Tax returns are the mechanism for an entity to report to the government the taxable income (or loss) of the entity. Tax returns often become involved in litigation as a method for determining and understanding financial performance either at a point in time and/or over a period of time. Because of this, it is important for litigation counsel to understand the implications of certain areas of tax returns. This article will go into some detail with regard to certain aspects of tax returns and how the information can be used or misused, understood or misunderstood, and hopefully give rise to a slightly higher level of understanding by counsel. 

In addition, it is important to understand that the form of required tax returns are a function of type of the legal classification of the entity. Generally, this article will review the business returns of Partnerships, LLPs, LLCs and Corporations. The Partnership, LLP and LLC will generally be filing a form 1065 (also referred to as a Flow Through tax return) and certain corporations that have elected “S” status will file an 1120S, which also allows for most of the taxable income or loss to flow through to the individual shareholders. Regular corporations (called C Corporations) will file Form 1120. 

The legal name of the entity will normally be displayed at the top of the corporate tax return, although in many cases accountants and companies are known to abbreviate or change names. In some cases, “DBA” names are utilized. The type of entity is normally indicated in the upper left hand corner where there are check marks available. Each of these items may be appropriate for review and/or may give information with regard to some legal issues with regard to the entity that may become important. In addition, in the upper right hand side of the tax return form is the employer identification number as well as certain information with regard to the total assets and/or liabilities of the entity.  Again, these numbers normally will tie into other figures on the tax return, and these can be scrutinized for accuracy, etc. The beginning of the real information with regard to the performance of the entity starts with the revenue lines. Generally gross receipts less the returns and allowances will be shown on the first line of the return. (In some cases, the line numbers will differ between an 1120, 1120S and a 1065 form, but the essence of the information below is what needs to be considered). Note that in come cases, if the entity is involved in a rental activity, the income and loss for this activity may not be reflected on the front of the tax return as it is reported on separate schedules within the body of the return itself.

When utilizing a corporate tax return with regard to litigation related issues, it’s important to recognize that there are often differences between amounts reflected on a tax return and a financial statement for a variety of reasons (to be discussed below) but also, in many circumstances, smaller entities do not have or require financial statements prepared and the tax return may be all that the attorney and the forensic accountant are working with. Where there are differences between financial statements and tax returns, it is important to understand and investigate the reasons for the differences. The single most common reason for a difference between tax return information and financial statement information is a different method of reporting. Certain entities are allowed to report their taxable income on a cash basis (or in some cases on a modified cash basis) of accounting. This allows revenue to be recognized only when it is received as opposed to when it is earned, and expenses are recognized when they are actually paid, as opposed to when they are incurred. This is most common in professional organizations (law firms, accounting firms, medical groups and the like) although there may be other circumstances where a cash basis of accounting is permitted for tax purposes. In some of these circumstances, the financial statements may be prepared on an accrual basis of accounting. The easiest way to determine the basis of accounting on a tax return is to see where the check mark appears (on most forms it is on page 2) or to determine whether or not the balance sheet includes accounts receivable and/or accounts payable, which generally indicates use of the accrual basis of accounting. 

If both the tax return and the financial statements are prepared on the accrual basis, most of the time, the tax and financial statement income and balance sheets will be essentially identical. Due to differences between the financial statement treatment of items under Generally Accepted Accounting Principles (GAAP) and tax rules under the Internal Revenue Code, there are quite often differences between the financial statement income and taxable income of the same entity. These differences in income are disclosed on page 4 of most tax returns on Schedule M of the tax return. These items all are not applicable for Schedule C (Sole Proprietor Businesses or LLC’s with a single owner) which are reported as part of an individual’s 1040 (Individual Income Tax Return) and do not include a balance sheet or much of the other information described in this article.

