Partner capital account reporting gets transition penalty relief

The operating agreement states that they are equal partners, with respective shares of capital, profits, and loss 50% each. Fred contributes cash in the amount of $100 and Ginger contributes a building with a basis $40 and fair market value of $100. Over the past few years, the IRS has issued, revised, withdrawn, revised again, and reissued new reporting requirements that it believes will help enforce the loss limitations of Code §704(d). After giving effect to the special allocations provisions [relating to appreciated contributed property] and allocations equal to the distribution of cash flow, the Profits and Losses for each Fiscal Year (or portion thereof) shall be allocated to the Members in proportion to their capital accounts. The revised instructions are part of a larger effort by the agency to improve the quality of the information reported by partnerships to the IRS and furnished to partners to facilitate increased compliance. Although the instructions include the methodology to be used by publicly traded partnerships, the discussion below does not address those rules.

• The three methods aside from reconstructing the transaction tax basis capital accounts are described in the following sections.
• 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.
• A federal tax specialist for 50 years, Lynn Nichols provides tax consulting services to CPA firms on complex federal income tax issues, professional standards in tax practice and effective tax practice management.
• Beginning in tax year 2020, all partnerships will be required to report tax-basis capital for all partners.
• This framework should make life easier for practitioners after the books are fixed—after the 2020 returns are completed.

The IRS has long been concerned that partners were deducting losses in excess of basis, but it was difficult to identify these situations because a partnership not only did not necessarily know the true amount of a partner’s basis; the basis also was not reflected on Form 1065 or Schedule K-1. If you have questions about partnership basis or reporting and record-keeping of partner tax basis or would like assistance with any matter involving tax preparation and strategy or audit and assurance, contact your Whittlesey advisor for assistance in protecting your audit risk exposure. Prior to the new rules, a partner, https://turbo-tax.org/ and not the partnership, was responsible for maintaining a calculation of his tax basis in the partnership. If the partnership or tax preparer had not previously kept a calculation of each partner’s tax basis, then catching up the calculation to 2020 could be a cumbersome process. In making the adjustments, the partnership may use the information required to be reported to it under Treasury regulations for nominee reporting of partnership information of Section 6031 and publicly available trading price information. This method looks at the outside basis of each partner’s capital account as a starting point.

Why would a partnership care about reporting these items if they only affect the partners?

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. 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. The concept of a “tax basis capital account” is important in determining a partner’s gain or loss from the sale of his partnership interest and from certain other partnership transactions.

However, for tax years prior to 2020, tax basis capital accounts generally did not need to be disclosed on a partnership’s income tax returns; instead, a partnership was permitted to report its partners’ capital accounts on some other basis, such as GAAP or so-called “section 704(b)” capital accounts. These other methods were often of limited use to the IRS in identifying potentially taxable situations; thus, for taxable years ending on or after Dec. 31, 2020, partnerships are now required to report each partner’s capital account on a tax basis. Property contributed to a partnership is Section 704(c) property if, at the time of the contribution, its fair market value differs from its adjusted tax basis. Section 704(c) property includes property with differences resulting from revaluations, also known as reverse Section 704(c) allocations. Note that Section 743(b) basis adjustments are not taken into account in calculating a partner’s capital account under the tax basis method.

Modified Previously Taxed Capital Method

Thus, IRS seems to say that all the assets are sold for the amount of the loan and the proceeds are used to pay off the loan. In other words, $5,000 amount realized exceeds $3,000 basis by $2,000, so gain equals $2,000. 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. A partnership that adopts the Modified Previously Taxed Capital Method would treat all liabilities as nonrecourse liabilities. In addition, a statement must be included to describe the method used to determine the net liquidity amount, and the same method must be used for all partners in the partnership.

