IRS proposes tax basis capital reporting methods

The IRS has released guidance (Notice 2020-43) proposing to allow partnerships to use one of only two alternative methods to report partner capital accounts on Schedule K-1 to satisfy capital account reporting requirements for partnership taxable years ending on or after Dec. 31, 2020.

The notice asks for comments on the reporting methods and is part of an IRS effort over the last few years to tighten requirements for reporting partners’ capital accounts on Schedule K-1. Partnerships had historically been free to choose from several different methods when reporting partners’ capital accounts. The IRS first tightened the requirements with new instructions for reporting negative tax basis capital accounts on the 2018 Form 1065. The IRS sought to expand the reporting in 2019 and is now proposing to limit the permissible methods for capital account reporting to just the two described in the notice. The proposed methods may present challenges for some partnerships. One, in particular, deviates significantly from previous guidelines for calculating a partner’s tax basis capital.

The proposed methods are not yet in effect, but they provide insight into the direction that the IRS appears to be headed on reporting partners’ tax basis capital accounts. Partnerships and their advisors should use Notice 2020-43 as an opportunity to assess their readiness to compute partners’ tax basis capital accounts and to gather any additional information that may be needed. They should also continue to monitor for developments in this area as the IRS moves to finalize its rules.


 

Background

Partnerships report partner capital accounts in Box L of the Schedule K-1 (Form 1065) or in Box F on the Schedule K-1 (Form 8865). Historically, partnerships have generally been allowed to choose between several methodologies to report partners’ capital accounts, including those described under Section 704(b) and Generally Accepted Accounting Principles (GAAP), “tax” or “other.” The first indication of change to this historical reporting occurred when instructions to Form 1065 for the 2018 tax year introduced a new requirement for certain partnerships to provide information about partners with a “negative tax basis capital account.” Specifically, the instructions required partnerships that reported partners’ capital accounts on a basis other than tax basis capital accounts to provide, on Schedule K-1, beginning and ending tax basis capital accounts for any partner who had negative “tax basis capital” either at the beginning or end of the tax year.

The term “tax basis capital” was a new term, previously undefined in published guidance and created by the IRS for the purpose of the 2018 reporting requirement. The initial 2018 Form 1065 instructions provided that the term “tax basis capital” generally reflected 1) the amount of cash plus the tax basis of property contributed to a partnership minus the amount of cash plus the tax basis of property distributed to a partner by the partnership net of any liabilities, plus 2) the partner’s cumulative share of partnership taxable income and tax-exempt income, minus 3) the partner’s cumulative share of taxable loss and nondeductible, non-capital expenditures.

Recognizing that partnerships might not be able to comply on a timely basis with the new tax basis capital reporting requirement, the IRS issued guidance in Notice 2019-20, waiving penalties under certain conditions and permitting certain partnerships to provide tax basis capital information on a delayed basis. The IRS also released guidance in the form of frequently asked questions (FAQ) in April 2019 that provided further information on the computation of tax basis capital accounts for partnership taxable years ending during 2018. The FAQ also provided a safe harbor under which a partnership may calculate a partner’s tax basis capital account by subtracting the partner’s share of liabilities from the partner’s outside basis in its partnership interest.

Initial draft instructions for the 2019 Form 1065 and 2019 Form 8865 would have required all partners’ capital accounts to be reported on Schedule K-1 using exclusively the tax basis capital method for 2019 partnership taxable years. In response to comments highlighting the difficulty of complying with the new reporting requirement, the IRS issued Notice 2019-66, which delayed the requirement to report all partners’ capital accounts using their tax basis capital until 2020. The 2018 reporting requirements for reporting negative tax basis capital accounts continue to apply for 2019 partnership taxable years. Notice 2019-66 also indicated that additional guidance on the definition of partner tax basis capital would be published in the future. Notice 2020-43 provides insight into the additional guidance by setting forth two proposed methods. 


 

Methods of computing partner tax basis capital under Notice 2020-43

Notice 2020-43 sets forth two proposed methods of computing partner tax basis capital, which the IRS currently anticipates will be the only permissible methods for satisfying the tax basis capital reporting requirement for partnership taxable years ending on or after Dec. 31, 2020. The notice states that it is intended that a partnership must use one of these two methods for purposes of satisfying the tax basis capital reporting requirement and the method selected must be used with respect to all the partnership’s partners.

