Understanding Partners' Capital Accounts

The challenges law firms have experienced since the onset of the recession have been widely documented, but as the recovery continues at a sluggish pace, law firms are shifting their focus to the challenges that lie ahead. After years of layoffs and diminished or negative growth, law firms are seeing increasing partner turnover. Too often these departing partners are surprised at the status of the capital accounts, leading to real and potential disputes with management. To proactively address this issue, law firm management should ensure that partners and senior associates (potential partners) understand the basic concepts pertaining to partners' capital accounts.

A partner's ownership interest in a partnership is tracked through the maintenance of a capital account. Failure to pay attention to the tax basis schedules and capital account balances can trigger unintended tax consequences.

Generally a law firm accounts for its operations annually, and its annual financial results are recorded on a tax basis for the purpose of filing annual income tax returns. Each partner has his/her own tax-basis capital account, which is adjusted upward or downward depending on the specific adjustment.

A partner's tax-basis capital account is increased by:

• A partner's initial capital contribution to the partnership (normally a cash contribution);
• The amount of additional money and the adjusted basis of additional property contributed to the partnership;
• A partner's distributive share of partnership taxable income; and
• A partner's share of partnership tax-exempt income.

A partner's tax-basis capital account is decreased by:

• The amount of money and the adjusted basis of property distributed to the partner. Distributions can be in the form of cash draws or disbursements made on a partner's behalf (such as retirement plan contributions, self-employed health insurance, automobile allowance, composite tax payments, etc);
• A partner's distributive share of partnership taxable losses; and
• A partner's share of nondeductible partnership expenses ( e.g., political contributions, club dues, life insurance, or the disallowed 50% of travel and entertainment expenses).

The computation of a partner's tax-basis capital account is very similar to the calculation of a partner's tax basis in his/her partnership interest. The largest difference between the two is that the tax-basis capital account does not take into account the partner's share of partnership liabilities, or optional basis adjustments under IRC ' 754. A partner's share of liabilities is important in situations where a capital account becomes negative as a result of losses and non-
deductible expenses.

Tax-basis capital accounts provide a shortcut to compute a partner's tax basis in their interest. To determine the tax consequences of a partnership transaction, one must take a partner's tax-basis capital account, add back the partner's share of partnership liabilities, and adjust for any inside/outside basis differences.

The above computation can be used to determine if a partner:

• Has enough basis to deduct a partnership loss;
• Will recognize gain on a contribution to or distribution from the partnership; or
• Will recognize gain or loss on a disposition of his/her partnership interest.

In addition, if a partner has a negative tax-basis capital account, it usually represents the minimum gain he/she would recognize if the partnership were to terminate or if the partner were to sell his/her interest for no cash consideration.

It is important to remember that GAAP and tax capital accounts may differ (for example, due to accelerated depreciation for tax purposes). When a partner leaves the firm, his/her payout is normally based on GAAP capital account. Accordingly, where GAAP capital account is larger than tax capital account, the difference will be taxable to the partner and likely result in ordinary income.

While the partnership's accountant is responsible for keeping track of the partners' capital accounts, it is each partner's responsibility to review such schedules and keep track of his/her individual tax basis schedules in order to avoid unintended tax consequences. Management's responsibility is to educate the partners on the factors that impact their capital accounts to avoid potential disputes.

Luda Mirne, CPA, MST, is a senior manager in CohnReznick's Law Firm Industry Practice. She may be contacted at [email protected] or 732-380-8646 for more information on this and other tax matters as they relate to law firms and their partners. Jacob Weichholz, CPA, is a director in CohnReznick's Law Firm Industry Practice, and also may be contacted at [email protected] or 646-625-5709 for further information.

The challenges law firms have experienced since the onset of the recession have been widely documented, but as the recovery continues at a sluggish pace, law firms are shifting their focus to the challenges that lie ahead. After years of layoffs and diminished or negative growth, law firms are seeing increasing partner turnover. Too often these departing partners are surprised at the status of the capital accounts, leading to real and potential disputes with management. To proactively address this issue, law firm management should ensure that partners and senior associates (potential partners) understand the basic concepts pertaining to partners' capital accounts.

A partner's ownership interest in a partnership is tracked through the maintenance of a capital account. Failure to pay attention to the tax basis schedules and capital account balances can trigger unintended tax consequences.

Generally a law firm accounts for its operations annually, and its annual financial results are recorded on a tax basis for the purpose of filing annual income tax returns. Each partner has his/her own tax-basis capital account, which is adjusted upward or downward depending on the specific adjustment.

A partner's tax-basis capital account is increased by:

• A partner's initial capital contribution to the partnership (normally a cash contribution);
• The amount of additional money and the adjusted basis of additional property contributed to the partnership;
• A partner's distributive share of partnership taxable income; and
• A partner's share of partnership tax-exempt income.

A partner's tax-basis capital account is decreased by:

• The amount of money and the adjusted basis of property distributed to the partner. Distributions can be in the form of cash draws or disbursements made on a partner's behalf (such as retirement plan contributions, self-employed health insurance, automobile allowance, composite tax payments, etc);
• A partner's distributive share of partnership taxable losses; and
• A partner's share of nondeductible partnership expenses ( e.g., political contributions, club dues, life insurance, or the disallowed 50% of travel and entertainment expenses).

The computation of a partner's tax-basis capital account is very similar to the calculation of a partner's tax basis in his/her partnership interest. The largest difference between the two is that the tax-basis capital account does not take into account the partner's share of partnership liabilities, or optional basis adjustments under IRC ' 754. A partner's share of liabilities is important in situations where a capital account becomes negative as a result of losses and non-
deductible expenses.

Tax-basis capital accounts provide a shortcut to compute a partner's tax basis in their interest. To determine the tax consequences of a partnership transaction, one must take a partner's tax-basis capital account, add back the partner's share of partnership liabilities, and adjust for any inside/outside basis differences.

The above computation can be used to determine if a partner:

• Has enough basis to deduct a partnership loss;
• Will recognize gain on a contribution to or distribution from the partnership; or
• Will recognize gain or loss on a disposition of his/her partnership interest.

In addition, if a partner has a negative tax-basis capital account, it usually represents the minimum gain he/she would recognize if the partnership were to terminate or if the partner were to sell his/her interest for no cash consideration.

It is important to remember that GAAP and tax capital accounts may differ (for example, due to accelerated depreciation for tax purposes). When a partner leaves the firm, his/her payout is normally based on GAAP capital account. Accordingly, where GAAP capital account is larger than tax capital account, the difference will be taxable to the partner and likely result in ordinary income.

While the partnership's accountant is responsible for keeping track of the partners' capital accounts, it is each partner's responsibility to review such schedules and keep track of his/her individual tax basis schedules in order to avoid unintended tax consequences. Management's responsibility is to educate the partners on the factors that impact their capital accounts to avoid potential disputes.

Luda Mirne, CPA, MST, is a senior manager in CohnReznick's Law Firm Industry Practice. She may be contacted at [email protected] or 732-380-8646 for more information on this and other tax matters as they relate to law firms and their partners. Jacob Weichholz, CPA, is a director in CohnReznick's Law Firm Industry Practice, and also may be contacted at [email protected] or 646-625-5709 for further information.