Continuing down the first page of the tax return, cost of goods sold will normally be completed for all but the simplest and/or personal service type entities.  Cost of goods sold will generally reflect the purchases of material for the manufacture or sale of products and should also include the beginning and ending inventory numbers. As with the indications above, if there is a cash basis of accounting, there will not be inventory in most circumstances. It may also be important to go to the top of Schedule A, on page 2 of the tax return, to understand the details of the cost of goods sold. The information here will give some indication with regards to gross profit, and the changes from year to year may be indicative either of changes in the methodology being used for accounting, for inventory and/or significant changes in the business operations, methodology, etc. It is also important to understand that there is a possibility for salaries of officers and/or other owners to be partially allocated outside of the normal line for officer’s salaries, if the officer is involved in any way in the production/manufacturing aspect of the business, and that needs to be clarified. That can usually be done by looking directly at a W-2 form for the individual(s) involved to make certain that all compensation with regards to any officers are properly understood and considered.

Continuing further down the first page, most of the other items in the top section of “income” are self-explanatory and, in most business circumstances are relatively nominal and/or de minimis. Certainly, if there are rents involved, it indicates that there is property, plant and/or equipment which is being rented out in some fashion. If this is indicative of a non-arms length transaction, and may be important to the litigation process. capital gains will be indicative of some type of capital transaction, often the sale of stock, bonds or business assets. When there are capital gains listed, it is important to understand whether that is some form of liquidation of the business and/or simply a non-recurring item that may be important in understanding the operations of the entity on an on-going basis. In a valuation context, capital gains it will almost always be eliminated for purposes of understanding the operations of the business in the valuation process. Note that for partnerships and S Corporation, capital gains and losses are reflected separately and shown on Schedule K of the tax return.

On most tax returns (1120S is an exception) there is a fairly clear indication of the compensation paid to the major owners. On the regular 1120 form this will be Line 12 Compensation to Officers. This should tie into a schedule on Page 2 that lists each of the owners and their compensation. This can also be verified by reviewing the W-2 forms. Officers’ compensation may come into play in Shareholder derivative suits and/or valuation in trying to understand whether or not “reasonable compensation” has been taken, or the compensation is in excess of reasonable compensation. (In some circumstances, especially in small and/or start-up businesses the compensation of the officers may in fact be less than a fair market value for their skills, hours worked, etc.). Salaries and wages for other individuals which will normally appear on Line 13 on the Form 1120 will be important, (with a portion of this possibly having been recorded in cost of sales) to tie out the total wages and to make sure that all wages paid to all individuals are fully understood. This can come into play if there is a concern or suspicion with regard to reasonable compensation and/or “ghost employees” (ghost employees may include a boyfriend or girlfriend or other family member who is not really working in the business but who is receiving compensation). This can only be best determined by looking at all W-2 information and making sure it ties into the tax return.

Rental expense on Line 16 may be indicative of simply a cost of operating the business, but in some circumstances, it may also be indicative of a non-arms length transaction.  Only with a full understanding of rents paid can it be determined whether or not there are properties or other assets owned by a related party or entity that are being rented to the business entity that is being reviewed. Taxes and licenses may be important to understand where the geographic operations of the business lie (local taxes should be paid) and/or to determine whether or not there is exposure and/or mismanagement (which could include tax fraud) if the entity if failing to file tax returns that are obviously required.  One typical example is a business that has its main operation outside the City of Philadelphia but which has nexus where City of Philadelphia taxes should be paid yet no Philadelphia taxes are being deducted.  Depending on the underlying litigation issues, it may or may not be important to understand this and other related nexus issues. It may also be beneficial to request a review of any state or local tax returns filed by the entity as a source of additional information about the activities of the business. State tax returns would report the location of assets, sales or employees in states other than the “home” state.

