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October 2020

New Rules for Reporting Tax Basis Partner Capital Accounts

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.

Transactional Method 

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. 

https://www.irs.gov/newsroom/irs-releases-draft-form-1065-instructions-on-partner-tax-basis-capital-reporting

https://www.irs.gov/pub/irs-drop/n-20-43.pdf 

https://www.tscpa.org/docs/default-source/comment-letters/federal-tax-policy/2020/tax-capital-reporting-july-2020.pdf?sfvrsn=12d4dcb1_2


Anticipate Tax Increase for Large Estates

By Tom Ochsenschlager, J.D., CPA

The Tax Cuts and Jobs Act (TCJA) increased the federal exemption for estate, gift and generation–skipping transfers to $11.18 million for singles and twice that ($22.36M) for married couples. The exemption amount is indexed to inflation and currently stands at $11.58 million per taxpayer ($23.16M for married couples). In effect, all but the wealthiest taxpayers are excluded from the federal “estate” tax. However, it is important to note that this provision of the TCJA expires Jan. 1, 2026, and the exemption amount then reverts back to $5.6 million per individual (indexed to inflation since 2018) – roughly less than half the current amount.

Regarding the presidential candidates, the Trump administration has indicated it will seek to extend the TCJA exemption amount. However, the Biden campaign has indicated it will propose two alternatives that would, in effect, tax the amount of the appreciation in assets passing through the estate. One alternative would be to reintroduce a proposal made by the Obama administration that would tax the estate for the appreciation of assets passed through the estate. The other alternative would be for the recipient of the assets from the estate to receive the estate’s basis in the property, in effect eliminating the stepped-up basis of current tax law.

Regardless of who is elected as our next president, given the historically high level of the federal deficit, there will be pressure on Congress to permit the higher exemption amount to expire in 2026 or perhaps even pass legislation to expire it earlier. Accordingly, wealthy clients should develop a plan to utilize the current exemption amount, as this could become a “use-it-or-lose-it” situation earlier than expected.

Taxpayers who are likely to be affected by the possible reduction in the exemption amount might consider making gifts directly to “descendants” who would be a beneficiary in the taxpayer’s will or, where the taxpayer desires to continue to maintain some control over the assets, set up a trust for the benefit of the descendants.

As under current law, in choosing what gifts to make or which assets to pass into a trust, it is important to identify assets that have a relatively low basis and assets that are expected to appreciate significantly in the future.

The taxpayer might consider retaining the “low basis” assets given that passing these assets through the estate will give the recipient a “stepped-up basis” at date of death whereas gifting the asset results in a “carryover” basis. However, if the taxpayer anticipates selling these low basis assets, it is also important to note that former Vice President Biden has suggested that he would propose to increase the tax on long-term capital gains to 39.6% for taxpayers with over $1 million of taxable income. Accordingly, significant taxes might be saved if high income taxpayers gift this appreciated property to a recipient subject to the lower capital gains rate prior to the possible change in the tax law.

Regarding the category of assets where significant future appreciation is anticipated, retaining these assets in the estate will enable the beneficiaries of the estate to receive a “stepped-up” basis as of the date of the taxpayer’s passing. 


IRS Issues Draft Form 1065 Instructions; Tax Basis Capital Accounts Will be Required for 2020

On Oct. 22, the IRS issued an early draft of the instructions for Form 1065. The instructions require tax basis capital account reporting for each partner, unless the partnership meets all four requirements to not complete the Schedule L. 

If a partnership did not maintain tax basis capital accounts for 2019, they may determine each partner’s tax basis capital account by using one of three methods: the modified outside basis method, the modified previously taxed capital method or the Section 704(b) method. These methods are described in the instruction. Although the three allowed methods may be problematic, this is a better solution than tracking a partner’s capital account from the inception of the partnership using the transactional method.

