By: Chris Catarino, CPA, MT and Joseph Criscuolo, CPA, MT
On October 22, 2020, the IRS released draft instructions to Form 1065, U.S. Return of Partnership Income, for the 2020 tax year. The draft instructions provide additional clarity on the new tax capital reporting requirements partnerships will face this upcoming filing season. Partnerships that have not previously tracked partners' tax capital accounts, especially older partnerships, will face significant challenges complying with these new rules.
We previously blogged about this topic in March 2019, when the IRS first attempted to impose these new reporting requirements on 2019 partnership tax returns, but ultimately delayed the requirement a year after receiving significant blowback from the practitioner community. While partnerships have had to report negative tax capital accounts for partners in since 2018, the new 2020 requirements apply to all partnerships, whether or not tax capital accounts are positive or negative.
From gathering prior-year tax returns and K-1's to determining the tax basis of all of the partnership's assets, complying with the new requirements can be onerous at best, and can shed light on prior-year reporting and allocation errors that present significant audit risk to the partners and the partnership, at worst.
Fortunately, the IRS has tentatively approved a few different methods partnerships may use to determine partners' beginning tax capital in the draft instructions, but each method has its pros and cons and selecting the right option takes careful considering.
Below is a short summary of the new guidance in the draft instructions. Of course, The Tax Warriors® are here to help you understand these methods better and advise on the best approach for your partnership to comply with the new requirements for 2020 tax returns.
Tracking Partnership Tax Capital Annually
In a significant win for simplicity, the IRS approved the "Transactional Approach" for calculating changes to partners' tax capital accounts each year. The Transactional Approach is based on how partners normally calculate their tax basis in their partnership interest. It generally includes increases to a partner's tax capital account for the tax basis of property contributed and the partner's distributive share of income and gains, and decreases for the tax basis of property distributed to the partner and the partner's distributive share of losses and deductions. This summer, the IRS issued guidance indicating it would not approve this approach for tax capital account reporting, but it appears to have changed course based on comments received from the tax community urging them to allow this approach due to its simplicity.
Determining a Partner's Beginning-of-Year Tax Capital
The most challenging aspect of the new reporting requirement for partnerships is how they will determine a partners' beginning-of-year tax capital account (1/1/2020 tax capital accounts for calendar year partnerships) if they have not previously tracked partners' tax capital. For years, the IRS has allowed partnerships to report capital accounts on virtually any basis, including GAAP, 704(b), tax, and the catch-all "other." Realizing partnerships in existence for many years may not have the necessary records available (i.e., all prior-year K-1's issued) to calculate tax capital for each partner under the Transactional Approach, the draft instructions approve three (3) alternative methods. Partnerships must report on their 2020 tax returns the method they are selecting, and provide certain additional information based on the method they select. Below is a short summary of the alternative options.
1) Modified Outside Basis Method
This calculation starts with the partner’s adjusted tax basis in her partnership interest as determined under the principles and provisions of subchapter K. Subtractions are then made for the partner’s share of partnership liabilities under section 752 and the sum of the partner’s net section 743(b) adjustments. Partnerships may rely on adjusted tax basis information provided by its partners.
This method is helpful if the partners have been tracking their outside tax basis and can provide this information to the partnership. The partnership may also be able to assist partners in determining their outside basis in their partnership interest and using this approach if the alternative methods below are not feasible.
2) Modified Previously Taxed Capital Method
This calculation begins with the cash the partner would receive if the partnership liquidated after selling all of its assets in a taxable transaction for cash equal to their fair market value ("Net Liquidity Value"). Each partner's Net Liquidity Value is then increased by the tax loss or decreased by the tax gain allocated to the partner in the deemed transaction, without considering any section 743(b) basis adjustments allocated to the partner following such a liquidation and after treating all liabilities as nonrecourse.
This approach may be reasonable for partnerships that use "targeted" or "forced" allocations in their operating agreements requiring a deemed liquidation to scenario be run each year to determine income/loss allocations. However, the calculations can be costly and complex for those that have not employed them. Determining FMV can also be a challenge, even though the IRS has provided some practical options in that respect.
3) Section 704(b) Method
This calculation starts with a partner’s section 704(b) capital account. This amount is then decreased by a partner's share of Section 704(c) net built-in gain and increased by a partner's share of Section 704(c) net built-in loss (including forward and reverse 704(c) layers).
This approach is likely best for those tracking partners 704(b) capital accounts. However, it is likely impracticable for partnerships not tracking this information.
Kudos if you have read this far! While the draft instructions provide partnerships with path a forward to begin calculating partners' tax capital accounts, the work for many partnerships is just beginning. With potentially significant non-compliance penalties, and a clear signal from the IRS they may focus on partnership tax basis as an examination subject, the new requirements should not be taken lightly. As additional guidance is issued, The Tax Warriors at Drucker & Scaccetti will keep you updated!
Contact us if your partnership needs help navigating this incredibly complex reporting.