Tax Basis Basics for Contractors
Tax basis is at the forefront of tax returns in 2020 for construction companies. Basis is an individual’s capital investment in their ownership interest, primarily for partnership or S corporation interests. In general, tax basis is the amount of money a shareholder contributes to the S corporation (including shareholder loans to the S corp), plus or minus any taxable income or loss and other income less any distributions received. For partnerships, basis calculations are similar to S corps, but partnership debt also can create basis. Basis is important to contractors because owners need basis to be able to claim losses if there are any. Basis also is required to support an owner’s distributions as tax-free. If an owner receives distributions in excess of their basis, then they’re taxed on that excess distribution. With enough basis, there’s generally no tax related to that distribution.
This is nothing new. These rules have been part of the tax code for years. Recently, the IRS has put more focus on basis reporting. For example, for the 2018 tax year, the IRS started requiring basis schedules to be attached to individual returns for S corp investments that had losses, distributions, loan repayment, or disposition of stock. Many times, the S corp will track basis for the shareholders, but it’s not required that the corporation actually track basis. The responsibility to track basis lies with the shareholder, which comes as a surprise for many owners.
That brings us to the new developments for 2020. Partnerships are now required to report all capital accounts on a tax basis method based on the transactional approach. On the 2018 Form 1065 (partnership instructions), partnerships were required to report both beginning and ending negative tax capital as a separate disclosure on line 20 with code AH on Schedule K-1. Starting in 2019, all capital accounts (line L of Schedule K-1) are required to be reported on the tax basis. Later that year, the IRS released Notice 2019-66, delaying reporting capital accounts on the tax basis until the 2020 tax year. 2020 is here now, and partnerships are having to look at partner capital accounts to see if any changes are needed. The IRS issued additional guidance in Notice 2020-43 stating that partnerships could use the modified outside basis method or modified previously taxed capital method in determining beginning tax basis. The modified outside basis method is like the modified previously taxed capital method, but we will not delve into that here. Most partnerships were already reporting capital on tax basis, and for them, no changes will need to be made. Even though most partnerships report on tax basis, several larger partnerships have been reporting capital accounts on another basis—probably generally accepted accounting principles—which is the basis the financial statements are reported on.
Overall, tracking basis isn’t that hard if it has been tracked since day one. However, a lot of shareholders and/or companies (both S corps and partnerships) aren’t tracking basis. The challenge is trying to re-create basis when it entails years of not tracking tax basis. With the IRS requiring basis reporting, tracking it is important. As mentioned earlier, without proper basis records, losses could be disallowed or distributions could be deemed to be taxable due to them being in excess of basis. If your tax preparer hasn’t been asking about tax basis in the past, it’s a good bet you will get asked this year. If you don’t know if basis is being tracked, you may want to ask your tax advisor.
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