 10 are the equivalent of salaries paid to partners. You may want to request a breakdown of these payments among the partners for each year. If the divorcing partner’s guaranteed payments have decreased in relation to the other partners in the year of the divorce, there may be a tacit agreement to make increased guaranteed payments to him or her once the divorce is finalized. Request a copy of the Partnership Agreement to determine if these payments comply with the agreement.

Rent expense reported on Line 13 should always be investigated. Is the partnership paying fair market rent? It is possible that the rent is either above or below market rates if paid to a related party? Inquire as to the ownership of the property being rented. It may be that the divorcing partner has an interest in the property.

Retirement plan expenses are reported on Lines 18. Request a copy of the summary plan description (SPD) for any plan maintained by the partnership. This will enable you to determine if the divorcing partner is covered by a defined contribution plan, a defined plan, or both. Also request the most recent statement of benefits for the divorcing partner.

Partners may be able to deduct personal expenses on Line 20 – Other Deductions. Carefully examine the schedule of these expenses attached to the return and request the details of any expenses that may be personal in nature.

The name and contact information of the tax preparer is provided at the bottom of Page 1 of the return. Request authorization to contact the preparer with any questions you may have about specific items or to review additional workpapers. If the divorcing partner is a minority owner, this permission may be denied.

Page 2 Form 1065 – Beyond the Numbers

Do not dismiss Page 2 merely because it does not contain any numbers. There is valuable information contained within these questions.

The answer to Question 3b – “Did any individual or estate own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital of the partnership?” – will identify if there is a controlling partner. If there is a controlling partner, Form 1065 Schedule B-1 must be attached to the return.

The following questions 4a and 4b may reveal other assets of significant value.

aI At the end of the year, did the partnership own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of stock entitled to vote on any foreign or domestic corporation?

bI At the end of the year, did the partnership own directly an interest of 20% or more, or own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital in any foreign or domestic partnership (including an entity treated as a partnership) or in the beneficial interest of a trust?

Page 3 Form 1065 – Beyond the Numbers

Similar to Page 2, there may be clues to additional assets contained in the answers to some of the questions.

If “yes” is checked in Box 13, the partnership either distributed property received in a like-kind exchange or contributed that property to another entity. This should spur further investigation into the nature of the property involved in the like-kind exchange, to whom it was distributed, and if contributed to another entity, the ownership of such entity. It may reveal another asset of the divorcing partner.

Likewise, if the answer to Box 14 is “yes,” the partnership distributed either a tenancy-in-common or other undivided interest in partnership property to a partner. Investigation into the details of the distribution may be warranted.

Finally, the IRS requires the name and contact information of the Designation of Tax Matters Partner. Is this the divorcing partner?
If so, it may indicate that he or she has significant influence over the tax treatment of income and expense items.

Page 4 Form 1065 – Numbers Worth a Second Look

The partners’ distributive shares of income, loss, and other items are reported on Page 4. Amounts reported here represent the sum of all items “passed through” to the partners. The individual shares allocated to each partner are reported on Form 1065 Schedule K-1 to be discussed later.

Net income or loss from rental real estate is reported on Line 2. Although rental properties often generate taxable losses, they can be a source of additional cash flow to the partnership and partners. Adding back depreciation, a non-cash expense should give a rough estimate of the activity’s cash flow. If the partnership interest is being valued, the property should be appraised.

An entry on Line 12 – Section 179 Deduction indicates that the partnership purchased a capital asset during the year and elected to expense the cost rather depreciate it. This will, of course, reduce the net income reported on the return.

Line 19 Distributions

Page 5 Form 1065 – Numbers Worth a Second Look

The partnership balance sheet at the beginning and the end of the year is shown on Page 5 of the return.

Investments reported on Line 4 (U.S. government obligations) and Line 5 (tax-exempt securities), are stated at their original cost to the partnership. These assets may, in fact, be worth more (or less) than the value shown.

Always review the attached schedules, which provide the detail behind Line 6 – Other Current assets and Line 13 – Other Assets. You may find non-operating assets that add value to the partnership interest.

Loans to partners are shown on Line 7. Are these legitimate loans or merely a vehicle to provide the partners tax-free income? Inquire as to the interest rate and terms of repayment of these loans. If the divorcing partner received a loan from the partnership, were the proceeds used for marital purposes or is it possible that the funds are in a previously undisclosed account?

Loans from partners are reported on Line 19. If the divorcing partner has made a recent loan to the partnership, inquire as to the reason for the loan and when it will be paid back. It may be that the partner was merely parking marital funds in the partnership pending the finalization of the divorce. Whatever the reason for the loan, it should be considered a marital asset.

Schedule M-1 is a reconciliation of financial statement income and tax basis income. If the partnership is a cash basis taxpayer, a review of the reconciling items may give a more accurate picture of the true profit or loss of the partnership.

Schedule M-2 summarizes the partnership activity during the year and the impact on the partners’ capital accounts from the beginning of the year to the end of the year. The impact on individual partners’ capital accounts is detailed on their respective K-1s as will be discussed later.

Form 1065 Schedule K-1 – Numbers Worth a Second Look

In addition to providing the individual partner’s share of each element of partnership income or deduction, Schedule K-1 provides information regarding the nature of the interest, the partner’s percentage ownership interests, distributions, and capital. Remember, the partnership agreement may stipulate that an unequal percentage of profit or loss is to be allocated to a partner regardless of the amount of his or her capital contribution.

Part II – Item G will tell you if the divorcing partner is a general partner or a limited partner. As a limited partner, he or she would have little, if any, control over the operations of the partnership or the timing and amount of distributions.

Item J shows the partner’s profit percentage, loss percentage, and capital percentages as of the beginning of the year and the end of the year. If there are significant changes in these percentages, particularly in the year of divorce, make sure there is a valid reason and that it is not merely “divorce planning.”

Item L provides a reconciliation of the partner’s capital account, including any capital contributions or withdrawals made during the year. While the capital account is not necessarily a true reflection of the value of the interest, it is a starting point.

Part III

Other deductions are reported on Line 13 and identified by codes prescribed by the IRS. Certain items reported here may play a role in settlement negotiations.

  • Code M. Any amounts paid during the tax year for insurance that constitute medical care for the partner and his or her family.
  • Code O. The partnership reports any dependent care benefits received by the partner. This may be a consideration in determining the amount of child support to be paid or received by the divorcing partner.
  • Code R. Payments made on behalf of the partner to an IRA, qualified plan, simplified employee pension (SEP), or a SIMPLE IRA plan. If there is a Code R entry, inquire as to the nature of the plan, the current balance, and expected contribution in the year of divorce.

Actual distributions made to the partner are reported on Line 19. Code A denotes distributions of cash and certain marketable securities. The marketable securities are included at their Fair Market Value on the date of distribution. The partnership may distribute all or none of the income or, in many cases, only an amount necessary to pay the tax on the pass-through income.

Comparing the level of distributions in relation to taxable income over a three to five year period should reveal any significant changes in the year of divorce. A significant decrease in the amount distributed in the year of divorce may indicate that the distribution is merely being deferred until the divorce is finalized.

Conclusion

If you have reason to believe the returns you have been provided may not be the actual returns filed, you can request tax returns (and amended returns) directly from the IRS using Form 4506 or 4506 T (for transcripts only).