IRS PROPOSES METHODS FOR REPORTING PARTNER CAPITAL ACCOUNTS

09 June 2020

In a Notice, IRS has proposed two new methods for reporting partner capital accounts on partnership income tax returns. The new methods are proposed to apply to partnership tax years that end on or after Dec. 31, 2020 and are proposed to be the exclusive methods for such reporting.

Background. Partnerships and certain other persons report partner capital accounts in Box L on the Schedule K-1 (Form 1065 (U.S. Return of Partnership Income)) or in Box F on the Schedule K-1 (Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships)), as they currently appear on the 2019 forms (Tax Capital Reporting Requirement).

On April 5, 2019, the IRS released Form 1065 Frequently Asked Questions (FAQs) explaining how a partnership should determine a partner’s tax capital account and providing a safe harbor approach based on a partner’s outside basis in its partnership interest. Thereafter, early releases of drafts of the 2019 Form 1065 and Form 8865 expanded partner tax capital reporting to require all partnerships and certain other persons who file Form 8865 to report all partners’ tax capital accounts using the tax basis method.

Thereafter, several commenters stated that partnerships that didn’t historically maintain partner tax accounts would not be able to comply with this requirement.

Accordingly, IRS released Notice 2019-66, 2019-52 I.R.B. 1509, removing the requirement that partnerships and other persons required to furnish and file Form 1065, Schedule K-1 or Form 8865, Schedule K-1, report partner capital accounts in Item L of the 2019 Form 1065, Schedule K-1, or in Item F of the 2019 Form 8865, Schedule K-1, using the tax basis method for 2019. See IRS delays tax basis reporting of capital accounts to 2020.

IRS proposes new methods. In the Notice, IRS proposes two new methods, the Modified Outside Basis Method and the Modified Previously Taxed Capital Method, for meeting the Tax Capital Reporting Requirement and anticipates that the two proposed methods will be the only methods that meet the Tax Capital Reporting Requirement for partnership tax years ending on or after December 31, 2020.

IRS intends that a partnership must use one of these two methods for purposes of satisfying the Tax Capital Reporting Requirement and the method selected must be used with respect to all of the partnership’s partners. For tax years after 2020, a partnership may change its Tax Capital Reporting Requirement method from the Modified Outside Basis Method to the Modified Previously Taxed Capital Method, or vice versa, by attaching a disclosure to each Schedule K-1 describing the change, if any, to the amount attributable to each partner’s beginning and end of year balances, and the reason for the change.

Under another technique, which IRS calls the Transactional Approach, partnerships maintaining tax capital

  1. Increase a partner’s tax capital account by the amount of money and the tax basis of property contributed by the partner to the partnership (less any liabilities assumed by the partnership or to which the property is subject) as well as allocations of income or gain made by the partnership to the partner, and
  2. Decrease a partner’s tax capital account by the amount of money and the tax basis of property distributed by the partnership to the partner (less any liabilities assumed by the partner or to which the property is subject) as well as allocations of loss or deduction made by the partnership to the partner.

Capital account amounts based on the Transactional Approach will not satisfy the Tax Capital Reporting Requirement.

The Modified Outside Basis Method. Under this method, a partnership determines, or is provided by its partners, the partner’s adjusted basis in its partnership interest, determined under the principles and provisions of subchapter K, and subtracting from that basis the partner’s share of partnership liabilities under Code Sec. 752.

If the partnership is satisfying the Tax Capital Reporting Requirement by using this method, a partner must notify its partnership, in writing, of any changes to the partner’s basis in its partnership interest during each partnership tax year, other than

  1. Changes attributable to contributions to and distributions from the partnership and
  2. The partner’s share of income, gain, loss, or deduction that are otherwise reflected on the partnership’s schedule K-1.

The partner must provide such written notification of such changes to the partner’s basis within thirty days or by the tax year-end of the partnership, whichever is later.

For example, if a person purchases an interest in a partnership that has chosen to use the Modified Outside Basis Method, the purchasing partner must notify the partnership of its basis in the acquired partnership interest, regardless of whether the partnership has an election under Code Sec. 754 in effect or has a substantial built-in loss, as defined in Code Sec. 743(d), at the time of such interest purchase.

For purposes of the Modified Outside Basis Method, a partnership is entitled to rely on the partner basis information that the partnership is provided by its partners unless the partnership has knowledge of facts indicating that the provided information is clearly erroneous.

Modified Previously Taxed Capital Method. Reg §1.743-1(d)(1) generally provides that a partnership interest transferee’s (transferee’s) share of the adjusted basis of partnership property is equal to the sum of the transferee’s interest as a partner in the partnership’s previously taxed capital, plus the transferee’s share of partnership liabilities. The reg further provides that the transferee’s previously taxed capital is equal to—

  1. The amount of cash that the partner would receive on a liquidation of the partnership following a hypothetical transaction; increased by
  2. The amount of tax loss (including any remedial allocations under Reg § 1.704-3(d)) that would be allocated to the partner from the hypothetical transaction; and decreased by
  3. The amount of tax gain (including any remedial allocations under Reg § 1.704-3(d)) that would be allocated to the partner from the hypothetical transaction. The hypothetical transaction is a disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the fair market value of the assets. See Reg § 1.743-1(d)(2).

The Modified Previously Taxed Capital Method modifies the calculation described in Reg § 1.743-1(d)(2) (for purposes of the Tax Capital Reporting Requirement only) as follows:

  1. The cash a partner would receive on a partnership liquidation and calculations of gain and loss in the hypothetical transaction would be based on the assets’ fair market value, if readily available. Otherwise, a partnership may determine its partnership net liquidity value and gain or loss by using such assets’ bases as determined under Code Sec. 704(b), GAAP, or the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management; and
  2. All liabilities are treated as nonrecourse for purposes of parts (ii) and (iii) of the calculation referring to gain or loss, respectively. This is to avoid the burden of having to characterize the underlying debt and to simplify the computation.

IRS requests comments. The Notice requests comments on the proposed methods