After providing a year-long reprieve, the IRS will require that partnerships present on their 2020 tax returns and corresponding Schedules K-1 partner capital using the tax basis method. For partnerships, compliance will be an extremely challenging and time-consuming endeavor. This article provides background of the requirement and its related developments, an overview of tax capital and the most recent IRS-prescribed calculation method.
Partnerships have long had the option of reporting partner capital account balances on a Schedule K-1 using generally accepted accounting principles (GAAP), on an Internal Revenue Code (IRC) section 704(b) basis (broadly, the economics of the partnership arrangement), on a tax basis or using any other acceptable method of accounting (for example, International Financial Reporting Standards, GAAP, etc.). In broad terms, a partner’s tax capital account is calculated using the rules and principles under the IRC — it is increased by contributions of property made by the partner to the partnership and the partner’s distributive share of the partnership’s taxable income; it is decreased by distributions of property made by the partnership to the partner and the partnership’s taxable losses. A partner’s tax capital account is additionally increased or decreased in connection with sales or transfers of their interest in the partnership, basis adjustments of the partner’s interest or the partnership’s property as well as several other possible transactions.
The IRS introduced a significant modification with respect to partner capital account reporting via the instructions to the 2018 Form 1065, U.S. Return of Partnership Income: Any partnership that uses any nontax basis method described above must disclose a partner’s beginning and ending capital account balances on a tax basis, if either amount is negative. While IRC rules prohibit a partner’s tax basis in their partnership interest from ever being negative, deficits in a partner’s tax capital account can arise in certain situations, most commonly when the partner is allocated partnership losses or receives a distribution funded by debt incurred by the partnership. The IRS’ interest in tracking these negative balances correlates to ensuring compliance with the requirements that (1) a partner must have sufficient basis in their partnership interest to utilize these losses on their personal returns and avoid capital gains on distributions, and (2) the partner generally must eventually recapture the capital account deficits as income in certain situations (such as when the debt is repaid or the partner’s interest is sold or redeemed).
Thereafter, in October 2019, the IRS released draft instructions for the 2019 Form 1065, which mandated that partner capital be reported by all partnerships on a tax basis for all partners. In response, taxpayers and practitioners lobbied the IRS to delay this requirement, citing the significant administrative and financial burden that would result from attempting to comply in such a short time frame (the extended due date for 2019 calendar-year returns was less than a year away from the issuance of the instructions). In December, the IRS acquiesced, releasing Notice 2019-66, which pushed back the mandatory tax capital reporting to 2020 (please see our previous tax alert).
While the Notice 2019-66 relief was most welcome, the additional year still left many partnerships with the massive undertaking of creating tax capital from inception within a relatively short time frame. Further, there was no guidance, either formal or informal, on how it should be computed — only the general principles described above. In June 2020, the IRS issued Notice 2020-43, which outlined two approaches for calculating partner tax capital: the modified outside basis and modified previously taxed capital methods. However, controversy surrounded the clarity: Under the notice, these were the only two methodologies partnerships could use, and each can be administratively difficult to implement, create distortive results or both.
Modified outside basis method
Use of the modified outside basis method involves the partnership determining or being provided by the partners, the partners’ adjusted bases in their partnership interests, and subtracting from these amounts the partners’ distributive shares of the partnership’s liabilities. For smaller, closely held partnerships, this is a relatively straightforward approach. However, for larger partnerships and, in particular, partnerships that are part of tiered structures, computing and/or gathering the necessary information from the partners could be an enormous and costly administrative burden and required on an annual basis. Small and large partnerships alike may also run into issues with partners being unwilling to share their outside basis information or not having the information at all. In short, several partnership taxpayers could be unable to fully comply with the modified outside basis method for reporting partner tax capital.
Modified previously taxed capital method
The modified previously taxed capital method broadly requires a hypothetical liquidation approach; whereby a partner’s tax capital account will be equal to the amount of cash the partner would receive if the partnership sold of all its assets for cash equal to the assets’ “fair market value.” This figure would be adjusted by any gain or loss the partner would be allocated as a result of the transaction. As a general matter, fair market value can be highly subjective, and measuring the capital accounts on this basis can produce distortive and/or useless results. Similar to the modified outside basis method, calculating this hypothetical liquidation annually could be a significant undertaking for many partnerships.
Baker Tilly, along with many other practitioners, submitted comments to the Treasury Department, highlighting the above issues and the significant difficulties they would create for taxpayers. In mid-October, the IRS again relented, providing in the draft instructions for the 2020 Form 1065 that the more commonly utilized “transactional approach” for computing tax capital would be the only methodology allowed. However, as discussed further below, this method is not without flaw.
Under the transactional approach, partner tax capital is generally computed by increasing a partner’s account by:
And decreased by:
The instructions go on to say that tax capital should be adjusted by the partners’ shares of any increase or decrease to the tax basis of partnership property under section 734(b) (broadly, these are adjustments that can arise when a partnership distribution of cash causes gain or loss to be recognized by the distributee partner or when the tax basis of property distributed by the partnership must be adjusted in the hands of the distributee partner). Further, the instructions state that tax capital should not include any basis adjustments under section 743(b) (generally, these are adjustments that can arise when a partner sells or exchanges their partnership interest or passes away) and, to the extent a section 743(b) adjustment is included in a partner’s tax capital account as of Jan. 1, 2020, it should be removed.
Lastly, the instructions allow partnerships that have previously maintained their capital accounts on a nontax basis to use the modified outside basis and modified previously taxed capital methods to determine tax basis capital as of Jan. 1, 2020, only.
We are hopeful the IRS will issue a notice to supplement the draft 2020 Form 1065 instructions to provide more authoritative and definitive guidance on computing tax capital.
As a closing reminder, while the transactional approach will be easier for partnerships to administer in computing tax capital than the modified outside basis and modified previously taxed capital methods, it may still be a significant undertaking for partnerships that have to create tax capital schedules from inception. Specifically, for partnerships that formed several years ago, have numerous partners, have undergone ownership changes or a combination thereof, this could be a time-intensive and difficult exercise that should be started as soon as possible.
We encourage you to reach out to your Baker Tilly tax advisor regarding how any of the above may affect your tax situation.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.