Big Dreams and Little Cash:

The Transfer of Negative Capital in Exchange for Services

I.                    Introduction.

In the early years, a startup typically runs at losses. In order to finance these losses, the company will either sell ownership interests or take on debt, or both. Tax law treatment differs depending on entity type, our focus here will be specific for partnerships. If a partnership takes on debt, it could run the risk of having negative capital. Negative capital means that if a partnership hypothetically liquidated all its assets, there would not be enough cash from the liquidation proceeds to pay off the debt.[1] A company in this situation may also be offering ownership interests to its employees to compensate for the lack of stability and lack of cash, and to motivate innovation. If the offered interest is for a share of the partnership’s net assets, the interest is called a capital interest.[2] The value of the capital interest is taxable to the recipient.[3] Proposed regulations have been released in an attempt to specify the valuation method and consequences to the recipient[4] and partnership when a capital interest is exchanged for services.[5] The proposed regulations are an attempt to settle issues that arise when following the current rules. When the capital of a company is negative, additional challenges arise when a capital interest is exchanged for services. The current and proposed regulations do not directly address the question of a transfer of negative capital in exchange for services, and so the challenge must be met by piecing together disparate rules and applying them as best we can to such a situation.

II.                 A Simple Example

A.                Facts

To illustrate the challenge that arises with transferring negative capital, we take a simple example. A company has zero assets, $900 of debt, and two equal owners that have not put in or taken out any cash. Their initial balance sheet looks like this:

Liabilities		900
Capital	Basis	Capital	Debt Allocation
A	0	-450	450
B	0	-450	450
Total Capital	0	-900	900
Liabilities + Capital		0

A and B decide to bring C into the partnership to be an equal owner in exchange for C’s services.

B.                 Rules

The rules specifying the steps for calculating and recognizing the amount transferred are based in case law regarding exchanging property for services[6] and several interlocking code sections that result in the following:

Step 1: Partner-to-be C provides services, or the promise of services. The partnership compensates C for her services by paying her a third of the partnership’s net assets.

In this step, C is taxed on the compensation for services.[7] The partnership recognizes two items that affect its taxable income: (1) the cost of services (which is either deducted or capitalized) [8] and (2) the gain or loss on disposal of the net assets. [9]

Step 2: C contributes those exact same net assets back to the partnership in exchange for a capital ownership interest.[10] If the assets are encumbered by any liability, C recognizes income to the extent that net liability relief exceeds the fair value of the assets she is contributing, since the liability relief is deemed a distribution of cash,[11] and cash distributions exceeding basis are recognized as capital gain.[12]

C.                 Application

Carrying out the rules yields the following result:

1.                  Step 1:

C is taxed on the compensation for services. The IRS rules calculate the amount that C must recognize as compensation as: “the excess of the fair value” of the net assets received “over the amount (if any) paid for such property.”[13] If the fair value is negative $300 and the amount paid is zero, there is no taxable income and no taxable deduction. The calculations are follows: For the fair value to be in excess of the amount paid, the fair value would need to be greater than the amount paid. Negative $300 is not greater than zero.  So there is no taxable income. There is no deduction either (there is no rule here that allows a deduction for the reverse, namely paying for a capital interest in excess of the fair value, let alone when the cash paid is zero).

The partnership recognizes (1) the cost of services, which is defined as the amount that C recognizes as income, which is zero.[14] The partnership also recognizes (2) the gain or loss on disposal of the net assets, namely a $300 income from debt relief.[15] This $300 income is allocated to the two partners who made up the partnership before the admission of C. Note, that though the partnership recognizes this income and allocates it to the preexisting partners’ capital accounts, the rules refer to this income as “unrealized.”[16] So this is book income, no taxable income.

The balance sheet, showing both basis and capital increased by the amount of income recognized by the partnership and allocated to the partners at the end of Step 1 looks like this:

Liabilities		600
Capital	Basis	Capital	Debt Allocation
A	0	-300	300
B	0	-300	300
Total Capital	0	-600	600
Liabilities + Capital		0

 

2.                  Step 2:

C contributes the exact net assets she received in Step 1, namely $300 of debt, back to the partnership. In doing so, C is relieved of the $300 debt handed over to the partnership while taking on responsibility for $300 of debt allocated to her out of the $900 partnership’s total debt. The net liability relief to C is zero, so C doesn’t recognize income for debt relief.[17]

Partners A and B witness the partnership liabilities increase from $600 to $900. A third of the total liabilities gets allocated to C as her right as a one third partner, the result being that the entire increase in liabilities ends up being allocated to C.

But what happens to the capital accounts? As you can see in the balance sheet below, liabilities have increased while capital has remained unchanged — and there are still no assets. (The reason capital stays the same is because capital is only increased by recognizing income or by capital contributions and is only decreased by recognizing losses or by capital distributions. [18] There is no income and no loss recognized in Step 2, and no infusion or distribution of capital in Step 2.) The balance sheet is out of balance. (Liabilities plus capital are supposed to add up to zero if there are no assets, and yet here they are adding up to $300.) The cause of the out-of-balance? C’s overpayment (zero) over the fair value of the net assets (negative $300) in Step 1. This overpayment was ignored at the time, since there wasn’t any specific rule addressing it in the context of transferring a capital interest in exchange for services.

The Balance Sheet at the end of Step 2:

Liabilities		900
Capital	Basis	Capital	Debt Allocation
A	0	-300	300
B	0	-300	300
C	300	0	300
Total Capital	300	-600	900
Liabilities + Capital		300

There are of course further code sections that can be utilized that will eventually resolve the above situation. The analysis is only just getting started. We will need to go back to step B, find more rules that are applicable, and apply them.

III.              An Approach to the Problem

The Internal Revenue Code is like a map, showing step by step, branching, back-tracking, merging, diverging routes. There are overarching rules to provide general guidelines, there are procedural rules to give specific guidelines, and there are anti-abuse rules to give micro-managing guidelines. As we look at this map, there are so many paths we can easily mistake one for another and not realize we are heading in the wrong direction.

So the first step to the approach is to step back and look for landmarks. When using a map, there are two places that are helpful to have in mind.

The first is: where are we? The second is: where do we want to go?

If a company transfers negative capital in exchange for services, for a capital interest in a partnership, what are the tax consequences?

That is where we want to go.

We are loath to divert off course, to arrive at a profit interest in a partnership instead of a capital interest, to exchange positive capital instead of negative capital, to check out capital in exchange for property instead of in exchange for services. Those are all for a different day, a different goal.

We might check out competing routes that are marked as short cuts, and as detours around accidents: proposed regulations, commentary, and innovative applications. If they offer a route that will resolve negative capital, in exchange for services, for a capital interest, we are willing to try them out. But first, where are we?

A.                What Is Our Starting Point?

How did we get here? Why are we interested in this? What kind of situation are we in? Whenever learning something, think why is it relevant. Very well, a little backstory to orient us.

It all starts with school. When discussing negative capital, it helps to start with school. Well, a couple years ago there existed a school that decided to graduate a young MBA who decided to start a company. Or perhaps, more likely, what happened was this: he was assigned a project for homework: go start a company, he handed in the assignment, he got an A and graduated, and then found himself released to the streets.

Where were we during all this? We were minding our own business, in an accounting office of course, safely far away from the escaped MBA graduate.

Then in barges this young graduate, together with his cofounder of his new company. We look at the financials. We look at the LLC operating agreement. We look at the operating agreement’s exhibit A. And we look at the attendant vesting schedule for all those developers.

We glance back at the financials. If you can call them that; they are more just a list of expense transactions. There’s pet food and toiletries mixed in them.

We glance back at the operating agreement. The initial capital contributions on exhibit A are all “Services in Lieu of Cash” and all the vesting interests are specified as capital interests. No member is responsible for any debt. No member is obligated to restore any negative balance in their capital account. No member is obligated to repay the capital contributions of any other member. All distributions, allocations, everything will be done in exact accordance to the ownership interest. Looks good.

We look at the financials again. The expenses are outweighing the income. This loan to the company from Founder 2, is it ok to consider that a capital contribution? No, that is a loan, otherwise it would throw off everyone’s ownership interest percentage.

This vesting agreement, each year another percentage vested, another percentage ownership of capital transferred from the two founders to the vesting developers. What is going to happen in year two, when you two founders transfer portions of your negative capital. To these others. In exchange for services. For a capital interest in the partnership?

What’s going to happen? Our ownership percentage will go down and theirs will go up, of course!

And then we are lost.

