New IRS Reporting Requirements for Partner Capital Accounts in 2020
By Audrey Yang, CPA, Senior Tax Manager, Alternative Investment Group
Big changes to Schedule K-1 reporting are on the way, and these changes might cause confusion for some partners in 2020. On October 22, the IRS released a draft of Form 1065, U.S. Return of Partnership Income Instructions for the 2020 tax year, which contain the IRS’s requirements for reporting a partner’s capital on the tax basis. The IRS will be accepting Form 1065 Instructions comments for 30 days.
2020 Tax Basis Capital Reporting for Partnerships
Prior to the 2018 tax year, partnerships were allowed to choose between several reporting methods, such as Generally Accepted Accounting Principles (GAAP), Section 704(b), Tax, or Other, to report the partners’ capital accounts on a Schedule K-1. In an effort to improve the quality of the information reported by partnerships, the IRS introduced a new requirement in 2018 that mandated partnerships to provide information for partners with a negative tax basis capital account and required all partnerships to switch to tax basis capital account reporting in tax year 2019. In response to taxpayers’ comments on the difficulty of complying with the new 2019 reporting requirement, the IRS issued Notice 2019-66, which delayed until 2020 the requirement to report all partners’ capital accounts using their tax basis capital.
The draft instructions indicate that partnerships filing Form 1065 for tax year 2020 are to calculate partner capital accounts using the transactional approach for the tax basis method. If the partnership reported the partner capital accounts in 2019 using a different method (e.g., GAAP, Section 704(b), or Other), it must use a tax basis method in 2020 as discussed below.
For partnerships that used methods other than tax basis in 2019, the taxpayer should use one of the following methods to satisfy the 2020 tax basis capital reporting requirement:
- Tax Basis Method
- Modified Outside Basis Method
- Modified Previously Taxed Capital Method
- Section 704(b) Method
The taxpayer needs to attach a statement to the partners’ Schedule K-1 indicating the method used to determine each partner’s capital account.
Tax Basis Method
Partnerships that have always reported using the tax basis method for partners’ capital should continue using that method. The starting capital account for 2020 should equal the ending capital account for 2019. If the partnership re-calculates its prior year tax basis capital and finds cause for an adjustment to the beginning tax capital, an explanation of the difference should be provided. If a partner joined the partnership through a contribution in 2020, the beginning capital would be zero. However, if a new partner acquired its interest from another partner in a purchase, exchange, gift, inheritance, etc., enter the transferor partners’ 2019 ending tax basis as the 2020 beginning capital for the transferee account with respect to the interest transferred. According to IRS data, most partnerships already use the tax-basis method, and these changes should not create a significant hardship.
Partnerships that used a method other than tax basis in 2019 but maintained capital accounts using the tax basis method (for example, for purposes of meeting the requirement to report partner negative tax capital accounts) must report each partner’s 2020 beginning capital account using the tax basis method. Partnerships that did not report partners’ capital accounts using the tax basis method and did not maintain capital accounts under the tax basis method in prior years may refigure each partner’s beginning capital account using the tax basis method or one of the three allowable methods discussed below. The same method must be used for each partner’s beginning capital account. A statement must be attached to each partner’s Schedule K-1 indicating the method used to determine each partner’s beginning capital account and certain other information.
Modified Outside Basis Method
IRS Notice 2020-43 provides guidance and the Service seeks public comments regarding this method. Under this method, the partner’s modified outside basis is the adjusted basis in its partnership interest, determined under the principles and provisions of Subchapter K (including those contained in IRC Sec. 705 – Determination of Basis of Partner’s Interest, IRC Sec. 722 – Basis of Contributing Partner’s Interest, IRC Sec. 733 – Basis of Distributee Partner’s Interest, and IRC Sec. 742 – Basis of Transferee Partner’s Interest), subtracting from that basis the partner’s share of partnership liabilities under IRC Sec. 752 – Treatment of Certain Liabilities.
If a partnership chooses to use the Modified Outside Basis Method, all partners must agree to the following:
- A partner must notify the partnership, in writing, of any changes to the partner’s outside basis in its partnership interest during each partnership taxable year. For example, if a person purchases an interest in a partnership that uses the Modified Outside Basis Method, the purchasing partner must notify the partnership of its tax basis in the acquired partnership interest, regardless of whether the partnership has an IRC Sec. 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property election in place or has a substantial built-in loss (IRC Sec. 743(d)) at the time of the purchase of that interest.
- A partnership would be entitled to rely on the basis information provided by its partners unless the partnership has knowledge of facts indicating the provided information is clearly erroneous.
The partner must provide a written notification of changes to its basis within 30 days or by the partnership’s taxable year-end, whichever is later.
One of the advantages of this method is that the partnership can rely on the adjusted tax basis information provided by its partners; the disadvantage is that this information must be received from ALL partners.
Modified Previously Taxed Capital Method
The modified previously taxed capital method is the second method described under Notice 2020-43. It references “previously taxed capital” in Reg. Sec. 1.743-1(d) with certain modifications. The partner’s beginning capital account, under this method, is equal to the following:
- The amount of cash the partner would receive on a liquidation of the partnership following a hypothetical liquidating transaction, if all assets were sold at fair market value or some other basis, such as 704(b), GAAP, or the other basis set forth in the partnership agreement, increased by
- The amount of tax loss (including any “remedial allocations” under Treas. Reg. 1.704-3(d)) that would be allocated to the partner from the hypothetical liquidating transaction, and decreased by
- The amount of tax gain (including any remedial allocations) that would be allocated to the partner from the hypothetical liquidating transaction.
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.
Section 704(b) Method
Section 704(b) Method is not previously described by the IRS. The partners’ beginning capital account under this method is equal to the partners’ section 704(b) capital account, minus any section 704(c) built-in gain or plus section 704(c) built-in loss for partnership assets. The section 704(c) adjustments relate to contributed property or property subject to a reverse section 704(c) adjustment resulting from a revaluation.
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.
2020 Proposed Penalty Relief
According to the IRS news release (IR 2020-240), the IRS intends to issue an additional notice providing penalty relief for the transition in tax year 2020, in order to promote compliance. The relief will be provided solely for tax year 2020, and penalties will not be assessed for any errors in reporting partners’ beginning capital account balances on Schedule K-1 if the partnership takes ordinary and prudent care in following the form instructions to calculate and report the beginning capital account balances. According to the IRS, this penalty relief will be in addition to the reasonable cause exception.
Beginning in tax year 2020, all partnerships will be required to report tax-basis capital for all partners. For specific questions, contact your Marcum professional. Our team can help review records and documentation to determine the tax basis capital for each partner or answer any questions you may have.