TXCPA’s Federal Tax Policy Committee commented on the proposed requirements in July, expressing to the IRS that individual partners should ultimately be responsible for tracking their own basis.

https://content.govdelivery.com/accounts/USIRS/bulletins/2a73bea

https://www.tscpa.org/docs/default-source/comment-letters/federal-tax-policy/2020/tax-capital-reporting-july-2020.pdf?sfvrsn=12d4dcb1_2


FBAR Deadline Extended to Oct. 31 After Confusion

On Oct. 14, Treasury’s Financial Crimes Enforcement Network (FinCEN) posted an inaccurate message on its Bank Secrecy Act E-Filing webpage that may have caused some FBAR filers to miss their Oct. 15 deadline. To correct this error, FinCEN has indicated that 2019 calendar year FBARs filed by Oct. 31, 2020, will be deemed as timely filed. The Dec. 31 extension is only available for victims of recent natural disasters.

https://www.fincen.gov/fincen-clarifies-fbar-extensions

https://www.journalofaccountancy.com/news/2020/oct/fbar-deadline-extended-oct-31.html


Due Diligence in a Pandemic World

William R. Stromsem, CPA, J.D. and Assistant Professor, George Washington University School of Business               

Tax professionals have been through one busy season with COVID and it’s hard to tell the direction of the pandemic, but at least early in the upcoming tax season we will likely still be preparing most returns remotely. In general, we have been able to set up protective procedures for ourselves and our clients while working remotely; these include safety from the virus and maintaining privacy of client tax information. We have implemented processes for virtual client meetings, document drop offs or electronic transmission of documents. We have also added extra safeguards such as passwords for virtual platforms, and encryption or VPN protection for electronically transmitted documents and for securing mail. However, some due diligence provisions in the tax law may require us to have increased personal contact with the client.

In addition to avoiding negligence penalties, the tax law provides a separate penalty for failing to apply “due diligence” for returns claiming certain benefits, including the child tax credit, additional child tax credit, the American opportunity credit, the earned income credit, and since the Tax Cuts and Jobs Act, the head of household filing status. For returns with these claims, preparers must complete Form 8867, the Paid Preparer's Due Diligence Checklist. You might review the form to refresh your knowledge of what is required. If your records do not support your compliance with the due diligence requirements, the penalty is $530 per credit for 2020 returns.

For current clients, you should have sufficient information in your files from prior due diligence inquiries (remember the three-year document retention requisite), but for new clients you may need to set up additional intake procedures and may be required to have greater interaction with the taxpayer. Many firms require that new clients show government-issued proof of identity and a Social Security card or ITIN to determine eligibility for the dependent-based benefits. Copies of these may be retained by the preparer as support for satisfying the due diligence requirements reported on Form 8867.

In a remote preparation environment, due diligence poses some particular problems. There is likely some leeway in accepting scanned or faxed copies of documents to avoid contact, but some clients may not have this technology. This may require mailing and returning original documents by certified mail – although mail has its own problems – so possibly the preparer could have the client drop off and pick up the required documents. Telephone and video conferences with clients to discuss specific issues should be documented to support positions taken in the return that require due diligence.

The preparer must be satisfied (and be prepared to satisfy the IRS) that the due diligence requirements of the various provisions have been met. Preparers should establish procedures for taking in new clients and should review Form 8867 to ensure compliance in all situations where taxpayers are seeking tax benefits with specific due diligence requirements.

We understand that the IRS is working on some new guidance on how preparers can show diligence in a pandemic world. These are expected later in October or early November to help us plan for the upcoming busy season. We will keep you informed.

https://www.irs.gov/instructions/i8867#idm139997623240960


New FAQs on PPP Loan Forgiveness

On Oct. 13, the Treasury Department issued new FAQs on Paycheck Protection Program (PPP) loan forgiveness. The FAQs address many questions relating to the timing of loan forgiveness and the method of accounting for qualifying expenses.  

The answer to FAQ No. 3 states,

“As long as a borrower submits its loan forgiveness application within 10 months of the completion of the covered period (as defined), the borrower is not required to make any payments until the forgiveness amount is remitted to the lender by SBA. If the loan is fully forgiven, the borrower is not responsible for any payments.”

The FAQs also address the loan forgiveness form’s expiration date of Oct. 31, 2020. This expiration date does not affect the time an application for loan forgiveness must be made, as shown in the answer to FAQ No. 4,

“Borrowers may submit a loan forgiveness application any time before the maturity date of the loan, which is either two or five years from loan origination. However, if a borrower does not apply for loan forgiveness within 10 months after the last day of the borrower’s loan forgiveness covered period, loan payments are no longer deferred and the borrower must begin making payments on the loan.”

