The IRS and Treasury have put partnerships and pass-through entities under a magnifying glass right now.
The IRS confirmed in October that partnerships would need to report partners’ capital accounts on the tax basis. After previous delays, tax basis capital reporting will be required on all Forms 1065, Forms 8865 and Schedules K-1 starting with the 2020 tax year. For many taxpayers, this may mean having to recalculate partner capital account balances. We sent clients a warning about this in the Fall: https://www.fuoco.cpa/https-fuocogroup-jj20su9m-liquidwebsites-com-cares-act-business-tax-moves-to-make-before-year-end/
So what steps should a partnership take to be safe?
Except for those who previously reported Schedule K-1 capital accounts on the tax basis or that otherwise maintained tax basis capital accounts in their internal books and records, partnerships will need to compute beginning capital account balances for 2020.
There are several ways to calculate a partner’s beginning tax capital account balance (let us help you pick the best one for your situation):
- Transactional Method or Tax Basis Method,
- Modified Outside Basis Method,
- Modified Previously Taxed Capital Method, and
- Section 704(b) Method – Partner’s 704(b) capital account, less share of 704(c) gain and plus share of 704(c) loss.
Most partnerships will likely end up using the transactional method. When complete information is available extending back to the beginning of the partnership’s life, and particularly with newer partnerships, the transactional method is likely to be the simplest and least labor-intensive method.
If full history is not available or the partnership’s longevity makes the transactional method unwieldly, the modified previously taxed capital method may be the only available option. It looks at the cash the partner would receive if the partnership liquidated following the taxable sale of all of its assets for their fair market values (FMV), plus the tax losses and less the tax gains that would be allocated to the partner.
After beginning tax basis capital is calculated, activity is recorded in the capital accounts on the tax basis going forward. Contributions and distributions of assets are recorded using the assets’ tax basis, not the FMV or book value. Current year net income and loss tracks taxable income, tax-exempt income and non-deductible expenses and not book income. Other increases or decreases on the Schedule K-1 should report items such as transferred capital and Section 734(b) adjustments.
Partnership capital accounts reported on Form 1065 (and 8865) Schedule M-2 will also be reported on the tax basis and should correspond to the total of the amounts reported on the partners’ Schedules K-1. In addition, unless the partnership’s balance sheet is reported (on Schedule L) on the tax basis, the balance sheet capital account balance will not correspond to the balances reported on Schedule M-2 or the Schedules K-1.
On January 19, 2021, the IRS announced penalty relief to taxpayers related to the new tax basis capital requirement. Penalties due to the inclusion of incorrect beginning capital account balances on 2020 Schedules K-1 are eligible for relief. A penalty will not be imposed if the partnership took “ordinary and prudent business care” in following the Form 1065 instructions to report beginning tax capital using any of the four methods outlined. No relief is available if the return is not timely filed or its beginning capital account balances are not included on the filed Schedules K-1.
Reach Out To Us: The IRS is actively hunting for pass through entities which claim losses, are not paying reasonable compensation, and have yet to present partner capital accounts on a tax basis. As your tax advisor partner, Fuoco Group simply cannot let you ignore this. Therefore, this needs to be resolved, and resolved quickly. You may email CPA@fuoco.com, or call toll free for an appointment: 855-542-7537.
