Exhibits 1 through 4 show the journal entries for these tax attributes, and Exhibit 5 shows a sample partners’ investment report.

Setting Up Basis Accounts

The first step is to set up accounts to keep track of each partner’s basis. As shown in Exhibit 1, A, B, and C set up the ABC Partnership. Partner A contributes $20,000 in cash; Partner B contributes an automobile worth $20,000 with a basis of $10,000; and Partner C (a lawyer) does start-up work worth $20,000. Each partner has three or four accounts in the general ledger, not unlike a personal set of books. These accounts show each partner’s investment and its sources. The partial net worth account balances the others.

The journal entries in Exhibit 1 show valuable new investment information. Although all partners end up with $20,000 of equity, Partner B’s basis in the partnership is only $10,000 and only Partner C has taxable income. When Partner B asks why she has no taxable income, the CPA can explain the built-in gains and the tax consequences all partners can expect in the coming years.

Exhibit 2 shows a common occurrence: a partner contributing an asset along with debt. E, F, and G are equal partners in the EFG Partnership. Partner E contributes a machine worth $50,000, with a basis of $15,000 and an attached debt of $30,000.

By placing the partners’ personal basis in the general ledger, Partners F and G will see their personal liability for partnership debt. They will also see that, with their increased basis, F and G are able to take more tax deductions for any forthcoming partnership losses, and Partner E can see why her basis decreased. This could be the start of an explanation about what happens when a partner’s basis reaches zero, preparing the partners for future tax consequences and equipping them to make asset and debt acquisition decisions.

The share of partnership liabilities account combined with the investment in EFG partnership account reconciles with the partners’ equity balances. Partners F and G each have equity balances of $10,000, equal to the netting together of the $20,000 and the ($10,000) credit in their basis accounts. If Partner E questions why her built-in gain account is not reflected in her basis, the answer can explain the difference between gains realized and gains recognized for tax purposes. Accounting for tax attributes in the general ledger provides the ability to reconcile basis with equity and the details to justify basis calculations to the IRS.

Built-In-Gain

Placing built-in gains in financial reports helps partners grasp the built-in gain, a common, though seldom discussed, tax attribute.

Exhibit 3 uses the same facts as Exhibit 2. When the partnership depreciates the machine the first year (for simplicity, over five years, straight line), the partners quickly notice that the built-in gain account bears Partner E’s name and appears under her equity section. It should be explained to Partners F and G that the difference between Partner E’s basis in the machine and its fair market value belongs completely to her.

This periodic recognition of Partner E’s built-in gain is best understood in light of the IRS regulation, which involves different tax and book bases for the machine and different depreciation expense deductions for each partner. Putting the built-in gain in the general ledger regularly keeps the tax attribute in the partners’ minds, preventing unexpected tax consequences at year-end.

Exhibit 3 shows the impact on the income statement for GAAP purposes, but the necessary information for tax purposes is in the general ledger as well. GAAP depreciation expense is $10,000. For tax purposes, this is netted with the $7,000 recognition of built-in gain to produce the $3,000 of depreciation allowed for tax purposes ($15,000 tax basis divided by five years). For GAAP, the recognition of built-in gain is credited directly to Partner E’s equity account. For tax purposes, the credit is first placed on the income statement as a contra-depreciation expense account under Partner E.

Having the tax attributes in the general ledger shows the built-in gain accounts as equity accounts for GAAP reports, but also allows the creation of a tax-basis balance sheet showing these accounts as contra-assets. The tax-basis partial balance sheet looks like this:

depreciation Partner E

Assets	Beginning of year	End of year
Machine	50,000	50,000
Accumulated		(10,000)
Built-in gain,	(35,000)	(28,000)
Net (tax basis)	15,000	12,000

Placing these built-in gains in the general ledger improves reliability and allows the partners to see their impact on regular financial statements.

IRC Section 754 Basis Adjustments

The financial statements can clearly and usefully reflect all the required or optional tax basis adjustments. IRC section 754 allows a buyer of a partnership interest to qualify for extra depreciation expense through adjusting the basis of certain partnership assets. That basis adjustment can be put in the general ledger without violating GAAP.

Exhibit 4 uses the facts of the EFG Partnership to show how partners can see their special basis election on the partnership’s financial reports. Consider a case where Partner G decided to sell his partnership interest to Partner H for $8,667, calculated as follows:

equity balance

Partner G’s

$6,667

Partner G’s share in the excess of the machine’s market value over book value

[($46,000 - $40,000) * 1/3 ownership share] 2,000
Total $8,667

Unless Partner H receives relief, she has paid $2,000 more for her partnership interest than she will ever be able to depreciate because this $2,000 extra is not reflected on the partnership books. Section 754 would allow the basis of the partnership’s machine to increase by $2,000. The journal entries in Exhibit 4 show how to record this special tax basis in the general ledger without violating GAAP.

The journal entries reveal extra useful information. Partners E and F see why Partner H gets a larger depreciation deduction. Partner G’s gain is clear from thebasis accounts. For GAAP purposes, the amortization of Partner H’s basis adjustment directly debits her equity account. For tax purposes, the debit is first placed on the income statement as additional depreciation expense allocated solely to Partner H. For GAAP, the special basis account is a contra-equity account, but on a tax basis balance sheet it is an asset—an increase in the basis of the machine. Like the built-in gain accounts, these special tax basis accounts do double work in presenting both GAAP and tax-basis information.

Reporting Tax Attributes and Partner Basis

For GAAP purposes, tax attribute accounts are also equity or contra-equity accounts. For outside users of the financial statements, the equity accounts can be netted and a single equity number presented for each partner. For the IRS, these tax-attribute accounts can move into the asset section where they become either assets or contra-assets.

The basis or investment accounts call for a new type of report, such as the report in Exhibit 5, which gives the sources of the partners’ investments.

Unavoidably, this method reports to all partners the personal tax information of each partner. Even without placing the tax attributes in the general ledger, a K-1 will reflect whether partners are paying taxes on more or less income than their share of the partnership taxable income. Explaining why that partnership income is different from the GAAP financial statements report will need to include a discussion of those same personal tax attributes.

There are other good reasons why these attributes belong in a partnership’s or LLC’s general ledger:

Editor:
Thomas W. Morris
The CPA Journal

©2009 The New York State Society of CPAs. Legal Notices