The IRS’s new draft forms for partnerships will create significant new compliance challenges for taxpayers, particularly with regard to new tax basis capital account reporting.
The recently released 2019 draft forms and instructions for Form 1065, U.S. Return of Partnership Income, and the Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., include significant new reporting requirements. The requirements will add to the compliance burden for many partnership, which are already dealing with many technical issues and uncertainties arising from the Tax Cuts and Jobs Act, including the interest limit under Section 163(j), ordinary income treatment for certain compensatory interests under Section 1061, and the deduction under Section 199A.
Most significantly, the draft forms require that partner capital accounts be reported solely on a “tax basis” and that information about each partner’s Section 704(c) built-in gain or loss (“net unrecognized built-in gain or loss”) be reported. Neither of these items had previously been required to be reported (except for negative tax basis capital amounts that were required to be reported for the 2018 tax year), and the instructions for the new reporting do not meaningfully define or describe the information that is being requested1
The IRS released the draft forms in late September 2019 and the draft instructions at the end of October 2019. In an information release accompanying the forms, the IRS said the purpose of the changes is to improve the quality of information reported by partnerships both to the IRS and partners, and to help the IRS assess compliance risk and identify potential noncompliance while leaving compliant taxpayers less likely to be examined. Presumably, the IRS will use this information to assist in partnership examinations, which are anticipated to increase under the new partnership audit regime under the Bipartisan Budget Act of 2015. Partnerships without proper records of tax basis and Section 704(b) book capital may fall under scrutiny in partnership examination.
Informal comments from the IRS have indicated that while the draft instructions may undergo revisions to reflect comments, the draft forms are expected to be finalized in their current state by the end of December. Commentators have recommended delaying the implementation of the new reporting by one year, but there is no assurance that the government will agree to a delay.
The requirement to report capital accounts on a “tax basis” for 2019 was foreshadowed by a requirement for 2018 partnership returns to report using tax basis capital in limited situations where a partner had negative tax capital. Prior to the 2018 tax year, partnerships were permitted to provide capital account information using one of several approaches (tax basis, 704(b), GAAP, or “other”) and, thus, had significant flexibility. Such flexibility was narrowed for the 2018 tax year with respect to any partner having negative tax basis capital either at the beginning or end of the tax year. In that situation, beginning and ending tax basis capital accounts for such partners were required to be provided. Thus, for 2018, not all partnerships were required to report capital accounts on a tax basis. For 2019, with the exception of certain smaller partnerships having total receipts for the tax year less than $250,000 and having total assets less than $1 million, all partnerships must report using tax basis under the draft forms.
When the concept of negative tax basis capital was first introduced for the 2018 tax year, there was some confusion about the meaning of the term. Informal commentary from the IRS eventually revealed that the concept was generally aimed at a partner’s share of inside tax capital. The IRS provided guidance as to the meaning of the term in form instructions2
and an FAQ that included a safe harbor3
. In addition, prior to releasing the FAQ, the Service issued Notice 2019-20, which allowed partnerships to report negative tax basis capital account information with their 2018 return or at a later date (but no later than 180 days after the six-month extended due date of the partnership’s Form 1065) provided certain conditions were met.4
New requirements in draft forms and instructions
The Draft Instructions explain that the term “tax basis capital” means:
- The amount of cash and tax basis of property contributed by a partner subtracted by the amount of cash and tax basis of property distributed to a partner net of any liabilities assumed in connection with or subject to such contributions or distributions
- The partner’s cumulative share of partnership taxable income and tax-exempt income
- The partner’s cumulative share of taxable loss and nondeductible, noncapital expenditures.
Notably, while the FAQ for 2018 included basis adjustments under Sections 734(b) and 743(b) in the computation, the new draft Instructions specifically exclude basis adjustments under Section 743(b) from the computation and do not address the inclusion of Section 734(b). Accordingly, at this time, looking to the FAQ for 2019 reporting does not provide clarity. It is expected that the IRS will clarify in the final version of the draft instructions whether the tax basis capital accounts include basis adjustments under Sections 734(b) and 743(b).
