New Tax Basis Reporting Requirements for Partners’ Capital Accounts
For tax years beginning in 2020, the IRS is requiring partnerships filing Form 1065 to report partners' capital accounts on the tax basis (which is what the IRS refers to as the transactional method). The IRS will require partnerships to use the transactional method in computing partners' capital on the tax basis instead of reporting using other methods, such as GAAP.
Form 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 their books and records may refigure a partner's beginning capital account for 2020 using one of the following four methods discussed below: the tax basis method, the modified outside basis method, the modified previously taxed capital method, or the Section 704(b) method.
The new reporting rules do not apply to partnerships that do not have to complete 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).
Under this method, the partner's tax basis capital account is calculated by starting with cash plus the tax basis of assets contributed, less any liabilities assumed by the partnership, plus income or loss allocated to the partner, less any distributions. There are many more adjustments that are required under this method, such as depletion, step-up and step-down adjustments for retired partners, tax-exempt income, etc., which are beyond the scope of this discussion.
It is clear, the transactional method is the method the IRS wants practitioners to use. The other three methods discussed below are only to be used to arrive at a beginning tax basis capital account for 2020, if necessary.
Modified Outside Basis Method
This method looks at the outside basis of each partner's capital account as a starting point. Assuming each partner can provide the partnership with this information, or the partnership has maintained such information for each partner, this provides a relatively simple method to make the conversion.
Modified Previously Taxed Capital Method
Under this method, the partnership assets are marked to fair market value (FMV) and deemed sold. The partners' beginning tax basis capital accounts are calculated by determining the amount of cash allocated to each partner and removing any gain or loss allocated to each partner to arrive at an approximation of their basis.
Section 704(b) Method
The beginning tax basis capital account is the partner's 704(b) capital account less any adjustments for Section 704(c) built-in gains plus any adjustments for Section 704(c) built-in losses.
Publicly Traded Partnerships
In the case of a publicly traded partnership, the following special method for computing the partners' beginning capital account applies:
In the case of a sale or exchange of an interest in a publicly-traded partnership, you may 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.
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.
If the partnership adopted the modified previously taxed capital method, it might apply the rules for optional adjustment to the basis of partnership property found in Treasury regulations under Section 743 in figuring a partner's beginning capital account.
Some partnerships may have been in existence for many years and may have had a taxpayer as a partner for decades. Prior to the new rules, a partner, 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.
To promote compliance with the tax-basis method, the IRS intends to grant penalty relief for the transition to the new rules in 2020. The relief will provide that solely for the 2020 tax year (for partnership returns due in 2021), the IRS will not assess a penalty for any errors in reporting a partnership's partners' beginning capital account balances on Schedules K-1 if the partnership takes ordinary and prudent business care in following the form instructions to calculate and report the beginning capital account balances. According to the IRS, this penalty relief will apply in addition to the reasonable-cause exception.
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.
We will be your personal advocate throughout the entire process.
For our thoughts on the industries we serve and firm updates, follow us on LinkedIn.
Ready to Connect?
We deliver personalized, expert services. Find out what we can do for you.