We stop for a moment here to ponder an existential riddle: Three accountants are stumbling through a snowstorm in the wilderness, and they see up ahead an abandoned, empty hut, the wind howling through it, the door hanging off its hinges and swinging wildly. Before they can reach it, they observe two people stumble up from the other side of the woods, go in, shutting the frail door behind them. A few moments later, the door opens and three people burst out and take off running. The three accountants stare, dumbfounded. Then the first accountant says, “we must have made a mistake. They must not have disclosed there was a person in there to begin with.” The second replies, “not necessarily. They must not have disclosed that they had a baby while in there.”

The third says, “I don’t see what you two are upset about. They’re just planning for one more person to go in so it will be empty again.”[19]

Ok, enough already, it is getting cold. We approach the hut. And as we get closer, we see something rustle in the wind, it appears to be a map that one of the strangers dropped.

B.                 What Are the Issues?

The map has boxes and lines, arrows and words. We skim over it and see:

IRS map landmark number 1. What is negative capital?

There is that school on the map here. Perhaps there is a dictionary or a math or history book in this school that will explain. Or perhaps a crushing student loan. Or a disruptive student. We shall have to check it out.

IRS map landmark number 2. Does it matter that the interest is exchanged for services rather than for property?

Yes, property seems to be depicted by nice gated communities. Services veer off into the wild.

IRS map landmark number 3. Does it matter that the interest is a capital interest rather than a profit interest?

Yes, the path in the wild splits, with profit interests continuing along a nice hike with blazed trees.  Capital interests lead straight to an unfordable river.

IRS map landmark number 4. Does it matter what kind of services are being exchanged for the capital interest?

The profits interests paths splits, though a couple faint paths veer off from the nicely marked trail (deer paths?) to meet up with the capital interest path at the foot of the unfordable river.

IRS map landmark number 5. Do we need to know the value of the capital interest in and of itself?

There is a rickety bridge over the raging river. This bridge is the value of the capital interest. Yet there seems to be some sort of troll under the bridge. And some danger signs about high winds.

IRS map landmark number 6. Do we need to know the value of the service in and of itself?

This path side-steps the bridge and the troll, ending up in a dead end a little further up river. But there is one dotted line that seems to cross the river. It is uncertain what that dotted line is. A path of desperation, no doubt.

IRS map landmark number 7. Does it matter when the capital transferred?

There seem to be some parts of the bridge that look a little more dangerous than others, depending on when and how often the capital is being churned over. But all the paths eventually lead to the other side.

IRS map landmark number 9. What is the tax basis of the capital received in the hands of the new partners in year 2?

A second river. Bigger than the first. No bridge. Just a row boat to rent. There is a makeshift structure on the banks of the river. The map just has an arrow pointing to it. No paths lead out of it. It looks familiar. We are here at the abandoned, empty hut in the snowstorm. Or perhaps it is worse than empty. Perhaps it will swallow one of us alive in order to become truly empty.

IRS map landmark number 10. Are any partners receiving liability relief upon the transfer of their negative capital?

What a ridiculous question. Did we not read that no partner is responsible for any debt? The operating agreement specifically said the debt belongs to the company, not to any member. However, strangely enough, the map shows the boat to use to cross the river is this landmark.

Ok, so now that we have discussed the facts, identified the issues, let’s look at how the rules apply to each of these issues.

C.                 What Are the Rules?

IRS rules applicable to issue 1. What is negative capital?

The reason there is an image of a school here is because at first blush a school is a terrible thing to spend money on. Children can’t work in the fields when they are in school. The cost of paying for the school plus the loss of child labor creates an unsustainable enterprise. Besides, children don’t even like school. However, communities and governments or whoever is paying for the school seem to think it has some value… in the long run. The thinking is, the money and time spent on school will somehow pay off in the future.

So what appears to be a negative, quite possibly is really a positive, just the timespan needs to be lengthened out. Just because the IRS insists that all money in and money out be measured once a year doesn’t mean that a year is enough time to convert the money out into money in.

The thinking is, there is a work in progress somewhere. The work in progress cannot have value to customers until it is complete, so it is not (usually) assigned any value. Once it is complete and a customer has bought it, all will be fine, so a little bit of temporary negative capital is, in retrospect, ok.

Differentiate here between negative capital and negative basis. Capital is allowed to go negative due to losses. It is a tally of sorts, showing how much is required to break even after debts are paid back.

But the basis in the capital is not allowed to go negative.[20] A negative capital avoids a negative basis by suspending the losses that brought the capital below zero. As long as no cash is distributed, the suspended loss waits for the day when the profits are sufficient to absorb it.

Basis is the concept of the amount paid to purchase something. If someone “paid negative dollars for the capital,” it would mean that they consummated the purchase by receiving money, rather than by paying money. If money is received, unless the recipient is somehow on the hook to pay it back, or to pay that amount of the company’s debts back, the amount bringing the capital below zero is considered income, and taxed. This only occurs when a cash distribution is involved. The amount recognized as income is deemed to bring the basis back up to zero.

IRS rules applicable to issue 2. Does it matter that the interest is exchanged for services rather than for property?

Property has special treatment by the IRS. The IRS map shows that property contributed to a partnership in exchange for a partnership interest creates a capital ownership in the company based on the fair value of the property, and does a pretty good job ensuring that the appreciated value will not be taxed upon receiving a capital interest.

Services is a different story. A partnership interest is commonly considered property, and the IRS as a general rule treats services exchanged for property as a taxable event. There are some exceptions, as we shall see as we continue along this path.

IRS rules applicable to issue 3. Does it matter that the interest is a capital interest rather than a profit interest?

A profit interest has special treatment by the IRS. The IRS acknowledges that it is hard to predict what profits will be, and so as a practical matter allows the speculative value to escape untaxed. The map shows this treatment is still in the wilds, but it is pretty tamed wilds by now. It has taken many years to achieve a nontaxable treatment for profits interests, and if unwary, a profits interest may be taxed like a capital interest.

Interestingly enough, the proposed regulations put forward a framework whereby the differentiation between a profits interest and a capital interest is irrelevant. “The proposed regulations apply section 83 to all partnership interests, without distinguishing between partnership capital interests and partnership profits interests.”[21]

IRS rules applicable to issue 4. What kind of services are being exchanged for capital interest?

One of the traps for the unwary lies in whether a profits interest is earned in exchange for services performed in anticipation of being a partner (management decision type services), or whether the services were performed as an employee/subcontractor (technical or mechanical type services). Since this distinction only effects profit interests, and since our issue is regarding a capital interests, this may be irrelevant to our path, but it is interesting that some leg of the profit interests has lost its non-taxable status and joined up with our path in such a circumstance.

The IRS Code differentiates different tax treatment for different kinds of services. Compensation for a service that is NOT in the capacity of a partner is treated the same way as any service paid for on the open market is treated.[22] It gets reported on a 1099 if it is provided by a subcontractor, or it gets reported on a W2 if it is provided by an employee (although the IRS doesn’t allow a “bona fide” partner to be treated as an employee,[23] there is debate regarding the treatment of an employee of a partnership who receives incentive partnership interest options[24]). The partnership will be able to either deduct it or capitalize it, whichever is appropriate,[25] however, if the partnership wants to deduct it, the timing of the deduction is dependent on whether the recipient is cash method or accrual method.[26]

Compensation for a service that IS in the capacity of a partner is treated as either a guaranteed payment or a distribution of profits. If the form of compensation is an interest in the partnership, and if the compensation is taxable, it is always treated as a guaranteed payment.

IRS rules applicable to issue 5. Do we need to know the value of the capital interest in and of itself?

If we have come to this point, and all paths point to the interest in exchange for services to be taxable as income to the recipient, the IRS rule is that the amount of income is determined by the fair value of the capital interest. [27]

IRS rules applicable to issue 6. Do we need to know the value of the service in and of itself?

No. Remember, this was a dead end on the map. What matters is the value of the interest received.  Which is why profits interests can be often analyzed as having a zero value: on the day that a profits interest is granted, by definition no rights are given to the assets in the company. Only after time elapses and the profits accumulate does it have any value. The IRS map has blazed a trail with safe harbor rules specifically exempting most profits interests from taxability.

The capital valuation in the example case of negative capital can mirror the valuation of a profits interest – if the only value is the hope of better days to come, the value on the particular day it is granted is often speculative. If someone was taxed on their usual living wage, as would be the case if the IRS rule was to tax the compensation on the value of the services instead of the value of the capital interest, it would be at odds with the allowance the IRS provides for not treating as compensation the income derived by “entrepreneurial risk.”[28]

But before we discount the possibility of valuing the compensation based on the usual price of such services, let’s take one last look at the map. Remember – there was some strange dotted line across the river here. Perhaps in some cases the value of the services is used to determine the amount of income to be recognized by the recipient, rather than the value of the partnership interest. And indeed, there are times when the courts determine the most objective valuation method is using the cost of services, absent any other measurable item.

