Episode 28 ---
Profit and Loss and K1’s and Taxable Income and a partridge in a Pear Tree (ok... too late for that-sorry)
Welcome to a ‘tax season’ episode (I recorded this in Jan. right after my last 1099 was filed—Whew!) I hope your tax season is going well if you are a bookkeeper or a small business owner. I’m Paul Rosenblum.
Today let’s talk about a specific situation that I have with one client. I have been putting together the books for a landscaping company for about 10 years. And we have an interesting arrangement in how we work together to put their books together.
Here are the bullet points:
- There are two partners, one of whom does designing, and the other does landscaping, maintenance and the invoicing of the clients.
- The partner does batches of invoices at one time, not every day or every week because of the work schedule involved.
- They use a MAC version of QuickBooks, so we can’t use a file sharing system like QBox, which only works for windows.
- At the beginning, I tried to log into their MAC remotely, and that didn’t work out for several reasons. So, we decided that periodically throughout the year, they would put their file on a google drive for me to download, open it up in my windows QB, and work on it an bring it up to date. The invoicing was done by them and the payments received by them.
- For bookkeeping, that mostly worked out. They would have a finished product in time to file 1099’s, and a finished set of books ready for tax filing way before the deadline that accountants need the file to file their partnership tax return. (They actually had an accountant who had an old version of QuickBooks, so that when I emailed the QB file to their office, they couldn’t open it, but I digress as usual). They did a partnership tax return from a Balance sheet and a Profit and Loss statement exported to PDF or Excel (which I am never happy with).
- Both partners took distributions every quarter based on their approximate profit (or money in the bank) each quarter.. One partner slightly above 50%, the other partner a little under 50%.
Now, that I set up the situation, this year, one of the partners wanted to understand why after taking distributions throughout the year, they didn’t have enough money in the bank account to split the net profit between them. The partner also wasn’t sure what was taxable on a K1 form. And why the taxes seemed high. I wasn’t 100% sure, so I called their current accountant and got a full explanation -- something that I was always a bit weak on, but since I have the information now in my head clearly, I wanted to share it with all of you.
If you have a partnership, there are two general ways to ‘book’ money that the partners pay themselves from the company’s bank account.
- Use the Equity section and book the distributions as 2023 Distributions, or 2024 Distributions and transfer money from the business checking account to your personal account using the percentages of the partners’ equity. So, for example, if you have $10,000.00 to use as distributions, and each partner is 50%, then each partner would have an Equity Distribution account and $5,000.00 would be transferred to each partner.
- The other way of ‘booking’ payments to partners would be if the partners are actually working in the business, and not just owning the business and hiring others to manage it. If this is the case, you can use an expense account which will be on the Profit and Loss report (not the Balance Sheet like the Equity accounts that I talked about earlier) – They would be called ‘Guaranteed Payments’, and each partner would have a subaccount to use underneath ‘Guaranteed Payments’ for payments made for them individually. You can almost look at these accounts as a ‘kind of’ payroll for partners of a business, without payroll taxes being deducted. It’s a straight transfer of funds from the business bank account to your personal account similar to distributions.
Now, let’s get a better understanding of what this looks like in the real world.
Distributions through Equity are reported on a K1 as part of the partners’ personal tax returns, but they are NOT taxable. What is taxable is the profit of the business. The distributions are on the balance sheet, and the profit is in the Profit and Loss Report. Two different reports to look at. If the business ends up making $100,000 net profit, and each partner has 50% equity in the business, then the taxable portion of the K1 form would be $50,000.00 for each of the partners.
Here's the tricky part:
If over the year, each partner receives $65,000.00 in distributions (on the balance sheet), (total paid out $130K) and the profit of the business is $100,000 (which translates to $50,000.00 a partner, this means that your distributions exceeded the profit in the business. It also means that there will be around $30,000.00 less in the bank account than the $100,000.00 profit that your books show (about 15K more than the profit for each partner).
So, it always confuses a business owner as to why the net profit isn’t equal to the bank account balance.
During the course of the year, income earned is supposed to be put into the bank account of the business. That’s an easy one.
However, not all money spent from the business bank account is reflected in the Profit and Loss Report. Some examples are:
- If you purchase a machine for your business and it has a life expectancy of more than one year, then that machine becomes a FIXED ASSET of your business. If you purchase a machine for $3,000.00 and it is being ‘depreciated’ at $1,000.00 a year for 3 years, then even though you spent $3,000.00 on machinery, only $1,000.00 is showing up in the current year in the Profit and Loss Report. So, it skews the profit for that year, because next year, you will have another $1,000 depreciation expense and the third year, you will have the last $1,000.00 depreciation expense on the books.
- If you take distributions and you use the equity accounts on the balance sheet, the distributions will not affect the profit and loss. So, the business departs with $65,000 a year for each partner (as used in this episode’s example), the net profit doesn’t change. It only reflects the amount of money that you have in the business bank account.
However, If you use the ‘Guaranteed Payments’ scenario, then since the guaranteed payments is an expense category, each time you pay yourself and your partner, it WILL reflect in the profit and loss. So, you will be able to see, based on what you pay yourself and your partner every month, what your profit is including your guaranteed payments because they show up on the profit and loss. If you ‘overpay’ yourselves throughout the year, you will see it reflecting in your profit and loss after your bookkeeper finishes the year completely. In this case, Guaranteed Payments ARE taxable along with whatever the much smaller profit that your company will show at the end of the year.
You are allowed to take out a ‘loan’ from the partnership LLC, and since you’d have to pay that loan back to the LLC, then it’s not considered income for you personally. So, that won’t affect the K1 in terms of taxable income. When you pay the LLC back, the bookkeeper will not book that transaction as income, but rather, as a loan repayment (same account on the balance sheet that you used for the outgoing loan). Talk to your accountant about that --- I’ve actually never seen that happen, although I have seen an S Corporation partner take a loan from the company and pay it back through their W2 payroll as a non-taxable deduction.
As I have said before, if you hire an accountant who you can talk to about this and do some planning at the beginning of every year, then you can make things easier through the year paying your quarterly estimates and at tax filing time, make it much less stressful on yourself.
Ok -- back to work for me -- Stay tuned for more client stories and situations next time.
I’m Paul Rosenblum