Expert: Paul Sid, CPA CFA - 1/31/2012

Question
QUESTION: I do in-house accounting for a partnership LLC.  The company has been in business for about 8 years and I have recently taken over the books.  The equal partners treat themselves as employees in that they take a monthly salary and pay themselves bonuses with all applicable taxes withheld as would be with any employee.  From this I will ask a very general question of whether or not I should be concerned about this set-up.  From a tax perspective, I would not imagine that the IRS would have an issue, since they have adequate withholdings, pay their share of FICA and medicare, and even are paying into unemployment on a state level.  Am I being short sighted?

I am also not sure of how this affects their equity. Your thoughts are greatly appreciated.

ANSWER: Hi Donna,

Thanks for your question.

On the surface the partnership appears simple- income is earned and all partners get an equal salary distribution.  However, I have a few questions so we can take a deeper dive.

1. In a partnership there are general partners and limited partners.  Is everyone a general partner?  Do all the partners have similar capital contributions and similar time spend in the business?

2. Do the distributions agree to the terms of the partnership agreement?

3. Are the partners related by blood or marriage?

4. What is the general business?  During the 8 years in existence, how many are profitable years and how many are loss years?

5. What percentage of the business activities are conducted in cash?

6. If the partnership make investments, what is the nature of the investments?  Are there a sizable investment in passive investments (e.g. real estate)?  What percent of the investments can be defined as "abusive tax shelters"?

7. What percentage of investments, including cash, are invested/held in offshore accounts/assets?

8. To your knowledge have the partnership been previously audited?

Thanks.

Regards,
Paul Sid

---------- FOLLOW-UP ----------

QUESTION: 1.  The tax return shows Limited partner for box G on the K-1s.  Both have equal capital contributions and time spent in the business.  

2. Define distributions for me as they only are taking from the business in the form of paychecks.  Nothing has ever been posted to Distributions in the G/L.  Have not seen the partnership agreement.

3. Not related at all.

4. This is a sales organization, selling products for outside vendors mostly.  All years have been profitable for tax purposes.  Since they take cash from the business via paychecks, the P/L reflects a net income after they have been paid which is their largest expense.  They receive both K-1 statements and W-2s.

5. If by cash, you mean the green stuff, the answer is none.  Most of their income comes from commissions earned via sales of product lines they represent.  They maintain and sell a small inventory of goods also.

6.  The only investments they have is the building we work in and their distributor license.  

7.  None.

8.  Never audited.  Sometimes you wish you could work for those that have so they take you more seriously.  It should be standard practice to have the IRS, state sale tax entities, and payroll authorities audit all businesses in their first year.

Answer
Hi Donna,

You are very smart in thinking ahead and anticipating potential problems before they arise.

Based on my questions, I believe that the IRS is more concern about certain issues:

5. Cash transactions.  The Service is concern about business that are conducted in cash an don't have an audit trail (e.g. hair salon, laundry mat, small restaurants).

Your partnership does NOT appear to have such issue.

6. Passive investments and abusive shelters.  The Service is auditing most of such transactions- big time.

Your partnership does NOT appear to have such issue.

7.  Offshore assets.  The Service is "actively" auditing most of such transactions- big time.

Your partnership does NOT appear to have such issue.

8. Prior audits.  It appears that the Service is comfortable with the partnership's activities and see little reason to audit it.

Additional issues which you should keep in mind include: expensing of home office, large meals/entertainment deductions, sizable write-off in use of personal autos (so-call listed properties).  However these figures should be large for sales people.

You may want to follow-up on a partnership agreement.  Similar to a marriage, it is best for all to agree on the ground rules in order to address and control issues as they arise.

Overall I believe that the partnership appears to handling its business affairs appropriate.  The partnership should be just fine from a tax audit viewpoint.

Wish you much success.

Regards,
Paul