By David Donnelly, CPA-Houston; Carr, Riggs & Ingram, LLC
On Oct. 22, 2020, the IRS released draft Form 1065 instructions for 2020. These instructions clearly require that partnerships and LLCs taxed as partnerships report their partners’ capital accounts on the tax basis of accounting. (For the remainder of this explanation, please understand that “partner” and “partnership(s)” refer to both traditional partnerships as well as LLCs taxed as partnerships, and their partners and/or members). Please note that these rules do not apply to partnerships that do not have to present Schedules L, M-1 or M-2 (receipts under $250,000, assets under $1 million, timely filed Schedule K-1s and no requirement to file M-2).
Although the instructions include the methodology to be used by publicly traded partnerships, the discussion below does not address those rules.
The predecessor requirement originally appeared in the Form 1065 instructions for 2018 returns and caused much consternation in the tax preparation community—many practitioners with small to mid-sized partnerships have clients with somewhat dubious accounting methods that are not tax basis. Determining the tax basis capital accounts for those clients would be difficult and time consuming at best and, for some clients, practically impossible.
TXCPA’s Federal Tax Policy Committee was one of the commentators raising this issue. The newly released draft instructions address the professional community’s concerns and provide some solutions to determine the partners’ capital accounts in those instances where the historical records do not support a readily ascertainable balance.
The instructions provide relief for two situations that are problematic for practitioners.
In the first situation, where the beginning capital account is on the tax basis, the instructions state: “If you figured the partner's capital account for last year using the tax basis method, enter the partner's ending capital account as determined for last year on the line for beginning capital account. If you reported a negative ending capital account to a partner last year and a different amount is figured for the partner's beginning capital account using the tax basis method this year, provide an explanation for the difference.”
This seems to provide a mechanism for correcting a previously incorrect tax basis capital account and should benefit those clients where the previous year capital account was incorrect. However, the instructions do not address correction of the previous year ending capital account where the capital account was positive.
For the second situation, the instructions state if the partnership, “...did not report partners’ capital accounts using the tax basis method last year and did not maintain capital accounts under the tax basis method in your books and records, you may refigure a partner's beginning capital account using the tax basis method, modified outside basis method, modified previously taxed capital method, or Section 704(b) method, described below, for this year only [emphasis added].”
There are now essentially four methods for determining tax basis capital accounts. It is helpful to be aware of the different methods and their applicability in order to understand the new instructions.
The four methods are the transactional method, the modified outside basis method, the modified previously taxed capital method and the Section 704(b) method. The descriptions below are greatly simplified and are only intended to provide a framework for understanding the instructions. These methods are explained in both the new instructions and, with the exception of the 704(b) method, in Notice 2020-43; practitioners should review both sources when determining how each method works and which one might be preferable for each partnership.
This is the traditional method of determining the partner’s capital account under Section 705—simplistically, the tax basis capital account is calculated by starting with cash plus the tax basis of assets contributed, less any liabilities assumed by the partnership, plus income or loss allocated to the partner, less withdrawals and distributions. This has many adjustments, such as depletion, Section 734(b) adjustments, tax exempt income, etc., which are beyond the scope of this discussion.
It is clear in the instructions that the transactional method is the method the IRS wants practitioners to use. The other three methods are only to be used to arrive at a beginning tax basis capital account for 2020, if necessary.
Modified Outside Basis Method
According to the instructions, the beginning tax basis capital account is “equal to the partner's adjusted tax basis in its partnership interest as determined under the principles and provisions of subchapter K, and subtracting from that basis the partner’s share of partnership liabilities under Section 752 and the sum of the partner’s net 743(b) adjustments.” The instructions further state that practitioners “may rely on the adjusted tax basis information provided by your partners.” The instructions are silent regarding a situation where partners provide new adjusted tax basis information which, in total, exceed the partnership’s tax basis capital account.
Modified Previously Taxed Capital Method
Under this method, the partnership assets are marked to fair market value (FMV) and deemed sold. The partners’ beginning tax basis capital accounts are calculated by determining the amount of cash allocated to each partner and removing any gain or loss allocated to each partner to arrive at an approximation of their basis. The instructions and Notice 2020-43 have a more detailed explanation of how this mechanism works; this method essentially allocates the tax basis of the partnership’s assets, net of liabilities, to each partner based on their ownership percentage.
Section 704(b) Method
The beginning tax basis capital account is the partner’s 704(b) capital account less any 704(c) built-in gain plus any 704(c) built-in loss.
All three of the new methods will present practical problems in their application. Some that seem apparent are:
- There could be winners and losers as a result of adjusting the capital accounts.
- Under the modified previously taxed capital method, determining the amount of imputed cash allocated to each partner could be difficult if the allocation percentages change due to the return of capital to the partners (a ”waterfall”).
- It is unclear how to adjust the balance sheet for outside basis adjustments.
- It is unclear how to adjust the balance sheet where the practitioner relies on the tax basis information provided by the partners.
Some commentators, including TXCPA’s committee, suggested to the IRS that each partner should be responsible for maintaining the records of their tax basis in the partnership, similar to the rules for S corporation shareholders. The IRS has seemingly rejected this concept (although the instructions do state that, “each partner is responsible for maintaining a record of the adjusted tax basis in its partnership interest”).
Regardless of the potential problems and the unaddressed issues, the new draft instructions do provide a framework for ”fixing” a client’s books to reflect an approximate tax basis capital account. This framework should make life easier for practitioners after the books are fixed—after the 2020 returns are completed.