New method provided for tax basis capital reporting

The IRS has released an early draft of the instructions to Form 1065, “U.S. Return of Partnership Income,” for tax year 2020 that require partnerships to use a transactional approach to report partner tax basis capital in Item L of the Schedule K-1.

The draft instructions, released on Oct. 22, follow up on Notice 2020-43, which proposed to allow partnerships to use either the modified outside basis method or the modified previously taxed capital method 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 (for more details on Notice 2020-43, see our story, “IRS proposes tax basis capital reporting methods”). However, after numerous comments, the IRS appears to be abandoning the two alternative methods in favor of using the transactional approach. The draft instructions require partnerships to use only the transactional approach for the tax basis method, which must be used beginning with the 2020 tax year (as opposed to GAAP, Section 704(b) or other), with some transition relief.

This reporting requirement applies to all partnerships other than certain smaller partnerships whose total receipts for the tax year were less than $250,000 and whose total assets at the end of the tax year were less than $1 million (i.e., partnerships that answer “yes” to question 4 of Schedule B). Additionally, the Schedule M-2 (Partners’ Capital Accounts) to the Form 1065 would align with the total tax basis capital account amounts of the partners reported on Item L of the Schedules K-1. However, solely for determining a partner’s beginning capital account for 2020, if a partnership did not use the tax basis method for 2019 and did not maintain capital accounts under the tax basis method, the partnership is permitted to use one of four methods — the tax basis method, the “Modified Outside Basis Method,” the “Modified Previously Tax Capital Method” or the Section 704(b) method.

The use of the transactional approach method reflects significant accommodation by the IRS to taxpayers’ situations, but it may entail additional work on the part of partnerships, including performing calculations not previously done. Partnerships will need to spend time determining the tax basis capital account to report on each partner’s Schedule K-1s, as well as computing and describing the items that affect the total tax basis capital on the Schedule M-2.


 

Draft instructions

The 2020 draft instructions provide guidance on the impact of partnership events or transactions on a partner’s tax basis capital account, explaining that taxpayers should account for an event or transaction in a manner generally consistent with figuring the partner’s adjusted tax basis in its partnership interest, without regard to partnership liabilities, taking into account the rules and principles of Sections 705, 722, 733, and 742.

However, the 2020 draft instructions distinguish between a partner’s adjusted basis in its partnership interest and its capital account as reported using the tax basis method, noting that the distinction is necessary because a partner’s adjusted tax basis in its partnership interest includes the partner’s share of partnership liabilities as well as partner-specific adjustments. They also make clear that each partner is responsible for maintaining a record of the adjusted tax basis in its partnership interest, presumably suggesting that the partnership is not responsible for maintaining such a record.

The draft instructions provide guidance on how to fill out the following lines in item L:

• Beginning capital account (whether tax basis method was previously used or not)
• Capital contributed during the year
• Current year net income (loss)
• Other increase (decrease)
• Withdrawals and distributions

The sum of these amounts listed above must equal the amount reported on the line for ending a capital account, which may be negative.

For the beginning capital account amount, if the tax basis method was used previously, then the amount entered will be the partner’s ending capital account determined from the last year. If a negative ending capital account was reported for 2019 and a different amount is determined for 2020, then an explanation must be given for the difference. If the tax basis method was not used previously for reporting partners’ capital accounts, but the tax basis method was used to maintain capital accounts in the partnership’s books and records, then the partnership must use the tax basis method for reporting the beginning capital account. However, if the tax basis method was not used by the partnership for both reporting partners’ capital accounts and maintaining the partnership’s books and records, then solely for 2020, the partnership may determine the partner’s beginning capital account using the tax basis method, the Modified Outside Basis Method, the Modified Previously Taxed Capital Method or the Section 704(b) method.

To determine the capital contributed during the year, the partnership must enter the amount of cash plus the adjusted tax basis of all property contributed by the partner to the partnership during the year. This amount will be net of any liabilities assumed by the partnership on contribution. The current year net income or loss will be “the partner’s distributive share of partnership income and gain (including tax-exempt income) ... minus the partner’s distributive share of partnership loss and deductions (including nondeductible, noncapital expenditures).”

All other increases or decreases that affected the partner’s capital account for tax purposes are to be included on the line for other increase (decrease). Such increases and decreases include the partner’s share of any increase or decrease to the basis of partnership property under Section 734(b). However, the draft instructions note that Section 743(b) adjustments are not included in a partner’s tax basis capital account and, if included in a partner’s beginning capital account balance, should be removed from the partner’s capital account in the 2020 tax year and reported as an “other increase (decrease) item.” Under withdrawals and distributions, the partnership is to enter “the amount of cash plus the adjusted tax basis of all property distributed” to the partner that year net of liabilities assumed by the partner in the distribution.

Upon a transfer of a partnership interest, the partnership is to report for the transferee an amount for beginning capital account that 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. The draft instructions do not specify how to determine the portion of the transferor’s capital account (using the tax basis method) that is transferred in a transfer of a portion of a partner’s partnership interest. In the case of a sale or exchange of an interest in a publicly traded partnership, the partnership is permitted to determine a transferee partner’s beginning capital account by adjusting the partner’s beginning capital account to reflect the transferee partner’s purchase price of the interest rather than entering the transferor partner’s ending capital account.

A news release published concurrently with the draft instructions indicates that the Treasury and the IRS intend to issue a notice providing penalty relief for the transition in tax year 2020. The release explains that the draft instructions are intended to give tax practitioners a preview of the changes and software providers the information they need to update systems before the final version of the updated instructions is released in December. Similar revisions, as applicable, to Form 8865, “Return of U.S. Persons with Respect to Certain Foreign Partnerships,” are planned. Additionally, the IRS will accept comments for 30 days. Thus, it seems reasonable to expect that the final version of instructions for Form 1065 for 2020 will be released before the end of the year.


 

Next steps

The 2020 Draft Instructions are part of a larger effort by the IRS to increase compliance by improving the quality of the information partnerships report to the IRS and furnish to partners. The use of the transactional approach method, which was requested by numerous commentators, reflects significant accommodation by the IRS to taxpayers’ situations. However, even the use of the transactional approach may entail additional work on the part of partnerships to perform calculations not previously done. Partnerships will need to spend time to determining the tax basis capital account to report on each partner’s Schedule K-1s, as well as computing and describing the items that affect the total tax basis capital on the Schedule M-2.