New Requirements for Partnerships Capital Reporting As Shared by ASCPA Magazine REDW Financial Advisors & CPAs

Capital accounts are reported on Item L of Schedule K-1 (Form 1065) and Item F of Schedule K-1 (8865 relating to foreign partnerships). In this article, I’ll address the prior rule, why the IRS wasn’t happy, the change they wanted, how to process the transition, and the need to maintain both the former capital account and the IRS-prescribed method. Gone are the days of simply multiplying an LLC owner’s percentage share of units by the separately stated items of income/loss/deduction, etc. for the purpose of populating the individual Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc. Unfortunately, however, the tax practitioner who needs to correctly allocate LLC income and loss pursuant to the terms of an operating agreement that might be somewhat less than clear and straightforward is left alone to deal with the complexities the target capital allocation structure creates. During the past decade, the target capital allocation structure has clearly become the most prominent structure used in the process of drafting a partnership operating agreement. In the age of centralized partnership audit regime exam implications and exit transaction due-diligence examinations, tax practitioners need more than ever to implement procedures that avoid allocation process errors.

The Taxpayer Bill of Rights describes ten basic rights that all taxpayers have when dealing with the IRS. Always try to resolve your problem with the IRS first, but if you can’t, then come to TAS. We work to ensure that every taxpayer is treated fairly and that you know and understand your rights under the Taxpayer Bill of Rights. TAS helps taxpayers resolve problems with the IRS, makes administrative and legislative recommendations to prevent or correct the problems, and protects taxpayer rights. If you still need help, TACs provide tax help when a tax issue can’t be handled online or by phone.

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In Vennes,21 taxpayers claimed passthrough theft loss deductions for losses from the husband’s S corporation and related partnership interests. The policy would reimburse the partners for any difference between the tax benefits they claimed and the tax benefits they are entitled to receive, regardless of any trade or business activity of the partnership. It did not matter that the partners did not include their share of the liabilities in their capital account. The partner’s share was reported on her Schedule K-1, and she reported that amount on her individual tax return but did not pay the tax on the gain.

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Exhibit 1 shows the allocations of depreciation for Sec. 704(b) book and tax purposes. For 2012, Partnership would receive Sec. 704(b) book and tax depreciation of $50 ($500 ÷ 10) and $30 ($300 ÷ 10), respectively. The flexibility of subchapter K is limited further by rules in the regulations, such as the anti-abuse rule5 and other rules regarding allocations attributable to nonrecourse liabilities,6 mixing bowl transactions,7 and allocations in connection with contributed8 and distributed9 property. This flexibility, however, also opened the door for taxpayers to abuse the provision.

This is consistent with the vast majority of agreements that require capital account maintenance and limitations on deficit capital account balances and that also include a qualified income offset provision. Since there was no risk of penalty, many taxpayers did not keep an accurate capital account balance. Before 2018, the IRS was fairly silent on the necessity of maintaining capital accounts.

GAAP capital plus these cumulative timing differences equals tax basis capital. Although rarely tracked, if a partner were to take the audited financial statements and multiply it by their ownership percentage, they would then arrive at their GAAP basis capital account. GAAP basis is the partner’s share of GAAP equity in accordance with accounting board requirements. Partners should always consider basis if contemplating a sale of their partnership interest or taking a distribution from a partnership.

Effects at Sale

A partnership that uses an accrual method of accounting cannot deduct any business expense owed to a cash basis partner until the amount is paid. The adjustment applies only for purposes of determining his new basis in the inventory, and not for purposes of partnership gain or loss on disposition. If the choice doesn’t have to be made for the distribution new rules for reporting tax basis partner capital accounts year, it must be made with the return for the first year in which the basis of the distributed property is pertinent in determining the partner’s income tax. To figure his basis in each property, Armando first assigns bases of $15,000 to property C and $15,000 to property D (their adjusted bases to the partnership).

Our panel of partnership experts will explain the importance of each method, compare and contrast annual recording differences for each, and discuss how to properly maintain these capital account balances for each partner. This requirement initially applied only to partners with negative tax capital balances, but in 2019 the IRS proposed expanding the rule to require disclosure of tax-basis capital amounts for all partners. Clarity from the IRS is expected soon, but it is a good idea for partnerships to get started on compliance now to allow for plenty of time and minimal disruption once the instructions are announced. A partnership may change from one method to another by attaching a disclosure to each Schedule K-1 describing the change, if any, to the amount attributable to each partner’s beginning and year-end balances, and the reason for the change. Instead of providing the definition of tax basis capital, the IRS proposed two alternative methods, which include the Modified Outside Basis Method and the Modified Previously Taxed Capital Method.

