IRS Changes to Partnership Capital Reporting Requirements

IRS Changes to Partnership Capital Reporting Requirements

by Bryce Johnson
February 08, 2021

In October 2020, the Internal Revenue Service (IRS) issued tax notices and additional guidance indicating that beginning in the 2020 tax year, partnerships will be required to calculate and report each partner’s capital account using a tax basis method. The new requirement is a change from prior tax years in which the partnership could calculate and report partners’ capital accounts using a variety of methods including GAAP, IRC Section 704(b) basis or tax basis.

This change is part of an effort by the IRS to facilitate increased compliance and improve the quality of the information reported by partnerships to the IRS and furnished to partners. A partner’s tax basis is important in determining a partner’s ability to deduct losses and is critical when a partner sells or disposes of their partnership interest.

Some partnerships may be reluctant to comply, but the IRS may impose a variety of penalties for noncompliance under Sections 6698, 6722 and 6721. Several of these available penalty options include per partner/per K-1 penalties and can quickly get very expensive.

However, the IRS recently issued penalty relief (Notice 2021-13) where certain requirements are met (generally ordinary and prudent business care). Where these requirements are met, Notice 2021-13 provides extremely valuable penalty relief on both errors related to the tax basis capital account conversion itself, as well as the possible impact of those errors on all subsequent partner tax basis capital account reporting.

The draft instructions for Form 1065, U.S. Return of Partnership Income, will require the partnership to calculate each partner’s capital account using the transactional approach for their tax basis reporting. By utilizing the transactional approach, partnerships will account for each partner’s share of contributions (either cash or property), allocation of partnership net income or loss, withdrawals, distributions (either cash or property), and other increases or decreases using tax basis principles.

Partnerships reporting partners’ capital accounts using a method other than tax basis for 2019, but also maintaining a partner's capital accounts under a tax basis method in their books and records (i.e. for purposes of reporting negative capital accounts), must report each partner’s beginning capital account balance for 2020 using the tax basis capital.

Alternatively, for partnerships reporting partners’ capital accounts using a method other than a tax basis method for 2019 and also not maintaining a partners’ capital account under a tax basis method in their books and records (i.e. for purposes of reporting negative capital accounts), may determine its partners’ beginning capital account balances for 2020 using one of the following methods:

  • Modified Outside Basis Method
  • Modified Previously Taxed Capital Method
  • Section 704(b) Method

Partnerships must provide certain schedule K-1 disclosures related to the tax basis capital account conversion, including identification of the method used, and if the previously taxed capital method is used, identification of the method used to determine the partnership’s net liquidation value.

Partnerships will need to evaluate and determine which of the methods for calculating partners’ 2020 beginning capital account balances is most suitable. They must also compute and define the adjustments that affect the total tax basis capital. The reporting requirement change for the 2020 tax year may entail additional work on the part of partnerships to perform these calculations if not previously done.

If you have any questions or need assistance in navigating and implementing these changes for your partnership, reach out to our experts.

February 08, 2021

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