Tax professionals have been waiting for the IRS to provide guidance with regard to partnership capital account reporting. To provide some history, the IRS unexpectedly launched the tax capital reporting requirement in 2018 via the 2018 Form 1065 instructions.Â The IRS then delayed this reporting for tax years 2018 and 2019. On June 5, 2020, the IRS issued Notice 2020-43, requesting comments on the proposed-required methods for reporting partnerâ€™s capital under the tax basis method (TBM). In prior years, taxpayers were permitted to use a number of methods to report partnerâ€™s capital including tax basis, GAAP, Section 704(b) or other. Reporting on the tax basis allows the IRS to determine if a partner has distributions in excess of basis and estimate the basis on sale of partnership units.
On October 22, 2020 and January 14, 2021, the IRS released Form 1065 draft instructions that would require, for the tax year 2020, taxpayers to calculate partner capital using a transactional approach for the TBM. This reverses the IRS previous position, that the transactional approach could not be used. At this time, the IRS has not finalized those instructions, but Notice 2021-13â€™s recent publication suggests that they will not again delay TBM reporting.
Notice 2021-13, provides broad penalty relief for 2020 and thereafter, should the 2020 beginning capital accounts include incorrect information, provided the partnership can establish â€œthat it took ordinary and prudent business care in following the 2020 Form 1065 instructionsâ€¦â€ .
For the many partnerships that have used the TBM, this is not a change or an issue. 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.
In addition to the TBM reporting, the draft instructions require several tax return statements:
- The method used to determine beginning tax basis capital.
- If the Previously Taxed Capital Method is used, state the method used to determine the partnershipâ€™s net liquidity value.
- If on the 2019 return, a partnerâ€™s ending negative tax capital was disclosed and that value does not agree with the partnerâ€™s beginning 2020 tax capital, explain the difference.
- If the Form 1065 balance sheet is tax basis and the beginning or ending balance sheet capital differs from the Schedule M-2 values, provide a reconciliation.
So, what is TBM? The most significant difference is market value adjustments under IRC Sections 704(b) and 743 adjustments under Section 754 are not included in TBM reporting. These adjustments would include step-ups due to sale of partnership interests and death of a partner. However, Sections 734 and 754 adjustments related to transactions with the partnership are included in TBM.
Notice 2021-13 reiterates the four permitted methods that the draft instructions state must be used to calculate beginning tax basis capital. If the partnership has been using TBM, it can simply continue. If the partnership has TBM data, it can use it. If the partnership has not previously computed TBM capital, it must establish beginning tax basis capital with one of the permitted methods. The same method must be used for all capital accounts. After beginning 2020 capital is established, the TBM is the only permitted method.
|Â Â Â Â Â Â Specified Methods to calculate beginning Tax Basis Capital|
1.Â Â Â Â Tax Basis Method
2.Â Â Â Â Modified outside basis method
3.Â Â Â Â Modified previously taxed capital method
4.Â Â Â Â Section 704(b) method
Tax Basis Method.
TBM is a transactional approach, applying partnership tax accounting principles:
The TBM increases a partnerâ€™s capital by:
- Money contributed.
- The tax adjusted basis of property contributed.
- Partnership liabilities assumed by the partner.
- The distributive share of income, gain, and tax-exempt income.
- The partnerâ€™s share Section 734 adjustments.
The TBM decreases a partnerâ€™s capital by:
- Distributions of money.
- The adjusted tax basis of property distributed.
- Partner liabilities assumed by the partnership.
- The distributive share of losses and deductions, depletion items (up to the property basis).
- The distributive share of the adjusted tax basis of charitable property contributions.
- The partnerâ€™s share Section 734 adjustments.
Modified Outside Basis Method.
Beginning tax basis capital equals the partnerâ€™s adjusted outside basis, reduced by the partnerâ€™s share of liabilities and the net of all Section 743 adjustments. The partnership may rely on the basis information provided by the partners.
Modified Previously Taxed Capital Method.
Beginning tax basis capital equals the amount of cash the partner would receive in a liquidation, after selling all of the assets in a fully taxable transaction for cash equal to the FMV. This cash amount is increased (or decreased) by the amount of loss (or gain) allocated on the sale. IRC 743(b) and remedial IRC 704(c) adjustments are not applied.
Section 704(b) Method.
Beginning tax basis capital equals each partnerâ€™s 704(b) capital account, minus the partnerâ€™s share of the IRC 704(c) built-in gain in the partnershipâ€™s assets, plus the partnerâ€™s share of the IRC 704(c) built in loss in the partnershipâ€™s assets.
Because IRC 704(b) capital account maintenance undergirds the allocation safe harbor, if TBM capital and IRC 704(b) capital do not equal, IRC 704(b) capital must continue to be computed for each partner. Workpaper schedules should identify the IRC 704(b) and 704(c) basis for each asset and each partnerâ€™s share of the tax cost and built-in gain or book-up amounts.
Best practices include reviewing capital that has been checked as â€œTax Basisâ€ in prior years. Look for items that are not TBM, such as IRC 743(b) adjustments and if the balance sheet is accrual and the partnership reports on the cash method.
Form 1065, Schedule M-2 must be reported on TBM. However, Schedule L (the balance sheet) reflects the partnershipâ€™s books and records and does not have to be tax basis. A reconciliation of capital between Schedules L and M-2 should be done to note differences.
Older partnerships might find computing beginning tax capital under the TBM impractical or impossible, leading them to using another method. Partnerships and CPAs must balance the burdens of these new rules, as they try to reach the Notice 2021-13 prudent business care standard.
Anne Davison, CPA, MBA is a tax manager at REDW specializing in small business entities, trusts & estates, and high wealth Individuals. Anne is a member of the AICPA and ASCPA. She can be reached at Anne.Davison@REDW.com.
Carl D. Harper, CPA is a senior tax manager at REDW specializing in partnerships, real estate development and high wealth individuals. Carl is a member of the AICPA and NMSCPA. He can be reached at Carl.Harper@REDW.com.
This article originally appeared in the March/April 2021 issue of the ASCPA Magazine. Reprinted with permission.