28.1 Financial Statements, Records & Owner Transactions
Key Takeaways
A balance sheet must reconcile assets to liabilities plus equity; borrowing is not operating revenue.
Owner withdrawals, contributions, and loan principal require balance-sheet treatment before tax classification.
Accountable-plan reimbursements require a business connection, substantiation, and return of excess advances.
Read the business before preparing the return
Part 2 requires more than applying a deduction percentage. A preparer must interpret the business's income statement, balance sheet, and supporting ledgers. The income statement reports revenue and expense over a period. The balance sheet reports assets, liabilities, and equity at a date. A tax return may require adjustments to both, so a balanced bookkeeping report is not automatically a correct tax return.
Identify the business's principal activity and the appropriate classification code from the return instructions. The code describes the principal business activity; it does not elect a tax classification or determine by itself whether an activity is an SSTB. A code copied from last year may be wrong after a major business change. Compare current operations with prior-year receipts, costs, payroll, inventory, and assets to identify unusual movements that require explanation.
Reconcile the balance sheet
The basic relationship is assets = liabilities + equity. Beginning balances should agree with the preceding year's closing records after documented corrections. Ending cash should tie to bank reconciliations, not merely the bank statement's unadjusted balance. Receivables should reflect actual rights to payment, inventory should reconcile to counts and purchases, and liabilities should agree with lender or vendor records.
Example: A corporation has beginning equity of $100,000, net book income of $35,000, a shareholder capital contribution of $20,000, and dividends of $15,000. Ignoring other equity changes, ending equity is $140,000. If the balance sheet reports $155,000, investigate whether dividends were omitted or another item is unsupported. Do not solve the imbalance by inventing an expense.
| Cash receipt or payment | Initial accounting question |
|---|---|
| Bank loan proceeds | Liability, rather than sales revenue |
| Owner capital contribution | Equity, rather than taxable operating revenue |
| Equipment purchase | Capital asset, rather than an automatic current expense |
| Loan principal payment | Reduction of liability, rather than interest expense |
| Owner withdrawal | Distribution or other owner transaction, rather than supplies |
Tax treatment can differ from these initial bookkeeping categories, but the transaction must first be identified correctly. The cash-method taxpayer also needs balance-sheet records for items such as assets and loans even when receivables and payables are not used to determine current taxable income.
Tie depreciation and book-tax schedules together
Maintain an asset rollforward showing beginning cost, additions, dispositions, and ending cost, together with book and tax accumulated depreciation. A removed asset requires both its cost and accumulated depreciation to be removed from the appropriate records. Sale proceeds do not equal taxable gain: compare amount realized with adjusted tax basis, including depreciation allowed or allowable.
Schedule M-1 or M-3 reconciles book income with the tax-return measure, while Schedule M-2 explains the relevant equity or adjustment account. The meanings differ across Forms 1065, 1120, and 1120-S. A partner's capital account, S corporation AAA, and shareholder stock basis are not interchangeable. Keep owner basis worksheets outside the entity's financial-statement equity computation when necessary.
Loans to and from owners
A genuine loan should have evidence of indebtedness: principal, repayment terms, interest, maturity, and conduct consistent with repayment. A transfer labeled loan on the general ledger can still be a distribution or compensation if the facts show no repayment obligation. Below-market corporate-shareholder loans can trigger §7872 imputed-interest and deemed-transfer consequences. Apply the appropriate AFR and demand- or term-loan rules instead of assuming zero stated interest means zero taxable interest.
In a partnership, an owner's advance may be a bona fide loan or a capital contribution, and partnership liabilities can affect outside basis under §752. In an S corporation, direct bona fide shareholder debt can create debt basis, while a guarantee of third-party debt generally does not do so until the shareholder pays. Classify the transaction before allowing a pass-through loss.
Personal spending from a business account is not transformed into a deduction. For a sole proprietor, personal withdrawals are owner draws. A corporation's payment of a shareholder's personal cost may be a dividend, compensation, or loan depending on the facts. Separate accounts and contemporaneous explanations reduce the chance of counting the same expenditure as both payroll and a vendor expense.
Substantiation and accountable plans
An employee reimbursement arrangement qualifies as an accountable plan when it has a business connection, requires adequate substantiation within a reasonable period, and requires employees to return excess advances within a reasonable period. Qualifying reimbursements generally are not wages. A nonaccountable allowance generally is wages, with employment-tax consequences. Renaming a fixed taxable allowance does not satisfy the requirements.
A mileage log should identify dates, destinations, business purposes, and miles, with total annual mileage supporting the business percentage. Preserve receipts and evidence of payment as applicable. Retain employment-tax records for at least four years and basis records while they affect open returns. A bank statement proves a payment, but ordinarily does not establish its business purpose by itself.
Official references
Publication 583, Publication 463, and the applicable 2025 business-return instructions, checked October 17, 2026.
A corporation receives $50,000 from a bank under a bona fide loan and pays $8,000 of principal later that year. What is the basic treatment?
$50,000 sales revenue and $8,000 interest expense
$42,000 net operating income
A liability receipt and principal reduction, with interest analyzed separately
A tax-free dividend and a charitable deduction
Sections you finish are checked off in the contents.