New reporting requirements released in the fall of 2019 dramatically change the way partnerships report capital and other items on their tax returns and Schedules K-1. However, acknowledging that there are changes and practically applying those changes to your partnership’s tax filing are two very different things.
Below are four key takeaways that all partnerships should consider before they file.
Takeaway #1: Computing the required information may be time consuming, which may affect your ability to timely file 2019 returns.
New Schedules K-1 dramatically change the way partner capital and other items must be reported. Many partnerships will need to compute and report “tax basis capital” and “unrecognized section 704(c) gain or loss” in 2019. Calculating this information may require substantial time and effort, and this may affect your ability to timely file your 2019 tax returns and Schedules K-1. Therefore, it is important to determine whether additional information or calculations are needed as soon as possible.
These computations were not always required in the past. In many cases, these tax attributes did not affect the taxable income of the partnership or the allocation of taxable income among partners. Therefore, it is not uncommon that these time consuming computations were deferred until an event that necessitated an analysis – such as a sale.
Takeaway #2: Although some disclosures were delayed, many taxpayers are subject to additional reporting.
The IRS did announce a one-year delay for some, but not all, of the new disclosure requirements. Although reporting of tax basis capital is not required in all cases, partnerships are required to report tax basis capital if any amounts are negative. In addition, all partnerships must report any unrecognized section 704(c) gain or loss. For many, the computation of section 704(c) attributes will effectively require a computation of tax capital. For more information, read our recent tax alert.
Takeaway #3: Section 704(c) reporting is more common than most expect.
While many may presume that section 704(c) is a complex set of tax rules that only apply to specific or complex transactions, it is key to remember that even a relatively straightforward transaction can create section 704(c) attributes. For example, a simple contribution of cash to an existing entity in exchange for new equity will often create unrecognized section 704(c) gains that must be computed and reported.
Other historic transactions, such as the contribution of additional cash for equity, the contribution or distribution of property to or from a partner, amendments to operating agreements or issuances of “profits interests” can also generate section 704(c) attributes that must be reported. The cumulative nature of these computations adds to their complexity, as the taxpayer must often review transactions back to the date of inception.
Takeaway #4: What is complicated today will provide for future benefits.
Although computing tax basis capital and section 704(c) attributes may add complications to the current filing season, the information is useful. Consider the following scenarios if you are:
PLANNING FOR A POTENTIAL SALE:
Understanding the tax ramifications of a sale – regardless of size – requires an understanding of tax capital and 704(c) attributes. Whether a partner were to sell some or all of their interest in a partnership, or the partnership were to sell some or all of its assets – this information is needed to inform decisions related to transaction structuring in order to achieve desired tax results, and to accurately estimate each partners’ potential gain.
INVESTING ADDITIONAL EQUITY:
The issuance of additional equity by an entity taxed as a partnership can lead to complex, and often surprising, tax results. The starting point for the analysis of an additional investment is an understanding of tax capital and 704(c) attributes of a partnership. Having this data ready can shorten the analysis process and ensure that needed equity funding is not delayed.
PLANNING FOR A MERGER OR ACQUISITION:
In addition to the valuable data provided to a seller or existing partners in planning a transaction, tax capital and 704(c) attributes will also affect the potential buyer or investor. The buyer will need this information to estimate their potential “step-up”, and an investor will need this data to understand potential income or loss allocations they will receive. Therefore, these records are a common request in the due diligence process. Having this data at hand may prevent a delay in the closing of a transaction.
COMPUTING A PARTNER’S BASIS:
Although partner’s share of tax capital and partner’s basis are separate and distinct concepts, they share many of the same computational steps. The existence of tax capital computations can dramatically reduce the amount of effort required to compute a partner’s basis in the partnership. These basis computations are key in the determination of taxability of distributions, deductibility of losses and gains upon the sale of an interest.
MAKING A DISTRIBUTION OR MODIFYING YOUR DEBT STRUCTURE:
The allocation of partnership liabilities to a partner increases their basis in the partnership and, as a result, affects the taxability of distributions and the deductibility of losses. In many cases, the determination of liability allocations is dependent on the partner’s tax capital and 704(c) attributes.