The FAQs are at https://home.treasury.gov/system/files/136/PPP--Loan-Forgiveness-FAQs.pdf

The Treasury webpage regarding the Paycheck Protection Program is at https://home.treasury.gov/policy-issues/cares/assistance-for-small-businesses.


IRS Adds QR Codes to Pay by Smartphone

The IRS, in Notice 2020-233, announced that QR technology would be added to Balance Due Notices CP14 and CP14 IA. Taxpayers can now use their smartphones to scan a QR code in the CP14 or CP14 IA to go directly to IRS.gov and securely access their account, set up a payment plan or contact the Taxpayer Advocate Service.

Among other benefits, this technology will allow practitioners to instruct their clients to arrange payment plans directly, which should limit the practitioner’s involvement in this process, especially for smaller taxpayers.

https://www.irs.gov/newsroom/irs-adds-qr-technology-to-key-balance-due-notices-to-help-taxpayers


Carried Interest Three-Year Holding Period

By Tom Ochsenschlager, J.D., CPA

Section 1061 enacted with the Tax Cuts and Jobs Act (TCJA) generally requires that a taxpayer, other than a C corporation, must hold a “carried interest” in a partnership for three years in order to be treated as a long-term capital gain. This is applicable for tax years beginning after Dec. 31, 2017. Recently issued Proposed Regulation 107213-18 provides the details for implementing the three-year requirement. The three-year holding period applies regardless of whether the receipt of the carried interest is not subject to tax in accordance with Rev. Proc. 93-27. The guidance is effective when the regulations are made final, but taxpayers have the option to apply them before.

A carried interest is described as an interest in a partnership received by an “applicable trade or business” in exchange for having provided “substantial services” for the partnership. Under Section 1061, a service is substantial if it consists of raising or returning capital, or investing in, disposing of, or developing specified assets. For example, such an interest is relatively common in real estate partnerships where an individual receives a partnership interest for having negotiated the terms and conditions for the purchase of, say, an apartment complex on behalf of the partnership. The proposed regulations provide a detailed definition of applicable trade or business that generally comports with an entity that is engaged in providing substantial services as described above.

It is important to note that the three-year holding period continues to be applicable to any individual or entity, other than a C corporation, to whom the partner transfers their interest in the partnership. The proposed regulation preamble clarifies that where the services are provided through a tiered structure, each passthrough entity in the tiered structure is subject to the three-year holding period requirement for long-term capital gain treatment. Transfers of a carried interest to a related or unrelated entity are subject to revaluations at the date of the transfer. If the transfer is a gift to a related person within the three-year holding period, it is subject to tax at the donor level – an exception to the general rule that gifts are not taxable. The three-year holding period cannot be avoided by utilizing an installment sale of the carried interest. The holding period is based on the date of the sale regardless of when the cash is received.

The three-year holding period requirement not only applies to a disposition of the partnership interest by the service provider, it also applies to that partner’s share of the partnership’s long-term capital gain other than the partnership’s Sections 1231 and 1256 gains (and losses), qualified dividends under Section 1(h)(11) and mixed straddle rules described in Section 1092(b). The proposed regulations provide an exception referred to as “partnership transition amounts” whereby the partnership can elect an exception for the disposition of assets that were held by the partnership for more than three years as of Jan. 1, 2018. The partnership can make this election for its taxable year beginning in 2020 or later but, once the election is made, it is applicable to all subsequent years.

The proposed regulations provide complex rules for a few exceptions whereby, in general, the three-year holding period does not apply to distributions from the partnership related to the amount of capital that was contributed to the partnership by the carried interest partner and/or distributions that are subject to tax under Section 83. However, it does apply to the distributive share of gain from the sale of any asset held less than three years by the underlying partnership.  

The proposed regulations explain that the entity receiving the substantial services must provide the carried interest taxpayer with information required to comply with Section 1061 and, similarly, the carried interest taxpayer must provide similar information for any recipient of its transfer of any portion of the carried interest.

This is a very general summary of 162 pages of proposed regulations. These proposed regs should be read in detail in situations that include carried interest.

https://www.irs.gov/pub/irs-drop/reg-107213-18.pdf