Executive Summary
The IRS has announced that it is seriously considering completely reversing its position – beginning in tax year 2020 (returns filed 2021) – on what would be acceptable methods of computing tax basis capital. Many in the tax and business community are expected to suggest that the IRS reconsider this proposal – in particular to allow the continued use of the so-called ‘transactional’ approach they formerly said was the only permissible method – and to allow any other reasonable method. Although this would be a significant change in policy, as a purely technical matter, this announcement has no effect.
Detailed Analysis
Overview
On June 5, 2019, the IRS issued Notice 2020-43 seeking public comments on two proposed methods for calculating partners’ tax capital accounts to satisfy tax capital reporting requirements on Schedule K-1 of Form 1065. Importantly, these two proposed methods are not in addition to the commonly accepted ‘transactional’ approach, but would completely replace it. This represents a significant change in course, as prior IRS guidance and common practice actually reflected the transactional method as the only permissible method. While this notice is only a request for comment and is not binding, it may raise concerns for some that have historically used the transactional method.
The notice proposes that partnerships would be required to compute and report partners’ tax capital account information on Schedule K-1 using one of two proposed methods for tax years ending on or after Dec. 31, 2020. These two methods, discussed in more detail below, differ from previous guidance and generally accepted methods of computing tax capital. For some taxpayers, these new methods may simplify the tax capital computation and reporting process. For most taxpayers, however, this change would bring added complexities.
Background
Beginning with the 2018 tax year, the IRS began to require certain partnerships to report tax capital for partners. All partnerships were expected to begin reporting these amounts on returns filed for the 2019 tax year. In response, commenters conveyed their concerns that partnerships would not be able to timely comply with this tax capital reporting requirement, especially when large volumes of information would need to be gathered and analyzed for partnerships with a multitude of owners or that have been in existence for numerous years. The IRS considered these concerns and subsequently issued Notice 2019-66 deferring this tax capital reporting requirement to the 2020 tax year.
Notice 2020-43 was issued in response to additional comments requesting guidance related to the computation of tax capital. The notice describes the ‘Transactional Approach’ in which a partner’s tax capital account is maintained by (1) increasing a partner’s tax capital account by the amount of money and the tax basis of property contributed by the partner to the partnership (less any liabilities assumed by the partnership or to which the property is subject) and by any allocations of income or gain made by the partnership to the partner, then (2) decreasing a partner’s tax capital account by the amount of money and tax basis of property distributed by the partnership to the partner (less any liabilities assumed by the partner or to which the property is subject) and by allocations of loss or deduction made by the partnership to the partner.
This Transactional Approach has been heavily used in practice and is similar, although not identical, to the calculation of a partner’s tax capital account outlined in previous IRS guidance.
The Treasury Department and IRS expressed concern that partnerships and other persons that have historically used the Transactional Approach may not have been adjusting partners’ tax capital accounts consistently under similar fact patterns, and as a result, have proposed under Notice 2020-43 that the Transactional Approach may no longer be used by partnerships to satisfy tax capital account reporting requirements. This disallowance may burden partnerships that have historically used this approach to calculate partners’ tax capital accounts as they will now be required to re-compute these amounts using a different approach.
The Notice Explained
Instead of issuing detailed guidance on how to consistently apply the Transactional Approach, the IRS has proposed two alternative methods that partnerships would be required to use in order to satisfy this reporting requirement:
1. Modified outside basis method: under this method, a partner’s tax capital account would be computed by taking the partner’s adjusted ‘outside’ basis in its partnership interest, reduced by the partner’s allocable share of partnership liabilities. This approach is similar to the safe harbor method that was authorized related to negative tax capital reporting requirements for the 2018 tax year.
The partnership would be allowed to either compute each partner’s adjusted basis in its partnership interest or rely on amounts provided by its partners. In either event, a partner’s adjusted basis should be determined by using the principles and provisions of subchapter K of the Internal Revenue Code.
Additionally, partners would be required to notify the partnership of any changes to the partner’s basis in its partnership interest attributable to amounts not otherwise reported on Schedule K-1 (i.e., amounts other than contributions, distributions and the partner’s share of income, gain, loss or deduction) during each partnership taxable year. For large partnerships, this would require data to be gathered from many owners each year and may not prove to be an efficient method.
2. Modified previously taxed capital method: under this method, a partner’s tax capital account would be calculated by applying modified principles to those described in regulations for computing a partner’s share of previously taxed capital (Reg. section 1.743-1(d)). Generally, these regulations provide that a partner’s share of previously taxed capital is determined by looking at the amount of cash a partner would receive in a hypothetical liquidation of the partnership and the amount of tax loss or tax gain that would be allocated to the partner in such a hypothetical transaction. The modifications under this proposed tax capital calculation method compared to those described in Reg. section 1.743-1(d) are as follows:
a. Calculations of gain and loss in a hypothetical sale transaction would be computed based on the assets’ fair market value, if readily available. Otherwise, the partnership may use section 704(b), GAAP, or another basis as set forth in partnership agreement.
b. All liabilities would be treated as nonrecourse when computing the amount of gain or loss that would be allocated to each partner in such a hypothetical liquidation.
This method allows for a snapshot approach by using current year data of the partnership itself and may simplify tax capital calculations. This approach may benefit some taxpayers, especially those without access to all historical data or those with a large number of owners.
These methods may simplify tax capital account calculations for some partnerships, however, they may also pose additional burdens to partnerships that have used the Transactional Approach historically. Additionally, these methods do little to help with the related, but separate, reporting burdens imposed associated with net unrecognized section 704(c) gains or losses.
Although these tax capital account calculation methods are proposed and may differ from the eventual methods allowed, partnerships and practitioners now have insight into how the IRS plans to address compliance with partner tax capital account reporting requirements.