The issue is of valuation of the capital interest. If the capital interest obviously has a value, an appraisal of that value can include the normal cost of creating a thing of similar value. In Phelps v. U.S., the courts consented on the difficulty of valuation with the following statement, and the reason for resorting to the value of the services in and of themselves:

The value of the partnership interest that the petitioner received is difficult to determine. There is no dispute, however, that petitioner and the individual owners dealt at arm’s length. Thus, presumably, the value of the interest petitioner received equaled the value of petitioner’s construction services. [29]

IRS rules applicable to issue 7. Does it matter when the capital transferred?

Well, it does matter, because the value can change wildly from month to month, and if it is taxable as income based on the value of the interest, then that value must be evaluated on the moment the interest is transferred. Because at the moment in time that a profits interest is granted, there are no rights to the assets, the valuation is zero on the day it is granted. [30] Before the IRS spelled out safe harbor treatment, and specified that a profits interest is considered as being transferred on the day it is granted, not the day it vests,[31] there was some confusion as to what value it had – the zero value on the day of grant or the-end-of-vesting period value. If an interest is not a profits interests that falls under the safe harbor rules, a special election needs to be made in order for the value of the interest to be on the day of grant rather than when the interest is fully vested.[32]

Once it is figured out what day an interest is transferred, the ownership must be weighted for purposes of allocations.[33]

IRS rules applicable to issue 9. What is the tax basis of the capital received in the hands of the new partners in year 2?

The new partners are considered to receive, and be taxed on, an amount based on the value of the capital interest. But what is that value? Here we come to the troll under the bridge, because an appraisal of a start-up company’s value, in its early years, even when income is actively being generated, is difficult. The company has yet to make a name for itself or iron out its kinks, a lot of it is still a work in progress. Proposed Regulations give the simplest method of the valuation by using the liquidation valuation method. If all assets are liquidated on the moment the interest is granted, how much is the recipient entitled to?[34]

In this case, the company has no assets, it just has a loan from Founder 2 and negative capital accounts from the remaining partners, who are not on the hook for any loan upon liquidation. So, the basis in their newly received capital accounts must be zero. Or is it?

We should be grateful that in this scenario the basis is zero. If there had been some value in the assets, the assets would have been treated as if partially sold, and the gain on the sale would have been allocated to the other partners, and the asset would have been deemed to have been contributed back.

IRS map landmark number 10. Are any partners receiving liability relief upon the transfer of their negative capital?

So here is where we look at the consequences on liquidation to each of the members with negative capital. None of them have a negative capital restoration agreement (meaning none of them are required to chip in money when their account goes negative). None of them have responsibility to take on any debt. So, Founder 2, who loaned money to the company, just realized a bad debt expense with respect to the company. Remember, the operating agreement specifically said that all debt belonged to the company alone. Consequently, the company realizes cancelation of debt income. This income is shared equally by all the members, including the newly minted members. The old members all had suspended losses to absorb the income and come out at zero. The new members upon the theoretical liquidation on the moment they received their capital interest, started at zero basis, were allocated income equal to their vested percentage, and received no cash, and so got taxed on ordinary income and recognized a capital loss.

IV.              The Unbalanced Balance Sheet

Let’s get back to our original illustration of our simple A, B, C service partnership, now that we have oriented ourselves a little more to what our question really is about. Our illustrative example of a small hiccup that might occur in the following of the rules regarding exchanging negative capital for cash left us with the capital account being $300 too little (or should we say $300 too much, since it is negative numbers we are dealing with).

Here again was the balance sheet where we left it last:

Liabilities		900
Capital	Basis	Capital	Debt Allocation
A	0	-300	300
B	0	-300	300
C	300	0	300
Total Capital	300	-600	900
Liabilities + Capital		300

The answer lies in the IRS rule about admitting a new partner to a partnership. When a new partner is admitted, the capital accounts must be “booked up” to reflect the fair value of the net assets. And here, after the partner got admitted, the new fair value of the company is negative 900 (the value of the liabilities). The capital account needs to be adjusted to reflect the fair value of the net assets. This fair value bookup is the bridge with the troll under it. The troll is our natural aversion to marking things up to fair value.

An accountant, unless trained to be an appraiser, is not an appraiser. Regarding the requirement for an accountant to make estimates of value, Robert Sterling, in this book “Theory of the Measurement of Enterprise Income,” says, “[Accountants] were not much more than specialized craftmen when an almost overwhelming responsibility was rather suddenly thrust upon them.” He goes on to describe:

The accountant passed through the era of swashbuckling manipulation; the era of watered stock and financial bubbles; in short, the era of chicanery by financial overstatement. In addition, he has always been faced with the effervescent optimism of the entrepreneur.

Accountants, apparently, prefer solutions which “are accepted and rather rigid.” If asked to provide their own theory about valuation, accountants will probably take a whole block quote from an authoritative source rather than venture their own guess.

The most widely accepted rule of valuation is said to be ‘historical cost’…. Occasionally, there is some difficulty in obtaining the cost figures, and the accountant reverts to conservatism by making a rather low estimate or, if the amount is “immaterial,” by assigning a zero value.[35]

The IRS rules, however, require a bookup of assets to fair value when a new partner is admitted,[36] the most pressing concern on the part of the IRS is in order to prevent income shifting,[37] however, as a secondary reason, in order to that the maintenance and allocation of the capital accounts properly reflects the operating agreement.

In our example of the three equal partners, the agreement between the partners specifically promised that each partner would be an equal sharer of capital upon the transfer of the capital interest to C:

Liabilities		900
Capital	Basis	Capital	Debt Allocation
A	0	-300	300
B	0	-300	300
C	300	0	300
Total Capital	300	-600	900
Liabilities + Capital		300

The capital represents the net assets which is negative 900, not negative 600. C is missing a share of capital. Once it is given to her, all is in balance again:

Liabilities		900
Capital	Basis	Capital	Debt Allocation
A	0	-300	300
B	0	-300	300
C	0	-300	300
Total Capital	0	-900	900
Liabilities + Capital		0

Now this leaves an uncomfortable feeling when beginning someone’s capital at a negative number, but it does give a simpler picture of what occurred. Partners A and B recognized relief of liability in the amount of $150 each. Partner C came in as an equal partner. If the partnership liquidated today, A, B, and C would recognize cancelation of debt income of $300 each and the company would close. C may know enough to trust that the company will be able to weather the early losses and will reach and overcome the make-break point soon enough.

Proposed Regulations eliminate the problem of the out of balance Balance Sheet by stipulating that the partnership should not recognize gain upon the transfer of net assets in Step 1.[38] Without recognizing gain, the liabilities would have remained at $900 and C wouldn’t have had a $300 excess of price paid for an interest over its fair value that she left out of the equation, and the re-shuffling of liabilities would have still given the same effect: A and B recognizing $150 each of income due to relief of liabilities and C helping out with the liabilities.

Proposed Regulations also give accountants a sigh of relief in that the definition of Fair Value is simply the liquidation value on the day the partnership interest is transferred. This eliminates some complicated valuation techniques such as forecasting the present value of future cash flows. The example we have worked through assumed that not only the capital but also the fair value actually was negative, but just because the capital is negative doesn’t mean the fair value has to be negative. A business appraisal might value such a company at 30 million dollars. If this were the case, a new asset would need to be put on the books for goodwill and going concern value, and each partner would need to be allocated it according to the operating agreement. It may cause some cash flow problems for C to be given a W-2, or 1099, or allocated a guaranteed payment (no matter which, it would be capitalized and not deducted by the partnership) for ten million dollars. And how would the appreciation of the business value be allocated? Only to A and B, in the same way that appreciated value customarily is allocated to the pre-existing partners as if it is their creation? What if C is the value that will create the future cash flows?

IV Recommendation

For anyone who finds themselves in the situation of having to assign a value to negative capital, step back. It is a mind-blowing concept to conceive that an entity has any value more than what it costed, or that it has a value of below zero even if that IS what it costed. And after we do entertain the notion that a value may exist that is more than cost, or less than zero, we have to instruct the client to go and find out that value, because it is not within our ability to do so. We have three scenarios: the client has not disclosed the value that makes it attractive to buyers, there are works in progress that about to birth value, or there is a vacuum waiting for the next sucker to join.

V.                Expanded footnotes:

1. Definition of negative capital: Reg. §1.704-1(b)(2)(ii) discusses consequences of a deficit balance in any one partner’s capital account, in terms of liquidation and obligations to creditors, the concept of deficit capital for a partnership as a whole can be inferred from this.