These methods present a significant departure from the formulation of partner tax basis capital that was contained in the instructions to the 2018 version of Form 1065. In particular, one of the methods proposed in Notice 2020-43 would require computing each partner’s tax basis capital for a year using only information from that particular partnership taxable year, rather than relying on a running total of historical contributions, distributions, and income and loss allocations, which some partnerships might have found difficult or impossible to compile. Notice 2020-43 indicates that partnerships would be allowed to change the method used to report partners’ tax basis capital accounts year to year, provided that a disclosure is attached to each Schedule K-1 describing the impact of the change in methodology.


 

Modified Outside Basis Method

Under the first method, the “Modified Outside Basis Method,” a partner’s tax basis capital account would equal the partner’s basis in its partnership interest, reduced by the partner’s allocable share of partnership liabilities, as determined under Section 752. The IRS previously provided the Modified Outside Basis Method as a safe harbor method of computing tax basis capital accounts in the April 2019 FAQ.

Notice 2020-43 indicates that if a partnership applies the Modified Outside Basis Method, its partners will be required to notify the partnership of any changes in the basis of their partnership interests, other than changes attributable to contributions to and distributions from the partnership and from the partner’s shares of income, gain, loss, or deduction that are otherwise reflected on the partnership’s Schedule K-1. Thus a taxpayer who purchases an interest in a partnership during the year would be required to notify the partnership of the taxpayer’s basis in the newly acquired interest. This notification would be required in writing and would be due within 30 days of the event giving rise to the change in the partner’s basis or by the end of the partnership’s taxable year, whichever was later.


 

Modified Previously Taxed Capital Method

The second proposed method for computing tax basis capital accounts set forth in Notice 2020-43 is described as the “Modified Previously Taxed Capital Method.” This method presents an approach that differs from those in prior guidance and adapts the existing approach for computing a transferee’s share of the adjusted basis of partnership property (which is equal to the partner’s shares of the partnership’s previously taxed capital plus liabilities allocated to the partner under Section 752) for purposes of computing the transferee’s Section 743(b) adjustment, with certain modifications, as described below.

The regulations under Section 743(b) provide that a partner’s interest in a partnership’s “previously taxed capital” is determined by examining the effects of a hypothetical transaction in which the partnership sells all of its assets for their fair market value and pays all of its liabilities. A partner’s share of previously taxed capital is equal to the amount of cash that a partner would receive on a liquidation following the hypothetical transaction, increased by any tax losses and decreased by any tax gains that would be allocated to the partner as a result of the hypothetical transaction (including any remedial allocations). Under the Modified Previously Taxed Capital Method, the balance of a partner’s tax basis capital account would equal its share of the partnership’s previously taxed capital as computed under the Section 743 regulations, subject to certain modifications, as discussed below.

Applying the hypothetical transaction concept used in computing a partner’s share of the partnership’s previously taxed capital requires the partnership to know the fair market value of its assets. The IRS acknowledged that requiring every partnership to determine the fair market value of its assets annually could present a significant compliance burden. Accordingly, if the fair market value of a partnership’s assets is not readily available, the proposed Modified Previously Taxed Capital Method would allow the partnership to use the bases of its assets for purposes of Section 704(b), GAAP, or as otherwise provided by the partnership agreement. In addition, in computing the amount of tax gains and losses allocable to a partner as a result of the hypothetical transaction, the Modified Previously Taxed Capital Method would treat all liabilities as nonrecourse liabilities.


 

Next steps

Both proposed approaches must be evaluated for their feasibility in implementation. For example, computing a partner’s tax basis capital account using the Modified Outside Basis Method may require the partnership to possess information about its partners’ outside basis in their partnership interests, which is not information that the partnership generally is required to maintain and to which the partnership may not have ready access. Accordingly, it is likely that many partnerships would need to gather outside basis information from their partners before applying the Modified Outside Basis Method.

The IRS requested comments on several topics covered in Notice 2020-43, and any comments must be received by Aug. 4, 2020. Notice 2020-43 does not constitute binding authority, and it is still possible that the IRS will permit or require partnerships to compute partners’ tax basis capital accounts using a methodology other than the Modified Outside Basis Method or the Modified Previously Taxed Capital Method for 2020 partnership taxable years and beyond. While partnerships should start preparing to begin reporting tax basis capital for their 2020 tax years, they may also consider waiting for final guidance before implementing any specific processes for computing tax basis capital. Partnerships and their advisors should assess their readiness to compute partners’ tax basis capital accounts and gather any additional information that may be needed (i.e., information about partners’ basis in their partnership interests). Additionally, partnerships and their advisors should continue to monitor for developments in this area.

Finally, Notice 2020-43 does not alter the reporting of negative tax basis capital accounts for 2019 partnership taxable years, for which the rules set in place for 2018 are to be followed.

 

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