• Categorized under ,, | Whether it is a partnership business, an entrepreneurship, or a corporate business, understanding the basics to account for business transactions is very important for the smooth running of business. Without knowing how to maintain your books, and what the different ways are to maintain them, you may not be able to properly present the information to people associated with the business. For example, there are many partnership businesses and limited liability companies (LLC) that are taxed as partnership businesses, where you are required to maintain two types of books. One book is maintained on the basis of Generally Accepted Accounting Principles, and the other one is based on the tax basis. Books, maintained on the basis of Generally Accepted Accounting Principles (GAAP), record business transactions according to the rules defined by the financial accounting board, whereas, in the tax books, transactions are recorded according to the rules of the Internal Revenue Code to calculate the taxable income.
However, there is another set of books that should be maintained by businesses, but are often not. These books are known as Section 704 (b) books, and these books are prepared in accordance with the rules defined under the Section 704 (b), and try to depict the economics of the deal. As already discussed, books prepared in accordance with the rules of GAAP are based on financial accounting principles. But the aim of 704 (b) books is to disclose the substantial economic effect of the allocation among partners. According to the regulations defined in 704 (b), capital accounts should be maintained as per the specific rules that are neither a part of GAAP or tax. For example, if a property is contributed by a partner as a part of a partnership business, then under the section 704 (b), capital account for the contributing partner must be credited with the FMV or fair market value of that property. Similarly, if the property is distributed, the capital account of a distributee should be debited with the fair market value of that property.
No special appraisal is required to identify the fair market value in maintaining the books under section 704 (b). As per the regulations, all the partners can agree on the fair market value if the parties are adverse and it is an arm’s length transaction. Generally Accepted Accounting Principles or GAAP are imposed by businesses in order to bring a minimum level of consistency in financial statements that is useful to analyze companies for the purpose of investment. Different businesses follow GAAP rules to prepare financial reports for stakeholders. Unlike 704 (b), under the GAAP accounting methods, fair market value of an asset is only adjusted on certain events that are known as “book up” or “book down” events. For example, if a new partner is joining a partnership business, the existing partners may wish to restate their books capital account, and for business purposes, they are permitted to document their ownership in the appreciation of assets that accrued before the new partner joined the firm.
In a partnership business, three sets of books are always required that are prepared in accordance with the tax laws to calculate the taxable income, GAAP to calculate the business income and 704 (b) to calculate the economic effect of business transactions. Let’s assume that there are two partners in a business, Partner A and Partner B. Partner A brings the funds of $1,000, whereas, Partner B brings the property with the fair market value of $1,000 in a partnership business. B claims accelerated depreciation, which reduces the tax basis of a property value to $400. The straight line depreciation method used for GAAP accounting, which decreases the value of a property to $700. Now the value of property contributed by B will have the following basis: $700 for GAAP, $400 for tax purposes, and $1,000 for section 704 (b). To calculate the depreciation of the depreciable property under section 704 (b), it should have the same ratio as tax depreciation has to the tax basis, unless it is done according to the remedial method under section 704 (c).
In the above example, if tax depreciation for the first year is $40, depreciation calculated under 704 (b) will be calculated as follows: Depreciation calculation under 704 (b) = $40/$400 times x $1,000 = $100 Liquidation – At the time of liquidation, the proceeds should be distributed among the partners in accordance with the positive capital accounts. These are referred to as Section 704 (b) capital accounts, and not tax or GAAP capital accounts. In case of GAAP, the proceeds are distributed among the partners according to the income and loss sharing ratios. Why to maintain Section 704 (b) and GAAP Books? –Section 704 (b) books are required to be maintained, because it is generally required by the tax law, but you are not required to show these books on the partnership’s tax return balance. Secondly, these books are used to identify the economic substance of the deal. GAAP books, on the other hand, are required to be maintained in order to meet the reporting requirement of the business, and to show consistency in the financial information presented to the shareholders and other stakeholders of the business.
Document PreviewAccess to the complete full textThis is a short preview of the document. Your library or institution may give you access to the complete full text for this document in ProQuest.Connect to ProQuestOnce connected, you can view documents in full as well as cite, email or print them. You can also find other documents related to your research within ProQuest.Targeted capital allocations are becoming standard in new LLC or partnership operating agreements. Historically, operating agreements typically provided for income/loss allocations to the partners based on the safe harbor provided under IRC Regulation 1.704-1(b)(2). This was more of a “cash follows tax” approach, in which the operating agreement provided a calculation for the allocation of taxable income/loss and distributions were then made based on the balance of the each partner’s capital account. The Regulation provides a safe harbor for economic effect if:1. Capital accounts of the partners are maintained under 704(b);2.
Upon liquidation of the partnership, liquidating distributions are to be made in accordance with positive capital account balances; If such partner has a deficit balance in his/her capital account following the liquidation of his/her interest in the partnership, he/she is unconditionally obligated to restore the amount of such deficit balance or the agreement provides for a “qualified income offset.”Conversely, the targeted capital allocation language we are seeing more frequently in partnership agreements is more of a “tax follows cash” approach. With this method, the partnership makes distributions based up on the liquidation provisions of the operating agreement (usually referred to as the “waterfall”). Taxable income/loss is allocated so that, after the income/loss allocation has been made, the balance in each partner’s capital account shall, to the extent that is possible, be equal to an amount that would be distributed to the partner based on a hypothetical liquidation of the partnership.
Distributions are made based on the waterfall calculation.Note that the term “capital account” referred to in the operating agreement means the capital accounts under IRC Section 704(b) and are referred to as the “book” capital accounts. This is a fair market value concept and should not be confused with the books as maintained by the business that may or may not be on a GAAP basis. Tax capital accounts can be different than “book” capital accounts. The intention of the targeted capital allocations is that each partner’s book capital account reflects the amount that partner would receive upon liquidation of the partnership. The book capital account often does not reflect this though, because income/loss does not always reflect the appreciation/depreciation of the entity’s value.There can also be an ongoing difference between book and tax capital accounts. These differences can be caused by a difference in the basis of the assets that were contributed to the partnership.
For book purposes, assets are accounted for and depreciated based on the fair market value on the contribution date; for tax purposes, assets are based on a carryover basis concept. Or it could be that the assets of the partnership were booked up or down as a result of a revaluation event, e.g., a new partner was admitted to the partnership. There are many reasons that book and tax income/loss amounts and book and tax capital accounts may differ. Because of these differences, the allocations of both book and taxable income need to be reviewed annually, and a standard formula will not work under the targeted capital allocations approach.The intent of targeted capital allocations is to allocate income/loss that reflects the economic arrangements among the partners. What does this really mean for a partnership? How do taxable income and losses get allocated? It depends on a multitude of factors, including:We often find in working with LLCs and partnerships that the economic arrangement or value of the entity is different than the taxable income/loss calculation.