• 1.704-1(b)(2)(ii)(b)(3):

• 1.704-1(b)(2)(ii)(g):

2. Definition of capital interest: Rev. Proc. 93-27, 1993-2 C.B. 343; Reg. §1.704-1(e)(1)(v)

Rev. Proc. 93-27, 1993-2 C.B. 343

Reg. §1.704-1(e)(1)(v)

3. The value of a capital interest is taxable to the recipient: R.C. §61; I.R.C. §83(a); Reg. §1.721-1(b)(1)

I.R.C. §61

I.R.C. §83(a)

Reg. §1.721-1(b)(1)

4. Proposed valuation method and consequences to the recipient: Notice 2005-43, 2005-1 C.B. 1221; Prop. Reg. §1.83-1(l)

Notice 2005-43, 2005-1 C.B. 1221

Prop. Reg. §1.83-3(l)

5. Proposed consequence to the partnership: Prop. Reg §1.721-1(b)(1); REG-105346-03

Prop. Reg §1.721-1(b)(1)

Notice 2005-43, 2005-1 C.B. 1221

6. Case law regarding exchanging property for services: McDougal, 62 TC 720 (1974)

McDougal, 62 TC 720 (1974)

7. The recipient is taxed on the compensation for services: Treas. Reg. §1.83-1(a) (2003)

8. The partnership recognizes the cost of services: Treas. Reg. §1.83-6(a) (2003)

9. The partnership recognizes the gain or loss on disposition: Treas. Reg. §1.83-6(b) (2003)

(Note: the proposed regulations stipulate the partnership does not recognize gain or loss on disposition. See footnote 5, supra.)

10. The new partner contributes assets to a partnership in exchange for a capital ownership interest: Treas. Reg. §1.721-1 (2011)

11. Liability relief is deemed a distribution of cash: I.R.C. 752(b)

12. Cash distributions exceeding basis are recognized as capital gain: I.R.C. §731(a)

13. The amount the recipient recognizes as compensation: I.R.C. §83(a)
14. The partnership measures the cost of services as the amount that the recipient recognizes as income: I.R.C. §83(h)

15. The partnership recognizes income from debt relief: I.R.C. §108(a)

16. The income would be allocated to the pre-existing partners: Treas. Reg. §1.704-1(b)(5) Example (14)(iv)

17. Debt relief is measured after netting the liabilities contributed with the liabilities assumed: Treas. Reg §1.752-1 (f)

18. Capital is increased by income and contributions, decreased by losses and distributions: Reg. §1.704-1(b)(2)(iv)

19. “Infinite Series and Power Series.” Calculus with Maple Labs: (Early Transcendentals), by Wieslaw Krawcewicz and Bindhyachal Rai, Alpha Science International, 2003, pp. 541–542, available at https://books.google.com/books?id=16MjPAH_CBYC.

20. Basis is not allowed to go negative. §705(a):

21. Proposed regulations intentionally don’t distinguish between capital and profits interest: REG-105346-03 (2005)

21. Compensation for a service not in the capacity of a partner: I.R.C. 707(a)(1)

23. “Bona Fide” partners not allowed to be employees: Rev. Rul. 69-184, 1969-1 C.B. 256

24. Debate regarding the treatment of incentive partnership interests for employees: T.D. 9766, 81 Fed. Reg. 26693 (5/3/16)

25. The partnership will be either to able to deduct it or capitalize to cost of services: I.R.C §263

For deducting the services, see I.R.C. §83(h), in footnote 14, supra)

26. The timing of deductions made by a partnership to a partner: I.R.C. §267(a)(2) and (e)

27. The value of a capital interest is taxable to the recipient: I.R.C. §61; I.R.C. §83(a); Reg. §1.721-1(b)(1)

(see footnote 3, supra.)

28. Arrangements that has significant entrepreneurial risk is not compensation for services: Reg. §1.707-2

29. Hensel Phelps Const. Co. V. United States, 413 F.2d 701 (1969)

29. The safe harbor rules for a profits interest to be considered nontaxable: Rev. Proc. 93-27

31. Proc. 2001-43, (8/2/2001)

32. R.C. 83(b)

33. Weighting interests to account for variation in ownership: I.R.C. §706(d); Reg. §1.706-4

34. Using liquidation value as the valuation method: Notice 2005-43, 2005-1 C.B. 1221

(see footnotes 5 and 21 for REG-105346-03 70 Fed. Reg. 29675 (5/24/05))

35.

VI.              Epilogue.

This paper was about a real client, new, who, two and a half years ago, came to our accounting office with his co-founder friend to ask us to prepare their company’s tax return. After puzzling over the finances, capital structure, and vesting schedule, we asked: “What is going to happen in year two, when you two founders transfer portions of your negative capital?” We were given a strange look, as if we had asked a question with the most obvious answer. We prepared the partnership’s Year 1 return, but the following spring we told the client they would need to pay for the Year 1 return before we could prepare the Year 2 return. And so the client was forced to find another accounting office.

I too left the accounting office around the same time, to find another accounting office. In my job interviews, often when I was asked about a weakness, or asked if I had any questions, I would mention offhand, “I don’t really know what to do with negative capital.” So I discussed it with many interviewers, and got many one-sentence answers, from “you recognize capital gain on the partner’s schedule D,” to “these start-ups can have tremendous amount of value,” to, more commonly, a disappointed frown indicating this is not the sort of question that is appropriate to ask in a job interview.

In preparing for this paper I went back to my old office and asked the owner if she would be able to dig up the client’s operating agreement and vesting schedule for me to look at again. I told her I was writing a paper and wanted to see what was so baffling at the time.

She graciously gave me with the two items I asked for – the operating agreement (with its exhibit A) and the excel vesting schedule.

One of the pieces to the puzzle that drove me crazy during my research for this paper was – why would the developers have agreed to work for their partnership interests without any concept of the value? “I know how these freshly graduated MBA types peddle their wares,” I kept thinking to myself, “it doesn’t make sense.” I knew the gig. I myself had once worked in a startup (many lifetimes ago in my youth) and the founders were straight out of their MBA program, telling us how they spent two years in business school developing the idea for this company as a school project. So this client, where was it – the school had to have made them make a business plan, I know they must’ve had a virtual bill of sale when they convinced those developers to work for them. What is value but what marketing convinces you it is when you buy it?

In the course of the research to this paper, I returned to the vesting schedule, staring at a spreadsheet I had created two and a half years ago, where I had created scenarios (what would happen if there was a 50,000 loss in Year 2? 50,000 positive income in Year 2?).

The vesting schedule workbook had a couple other worksheets that I had never fully looked at before. In addition to the most recent vesting schedule, “Amendment 3,” there was also “Amendment 2,” “Amendment 1,” and “OG” (don’t know what the abbreviation “OG” was for, but it looked like the earliest draft of the vesting agreement). I studied the “Amendment 3” worksheet that we had used to report the ownership interest percentages on the return. I then idly flipped to the “Amendment 2” worksheet. And then to the “Amendment 1” worksheet. Each amendment looked basically the same as the prior, with the exception of some names and percentages. But there, on “Amendment 1,” a tiny cell at the bottom of one of the columns caught my eye, with a label beside it. “Valuation on 9/7/15:” and next to it: “$88,425.”

In the middle of confusion, by definition, nothing makes sense, but by taking a step back and looking with fresh eyes and going through the rules and concepts involved, and knowing what to search for, it begins to make some sense. Out of curiosity, two days ago I checked the Secretary of State website. The business dissolution papers for the company were filed only seven months ago.

[1] Reg. §1.704-1(b)(2)(ii) discusses consequences of a deficit balance in any one partner’s capital account, in terms of liquidation and obligations to creditors, the concept of deficit capital for a partnership as a whole can be inferred from this.