• Practitioners are well aware that a partner’s basis can and often does differ from the partner’s capital account.
• The use of the transactional approach method, which was requested by numerous commentators, reflects significant accommodation by the IRS to taxpayers’ situations.
• LexisNexis® and Bloomberg Law customers are able to access and use ALM’s content, including content from the National Law Journal, The American Lawyer, Legaltech News, The New York Law Journal, and Corporate Counsel, as well as other sources of legal information.
• We stand ready to help you plan effectively and to navigate through these reporting requirements.
• Partnerships with historical partner tax capital information will experience an easier transition into the new reporting requirements.
• Additionally, the following capital account reconciliation’s have been update to reflect the above changes removing the books to tax reconciliation and providing more detail on the partner’s share of taxable income and other increases/decreases.
• Under the Modified Outside Basis Method, a partner’s beginning capital account balance is equal to the partner’s adjusted tax basis in its partnership interest (outside basis), except the partner’s outside basis does not include the partner’s share of partnership liabilities or net Section 743(b) adjustments.

On the line for other increase (decrease), enter the sum of all other increases or decreases that affected the partner’s capital account for tax purposes during the year and attach a statement explaining each adjustment. Baker Tilly, along with many other practitioners, submitted comments to the Treasury Department, highlighting the above issues and the significant difficulties they would create for taxpayers. In mid-October, the IRS again relented, providing in the draft instructions for the 2020 Form 1065 that the more commonly utilized “transactional approach” for computing tax capital would be the only methodology allowed.

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Partnerships should form and implement a compliance plan now, as the scope and complexity of the calculations and data gathering will be impractical to administer at the same time that the 2020 return is filed. Partnerships with historical partner tax capital information will experience an easier transition into the new reporting requirements. However, certain adjustments may still be needed to the historical tax capital calculations to meet the new Schedule K-1 reporting requirement, including the exclusion of any Section 743(b) adjustments that may have been included in a partner’s capital account.

Regardless of the potential problems and the unaddressed issues, the new draft instructions do provide a framework for ”fixing” a client’s books to reflect an approximate tax basis capital account. This framework should make life easier for practitioners after the books are fixed—after the 2020 returns are completed. If the Schedule L balance sheet https://turbo-tax.org/reporting-partnership-tax-basis/ is kept on a book or GAAP basis, you’ll need to override the ending partners’ capital accounts on Screen 24, Balance Sheet with the appropriate book/GAAP amount from the partnership’s records. If you don’t override this amount, the program will use the amount from Schedule M-2, line 3, to calculate the ending balance on Schedule L, line 21.

Partnership tax basis capital reporting requirement for tax year 2020

The taxpayer needs to attach a statement to the partners’ Schedule K-1 indicating the method used to determine each partner’s capital account. The believed intent of the IRS is to identify circumstances in which the partners are required to recognize income or gain or to identify losses that the partners are limited in deducting as a result of having a negative tax basis. Most partnerships will likely end up using either the transactional or the modified previously taxed capital method. When complete information is available extending back to the beginning of the partnership’s life, and particularly with newer partnerships, the transactional method is likely to be the simplest and least labor-intensive method. However, for those that have used an alternative capital account method, such as 704(b), GAAP, or other, and for those partnerships that have errors in their tax capital accounts, this can present a challenge.

Determining the tax basis capital accounts for those clients would be difficult and time consuming at best and, for some clients, practically impossible. These instructions clearly require that partnerships and LLCs taxed as partnerships report their partners’ capital accounts on the tax basis of accounting. (For the remainder of this explanation, please understand that “partner” and “partnership(s)” refer to both traditional partnerships as well as LLCs taxed as partnerships, and their partners and/or members). Please note that these rules do not apply to partnerships that do not have to present Schedules L, M-1 or M-2 (receipts under $250,000, assets under $1 million, timely filed Schedule K-1s and no requirement to file M-2). The tax basis method reporting requirement was initiated in part due to the Internal Revenue Service’s inability to calculate partner’s tax basis when a partnership would report the capital accounts on a different method of accounting. For tax year 2021, “small partnerships” do not need to complete the Partner’s Capital Account Analysis on Schedule K-1 if the partnership meets the requirements of 2021 Form 1065, Schedule B, Question 4.

In the end, it appears the IRS not only relented and will allow continued use of the transactional approach, but has decided that is the only method to be allowed to be used following the computation of beginning partners tax basis capital for 2020 Schedules K-1. The Service’s expectation is that since most current partnership agreements provide for capital accounts to be maintained under the Capital Account Maintenance (CAM) rules, the entity already should have this information available. A partner who purchases partnership interest from another partner takes carryover tax-basis capital account.