Proposed Partnership Capital Account Reporting

Thoughtware Article Published: Sep 25, 2020
Tax Advisor 2020

Tax Capital Reporting – Out with the Old, in with the New

In September and October of 2019, the IRS released draft versions of 2019 Form 1065, Schedule K-1, and related instructions. Among the many changes, the instructions required tax basis capital reporting. In prior years, partner capital accounts could be presented in the partnership return according to tax basis, generally accepted accounting principles (GAAP), 704(b), or other methods consistent with the taxpayer’s books and records. Responses from the public prompted the U.S. Department of the Treasury (Treasury) and the IRS to issue Notice 2019-66, which postponed mandatory tax basis capital reporting until tax years beginning on or after January 1, 2020. Beginning with the 2018 taxable year, partnerships are required to report negative tax basis capital accounts in either Item L of Schedule K-1 or in Box 20; subsequent guidance hasn’t changed this requirement. 

In Notice 2020-43, issued June 5, 2020, Treasury and the IRS chose not to define tax basis capital but instead to reject the tried-and-true transactional approach and propose two new methods: Modified Outside Basis Method and Modified Previously Taxed Capital Method. 

Modified Outside Basis Method

Under the Modified Outside Basis Method, the partnership would determine itself or request each partner’s computation of his or her outside basis. The partnership would subtract allocated liabilities to produce tax basis capital for each partner. A partner must notify the partnership, in writing, of any changes to the partner’s basis in its partnership interest during each year that don’t relate to contributions to and distributions from the partnership and the partner’s share of income, gain, loss, or deductions otherwise reflected on the partnership’s schedule K-1, i.e., changes related to sales, exchanges, gifting, and inheritances.  

Modified Previously Taxed Capital Method

Under the Modified Previously Taxed Capital Method, partnerships must compute tax capital according to existing rules for previously taxed capital pursuant to partner basis adjustments described in Reg. Section 1.743-1(d)(1). The regulation computes partner economic rights by imagining a hypothetical taxable sale of all partnership assets at fair market value for cash and distributing those proceeds to each partner per the relevant provisions of the partnership agreement after fully satisfying all company debts. Previously taxed capital is simply the sum of cash the partner would receive, increased by the amount of tax loss or decreased by the amount of tax gain that would be allocated to the partner from such hypothetical transaction. 

Transactional Approach

The method currently on the out—the transactional approach—is widely implemented (whether by way of GAAP, 704(b), tax, or other) and conforms nicely with current accounting systems. The transactional approach mirrors the existing 704(b) capital account maintenance provisions of Reg. Section 1.704-1(b), which 1) increases capital by money or the fair market value of property contributed (net of liabilities assumed by the partnership or to which the property is subject) or income or gain allocated to such partner and 2) decreases capital by money or the fair market value of property distributed (net of liabilities assumed by the partner or to which the property is subject) and deduction or loss allocated to such partner. 

The two proposed methods above are likely to create balance sheet and aggregate partner capital account disparities. Where the balance sheet presented in the partnership return is reported on a method different than the capital accounts, a reconciliation must be attached to the return. 

How the Information Will Be Used

Presumably, the IRS will use this information to quickly estimate a partner’s outside tax basis by adding a partner’s share of liabilities to tax basis capital. Outside tax basis is the measuring stick by which tax losses and deductions are allowed, disposition gains and losses are computed, and distributed property basis is adjusted. It’s easy to see how the IRS might benefit from clearer and more readily usable information. The added compliance cost will fall on partnerships in older businesses, partnerships with numerous partners, numerous transactions, or poor accounting records, and uncooperative partners. 

The IRS requested comments on the approaches outlined in Notice 2020-43 and has received many thoughtful responses to date. These two new methods will take effect for 2020 partnership tax reporting unless the IRS postpones or altogether drops this effort, neither of which is out of the realm of possibility considering the COVID-19 pandemic, the state of the economy, and the various new tax laws and regulations in 2020. 

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