IRS Addresses Tax Capital Reporting for 2020
June 25, 2020
By Richard Shapiro
In advance of the 2019 tax filing season and in response to numerous comments on its 2019 draft Schedule K-1, the IRS announced in Notice 2019-66 that the requirement to report partners’ share of partnership capital on the tax basis method (the “tax capital reporting requirement”) would not be effective for 2019 (for partnership taxable years beginning in calendar 2019). However, it would be effective in 2020 (for partnership taxable years beginning on or after January 1, 2020). With calendar 2020 well in process, the IRS has just addressed tax capital reporting for 2020 -- through the issuance of Notice 2020-43 (the “Notice”).
The purpose of the Notice is to seek public comment on a proposed requirement for partnerships to use only one of two alternative methods to satisfy the tax capital reporting requirement -- the “Modified Outside Basis Method” or the “Modified Previously Taxed Capital Method” (both described below) with respect to partnership taxable years that end on or after December 31, 2020. No definition of tax basis capital is provided. Partnerships and certain other persons would no longer be permitted to report partner capital accounts using any other method, including IRC Sec. 704(b) and U.S. generally accepted accounting principles (“GAAP”). The method selected would be used with respect to all of a partnership’s partners. According to the Notice, for taxable years after 2020, a partnership could change from one permitted method to the other, by attaching a disclosure to each Schedule K-1 describing the change, if any, to the amount attributable to each partner’s beginning and end of year balances, and the reason for the change.
The Modified Outside Basis Method
Under the Modified Outside Basis Method, a partner’s adjusted basis in its partnership interest is determined under the principles and provisions of subchapter K of the Internal Revenue Code (“Partners and Partnerships”), including those contained in IRC Sec. 705 (“Determination of Basis of Partner’s Interest”), IRC Sec. 722 (“Basis of Contributing Partner’s Interest”), IRC Sec. 733 (“Basis of Distributee Partner’s Interest”) and IRC Sec. 742 (“Basis of Transferee Partner’s Interest”), and subtracting from that basis the partner’s share of partnership liabilities under IRC Sec. 752 (“Treatment of Certain Liabilities”).
If a partnership is using the Modified Outside Basis Method, the following rules would apply:
- A partner must notify its partnership, in writing, of any changes to the partner’s basis in its partnership interest during each partnership taxable year other than changes attributable to contributions to and distributions from the partnership and the partner’s share of income, gain, loss or deduction otherwise reflected on the partnership’s schedule K-1. For example, if a person purchases an interest in a partnership that uses the Modified Outside Basis Method, the purchasing partner must notify the partnership of its basis in the acquired partnership interest, regardless of whether the partnership has an IRC Sec. 754 (“Manner of Electing Optional Adjustment to Basis of Partnership Property”) election in place or has a substantial built-in loss (IRC Sec. 743(d)) at the time of the purchase of that interest.
- The partner must provide that written notification of changes to partner’s basis within 30 days or by the partnership’s taxable year-end, whichever is later.
- A partnership would be entitled to rely on the partner basis information that the partnership is provided by its partners unless the partnership has knowledge of facts indicating that the provided information is clearly erroneous.
Modified Previously Taxed Capital Method
Referencing the Income Tax Regulations (Treas. Reg. 1.743-1(d)(1)), subject to certain modifications, a partner’s “previously taxed capital” is equal to
- The amount of cash that the partner would receive on a liquidation of the partnership following a hypothetical transaction (see below), increased by
- The amount of tax loss (including any “remedial allocations” under Treas. Reg. 1.704-3(d)) that would be allocated to the partner from the hypothetical transaction, and decreased by
- The amount of tax gain (including any remedial allocations) that would be allocated to the partner from the hypothetical transaction.
The hypothetical transaction is a disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the fair market value of the assets. Item (i) above is intended to quantify, for each partner, the partner’s economic right to a share of the distributable proceeds of the partnership immediately after the hypothetical transaction and the payment by the partnership of all of its liabilities (the “partnership net liquidity value”). The cash a partner would receive on a partnership liquidation and calculations of gain and loss in the hypothetical transaction would be based on the assets’ fair market value, if readily available. If not readily available, a partnership may use such assets’ bases as determined under IRC Sec. 704(b), GAAP, or the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management. Also, all liabilities would be treated as nonrecourse liabilities for purposes of “(ii)” and “(iii)” and the calculation of gain or loss.
A partnership that adopts the Modified Previously Taxed Capital Method would be required, for each taxable year in which the method is used, to attach a statement indicating that this method is used and the method it used to determine its partnership net liquidity value (e.g., fair market value, IRC Sec. 704(b) book basis, etc.).
The Notice provides an example of the Modified Previously Taxed Capital Method:
Facts. A and B are equal partners in AB LLC, a calendar-year partnership. On December 31, 2020, AB LLC’s balance sheet reflects the following assets and liabilities:
- $500 in cash
- Inventory with a tax and book basis of $1,000
- Equipment with a tax and book basis of $500
- Land with a tax and book basis of $1,000
- A long-term loan of $5,000
AB LLC uses the Previously Taxed Capital Method and calculates liquidation values, gains and losses based on the book value of the assets. Each of A and B’s Previously Taxed Capital under that method would be ($1,000). That is an amount equal to (i) the cash each partner would receive after the hypothetical liquidation ($0, because the debt of $5,000 exceeds the $3,000 book basis of the assets), less (ii) gain that would be allocated each partner on the hypothetical liquidation and sale ($1,000, each partner’s 50% share of the excess of the $5,000 amount realized on a sale of the property for the debt over the tax basis of $3,000), plus (iii) loss that would be allocated to each partner ($0).
IRS Soliciting Comments
In addressing the implementation of tax capital reporting, the Treasury Department and the IRS are soliciting comments on the following questions through the Notice –
- Whether the methods used to satisfy tax capital reporting described in the Notice should be modified or adopted.
- Whether an ordering rule should apply to the basis used in determining the partnership’s net liquidity value, for example, use of the fair market value is required, but if not available, then IRC Sec. 704(b) book basis is required, and if the partnership does not maintain IRC Sec. 704(b) capital, then GAAP is required, etc.
- How, if at all, the tax capital reporting requirement should be modified to apply to partnerships treated as publicly traded partnerships.
- Whether other methods (such as one based on a historical transactional analysis of events) should be permitted for purposes of meeting the tax capital reporting requirement and, if recommended, what additional guidance would be necessary.
- Whether and in what circumstances limitations should be imposed on partnerships to change from one method to another (e.g., whether there should be a limit on how many times the method can be changed over a period of years), including compliance with such rules in the case of a merger of partnerships using different methods.
EisnerAmper will keep you informed on latest developments with regard to tax capital reporting for 2020 and beyond.