Not every party from which financial discovery is sought will have financial statements, but almost all will have a federal income tax return. Here, we address how to use tax returns for financial discovery. Remember, individual return forms and their instructions can be found at irs.gov.
Form 4506 allows the taxpayer or an authorized third party to obtain the return from the IRS up to seven years after its filing date. The returns available through the 4506 are the Form 1040, the Form 1065, and the Form 1120. Using the 4506 is usually the only way to obtain the signed return actually filed with the government.
Individual taxpayers file the 1040, which summarizes the income and certain expenses in the form of allowed deductions. The marital status and dependents of the taxpayer will be represented and, like all information on the form, sworn to under penalty of perjury. The summary line item entries on the 1040 reveal multiple financial attributes which can be further analyzed on the individual schedules attached to the return. These are:
- Schedule B: Interest-bearing and dividend paying assets
- Schedule D (and Form 4797): Sales of capital assets
- Schedule C: Sole proprietorship—including single member LLC—earnings
- Schedule E: Investment real estate and earnings from partnerships and S-Corporations as well as trusts
- Schedule F: Farm and ranch income
An individual’s assets and liabilities can be partially inferred from these schedules. Unlike corporate and partnership returns, the 1040 lacks a balance sheet listing assets and liabilities. Identifying assets by virtue of their reported earnings allows one to begin valuing the assets and furthers the evaluation of whether lost earnings or lost profits exist. Additional information can be inferred based on historical trends from return to return. Foreign bank accounts and asset holdings should be reported and found on the Foreign Bank Account Report or Form 8938, the former being filed independently and the latter attached to the tax return.
Together with financial statements given to lenders, the 1040 forms the foundation of financial discovery regarding an individual, from which a more effective deposition may proceed. A competent CPA or tax attorney should be helpful toward further identifying the underlying assets, liabilities and earnings represented on the 1040 and its related schedules.
While it’s likely a corporation or entity choosing to be taxed as a corporation will have its own books and records, prudent financial discovery involves comparing those books and records to the Form 1120 filed with the IRS.
Did you know? There is in fact a specific section of the 1120, Schedule M-1, which reconciles the books to the tax return while disclosing travel and entertainment expense.
The first page of the 1120 sets out the revenues and expenses of the corporation, including specifically, the compensation of its officers. A separate schedule further detailing certain expenses not listed on the face of the return is often attached so all pages to this and any other return should be obtained, including K-1s for S-Corporations.
Schedule K to the 1120 describes the business activities of the corporation, its affiliations to other corporations and changes in its ownership. Schedule L to the 1120 provides a balance sheet comparing the prior to the current year assets and liabilities as well as equity accounts. Note should be made of the accounting method disclosed on the return; cash, accrual or “other,” as it will affect the timing of revenue and expense reporting. Because a balance sheet and statement of income are provided, assessing the value of a corporation is easier using only the tax return than it is for an individual because in contrast to the 1040, the 1120 provides a balance sheet to show all assets and liabilities. Regardless, note that on the 1120, assets are usually at their cost and not their market value.
Similar to the 1120, the Form 1065 for a partnership provides a balance sheet on Schedule L and statement of income on the first page with subsequent details as schedules. A similar narrative of the nature of the business and ownership transactions appears here on Schedule B. As with an S-Corporation, the attached K-1 forms describe each owner’s capital, distributions and allocated share of income and expense.
When financial discovery is needed, tax returns offer a productive starting point to discover the earnings, assets, liabilities and capital accounts of an entity. Reading sequential years’ returns carefully, with the help of the instructions or a financial expert, will reveal earnings growth or decline, asset accumulation or decline and the amount of investment made. Having this information will inform subsequent discovery for the better.
Jeff Compton has worked as a certified public accountant since 1980, and a certified fraud investigator since 1991. He’s a member of the Texas Society of CPAs, and has been accredited in Business Valuation by the American Institute of Certified Public Accountants, as well as in Petroleum Accounting by the Council of Petroleum Accountants Societies, Inc. Allen Wendler is a member of the Texas Society of Certified Public Accountants, as well as the Tax Section of the American Institute of Certified Public Accountants.