Buried in the 2018 instructions to Form 1065, U.S. Return of Partnership Income, is a new reporting requirement with a whopping noncompliance penalty. The blow-back from practitioners on this sneaky new disclosure was so great the IRS issued penalty relief provisions this week… here's the scoop.
In its simplest form, the TCJA created a nightmare of new limitations, calculations and disclosures for pass-through entities in 2018. Keeping most CPA's up all night, coffees full, are the interest expense limitations under IRC Section 163(j) and the Qualified Business Income Deduction rules under IRC Section 199A, both of which require analysis and calculations that test the limits of the human mind. While the tax community was busy building NASA-worthy excel spreadsheets to meet these reporting requirements, the IRS slipped in an additional disclosure requirement for 2018 partnership filings that went mostly unnoticed until a few weeks ago.
The instructions now require partnerships to report each partners' tax basis capital on Line 20AH of their schedule K-1 if the amount was negative at either the beginning or end of the year. The penalty for nondisclosure is a cool $195 per partner, per month, capped at 1 year. For a partnership with 25 investors with negative tax capital, that penalty could be $58,500 for one year… even if only one of those partners has negative tax capital. Yikes!
Traditionally, partnerships report each partners' capital in Item L of their Schedule K-1. For partnerships that have been reporting this capital on a tax basis, the new reporting requirement doesn't cause a stir. However, partnerships that have reported partners' capital on a non-tax basis, such as GAAP, 704(b), or our personal favorites "hybrid" or "books and records," there's a problem if separate tax capital schedules haven't been maintained by the partnership for each partner. Since it has traditionally been the partners' responsibility to maintain and track their tax basis in their partnership interests, it is not uncommon for partnerships to come up empty handed on this, raising CPA anxiety levels to record highs.
Now, in true Tax Warrior fashion, we initially questioned whether the IRS has the authority to impose this requirement (and penalty), given it was not statutorily enacted or included as part of the TCJA. Our efforts didn't turn up much that could be helpful since Reg. 1.6031(b)-1T(a)(3)(ii) indicates information must be furnished to the partners to the extent provided by forms or instructions and IRC Section 6698(b) applies the penalty to partnerships that fail to provide such information. While the regulation was issued in temporary form, it was issued before 1989, so the rule causing post-1989 temporary regulations to expire after 3 years likely doesn't apply.
So, with the March 15th partnership filing deadline closing in, and many practitioners including Drucker & Scaccetti asking for clarification and relief, the IRS came to (its senses) the rescue this week with Notice 2019-20. This pronouncement provides penalty relief for partnerships which timely file (with extensions) their 2018 returns and Schedules K-1, if they submit schedules showing partners' negative tax capital to the IRS by March 15, 2020. This allows partnerships to file their 2018 tax returns and issue K-1's on time, so long as they provide the required information to the IRS later. Deep exhale.
While the relief is welcome, it sets the stage for a summer's worth of partnership tax basis studies, which often require a review of all prior year tax returns and Schedules K-1 since the partnership's inception. Many real estate investment partnerships will be affected as depreciation deductions often drive partners' capital accounts negative. Private equity, hedge funds, and other feeder-funds will also be affected as they may maintain partners' capital accounts on a GAAP or Fair Market Value basis and previously relied on the partners to track their own tax basis. Partnerships that have partners' buying and selling interests each year will face additional complexities in determining their partners' tax capital. Tax basis studies generally aren't cheap, easy, or quick to put together, but in most cases the potential penalties will dwarf their costs.
S-corporations don't get off scot-free in all of this either. Schedule E and the instructions to the new Form 1040 for individual tax returns now require S-corporation owners to attach tax basis computations to their returns if they report a loss, receive a distribution, dispose of stock, or receive a loan repayment from an S-corporation… that pretty much runs the gamut. Bring on 'basis season.'
What caused the IRS to pursue this agenda is not yet entirely clear, but we believe the IRS is looking more closely for unreported taxable distributions in excess of basis and improper loss deductions on S-corporation and partnership owners’ personal tax returns. The new disclosures will allow the IRS's computer systems to automatically flag tax returns with basis issues for further review. It's not surprising the new disclosure requirements come on the heels of recent changes to 'bottom-dollar guarantees,' which have eliminated their favorable impact on tax basis... Those in the REIT/real estate world with these types of arrangements should be especially cautious.
If you're concerned you or your partnership may be affected by these changes, contact us to discuss what steps can be taken to comply with the new rules.