FOX Business

The Tax Court also agreed with the IRS that the partnership was a sham for tax purposes. Most TEFRA cases revolve around either a statute-of-limitation issue or whether the income or deduction is a partnership item. According to the IRS, all Sec. 965 amounts are partnership-related items. In an effort to streamline the audit process for large partnerships, Congress enacted Section 1101 of the Bipartisan Budget Act of 2015 (BBA),9 which amended in its entirety Sec. 6221 et seq. The revenue procedure also explains how a partnership under the centralized partnership audit regime that wishes to change its recovery period under Sec. 168(g) of the Code for such property may do so without filing an administrative adjustment request. The final regulations include general definitions, guidance, and rules specific to applicable partnership interests (APIs) and applicable trades or businesses and exceptions to the definition of an API.

For tax year 2021 and later returns:

If contributed property is subject to a debt or if a partner’s liabilities are assumed by the partnership, the basis of that partner’s interest is reduced (but not below zero) by the liability assumed by the other partners. The basis of an interest in a partnership is increased or decreased by certain items. If a partner acquires an interest in a partnership by gift, inheritance, or under any circumstance other than by a contribution of money or property to the partnership, the partner’s basis must be determined using the basis rules described in Pub.

Date + Time

TEFRA is the common acronym used for a set of consolidated examination, processing, and judicial procedures which determine the tax treatment of partnership items at the partnership level for partnerships and LLCs that file as partnerships. These payments are included in income by the recipient for their tax year that includes the end of the partnership tax year for which the payments are a distributive share or in which the partnership is entitled to deduct them as guaranteed payments. If the amount is based on partnership income, the payment is taxable as a distributive share of partnership income. Payments made by the partnership to a retiring partner or successor in interest of a deceased partner that are not made in exchange for an interest in partnership property are treated as distributive shares of partnership income or guaranteed payments.

Signing partnerships’ returns and other tax documents

As previously noted, forward or reverse Sec. 704(c) allocations are deemed unreasonable if they are made to shift tax consequences among the partners to reduce the present value of the partners’ combined tax liabilities.32 Indirect partners, as well as direct partners, must be considered when determining if there is taxpayer abuse. In the above method, Partnership uses a first-in, first-out (FIFO) approach for its Sec. 704(c) layers when allocating its tax depreciation since it allocated tax depreciation to the first Sec. 704(c) layer created. These disparities would still exist even if Partnership used the traditional with curative allocations method since there are no other tax items with the same tax character as the depreciation to cure the distortion.

Likewise, the net investment income tax imposes a 3.8% tax on “net investment income” on individuals that have a modified adjusted gross income over defined thresholds. In response, taxpayers and practitioners lobbied the IRS to delay this requirement, citing the significant administrative and financial burden that would result from attempting to comply in such a short time frame (the extended due date for 2019 calendar-year returns was less than a year away from the issuance of the instructions). Baker Tilly Advisory Group, LP and its subsidiary entities provide tax and business advisory services to their clients.

If the lookthrough rule applies, a percentage of the gain or loss on the sale is potentially subject to Sec. 1061(a) recharacterization, based on the relative gain inside the partnership on a hypothetical sale of the partnership’s assets at the aggregate fair market value (FMV). The final regulations also provide that if a partner disposes of a partnership interest, the adjusted basis of the partnership interest is increased immediately before the disposition by the entire amount of the partner’s remaining EBIE (basis addback rule). Further, Wyden’s proposal would change the tax treatment for many publicly traded partnerships (PTPs). In the proposal, a basis adjustment would be mandatory when a partnership interest is transferred or when property is distributed to partners under Secs.

In that case, the partnership might re-figure a partner’s starting capital account utilizing the tax basis method, modified outdoors basis methodology, modified beforehand taxed capital methodology, or §704(b) technique (described in the directions on page 32) for 2020 solely. However, if the partners’ capital accounts were not reported on the tax basis methodology, work will be wanted to regulate every partner’s beginning capital account to their tax basis. Any partnership that does not meet all four of these conditions must disclose partners’ capital account information using the tax-basis method. After a backlash from the tax and business communities, the IRS delayed the expanded requirements for one year, but as of the 2020 tax year, partnerships must now calculate and disclose tax-basis capital information for all partners. Historically, partnerships could use any reasonable method—including generally accepted accounting principles (GAAP), Section 704(b) book, or the tax-basis method—to report partners’ shares of partnership capital. Based on the foregoing, for partnerships that did not previously use the tax basis method, the amounts on a partner’s Schedule K-1 may look different for taxable year 2020.

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Other than for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. The character of the gain is determined by reference to the character of the net precontribution gain. The gain recognized is the lesser of the following amounts. Similarly, a deduction may be available to a corporate partner if the FMV of the debt at the time of distribution exceeds its adjusted issue price.

See Revenue Ruling for more information on determining if a loss incurred on the abandonment or worthlessness of a partnership interest is a capital or an ordinary loss. In certain cases, the adjusted basis of a partnership interest can be figured by using the partner’s share of the adjusted basis of partnership property that would be distributed if the partnership terminated. While each partner has increased his capital account by $1,000, which will be reflected in the partnership’s books, the adjusted basis of Enzo’s interest is only $400 and the adjusted basis of his partner’s interest is $1,000. The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership interest.

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