Regarding reporting on Section 704(c), the draft instructions are not clear on the meaning of the term “net unrecognized built-in gain or loss.” In addition, if a partner received any Section 704(c) income or deduction items that are included in any line item on Schedule K-1, reporting is required on Line 20 of Schedule K-1 (Code AA) of “net section 704(c) adjustment,” but this has not been previously defined in the regulations or guidance issued by the IRS.
The draft Schedule K-1 also includes the following other notable new reporting:
- Identifying if a partner’s share of profit, loss, or capital decreased in the year due to a sale or exchange of a partnership interest
- Indicating if a partner’s share of partnership liabilities includes amounts allocated from lower-tier partnerships
- Distinguishing between guaranteed payments to a partner for services versus for the use of capital
- Checking a box if the partnership is engaged in more than one activity for at-risk and/or passive activity purposes, and providing information separately (on a statement that is attached to the Schedule K-1) for each at-risk activity if the partnership conducts more than one of them
- Showing separate amounts for a current year increase or decrease in the tax basis capital account between current year net income (loss) versus other increase (decrease)
- Showing the amount of net positive or net negative income effect from Section 743(b) adjustments
- Identifying if the partner is a disregarded entity (“DE”) and showing information about both the DE and its owner
Notable new requirements to the draft Form 1065 include:
- Providing the number of foreign partners that are subject to Section 864(c)(8) as a result of transferring all or a portion of an interest in the partnership or receiving a distribution from the partnership
- Indicating whether there were any transfers between the partnership and its partners that are subject to the disclosure requirements in Treas. Reg. Sec. 1.707-8 if the transferred amounts are not treated as consideration in a disguised sale
Because many of the changes to the forms represent new material reporting requirements and do not clearly define the information requested, the requirements will present challenges to partnerships and their tax advisors in their current form. Quite simply, because partnerships have historically had flexibility to report capital accounts using various approaches, they may not have access to capital accounts based on tax basis and will likely need additional work to prepare the needed computations. This extra work may entail looking at historical data of the partnership and its current and former partners. In addition, older partnerships might not have detailed records at their disposal. Even if the IRS provides a safe harbor similar to that for 2018 (using a partner’s outside basis, minus liabilities), the safe harbor may not be viable for partnerships that typically do not keep records of partner outside basis. Further, efforts to properly roll forward tax basis capital amounts of partners could take time and be very difficult to complete for Schedule K-1s to be issued in February or March, when many partnerships are contractually obligated to furnish them to partners.
Additional guidance providing clarity to the reporting requirements, in particular in the form of safe harbors and/or simplified methods of computing tax basis capital, would be helpful. In addition, for partnerships that must dig for historical information, a delay in reporting tax basis capital similar to that provided in Notice 2019-20 would be welcome. Further guidance from the IRS would also be welcome regarding how sales or exchanges of partnership interests, including in the event of a partnership merger or division, should be taken into account in computing tax basis capital accounts.
As stated earlier, informal comments from the IRS have indicated that while the draft instructions may undergo revisions to reflect comments, the draft forms are expected to be finalized in their current state. So partnerships that do not already report partner capital accounts using tax basis should brace for the change and start preparing for the new reporting. Realistically they should expect significant additional work to ensure compliance with the new reporting. Below are some points to keep in mind:
- The potential for additional work means that partnerships, especially those obligated to furnish Schedule K-1s to their partners in February or March, should start their tax return preparation work earlier in the compliance season than in prior years.
- For partnerships that have not previously tracked tax basis capital accounts, the accounts as of the beginning of the 2019 taxable year could be determined by rolling forward the historical information of the partnership since its formation. However, the following alternatives approaches may be possible. In the absence of full Section 704(b) and tax capital information, which is the ideal situation, consider:
- Obtaining each partner’s outside tax basis and subtracting the partner’s share of Section 752 liabilities. This could provide an estimate of each partner’s tax basis capital similar to the safe harbor in the FAQ for the tax basis capital reporting for the 2018 taxable year.
- Using tax basis balance sheet information to determine each partner’s proportionate share of adjusted basis of partnership property upon a hypothetical sale and liquidation of the partnership. This approach is similar to the concept of previously taxed capital for Section 743(b) purposes as an approximation of each partner’s tax basis capital.
- In all instances, having all key documents available, including the partnership agreement, debt documents, and compensatory award documents, is critical. Information gathering should begin immediately.
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