An annual challenge in tax return preparation services is obtaining partnership K-1 forms for our clients partnership investments, incorporating the information into tax returns, and delivering the completed return to the client. A significant number of partnership K-1 forms are slow in arriving, which can lead to a hurried completion of the return. Given the time constraints and the level of information access, many of us do not perform more than a cursory test of the partnership K-1 information. Unless there is a discrepancy on the face of the K-1, the information is simply transferred onto computer input sheets.

Significant opportunities exist for both potential client billings and client satisfaction by performing detailed and specific reviews of each material partnership interest. We often learn of an investment in a limited partnership after the fact while we are preparing the return. Thus, recommendations or assistance prior to the investment can not be provided. Even after the investment is made, however, the CPA may be able to offer assistance by reviewing financial information generated from partnership investments.

Receiving Information

We recommend that you obtain the following information to enable you to perform a diagnostic review:

1. Limited partnership agreement;

2. Prospectus and/or offering memorandum;

3. Financial statements, preferably audited;

4. Partnership tax returns and K-1's;

5. Annual reports describing operations, if any;,

6. Financial projections and/or valuations, if any; and

7. Current information about the industry in which the partnership operates.

While there may be a temptation after receiving the information to dive right into the numbers and check for mechanical accuracy, we recommend that the practitioner first read the prospectus and/or offering memorandum and the limited partnership agreement. This will give the CPA a base understanding of the partnership. Notes should be taken regarding among other things how cash will be distributed; how income or loss will be allocated from operations, refinancing, and disposition; what percentage of interest your client has in the deal; access to books and records; funding of operating deficits; ability to transfer interest; and management and other fees. A careful review and documentation of the understanding of special or unusual allocations between the partners should be made and the additional taxes as a result of these tax implications should be considered. We recently came across a situation where the investor had blindly signed all the documents presented to him. We were faced with having to inform him that he was not a limited partner but rather one of ten general partners with no administrative responsibilities but unlimited liability.

Promises, Promises

Next, review the prospectus and/or offering memorandum to obtain an understanding of how the deal was supposed to perform. When reviewing this information, consider the changes in the tax laws, other legislation in the past few years, and proposed legislation to evaluate these changes' effect on the transaction. For example, consider the effect on projected tax benefits if losses become suspended. Consideration should also be given to market changes such as current rental rates compared to those assumed in the projections. Also review whether your client is responsible or expected to make further capital additions and under what conditions.

Start the Crunching

Now the number crunching can begin. Review the partnership tax return for reasonableness and mechanical accuracy. Even if computer generated, the information may not be correct or may raise questions regarding the operations of the partnership. For example, a review of Schedule L Balance Sheets may show substantial increases in liabilities. The increase may have been necessary to fund operating deficits or reflect the nature of the debt (zero coupon bonds). If the value of underlying assets of the partnership are less than the amount of the debt level, it may be prudent to pressure the managing partner to restructure the debt or liquidate the partnership. The cancellation of indebtedness may be an effective strategy to create value with minimal tax consequences. Additionally, the review may pick up that the managing partner has been taking excess cash out by borrowing money or that depreciation or amortization of assets is not right.

After the review of the tax return is completed, attention should next be focused to your client's K-1. The review should include checking whether the information is accurate. This includes:

* Is the partner's identifying number correct?

* Is the name and address accurate?

* Are the partner's share of liabilities reasonable?

* Are the partner's percentage of profit, loss, and ownership of capital accurate?

* Is the analysis of the capital account correct?

* Does the beginning capital account balance equal the prior year's capital balance?

* Does the capital contributed, withdrawals and distributions during the year agree with your client records?

* Do you agree with the allocations from the partnership return of income and expenses?

Follow-up

Your next course of action may be either to assure your client that transactions and operations appear to be in accordance with the documents or to inform him or her that there may be discrepancies, which when corrected, would result in either additional tax benefits and/or cash flow requirements. If the partnership permits it, you may want to propose that either you or your clientor inspect the underlying books and records. In suggesting additional follow-up work, you may want to discuss the costs versus benefits of additional work. While most differences can be resolved by a telephone call, e.g., resolving a misunderstanding or informing the managing partner of a potential error, some differences could require significant additional expenses (legal, accounting, travel, etc.) which might exceed the benefits (especially if the additional losses would be suspended).

Experiences

Our work in reviewing partnership matters has revealed the following kinds of problems and discrepancies:

* Incorrect Tax Identification Numbers. This has resulted in confusion during tax audits as the tax authority records do not match the partnership information and client returns.

* Incorrect Partnership Allocations. We have noted instances where clients have not received their correct allocation of income/loss (including capital gains/losses, interest expense/income, etc.) or distribution. In addition, if the managing partner's information turns out to be incorrect, requested capital contributions could also be miscalculated or misclassified as a loan.

* Additional contributions. The partnership agreements may provide some limit on additional capital contributions or additional contributions to be funded by the managing or general partner. Most agreements do not limit the managing or general partner from requesting additional capital contributions in excess of what the agreement stipulates.

* Additional Basis. The K-1 may not have correctly allocated basis resulting in partners not being able to utilize losses.

* Depreciation, Amortization, Depletion, etc. The reasonableness review may indicate a possible error. These inquiries have sometimes resulted in increased tax deductions.

* Management Fees. A recalculation of this fee may result in additional income and cash to the partners.

Other Potential Services

Additional services that could potentially be provided by the CPA are:

* Cost/Benefit Analysis. For services performed on behalf of the partnership investment or managing partner, there may be an opportunity for the CPA to provide cost/benefit analysis on various contemplated projects. For example, the owner or manager of a real estate investment may be considering out-sourcing various services such as custodial or bookkeeping services. The experienced CPA should be able to develop a report detailing all the tangibles (e.g., project cost savings) and intangibles (e.g., tenant and client satisfaction) relating to the contemplated project.

* New Investment Analysis. There may be an opportunity to assist investors in analyzing potential investments. For example, for those investors who are now frequenting auctions seeking bargains, the CPA can act as a business advisor. This type of advice can include redirecting the investor's focus away from how the replacement costs of assets to the actual underlying operations and potential contingencies (e.g., funding of cash flow deficits). The determination of fair value using cash flows and other assumptions (income, cost, or comparable value) may need to be addressed and evaluated.

* Evaluating Reorganizations. Opportunities may exist in evaluating and proposing reorganizations. Proposals to combine investments into master limited partnerships or to separate real estate investment trusts into multiple investments (spin-offs), may need to be evaluated. It may be that the greater liquidity and diversification of the new entity will offset the disadvantages such as high promoter fees and loss in equity value.

A Word of Caution

Before undertaking any potential assignment of this type of work, be sure the expected benefits to the client will be greater than file expected costs to undertake the task. Also make sure the fee arrangements are clearly understood and agreed to in advance.

Philip Wolitzer, MBA, CPA, is Professor Emeritus at Long Island University and a Visiting Professor at Marymount Manhattan College. Mark E. Mildner, MBA, CPA, is an accounting manager at a major securities firm in New York City, monitoring and evaluating real estate investments.