IRS issues new tax capital reporting requirements

The Internal Revenue Services (“IRS”) previously issued Notice 2020-43, which permitted two alternative methods (discussed below) to satisfy the tax capital reporting requirements: (i) the Modified Outside Basis method; or (ii) the Modified Previously Taxed Capital Method. The notice explicitly disallowed the use of the Transactional Approach as a method to achieve compliance. Subsequently, the IRS issued draft instructions in October 2020 for completing 2020 Form 1065 that require the use of the Transactional Approach as the sole means of computing partner capital accounts under the tax basis method. Consequently, the Modified Outside Basis and Modified Previously Taxed Capital Method, as well as the 704(b) Method, are now only offered as alternatives in determining partners’ beginning tax basis capital accounts only for 2020, if the tax basis method was not previously used.

Small partnerships (generally those with less than $250,000 in total receipts and less than $1 million in total assets) are exempt from capital account reporting requirements.

Transactional approach

Under the Transactional Approach, increases to a partner’s capital account (such as contributions and share of partnership net income) and decreases to the capital account (such as withdrawals, distributions and share of net loss) are calculated and reported using tax basis rules and principles.

Modified outside basis method

Under this method, a partner may calculate their beginning tax capital by subtracting from their adjusted tax basis in the partnership interest their share of partnership liabilities under section 752 and any previous net section 743(b) adjustment.

In order to adopt this method, the partnership must receive, in writing, notice from the partner of any changes to their  basis in the partnership interest during each taxable year, with the exception of changes attributable to contributions to, and distributions from, the partnership, as well as any changes to their  allocated share of income, gain, loss, or deduction reflected on Schedule K-1.

The partner is required to disclose such information by the later of 30 days after the occurrence of such change, or the tax year-end of the partnership. The partnership is permitted to use and rely on the adjusted tax basis information furnished by the partners as long as the partnership is not aware of any facts that may prove otherwise.

Modified previously taxed capital method

Current regulations define a partner’s previously taxed capital as (i) the amount of cash the partner would receive upon a liquidation of the partnership in a “hypothetical transaction;” (ii) increased by  the amount of tax loss that would be allocated to the partner from such  transaction;  and (iii) decreased by  the amount of tax gain that would be allocated to the partner from such transaction. A “hypothetical transaction” is one where partnership assets are disposed of for fair market value as described in Reg. §1.743-1(d).

If the fair market value of the assets is not readily available, the partnership may use the basis of assets as calculated under section 704(b), for GAAP financial reporting purposes or as set forth in the partnership agreement for purposes of liquidation.

In addition, for simplicity, all liabilities are considered to be non-recourse for purposes of gain and loss calculations.  All partners must adopt whichever method is selected by the partnership to determine its net liquidity value.

The partnership is required to attach a statement indicating that the Modified Previously Taxed Capital Method was used and identify the method used to determine its partnership net liquidity value.

Section 704(b) method

Under this method, a partner’s beginning capital account is its section 704(b) capital account, less any 704(c) built-in gain in partnership assets and increased by any 704(c) built-in loss in partnership assets.

Summary

The alternative methods described above are applicable for tax year 2020 only.  The Transactional Approach must be used for all subsequent taxable years.  The method chosen to determine a partner’s beginning tax capital for tax year 2020 must be the same for all partners in the partnership. A statement must also be attached to each partner’s Schedule K-1 indicating the method used to determine its beginning capital account. All other lines in Item L of the Schedule K-1 must be computed through the application of the tax basis method, as under the Transactional Approach.

The IRS intends to issue a notice providing penalty relief for tax year 2020 for any errors in reporting partners’ beginning capital account balances if the partnership has taken reasonable care and exercised prudent judgement in its calculations.

Please contact your Mazars professional for additional information.

Published on January 8, 2021

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.