[2] Rev. Proc. 93-27, 1993-2 C.B. 343; Reg. §1.704-1(e)(1)(v)

[3] I.R.C. §61; I.R.C. §83(a); Reg. §1.721-1(b)(1)

[4] Notice 2005-43, 2005-1 C.B. 1221; Prop. Reg. §1.83-3(l)

[5] REG-105346-03 70 Fed. Reg. 29675 (5/24/05); Notice 2005-43, 2005-1 C.B. 1221

[6] McDougal, 62 TC 720 (1974)

[7] Treas. Reg. §1.83-1(a) (2003)

[8] Treas. Reg. §1.83-6(a) (2003)

[9] Treas. Reg. §1.83-6(b) (2003)

[10] Treas. Reg. §1.721-1 (2011)

[11] I.R.C. 752(b)

[12] I.R.C. §731(a)

[13] I.R.C. §83(a)

[14] I.R.C. §83(h)

[15] I.R.C. §108(a)

[16] Treas. Reg. §1.704-1(b)(5) Example (14)(iv)

[17] Treas. Reg §1.752-1 (f)

[18] Reg. §1.704-1(b)(2)(iv)

[19] “Infinite Series and Power Series.” Calculus with Maple Labs: (Early Transcendentals), by Wieslaw Krawcewicz and Bindhyachal Rai, Alpha Science International, 2003, pp. 541–542, available at https://books.google.com/books?id=16MjPAH_CBYC

[20] I.R.C. §705(a)

[21] REG-105346-03 (2005)

[22] I.R.C. §707(a)(1)

[23] Rev. Rul. 69-184, 1969-1 C.B. 256; T.D. 9766

[24] 81 Fed. Reg. 26693 (5/3/16)

[25] I.R.C §263; I.R.C. §83(h)

[26] I.R.C. §267(a)(2) & (e)

[27] I.R.C. §61; I.R.C. §83(a); Reg. §1.721-1(b)(1)

[28] Prop. Reg. §1.707-2

[29] Hensel Phelps Const. Co. V. United States, 413 F.2d 701 (1969)

[30] Rev. Proc. 93-27

[31] Rev. Proc. 2001-43, (8/2/2001)

[32] I.R.C. §83(b)

[33] I.R.C. §706(d); Reg. §1.706-4

[34] REG-105346-03 70 Fed. Reg. 29675 (5/24/05); Notice 2005-43, 2005-1 C.B. 1221

[35] “The Accounting Tradition.” Theory of the Measurement of Enterprise Income, by Robert R. Sterling, Scholars Book Co., 1979.

[36] Reg. 1.704-3(a)(6)

[37] Reg. 1.704-3(a)(10)

[38] Prop. Reg §1.721-1(b)(1); REG-105346-03

Next time something irks you, step back and look at it in a different way. Next time someone tries to make you feel like you messed up, instead of defending yourself, stop and wonder – well, what if I did mess up? What if that is a possibility?

A scientist, or, perhaps, a scientist without special interest in proving one hypothesis over another, should actually be intrigued by mistakes. If you are going for a grade or a grant, though, it can be disappointing to fail. But if you are just a child, experiencing gravity or entropy or chaos, it can be pretty fascinating.

Freud pointed to embarrassing things as the beginning of the solution. If someone could just fess up to something embarrassing, it might help.

Don’t let being embarrassed about something stop you from learning that thing.

It is hard to find a good teacher. Good teachers have flavors, like chocolate cookies. They have laughter. They sometimes have comfort and they sometimes they do not have comfort, like a strenuous soccer coach. Sometimes they have tears. Sometimes when someone does something that actually helps, the tension you have been holding in yourself releases like a rubber band coming out of shock.

Even though people learn a lot on their own, blossoming in neglect, given time to explore on their own without being interrupted by helicopters and micro-managers, even so, good teachers are nice to have. Self-learners, if you really prod, will smile fondly when talking about some strange person or conversation or somebody’s way of approaching a problem that made an impression on them and caused them to stop and think about something they wouldn’t have otherwise thought about.

But what do you do if you really want to learn something but you just can’t master it? When you go to the library and take out books on a subject and are so excited and interested but your eyes droop and boredom and pain set in when you start reading. And everyone raves about the author or the approach but you just don’t get it. And you stumble year after year with a subject that you wish you learned in school but you aren’t in school anymore. Where do you find a teacher?

Unfortunately, odds are against you that you will find a good teacher, especially when you aren’t in  school. Even when you are in school the odds are against you.

You are going to have to cobble together a teacher from the assortment of people and media around you. The IRS agent who audits you will teach you things; consider the penalty you pay to be a tuition. The boss who humiliates you by reminding you constantly of your mistakes; realize that you are gaining more out of the humiliation than your boss is – after all they have to suffer the fact that they hired the wrong person; you, on the other hand, are growing in your knowledge. The random conversation you overhear that exactly explains some concept you have failed to learn over the years from dry books – here is your chance to jump in and get some back-and-forth dialogue going.

The best teacher, absent a good teacher, is persistence. It is hard to find a good teacher.

Necessity -> Invention. Are these two really correlated? If so, then why do people find it unusual when someone overcomes terrible difficulties. Shouldn’t terrible difficulties always result in the invention of a solution?

But if the norm is that most people do not overcome terrible difficulties, then where did the saying (necessity is the mother of invention) come from?

Necessity sure can be a great motivator. But not always. It can’t be motivating when a person doesn’t realize their necessity. Immersed in their situation, shaped by it, pickled by it, they may not think anything is wrong. Or maybe they do feel something is wrong, feeling despair, guilt, terror, rage, jealousy, masochism, amusement, self-pride at their own endurance, but don’t conceive of the possibility that there is something different that they can do.

If you study Darwin, perhaps mistakes are the mother of invention. A nondeliberate evolution, the result of random errors. Penicillin discovered in a dirty laboratory, caused by accident, not the planned variables.

Perhaps boredom is the mother of invention. Or happiness.

I think invention is the mother of invention. Every now and then you simply have an inventor. One who doesn’t mind a mistake or two (hmm, what if we take these byproducts of failure and find a use for them). And what happens is that the inventor will, partly motivated by the sheer joy of it, poke and prod and research and build and rebuild until they have a solution, for which they hopefully will one day have a problem.

And here is where teachers come in. Teachers take these pure products of joy, these inventions, and they force students to memorize them. Here is the kicker – you can’t memorize an invention. Invention means exploring the unknown, not memorizing the known. And the students are paralyzed with fear of forgetting a step, of misremembering the components, of placing the wrong shape in the wrong hole, the wrong number, the wrong rule at the wrong time.

If you don’t want to micromanage someone, you have to let them become an inventor. You have to say, here are some problems – wait, scratch that, reverse – here are some knickknacks – go play with them. We can give them the problems later. It is no accident that kittens spend their early life playing before they grow up and hunt. Or perhaps it is an accident. A fun accident of genetics that instilled the instinct to play before the necessity to hunt.

You can invent all the Excel templates you want. But don’t expect anyone to have an easy time learning to use the template that you invented. Until you teach someone how to invent their own Excel template, you don’t do any good by giving the template to anyone.

But how do you teach someone to invent something? Do you put them into that paralyzed state of the student trying to memorize one step and then another? Or do you tell them to just go out and discover?

Give them something to play with. Tell them – once a month, I want you to build a report out of this raw data. The data can be retrieved from that mainframe over there. You will ask that mainframe just for the data for these investors, for this time frame. Once you have that data, you will filter, calculate, present the data, you will show details of certain aspects of the data, you will find out if sums of data meet certain criteria, you will find out whom to pay what portion according to these rules.

Once the person knows they have to create such a thing on their own, they may confess they have no familiarity with the tools, in which case, show them. Show them how you retrieve something from the mainframe. Show them the way you limit the query to just these investors and this time frame. Show them how to type in a formula. Show them cool ways to present the data. Show them ways to drill in on detail for data, and ways to see if criteria are met. Maybe you do it once to show them these tools exist. But then you wait for them to ask. Because they won’t absorb it until they ask.

If simply telling someone to “go out and discover” ways to accomplish such things doesn’t work, then maybe you are dealing with people who are not inclined to explore or initiate. They need instructions line by line, step by step. If so, it is a big responsibility to supply those things to them. This is why most companies follow something called “Best Practices.” The goal of these Best Practices is to allow as much production as possible, as much morale, as much utilization of resources and development of people as possible.

Most people already know (that vague jealousy, remember) that there is something different that other people can do. But they need to know that there is something different that they themselves are capable of doing. Best Practices are designed to provide an environment that tempt people to explore. Such practices can be as simple of having two monitors at a computer, so a person can have a wider work surface, or subsidizing a staff member’s education costs. It could be giving feedback on someone’s work, so the person knows if they got 100% correct, or if they have a blind spot they didn’t realize. It could be subscribing to a research database. It could be allowing cross-training. It could be having a suggestion box.

Best Practices can be as complex as having a change-management process whereby problems and solutions are brainstormed and solutions are implemented with the understanding that implementation requires effort, repetition, feedback and patience while the kinks get ironed out and the vulnerabilities are discovered, and that it requires the input, support and understanding of a team, and that it might fail and that’s part of the process, but that the people involved need to feel empowered to fix things that fail and to not give up.

These are the things that by consensus companies have discovered to be most conducive to having a workforce that is capable of inventing and/or producing. Of course there may be better ways. I think that a better term may be “Recommended Practices.”

