IRS Makes Changes to Tax Capital Reporting Requirements
IRS Makes Changes to Tax Capital Reporting Requirements
In a welcome development, the IRS has changed course with regard to partnership capital account reporting requirements, after its early release of draft instructions to Form 1065, U.S. Return of Partnership Income, for tax year 2020 on October 22, 2020. The draft includes revised guidance for partnerships required to report capital accounts to partners on Schedule K-1 (Form 1065).
In an effort to improve the quality of information reported by partnerships, the IRS issued Notice 2020-43 on June 5, 2020, reminding taxpayers that beginning with the 2020 tax year, all partnerships will be required to report partner’s capital using a tax basis method. In prior years, taxpayers were permitted to use a number of methods to report partner’s capital, including tax basis, GAAP, Section 704(b) or other. Notice 2020-43 proposed two alternative methods that a partnership would be required to use to comply with the reporting requirement. For this purpose, a partnership would report for each partner either (i) the partner’s basis in its partnership interest, reduced by the partner’s allocable share of partnership liabilities as determined under Section 752 (known as the modified outside basis method), or (ii) the partner’s share of previously taxed capital, as calculated under a modified version of Section 1.743-1(d) of the Income Tax Regulations (known as the modified previously taxed capital method).
The revised instructions indicate that partnerships filing Form 1065 for tax year 2020 would instead calculate partner capital accounts using a transactional approach for the tax basis method. As outlined in the draft instructions, under the transactional approach, partnerships report partner contributions, the partner’s share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax basis principles as opposed to reporting using other methods, such as GAAP, the modified outside basis method, the modified previously taxed capital method or the Section 704(b) method.
Determining Beginning Capital Accounts for Tax Year 2020
According to IRS data, even though partnerships could previously report capital accounts determined using several methods, most partnerships already use the tax basis method. The new guidance, which would require the transactional approach, is in response to comments received by the IRS from many practitioners, including BDO.
As per the Form 1065 revised instructions, if a partnership calculated the partner’s capital account for last year using the tax basis method, the partner’s ending capital account as determined for last year is entered on the line for the beginning capital account. If a partnership reported a negative ending capital account balance for a partner last year and a different amount is calculated for the partner’s beginning capital account using the transactional approach, the partnership must provide an explanation for the difference. If a partner joined the partnership through a contribution to the partnership during the year, zero is entered as the partner’s beginning capital account. If a new partner acquired its interest in the partnership from another partner in a purchase, exchange, gift, inheritance or as the result of death, the beginning capital account is equal to the transferor partner’s ending capital account with respect to the interest transferred immediately before the transfer figured using the tax basis method.
Partnerships that did not prepare Schedules K-1 under the tax basis method for 2019, but also maintained tax basis capital accounts in their books and records (for example, for purposes of reporting negative capital accounts), may determine each partner’s beginning tax basis capital account balance for 2020 using one of the following methods: the modified outside basis method, the modified previously taxed capital method or the Section 704(b) method, as described in the instructions, including special rules for publicly traded partnerships. The calculations for determining a partner’s beginning capital account under each of these methods are as follows:
Modified outside basis methodThe amount to report as a partner’s beginning capital account under the modified outside basis method is equal to the partner’s adjusted tax basis in its partnership interest as determined under the principles and provisions of subchapter K including, for example, Sections 705 (determination of basis of partnership interest), 722 (basis of contributing partner’s interest), 733 (basis of distributee partner’s interest), and 742 (basis of transferee partner’s interest), and subtracting from that basis (1) the partner’s share of partnership liabilities under Section 752 and (2) the sum of the partner’s Section 743(b) adjustments (that is, net Section 743(b) adjustments). For purposes of establishing a partner’s beginning capital account, a partnership may rely on the adjusted tax basis information provided by its partners.
Modified previously taxed capital method
The amount to report as a partner’s beginning capital account under the modified previously taxed capital method is equal to the following:
- The amount of cash the partner would receive if he or she liquidated after selling all assets in a fully taxable transaction for cash equal to the fair market value of the assets; increased by
- The amount of tax loss determined without taking into account any Section 743(b) basis adjustments (including any remedial allocations under Treasury Regulations §1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse); and decreased by
- The amount of tax gain determined without taking into account any Section 743(b) basis adjustments (including any remedial allocations under §1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse). Instead of using the assets’ fair market value, the partnership’s net liquidity value, and gain or loss can be ascertained by using either:
- The basis of such assets determined under Section 704(b) for financial accounting purposes, 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 decided by partnership management.
Section 704(b) method
The amount to report as a partner’s beginning capital account under the Section 704(b) method is equal to the 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. Property contributed to a partnership is Section 704(c) property if, at the time of the contribution, its fair market value differs from its adjusted tax basis. Section 704(c) property includes property with differences resulting from revaluations, also known as reverse Section 704(c) allocations.
Note that Section 743(b) basis adjustments are not taken into account in calculating a partner’s capital account under the tax basis method. If Section 743(b) adjustments are included in a partner’s beginning capital account balance (because they were included in last year’s ending capital account), those adjustments, whether positive or negative, should be removed from the partner’s capital account in the 2020 tax year and reported as a 2020 tax year other increase (decrease) item.