As small business owners, most of our choices and business decisions are reflected on our tax return. Whether it is the type of entity we select or the manner in which we choose to maintain our financial records during the year, our tax return is its final resting place (so to speak).
Potential IRS Inquiries And Audits
The inspiration for this post is based on recent conversations I have had with potential clients regarding IRS inquiries and audits.
Some of the IRS inquiries are based on the non-allowable use of partnership and S corporation pass-through losses. A single member LLC can also elect to be taxed as an S corporation and as such, must abide by the taxation rules of an S corporation. A multi-member LLC is automatically required to file a partnership return.
Income/Loss from Partnerships and S Corporations
Partnerships, multi-member LLCs, S corporations, and any entity that chooses to be taxed as an S corporation have the advantage of only being taxed once on its income, unlike C corporations that experience double taxation.
Because partnerships and S corporations do not pay income tax, the net income and net losses derived from these entities are passed through to their partners and shareholders. According to IRS rules, a loss passed through to shareholders and partners can only be deducted by the taxpayer on his or her personal return if they have a positive basis in the partnership or S corporation they are a part of. If the taxpayer has a zero basis in the business, the loss passed through from the business is generally carried forward by the taxpayer to future years and can be used when the partners or shareholders basis rises above zero dollars.
Because most taxpayers do not understand the concept of “basis” and the fact that some preparers neglect to prepare a basis worksheet for their client, the IRS has a field day sending out notices that ultimately end up with previous losses taken by the taxpayer recategorized as taxable income. The net effect of the recategorization is that the taxpayer owes additional income tax as well as penalties & interest on the additionally assessed tax. Depending on how much loss was claimed, this reversal can be very costly.
Poorly kept financial statements or even worse no financials at all, can affect your ability to maintain an accurately prepared basis worksheet. Here are some of the items used to calculate a shareholders or partners basis (this is not all-inclusive, and some items may relate to a partner’s basis calculation and not the calculation of a shareholders basis):
- Cash contributed
- Taxable and nontaxable income & deductions
- Cumulative distributions
- Adjusted basis of property contributed
- Amount of gain recognized under Section 721(b)
- Cash and basis of property distributed
- Partners share of liability in the partnership
As you can see, all of the items listed above are found on either the balance sheet or the income statement. If you neglect to record these items properly, or you do not record them at all, your basis worksheet will not be correct.
IRS Inquiry Letter
If you happen to be one of the unfortunate people to receive a letter from the IRS regarding a pass through loss you received from your partnership or S corporation, the IRS will expect a basis worksheet to be reconstructed showing your eligibility to claim the loss. Ultimately it is up to you the taxpayer to present the IRS with the information proving your eligibility to deduct the loss. If due to bad or no records, you are unable to reconstruct the worksheet, the loss you claimed may be denied.
Alternate Method of Determining a Partners Basis In The Partnership
If the business has existed for an extended period of time, historical data may be difficult to recreate as a means of reconstructing the partner’s basis. In such a case the IRS may allow the taxpayer to apply the Section 705(b) rule which allows the partner to reconstruct his or her basis worksheet by using the partner’s proportionate share of the adjusted basis of partnership property upon termination of the partnership. For the IRS to allow a taxpayer to use this alternate method, you must convince them that the result will not be substantially different from what it would have been if you created the worksheet the proper way. Personally, I am not sure how one can truly convince the IRS of this, but let’s go with it.
Three Reasons a basis worksheet is relevant
- To determine a partners or shareholders loss limitations
- To determine taxable income in the event of disposition or liquidation of the business
- To determine if non-liquidating distributions are taxable and to determine the basis of property received during a non-liquidation.
Desarie Anderson, CPA, EA