Here are some of my “Recommended Practices” regarding inventing an Excel template:

• Color code cells with formulas blue – so other people don’t overwrite them. You can highlight all formulas on the home menu at once by clicking Find & Select -> Formulas (or by hitting control+g and choosing special -> formulas). Once they are highlighted, you can color all the cells with formulas blue with one click.
• People will still overwrite formulas with hard-coded values, even when the cells are colored blue. Figure out a solution to this. I do not recommend password protecting the cells, because I find it insulting to the user or to the next creator, and is contrary to the intention of allowing people to understand and invent. So far the only solution I have found is to create a macro that makes a cell bright pink when it is supposed to have a formula but instead now has a hard-coded value. Since macros are often disabled by default, there must be a better solution – please let me know it.
• Color code cells intended for input yellow – so other people know cells that can be overwritten or the blanks that should be filled in
• Label columns
• If you are filling in text fields, only one concept should be shown in each cell. For example, if the column header is “PAID?” a yes or X is easier for the user to glance at than “they paid $800, but paid late, and with cash, and in two installments, and they are still short by $100.” If the info is that vital, make separate columns: open balance // due date // pmt 1 amount paid // pmt 1 date paid // pmt 1 method // pmt 2 amount paid // pmt 2 date paid // pmt 2 method. Most likely such info is just noise, so if you are filling in such data, try to simplify the amount of info you provide, so the user can hide the columns that are extra inapplicable data.
• As much as possible, do not hard code numbers in formulas. Instead, have all formulas be functions of other cells – so others can see the components of the formula labeled in their own cells, in case the components need to be changed. If the cell references are too confusing for people to follow the logic of, consider using name references instead (it may be easier for someone to understand a formula that says FUTAwages * FUTApercent then to read a formula that says AE21 * BH7). There may be some drawbacks to using name references, so weigh the pros and cons. It may be hard for others to edit your template if they do not know how to work with name references. Also since name reference are absolute references, the formulas do not adjust when dragged across cells, which may call for some tedious editing. The ultimate goal is to allow people to understand which values are being used in a formula, and where those values are coming from, which can be nicely accomplished with name references.
• If possible, break formulas down into sub functions on separate lines, like in school when you were told to “show your work” – so other people understand the process. Label your reasoning on each line (for example: first line: beginning inventory. Second line: plus purchases. Third line: less sales. Fourth line: ending inventory). Sometimes this is not feasible, since intermediate lines get in the way of charts or make it impossible to do calculations on rows of contiguous data. In such cases, consider if the data can be pulled from another tab or location on the worksheet where the formula is broken out.
• In general, do not obfuscate. The template may be one that you yourself only use once a year. Assume you will be pulling it out having totally forgotten how to use it. Leave yourself some hints, or better yet, spend the extra time in making the template so clear and simple to use that you can see immediately how it works.
• Learn the purpose of filters. Learn the purpose of subtotals. Learn the purpose of pivot tables. A pivot table will filter and subtotal for you, however sometimes a simple subtotal or filter will be faster and more useful than getting all fancy with a pivot table.
• Learn how to make an IF( ) function, and a nested IF( ) function. Learn similar logical functions such as AND( ) and OR( ).
• Learn the joys of conditional formatting. Also learn that applying a filter may do a better job of drawing your attention to items of certain values.
• Learn how use the various lookup functions. Learn their limitations and what functions to use to overcome these limitations (for example, VLOOKUP requires that the value you want to retrieve is in a column that is to the right of the column with the value you are supplying – learn what to do if you must retrieve a value on the left side instead of the right).
• Learn how to copy->paste values in case you ever need to work with a bunch of data as their value instead of as their formulas. This can be useful for some actions such as concatenating cells and then wanting to show the result as new numbers, or new dates, or new beings unto their own right.
• Ask the internet if a function for a certain task exists. You will be amazed at the number of functions that exist.
• Learn about functions and add-ins specific to your field. They are too numerous and diverse to list.
• Learn how to use the Formula tab to trace and evaluate the values of cells in a formula and troubleshoot errors.
• Find a coworker who can show you stuff, watch a YouTube tutorial, use the tutorials built into Excel itself (for example, Excel 2016 has a “Take a Tour” in its Open Template screen), read an online tutorial, take a course, pay for a webinar, buy or borrow (love your library) a manual, whatever it takes to learn Excel.

When you are in the flow, the last thing you want is to be interrupted.

Usually what interrupts you is another person in their own flow, crossing paths, who wants you to switch gears just for a second.

If you don’t help them out, their flow is interrupted.

If you do help them out, your flow is interrupted.

Another thing that interrupts the flow is a slow program or a slow page loading.

Because your mind is working faster than the computer, you don’t want to put on the brakes and wait. So you switch gears to another program, to give the first program time to load. This is called multitasking. It builds up so that end of the day you find yourself trying to close out of fifteen open, half-completed windows, wondering why it takes you hours to wrap up for the night.

A third thing that interrupts the flow is when an important task invisibly (like a thought or a verbal reminder) pops up on your radar. Not wanting to forget, you either drop everything to begin the new project immediately or scramble for a scrap of paper or for the electronic scheduler to write yourself a reminder. The mere act of scrambling interrupts the flow.

If you are a receptionist or the kind of person who gets calls and questions and barrages or demands every half minute, it is likely you will skip steps, close out items incompletely, send off packages with no postage, checks without signatures.

If you are an accountant and do not have a receptionist to take the brunt of your interruptions, or if your receptionist solves their questions by yelling out the problems across the room so that everyone in the room is blinded into roadkill, well…

It is about opportunity cost. Will switching to a different activity benefit myself, the client, the company, or will it cause more things to be left undone? When things are hectic, each decision needs to be weighed. The beauty of multi-tasking is getting more done in the same amount of time. The disasters of multi-tasking are messing up more in the same amount of time.

During tax season, my house gets messy.

Cleaning is like paying bills. If you don’t do it on time, you get penalties and interest.

When not kept in check, the mess spreads.  A sandwich plate with a few crumbs, that would have taken only a few moments of time to rinse off, inherits the slime of dishes packed on top. Unable to find things that have piled up, I overturn the piles and spread the mess further.

The clients that rebel the most against paying their taxes end up paying the most to the government in the long run. Those who do not set aside money for their taxes, year after year are punished with penalties, interest, garnishments, tax liens on credit reports, and more.

I shouldn’t judge if I don’t set aside the time to keep my house clean during tax season, knowing the consequences. To set aside something requires joy, or an understanding and control of chaos, or just plain discipline if all else fails. It is like exercise and healthy diet – fun to some, sensible to others, and an act of force by the rest. Without it, you get sick, overweight, depressed. It isn’t something you can do only sporadically.

What else is paying bills analogous to?

TIME TO DIG IN!

The next step, after entering your bank account transactions, is to output some basic reports, to see the effect of your entries.

If you are working in excel, the closest thing you will get to a report is a pivot table. However, you will need to have a structure in mind to guide your creation of the pivot table. If you are not familiar with the concepts behind basic financial reports and how they are supposed to be presented, I recommend that you do not use excel. Instead, use a bookkeeping software that creates the structure for the basic recommended reports.

Here are the two most basic financial reports:

• The Profit and Loss. This report may be referred to using various names. For our purposes, consider the following to be synonyms: “Profit and Loss Statement,” “Income statement,” “Statement of Revenues and Expenses,” “Statement of Operations.”
• The Balance Sheet. Again, known by various names, any of which are sufficient for our purposes: “Balance Sheet,” “Statement of Financial Position,” “Statement of Assets, Liabilities and Net Assets.”

The Profit and Loss is the report that is most familiar to people.

However, an accountant will usually spend their initial time looking at and fixing the Balance Sheet, not the Profit and Loss. The reason for this is that the Balance Sheet is a major way to proof the Profit and Loss.

The Balance Sheet has, as one of its components, the net income.  If your software program allows you to drill in on the line item “Net Income” on the balance sheet, you are in essence creating the Profit & Loss report.

Because a Balance Sheet has to, well, balance, a change in the balance of any one account (a bank balance, a loan balance, or owner’s equity) will affect the balances of the remaining accounts.

The Balance Sheet represents “The Basic Accounting Formula.”

Assets = Liabilities + Equity

Sometimes a Balance Sheet is presented in a side by side manner, to emulate the formula, and to emphasize that debits (which represent increases to asset accounts) are on the left and that credits (which represent increases to liability or equity accounts) are on the right.

(left side) Assets = (right side) Liabilities + Equity:

Note in the example Balance Sheet given above, that there is a negative number in one of the accounts (Current Liabilities). This is where an accountant usually frowns.

A negative number is contrary to what is expected. Sure, it is possible for a liability to be negative (for example, by overpaying a credit card), however, it is more likely that the balance is just plain wrong (why would anyone deliberately overpay a credit card?).

