On October 22, the IRS made its opening foray into the expanded 2020 tax basis capital reporting requirement that will apply to all partnerships. The IRS news release summarizes proposed rules for the reporting requirement that are more fully described in draft Form 1065 instructions for the 2020 tax year. The 2020 reporting requirement is broadened from years past, with all balances of tax capital (both positive and negative) required to be reported. The IRS requested comments on the new reporting requirement and indicated that it may update the instructions based on the comments it receives. In any event, it is fairly clear that the IRS is resolved to move forward with the expanded reporting requirement for the 2020 tax year. 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.
The IRS unexpectedly launched a tax capital information requirement in 2018 through the 2018 Form 1065 instructions. The IRS clarified many of the new reporting details in a subsequent list of frequently asked questions, and provided 2018 penalty relief for a failure to comply with the reporting requirement. The 2018 reporting requirement pertained only to those partners with negative tax capital balances. Partnerships could continue to report 2018 capital account data to all partners using the historical computation method (e.g., GAAP, tax capital, section 704(b), or other). In the event certain partners had negative tax capital balances – using a newly-defined IRS computation method – the partnership was then required to disclose such balances only to those affected partners.
The IRS then proposed to expand the tax capital information disclosure requirement in 2019 by requiring disclosure of all tax capital amounts, whether they were positive or negative. But after a backlash from the tax community, the IRS retreated from the expanded requirement and instead imposed for 2019 the same reporting rules that applied in 2018 (negative balances only). This was only a 1-year delay, meaning the expanded reporting requirement for both positive and negative balances would apply in the partnership’s 2020 tax year. In June of 2020, the IRS requested comments on two exclusive computational methods that it proposed to require in order to satisfy the 2020 disclosure requirement.
This sets the stage for the 2020 reporting rules that the IRS announced on October 22 in the draft Form 1065 instructions.
2020 Tax Capital Reporting Requirement
Except for “small partnerships,” all partnerships must calculate and disclose tax basis capital information to all partners for tax year 2020. Disclosure is required regardless of whether the balance is positive or negative. Small partnerships that are exempt from the disclosure requirement are those that meet all four of the following requirements:
1. The partnership’s total receipts for the tax year were less than $250,000;
2. The partnership’s total assets at the end of the tax year were less than $1 million;
3. Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return; and
4. The partnership is not filing and is not required to file Schedule M-3.
Many partnerships may have reported capital account information to partners historically on some other method. Possibilities include methods in accordance with GAAP, internal books and records, section 704(b), or tax basis capital that did not strictly conform to the IRS definition. Starting with the 2020 tax year, partnerships no longer have a choice over the method used to report a partner’s capital account rollforward (Schedule K-1, Item L). There is now only one method that partnerships may use to report capital: the “Tax Basis Method.”
The Tax Basis Method is a “transactional approach” that references Schedule K-1 items of income, deduction, gain, loss, contribution, and distribution data. Because all of this incremental Schedule K-1 activity must now be determined on the tax basis, the cumulative balances of tax capital for each partner are a proxy for each partner’s share of the partnership’s tax basis in its assets (inside basis). A partner’s share of partnership liabilities are not included in tax basis capital under the Tax Basis Method, however.
In order to transition to the new reporting regime, the IRS provides that the partnership must restate beginning of year capital balances for each partner to a method that conforms to one of four approaches:
- Tax Basis Method,
- “Modified Outside Basis Method,”
- “Section 704(b) Method,” or the
- “Modified Previously Taxed Capital Method.”
From there, partnerships must update each partner’s tax capital balance annually under the Tax Basis Method. The reason for these four choices comes from recognition of the fact that many partnerships do not have access to many years of historical data that would be needed to re-construct each partner’s capital account under a “pure” Tax Basis Method. The following discussion describes briefly the other three choices that a partnership may use to restate beginning capital account balances. Note that the partnership must apply the same choice to all of its partners’ capital accounts.
Modified Outside Basis Method
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. This method is simple when such data exists for all partners, but is no more practical than the Tax Basis Method for those partnerships that do not have access to many years of historical data.
Section 704(b) Method
Under the Section 704(b) Method, a partner’s beginning capital account balance is equal to the partner’s Section 704(b) capital account, except section 704(c) built-in gains or losses are not included. The exclusion of Section 704(c) built-in gains and losses roughly translates a partner’s Section 704(b) capital account from a fair value basis to a tax basis. Section 704(b) data should be available to all partnerships, because partnerships must maintain Section 704(b) capital account schedules for each partner in order to properly make allocations of income and deductions (or to verify that the allocations are proper). Still, it is conceivable that some partnerships may not have this data. Those partnerships must again resort to many years of historical data to re-construct it, making this method as untenable as the other choices.
Modified Previously Taxed Capital Method
Under the Modified Previously Taxed Capital Method, a partner’s beginning capital account balance is equal to the partner’s share of the partnership’s previously taxed capital (PTC). Very generally, a partner’s share of PTC (i.e., the partner’s share of inside basis net of liabilities) is determined by subtracting a hypothetical gain or loss from a hypothetical cash liquidation amount. Although it is not immediately obvious, a partner’s share of PTC should normally be unaffected by fluctuations in the partnership’s valuation method. This is because fluctuations in the top-line valuation normally should correlate equally with the gain or loss subtraction amount, in which case the partner’s PTC result would be the same. The Modified Previously Taxed Capital Method has appeal in its “snapshot approach” to measure a partner’s tax capital balance, because it does not require many years of historical data. The downside of the Modified Previously Taxed Capital Method is its vast complexity compared to the other choices.
The IRS stated that the new disclosure requirement “. . . assists the IRS in assessing compliance risk, and identifying potential noncompliance, while ensuring that compliant taxpayers’ returns are less likely to be examined.” Furthermore, the IRS announced that it will provide penalty relief pertaining to the 2020 reporting requirement as long as the partnership “. . . takes ordinary and prudent business care in following the form instructions . . .” While the latter statement should alleviate some potentially harsh results, the former statement is a stern reminder that partnerships must take the 2020 tax capital reporting requirement seriously. The penalty for an incomplete return under Section 6698(a)(2) has a punitive multiplier effect: the penalty for 2020 is $210 per-partner, per-month until the incomplete return is corrected (maximum $2,520 per-partner). Therefore, partnerships should review the available transition method and immediately implement a plan to comply with the 2020 tax basis capital reporting requirement.
For more information about the 2020 tax basis capital reporting requirement, including assistance with the calculations to comply, please contact us.
Published on October 23, 2020