On June 5, 2020 the Department of the Treasury and the Internal Revenue Service (“IRS”) issued Notice 2020-43 (the “Notice”) proposing two alternative methods to satisfy tax capital account reporting requirements as the only methods for reporting partner’s capital accounts under the tax basis method for taxable years that end on or after December 31, 2020. While some taxpayers may have concerns about these changes, the implementation of the new reporting requirement should not change or adversely affect the partners and should provide a better understanding of their tax capital accounts. With the year-end approaching, partners and partnerships should review the IRS guidance and begin conversations with their accountants about the use of tax capital reporting and conversion from other methods used in prior periods.
Partnerships, including limited liability companies taxed as partnerships, have been under the IRS’s focus for the past several years. Initially, the U.S. Congress and the IRS made significant changes to the partnership audit procedures pursuant to the centralized partnership audit rules under the Bipartisan Budget Act of 2015, which are generally applicable to partnerships for taxable year 2018 and thereafter. Subsequently, in an effort to simplify reporting and identify any issues, the IRS released guidance seeking a change to partner capital account reporting on Schedule K-1, as discussed below.
For tax years prior to 2018, a partnership could report a partner’s capital account balance on Schedule K-1 based on one of the following methods: tax basis, generally accepted accounting principles (“GAAP”), Section 704(b) of the Internal Revenue Code (“Code”), or another method. Beginning with 2018, if a partnership reported its partners’ capital accounts on a method other than the tax basis method, in addition to reporting information in part 1, item L of Schedule K-1, the partnership was required to report a partner’s tax capital account at the beginning and the end of the partnership’s taxable year if either amount was negative on line 20 of Schedule K-1 under code AH.
On April 5, 2019 the IRS released Form 1065 Frequently Asked Questions (“FAQs”) which provided guidance on how to determine a partner’s tax capital account and a safe harbor approach based on a partner’s outside basis in the partnership interest. Thereafter, early releases of Form 1065 and Form 8865 and related instructions required that all partners’ tax capital accounts be reported using the tax basis method. The IRS subsequently issued additional guidance removing that requirement and promising further guidance regarding the definition of partner tax capital. Thus, for 2019 partnerships continued to report partner capital accounts using prior methods, subject to the same reporting requirements as in 2018.
Consistent with its prior guidance, the IRS issued the Notice proposing that partnerships report partner capital accounts using only the tax basis method and eliminating any other method, including Section 704(b) and GAAP. For these purposes, the IRS indicated that a transactional approach to maintaining tax capital account information based on the principles of subchapter K of the Code will not satisfy the tax capital reporting requirement. Instead of providing the definition of tax basis capital, the IRS proposed two alternative methods, which include the Modified Outside Basis Method and the Modified Previously Taxed Capital Method.
Under the Modified Outside Basis Method, a partnership must report for each partner the partner’s adjusted basis in its partnership interest, determined under the principles and provisions of Subchapter K and subtracting from that basis the partner’s allocable share of liabilities, as determined under Section 752 of the Code. A partner is required to notify the partnership in writing within thirty days or by the taxable year-end of the partnership of any change to the partner’s basis during each partnership taxable year other than changes attributable to contributions, distributions, and the partner’s share of income, gain, loss or deduction that are otherwise reflected on Schedule K-1.
Under the Modified Previously Taxed Capital Method, a partnership must report the partner’s share of previously taxed capital, as calculated under a modified version of Regulation § 1.743-1(d) which applies to basis adjustment in partnership assets pursuant to a Code Section 754 election. Thus, the Modified Previously Taxed Capital will be equal to:
- the amount of cash that a partner would receive on a partnership liquidation following a hypothetical transaction; increased by
- the amount of tax loss (including any remedial allocation under Regulation § 1.704-3(d)) that would be allocated to the partner from the hypothetical transaction; and decreased by
- the amount of tax gain (including any remedial allocation under Regulation § 1.704-3(d)) that would be allocated to the partner from the hypothetical transaction.
For these purposes, the hypothetical transaction is a disposition by the partnership of all assets in a fully taxable transaction for cash equal to the fair market value of the assets. If the fair market value is not readily available, the Notice provides that a partnership may determine its partnership net liquidity value and gain or loss by using such assets’ bases as determined under Code Section 704(b), GAAP, or the basis set forth in the partnership agreement. In addition, the Notice provides that all liabilities are treated as nonrecourse for purposes of (ii) and (iii) of the calculation in order to avoid the burden of having to characterize the underlying debt and to simplify the computation. A partnership that adopts the Modified Previously Taxed Capital method would be required to attach a statement explaining the use of this method and determination of its net liquidity value.
Pursuant to the Notice, a partnership will be required to use one of these two methods and the method selected must be used with respect to all of the partners. A partnership may change from one method to another by attaching a disclosure to each Schedule K-1 describing the change, if any, to the amount attributable to each partner’s beginning and year-end balances, and the reason for the change. The deadline for public comments on Notice 2020-43 expired on August 4, 2020. This Notice should serve as the basis for changes to Form 1065, U.S. Return of Partnership Income, and its instructions, Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, and Partner’s Instructions for Schedule K-1 (Form 1065), for taxable year 2020. To ensure continued compliance, the IRS plans to issue additional guidance which will provide penalty relief for taxpayers for the 2020 tax year.
Based on the foregoing, for partnerships that did not previously use the tax basis method, the amounts on a partner’s Schedule K-1 may look different for taxable year 2020. However, as mentioned above, the new guidance modifies capital account reporting requirements only and does not cause any adverse economic consequence to taxpayers. On the other hand, switching to the tax basis method may be helpful to some partners, especially those with potential negative capital accounts, as such reporting may help partners better understand potential tax consequences on exit from a partnership. With the year-end approaching, partnerships and partners should begin conversations with their tax advisors about tax capital account reporting requirements and the process for conversion from GAAP, Section 704(b) or other method to the tax basis method, as provided by the Notice.