It is for this reason that an accountant usually asks the client for their year-end bank statements, loan statements, credit card statements, year-end inventory count, list of equipment on hand, etc. The accountant then looks at these items and compares them with the Balance Sheet.

Does the credit card company really agree that they owe you a refund for the overpayment? Or did you just forget to record some of your credit card purchases? Drilling in on the line item may uncover something like this:

Which shows that no credit card charges were entered after October 26, 2017. Were there really no credit card purchases after that date? Very unlikely, considering that a payment dated December 3^rd indicates there was probably a running balance of at least $4,513.04 in mid-November. More likely the bookkeeper went on holiday and didn’t enter the remaining credit card charges.

Once the bookkeeper does enter the remaining credit card charges for the year, the net income of the company will be affected by the additional expenses.

So the point here is to look at the Balance Sheet. If the Balance Sheet jives with what really is in the bank (factoring in checks and deposits in transit), what inventory and equipment really exists, what really is owed on credit cards and other loans, then it is fine to look at the Profit and Loss. On the other hand, if there are glaring negatives or out-of-the-ballpark figures on the Balance Sheet, then why even look at the Profit and Loss?

Now, this is not an attempt to teach you accounting. It is simply an attempt to get a handle on whether your entries are complete and reasonably accurate. Too often people get caught up in the details and don’t know the consequences of their details. Looking at basic reports and seeing if they reflect reality is the best way to learn whether you have been entering the details correctly.

Using this concept, the concept of looking at reports to see if your entries are correct, you can begin to organically learn accounting concepts. My first bookkeeping software in the late 1990’s was Peachtree, which had a button next to every entry that displayed the transaction in a text window showing what increased on the debit side and what increased on the credit side. It was like a mini report for any transaction that I entered. I had never been formally introduced to the concept of what a debit was and what a credit was, but this was a way to experiment and learn. See if your software has this feature (in QuickBooks there is something similar: if you are in a transaction you can go to the reports menu (or in some of the newer versions of QuickBooks there is a button in the reports tab in the transaction itself):

This should show you the debit and credit for the particular transaction:

If you notice, the Amex account is increasing on the right, since Amex is a liability. The insurance expense is increasing on the left, since an expense is an asset.

Of course, if you have any sense at all, you are not going to accept that an expense is an asset. Wrestle with it a little bit. Come up with arguments for and against it being an asset.

Isn’t insurance like an emergency fund, in a way? It sure is good to have when you need it. Supposedly, all expenses, assuming your goal is to make a profit, all expenses can be thought of as the subproducts and services that go into building and selling your own products to make income.

And when you convince yourself of that, then turn it around and think of examples that don’t fit. My favorite example was from the lecture I was listening to for my CPA Review. The instructor was trying to explain governmental accounting. A government decides to spend money on weapons. Is buying weapons going to bring in more revenue? “Not unless it points those weapons on the taxpayers to force them to pay their taxes.” Similarly, is spending on the elderly and disabled going to bring in more revenue? Are we creating assets with such expenditures? Or are we asking the wrong question. A government is not supposed to be a business, making profit for itself to the detriment of the people for which it is supposed to serve.

Which is why the ultimate definition of a debit and a credit is simply “debits are on the left, credits are on the right.” If assets happen to be on the left, then so be it. And if expenditures happen to be on the left along with assets, then it may or may not mean anything profound. Approach it like a scientist, see the results, experiment. When there is a concept that seems to be hard to accept, try to think about it in various ways.

Another example of a concept that throws newcomers off is that a bank account increases with debits. Pretty much all of us have received  a statement or message from the bank that our bank account has been “credited” with a deposit to it, and has been “debited” by a withdrawal from it. However, in the bookkeeping software, when you look at a deposit to the bank, your own software shows it as a debit, not a credit. And vice versa for a withdrawal.

Look:

See how, in the image above, the bookkeeping software indicates Deposits=Debits and Withdrawals=Credits.

Next to it is the bank website which indicates Deposits=Credits and Withdrawals=Debits.

The reason the bank treats your deposits and withdrawals in a backwards fashion is that the money is not their money. It is your money. So when you deposit money into the bank, their liability to you goes up (credit).

Now take the case where the bank loans you money, say, in a credit card.

Their statement will say that the payments are credits and the purchases are debits:

The bank, loaning you money, treats their loan to you as their asset (and assets increase with debits).

If you are anything like me, when I loan money to someone I definitely do not consider it an asset. I consider it a foolish waste of my hard-earned money, knowing that I will never see it again. It may take a while to see why anyone would think of a loan receivable as an asset.

To a bank, they still own the rights to that money and they feel relatively confident that most of their loans will get repaid.

Again, your gut instincts may be fine. How can it be an asset if you know you will never see that money again (when your whining relative guilts you into lending them money, trust me, you will never see it again. It is not an asset). This is what happened in the 2008 recession. All the banks had all these “assets” (after all, when they recorded the transaction and lent the money, their bookkeepers had to debit an asset called “mortgage receivable” to record the loan). By now we know what types of loans these were. They were kiss-your-money good-bye loans that the bank would never see come back. The financial collapse was magnified because the banks kept trying to present these loans as assets.

But I digress. The point is that the banks give you pages out of their company financials. They show you their own statements, where their loans to you are their assets, and your bank accounts with them are their liabilities. You have lent them money when you deposit money into the bank, so it is your asset increasing (as a debit in your own bookkeeping software) and is the bank’s liability increasing (as a credit in the bank’s bookkeeping software).

Just remember. Debits on the left. Credits on the right. And that right and left are relative depending on which direction you are facing.

Approach all bookkeeping software the same way, no matter the year, make and model of bookkeeping software you have (QuickBooks, Quicken, Accountedge, Peachtree, Microsoft Money, excel templates, etc).

Figure out how to open the right file.

The software is a program that allows you to view and edit a file. The software may be stored in one location (e.g. Program Files) while the file it is opening may be stored in a different location (e.g. My Documents).

The software is a program that theoretically allows you to open an infinite number of files, as long as those files are readable by the program.

For example, Microsoft excel is a program that allows you to open, view and edit excel files. Microsoft excel is also capable of viewing and editing plain text files and some other types of files.

The reason I mention this is because sometimes people get the program itself confused with the file the program is opening.

By convention, no matter what type of program you have, there is a File menu. If you click on the File menu, you will be able to either:

Create a new file

Or

Open an existing file

These choices may be presented in various ways, but the gist is the same:

If you create a new file, be sure to note where it is saved, so that you can open that file again later:

If you have many versions of the file (the file, not the program) saved on your computer or among your team you are liable to get into trouble. This happens when a file gets sent back and forth between people, or when someone sends themselves a copy of the file to work on a different computer or saves copies of a file for other reasons. Often what ends up happening is that nobody knows which is the working file and which file is the rough draft. My solution is to one have only ONE bookkeeping file on your computer. Trash all draft files except the working file. If it turns out that you trashed the wrong file, you can hopefully retrieve it from the trash.

Ok, enough already, by now you have performed the first step: opening the right file.

Once you are in the right file, figure out how to view the check register.

The learning curve in using any bookkeeping software is two-fold:

Understanding where the software hides its menu items

Understanding accounting principles

The reason to go straight for the check register is because this will put learning curve item #2 on hold (a check register is the most instinctively understood thing about accounting, so there are no real principles to learn), leaving only learning curve item #1 to tackle.

A check register looks like some variation on this:

An excel check register may look like this:

The point is, you will know it when you see it. When you are creating a new file for the first time, there will be no check register, or, if the software creates a skeletal structure, there will be an empty register:

In order to find where the program hides the check register, or how to create a bank account register, you have to google the instructions, or browse the help files. Each program is different, and each year companies that sell these software programs “improve” them by changing where the menu items are hidden. So it is up to you to poke around until you find how to create or open a check register. If you are using excel as your bookkeeping software and you don’t know how to create a check register, google the instructions. Somebody is bound to post instructions on any question you have.

Ok, once you have figured out how to get a check register in front of you, you now need to enter your first transaction into the register.

If you are taking over the bookkeeping file from a prior bookkeeper, then there already should be a bunch of transactions entered, and you just continue where the prior bookkeeper left off. This is the easiest scenario, since you can always use the prior bookkeeper’s style of entry as a model to figure out the gist of how to continue entering items.

If you are creating a company file from scratch, and creating a check register from scratch, and the bank account has newly been hatched at the bank, with a beginning balance of zero, then the first transaction will be the deposit into the bank that caused the bank account to be opened. The explanation of this amount could be any one of the following: from “income,” from “bank account xyz,” from “owner’s investment,” or from “loan.” If it is a loan, it is good to be clear whom the loan is from, so as to know whom to pay back (“loan from mafia” versus “loan from parents.”)

