As we visit with fiduciary industry professionals, we often hear that a partner’s Schedule K-1 (from Tax Form 1065) is relied upon as the source of value for a closely held business interest held within a trust or IRA account.  Although the Schedule K-1 may help verify some key factors for the Trustee, it should not be used for valuation purposes alone, particularly when attempting to derive a fair market value (“FMV”)[1] for the investment. Rather, you should strive to obtain the complete Form 1065 tax return as it provides more relevant financial information related to the value of the entity.

Let’s explore: 1) Why a Form 1065 is useful to obtain during the valuation process and 2) How the supporting Schedule K-1 statement can help Trustees more effectively manage these asset types.

A. Tax Form 1065 – U.S Return of Partnership Income

Form 1065 is an information tax return issued by the IRS used to declare the profits, losses, deductions and credits of a business partnership. However, oftentimes for an investment holding company, this first page may be blank as the business may be focused more on asset appreciation rather than generating earnings. In these situations, it may be more important to understand the financial position of the company by learning more about the underlying assets and liabilities held at the end of the tax year. This is reflected on Schedule L of the tax return, as shown below:

Schedule L (Important!) – Balance sheet with assets and liabilities.

Schedule L provides detail on the assets and liabilities at the beginning and end of the tax year; which may not reflect fair market value.  A few common areas to watch closely are:

• Other Investments – Data listed in row 8 typically references a particular “STATEMENT” included towards the back of the Form 1065 which provides additional detail on the specific type of investment(s). Examples include a breakdown of equities, bonds, mutual funds, and other various other investments.  If this is noted, the appraiser may ask if a brokerage statement exists to get a current FMV for these assets.
• Real estate – Arguably the most common type of investment held by LLCs and LPs (in our experience), buildings, land and other real property investments can be found in rows 9-11 on Schedule L.  Unless the real estate was recently acquired or you were provided with a current appraisal, the “book value” figure will not reflect fair market value and you will need to explore other methods for estimating FMV.

• For example, if the real estate generates income, an additional schedule (Form 8825) will be provided within Form 1065 that presents the type of property, the address of the property, and all income and expenses associated with the property. Based on this information, a capitalization technique can be employed to approximate FMV based on cash flow rather than relying on the book value indication.

Schedule M-2 – Analysis of Partners’ Capital Accounts.  The detail in this section can help you determine the amount of distributions, if any, the company paid in cash or property to the partners.

B. Schedule K-1 – Partner’s Share of Income, Deductions, Credits, etc.

This schedule is used for reporting a partner’s share of the company’s earnings, losses, deductions and credits. Many times, this may be the only document the Trustee receives in his/her quest for obtaining relevant data and, as a result, he/she will assume the number shown in Box L next to “Ending capital account” to reflect fair market value. This is not accurate, as this figure merely reflects the partner’s original investment basis adjusted for contributions and withdrawals.

Despite this, the Schedule K-1 can serve to validate a few beneficial areas for the Trustee:

Asset titling – Double check Part II to validate that the partner’s name is titled properly.  Is it in the trust’s name?  Is the EIN a correct match?

Ownership % – Does your trust accounting system ownership % match the % in Part II, Section J?

Level of control – Box G verifies the partner’s control status (General Partner vs Limited Partner); a key determinant when employing shareholder-level discounts for lack of control and marketability.

Tax year and/or Final K-1 – Make sure your tax year matches your fiduciary account.  Be careful if this asset is held in an IRA as the value reported on Tax Form 5498 should be as of 12/31, not any other date.  If it is the final K-1, did your asset receive the final distribution check?

Income/Deductions (Part III) – Pay attention to any oil/gas royalties received (Box 7) for valuation purposes.  Absent reserve reports, appraisers may employ a capitalization technique if multiple years can be provided.

In summary, the partnership returns and supporting schedules may not have all the answers for you to credibly determine a fair market value; however, there is certainly some valuable information to help you verify as a Trustee. It’s also worth noting that the name, address and phone number of the tax preparer is presented on the first page of the return and can oftentimes provide additional information on the company. In efforts to derive a fair market value, we advocate you request the actual Form 1065 (not simply the Schedule K-1), as a closely held business cannot be valued based solely on a partner’s Schedule K-1. Remember…since the trust is the owner, you are entitled to the entire Form 1065!

[1] The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. – AICPA SSVS1

For more information regarding RIC’s closely held valuation solutions, please click on the following link   https://ricomaha.com/solutions/closely-held/ or email Patrick @ Patrick.Alyward@ricomaha.com.