Depreciation is one other area that normally differs between tax returns and financial statements. This can occur primarily because of a difference in useful lives and/or depreciation methods. Tax laws have been utilized extensively with regard to “economic stimulus” by allowing accelerated depreciation in many business circumstances. In addition, the useful lives of assets for tax purposes will often be different than that for their real economic lives which are used in accrual basis financial statements. A reconciliation of the depreciation between the tax return and the financial statement should not be difficult, and should have been prepared by the tax return preparer/accountant for the business entity. This may be an area of discovery that will be requested. By getting full depreciation records it will be easier to clarify all assets that are owned by the entity, ascertain whether or not there are assets that, in fact, are not used by the entity, but are used by the individual owner(s) or others that may be relevant for certain litigation purposes. The pension and profit-sharing lines will give rise to an understanding of what benefits of this sort are in place at the entity and concurrently whether or not the individual owner(s) has a benefit that may be relevant to the litigation.  In divorce circumstances pension plan contributions (in Pennsylvania) are normally considered part of compensation even though the owner may or may not be able to get access to pension contributions without serious negative tax implications. It may be important to ascertain the exact details of a plan (401K, Defined Contribution Plan, Defined Benefit Plan or other) in order to fully understand the implications for the particular litigation involved. 

The other administrative deductions, which appear at the bottom of the expense section on Page 1, will normally be delineated with some detail elsewhere in the tax return. This can either be a mundane list of typical expenses, or not uncommonly, have a variety of unclear or obfuscating terminology utilized if the company is interested in such endeavors. A forensic accountant who is familiar with business and tax return issues will more readily be able to determine which of these items are likely to give rise to questionable issues, depending on the business, the size of the expenditure listed and trends from year to year. It is especially interesting from a litigation perspective when the categories are changed from year to year on the Other Deductions page, making it more and more difficult to make comparisons between consecutive years.

For those tax returns that are actually calculating a tax at the bottom of Page 1, the tax calculation itself may be relatively mundane. The most interesting areas are when the tax calculation includes extensive credits or other items that reduce the amount of tax that would otherwise be paid. These might be investigated to ascertain what in fact is happening at the entity. 

The questions at the bottom of Page 3 again are generally mundane and routine, but a review of those will ascertain whether or not there are areas of any concern or particular interest. The method of accounting as noted above is indicated here as well as the official designation of the business activity. The selection of terminology for the business activity and product or service sold is largely up to the entity, although, it should not be completely misleading. Likewise, the business activity code number has a fair amount of flexibility and is most relevant for those circumstances where a valuation may be performed to ascertain what other comparable companies may appropriately be utilized and/or what business trends should be considered for comparable companies.  It is not uncommon (often for no sinister reason) to have some level of disconnect between an objective view of the company and the designation and this part of the tax return of the entity’s business description. This can occur because of the evolving change in the business pattern over years, which is not reflected on the tax return, a simple misunderstanding by the accountant/tax return preparer, or for many other reasons. These questions also shed light on the ownership structure of the entity (i.e. greater than 50% ownership).

Page 4 contains the Balance Sheet, which is typically the list of the assets and liabilities of the entity as of the end of the fiscal year. Like a financial statement balance sheet, it will have various categories, but unlike a financial statement balance sheet, the initial indications of terminology are all prescribed by the Internal Revenue Service. The subsidiary schedules, where they exist, can give some additional understanding of the details of the assets and liabilities. We find in many circumstances that there is inadequate information in a tax return to fully understand the values of the assets and liabilities, and that many of these then require discovery requests for underlying detail.

Finally, it may be useful to review the schedule M-2 on a corporate return or the corresponding reconciliation of partner’s capital accounts. These schedules reflect the change in net equity during the year and should indicate the amount of any distributions or return of capital removed from the business by the owners. For example, in an S Corporation, any distributions to shareholders must be made on a pro-rata basis to all shareholders. A detailed review of distributions can identify exactly to whom these amounts were paid.

So, as you can see, tax returns contain valuable information about the operational and financial position of an entity. Analysis of the information can be used to support business valuation and/or lost profit calculations. These analyses usually require the use of forensic accounting skills and individuals knowledgeable in tax return preparation, as well as the underlying areas of litigation being contemplated.

David H. Glusman, CPA, DABFA, Cr.FA, CFS is Chair of our Forensic and Litigation Services Group and has over thirty-three years of experience. Contact David at dglusman@marg.com.