If you are creating a company file from scratch, and if you are entering a checking account that you have had for years, the beginning balance will be the balance on the last day of the prior year. You enter this amount as a deposit, and the explanation of this amount can be “opening balance.”

By now, you will have had all sorts of pop-up messages from the software, asking you to add names and accounts to its names list and accounts list. Humor the software by saying yes to add the names, but do not feel the need to fill out all the details about each name or account. Keep everything as minimal as possible. Do not worry about the effect of choosing the wrong name type or the wrong account type. Mistakes will be inevitable, your goal at this time is to just enter one transaction as best you can.

As an aside, if you really insist on a rule of thumb for a name type, choose “vendor.” And if you insist on a rule of thumb for an account type, choose “expense.” These are the safest choices to make when in doubt. Later, when you understand more about the program, you can at least find where you have created your objects and fish them out and correct them from there.

Ok, once you have figured out how to enter the first transaction, you now need to enter all the remaining transactions.

Watch the running balance in the register, to see if it is reasonably within range of the bank balance that shows up on the bank statement. If the balance drifts away from what the bank shows on the statement, then evaluate why it is at such variance. You may want to copy the bank statement line by line, to get a feel for the software’s ability to mimic the running balance exactly as the bank presents it to be.

As you get more sophisticated with the check register entry, you will find it much more useful to enter checks dated the day you actually write the check, rather than the date the check clears the bank. Realize that this will cause your running balance to differ temporarily with the bank’s running balance during the days that the checks are outstanding, but that the balance will eventually agree after the bank clears all the outstanding checks.

Do not do so much that you get allergic to bookkeeping. Now is a good time to take a break.

Above and Beyond

Performance reports. I am not talking exemplary employee performance here. I am talking company performance.

Ok, imagine this. You are trying to get away from the everyday grind of your accounting office, and so you start looking for another job, while not yet quitting. For whatever reason, even working at a gas station seems better than your life at your current accounting office. So there you are one morning, interviewing for a job at a gas station, and after the few minutes of employee initiation, you are given some spreadsheets to work on.

As you sit calculating and pouring over and formulating these spreadsheets, time flies by you, lunch time is not important, you are understanding the numbers and where they are heading and what shape they are taking. Ideas multiply with every new formula you put in place, and you are developing the spreadsheet like a computer programmer, enveloping the system, separating it, searching it, building off triggers, digging into it, breaking through it. The walls of the gas station are a dry husk depending on you to run their numbers, witness the vitality beneath their façade, the variances they are subjected to, the environment they are part of.

When you finally look up, it is only due to the eventual urgency of needing to go to the bathroom. You stumble up from the table, your stiff muscles unfolding, you look around disoriented and ask the nearest team member to show you where to go. You follow him and as the two of you walk through the back room, you see a tiny dingy bathroom off to the side, which the two of you have walked past. He sees your questioning glance and says, “oh no, not that bathroom, I could see that you are working on a whole ‘nother plane, you can use the bathroom over here –“

And you are brought to a whole new section that is undergoing construction, but certainly isn’t tiny, dark, dingy and used. No, this is new, the blue tape still on the base-boards, wood trimming still in stacks, the drywall still bare in some places.

And after you have freshened up in the unfinished bathroom and come out, the team member tells you that you are ready to see a whole ‘nother location for the job, and you get into the passenger seat of his convertible sports car, strap on your seat belt…

… and realize it is 6 o’clock at night and that your accountant employer is expecting you (remember, the accounting office you were trying to get away from). Yes, apparently your boss at the accounting office begins working with staff only after the last of the client appointments of the day, beginning at six at night.  You are not ready to confess that you have been testing the waters of other employments. However, you don’t have your cell phone with you to call and make lame excuses to your boss.

So, you curiously take stock of your situation. Like I said, you have your seat belt on. The warm evening summer breeze is traveling across your face and the car is running happily along the empty beach highway.

You arrive at the beach, and you ask, what is this place? People are hiking the tall dunes, or along the sands or swimming deep along the surf parallel to the shore. This is the place of realization, you are told. You look around and look at the people a little more closely. Even though they are all ages, some extremely elderly, they are all strong, swimming in the surf, walking up the hills. So you start walking steeply up the mountainous dunes, looking out at the beautiful view of the ocean along side. The sand pours off the high dunes in the wind, gets in your eyes, and you continue, realizing you are happy. Even with the sand forcing your eyes closed and your hands to shield your nose and mouth, your legs and lungs battling the exhausting and difficult slope, you are happy.

And that is my description of developing and working on reports. I am talking budget reports, aging reports, compliance reports, break-even analyses, and all the reports that are not the “basic” financial statements.

I am also talking of all the nameless reports that cannot be spit out of any boiler-plate template. This is where your own filters, customizations, excel magic come to life.

These are the reports that are meant to be mulled over, for ideas to be teased out of, for plans to be sprung from. If you ever want to feel the beauty of bookkeeping and accounting, if you ever want time to fly by without noticing it, if you ever want to solve a problem, illustrate an idea, follow a theoretical, identify an anomaly, then create a report, and play with it.

I know some are looking back to their school days and the word report has a nasty taste. Or they are thinking of a report that someone ordered them to create out of fluff, to give the illusion of profits or potential. True enough, these reports are painful and time moves slowly during their creation.

A real report is a path to a realization. It is an attempt to explore questions that have moving parts to them. A real report shows how variables affect and compare with other variables. A real report has triggers that sound alarms or perform new functions when thresholds are reached, and that presents results clearly. A real report is a fun thing to create.

There is an old story that goes like this:

Two Skunks

Once there were two skunks, In and Out.

When In was in, Out was out,

and when Out was in, In was out.

One day Out was in, and In was out.

So Mother Skunk told Out:

“Out, go out and bring In in.”

So Out went out and brought In in.

“How did you find In so fast?” asked Mother Skunk.

“It was easy,” Out said: “Instinct.”

I liked that story when I was a kid, it had a lilt to it. I liked that when In was In, Out was out, and vice versa. I liked that there was a surprise ending, and that it had to do with stinking.

And still, as an adult, I like the in-and-out concept. It explains the balance sheet. It explains debits and credits. When something comes In, it had to have come Out of something else. And vice versa. The whole system of double-entry accounting revolves around this concept. Things don’t just come out of nowhere, or go nowhere. If you are handed a set of financials with holes regarding where things came from or where they went, something stinks.

Many client simply use spreadsheets, or paper and pencil, which is a single-entry accounting system. Or they treat their accounting software as if it is a single-entry accounting system, and don’t understand why you insist on looking at their balance sheet.

Well, at some point in your life, you are going to have to explain this concept. Most likely you won’t speak directly about debits and credits, but you allude to their existence when you point to the client’s financials and ask for an explanation for a negative account balance, or ask how they came up with enough money to pay their mortgage if they made no income.

Some clients lose track of where things have gone “into” and so when later it is time to take the things “out” they take them out of the wrong place, leaving unresolved accounts open. They enter their credit card transactions into their credit card register, and then when they pay their credit card, they enter the credit card payment as an itemized list of new expenses, rather than a satisfaction of the debt. Or maybe they enter a receivable on their balance sheet and then leave the receivable open after the money has come in. Or they show up with a handful of receipts and tell you to enter them to reimburse themselves, not realizing those expenses were already entered. Or they won’t track their credit card transactions at all, thinking that such transactions “don’t count.”

You would be surprised to find out how many people do not know the names of their investors, what amounts they received, what the pay-back terms are, or why the information would be important to someone.

Just don’t be surprised when a client says, “why do you need a balance sheet? Isn’t the profit and loss all that you need?” And no matter how you try to explain that the balance sheet “proofs” the profit and loss, or that the balance sheet contains the profit and loss plus so much more – they still don’t see why you like the balance sheet so much better than the profit and loss.

The balance sheet is kind of like the checks and balances of a government, whose function it is to give some transparency to the functions of government, and to expose lies and pretenses and the over-extension of power. It gives a trained observer the ability to see if things “add up,” and to ask questions.

It is a marketing problem, truly, to market the balance sheet as an important financial document. Is there anyone who can come up with a good way to market it? A slogan, perhaps, with all the fashionable associations? How about, “keep your company stink free with this amazing, eco-balanced sheet.” How about, “Don’t hold the stink in, correct it with this balancing, clinically tested sheet.” How about, “Keep out the Denmark rot with this authentic, centuries-old invention of the balance-proofed sheet.” Or “follow your instincts with this sexy see-all balance sheet.” I want to hear people squeal with excitement and giggle when asked to produce a balance sheet. I want them to laugh with recognition when it is pointed out to them that something stinks.