Partnerships are required to report partners’ capital on Schedule K-1 on the tax basis method for taxable years that begin on or after Jan. 1, 2020. The IRS has recently furnished draft Form 1065 instructions for the 2020 tax year, providing further details on satisfying the new reporting requirement. With those instructions in hand, it’s now time for taxpayers to work with their tax advisors and consider what actions should be taken to construct the appropriate capital accounts.
What happened with the tax basis capital account reporting?
The IRS initially intended for tax basis capital account reporting to begin in 2019, but that was deferred until 2020 due to concerns about whether partnerships would be able to comply with the new reporting requirements. In August 2020, the IRS issued Notice 2020-43, which describes two proposed methods for complying with the tax basis capital reporting requirement and requested comments. After considering the comments submitted in response to that notice, the IRS has now provided updated guidance on satisfying the tax basis capital requirement with the release of draft Form 1065 instructions for tax year 2020.
The draft Form 1065 instructions released on Oct. 22, 2020, state that the transactional approach is the tax basis method and must be used to determine ending partner capital accounts for 2020 and both beginning and ending capital accounts for future tax years. The instructions change course from the methods described in Notice 2020-43, but some flexibility is offered on how the partners’ beginning capital may be determined.
The beginning partner capital accounts for 2020 must also be determined using the tax basis method if (1) partner capital accounts for the previous year were reported using the tax basis method, or (2) the partnership maintained capital accounts in its books and records using the tax basis method. However, if neither of the two statements are true, then beginning partner capital accounts for 2020 may be computed using one of four methods: (1) tax basis method, (2) modified outside basis method, (3) modified previously taxed capital method, or (4) Section 704(b) method. The same method must be used for all partners.
Tax basis method (transactional approach)
Partnerships that have historically kept partner tax capital information have generally maintained partner tax capital using the transactional approach. Under this method, partners’ tax capital accounts are:
- Increased by (i) the amount of money and tax basis of property contributed by the partner to the partnership (less any liabilities assumed by the partnership) and (ii) allocations of income or gain to the partner (including tax-exempt income).
- Decreased by (i) the amount of money and tax basis of property distributed by the partnership to the partner and (ii) allocations of loss or deductions (including nondeductible expenses) made to the partner.
Partnerships with historical partner tax capital information will experience an easier transition into the new reporting requirements. However, certain adjustments may still be needed to the historical tax capital calculations to meet the new Schedule K-1 reporting requirement, including the exclusion of any Section 743(b) adjustments that may have been included in a partner’s capital account. The transactional method can also be used to rebuild the tax capital accounts if all of the historical tax returns are readily available.
Restating beginning tax capital
Each of the additional methods that the IRS provided for restating beginning tax capital in instances where tax capital wasn’t historically tracked in the books and records of the partnership has limitations on when it will be practical to use.
The modified outside basis method requires the partnership to either determine the outside basis of the partners or be provided the outside basis by its partners. Each partner’s share of partnership liabilities under Section 752 and the net tax value of any Section 743(b) basis adjustments are then subtracted from the outside basis to arrive at the partner’s tax capital. However, determining outside basis may be very difficult for a partnership, particularly in situations where prior transactions among the partners have occurred. While the partnership is generally allowed to rely on the partner basis information provided by its partners, it’s important to note it may be challenging in certain situations to receive information from the partners regarding their outside basis in a timely manner.
The modified previously taxed capital method is determined based on the amount of cash a partner would receive on a partnership liquidation and tax gain and/or loss that would be allocated to a partner following a hypothetical transaction. Realizing that the fair market value may not be readily available for all partnerships, the IRS stated that if fair market value isn’t available a partnership may perform the calculations using the assets’ basis as determined under Section 704(b), GAAP, or the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management. This approach may be useful in cases where outside basis can’t be determined by the partnership. However, where Section 704(c) gains haven’t been properly tracked this method will be difficult to use.
The Section 704(b) method would use each partner’s Section 704(b) capital account, minus the partner’s share of Section 704(c) built-in gain in the partnership’s assets, plus the partner’s share of Section 704(c) built-in loss in the partnership’s assets. While this approach may be less complex, in practice some partnerships may not have been tracking historical Section 704(b) capital accounts for partners.
What to do now
It is critical now for taxpayers to begin working with their tax advisors to review the tax capital reporting requirements and the proposed methods that may be relevant to refigure beginning capital accounts, and consider the actions required to construct the appropriate capital accounts.
