William Stromsem, CPA, J.D., Assistant Professor of Accountancy, George Washington University School of Business
Partnership returns for 2020, due on March 15, will have a new requirement that partnerships report and analyze each individual partner’s capital account. This presents partnerships and their representatives with a challenge to obtain or develop information that they likely have not previously maintained and that may not even be available. Partnerships and their representatives are scrambling to decide how to comply with this late-breaking requirement. Outside basis has always been – and will continue to be – the responsibility of individual partners. In the past, the IRS generally preferred that partnerships use their book method of reporting partner capital accounts rather than tax, so records may not have been maintained at the partnership level for the required reports.
Four “creative” and potentially complex and possibly unrealistic methods for complying are suggested in two pages of the draft instructions to Form 1065. Item L, Partner’s Capital Account Analysis, and Schedule M-2, Analysis of Partners’ Capital Accounts, in the draft Form 1065 instructions (still in draft form as of Feb. 9) describe the four methods. There is also a suggested method for complying for publicly traded partnerships. Following one of these methods can help avoid penalties for errors in reporting partners’ capital accounts (see below).
The methods provided may not give an accurate number for outside basis because there may be basis adjustments that only the partner knows. The partnership, for example, would not know the partner’s initial basis, which could vary depending on whether it was acquired by purchase, gift, inheritance or exchange. Outside basis needs to be maintained annually to recognize distributable income, distributions, capital contributions and withdrawals, recognized gains and so forth. An example of information unknown to the partnership that could affect outside basis is where elections are made at the partner level, like cost or percentage depletion, where percentage depletion allows deductions in excess of basis. The calculation of tax capital also requires the partnership to exclude the outside basis differences it is aware of in the form of Section 743(b) adjustments. So, the basis information the IRS is requesting be developed by partnerships at great trouble and expense may not serve IRS needs and could cause unnecessary administrative controversies.
The objective of the new reporting requirement is apparently for the IRS to ensure that partners are reporting gains on distributions in excess of basis and are limiting losses that exceed basis. However, if the IRS uses incomplete information, the notices may be erroneous. If the IRS uses tax capital information from the partnership that is lower than the outside basis records maintained by the partner, this can result in an erroneous notice and can require some complex correspondence to resolve the issue. It should be noted that the new partnership requirement to report tax capital method does not relieve the partner of responsibility for retaining his/her own records, and the separate and possibly different records seem to invite controversy with the IRS.
Recognizing the complexity and possibly imprecision of reporting results, on Jan. 19, 2021, the IRS issued Notice 2021-13 that provides that, “A partnership will not be subject to a penalty under Sections 6698, 6721 or 6722 due to the inclusion of incorrect information in reporting its partners’ beginning capital account balances on the 2020 Schedules K-1 if the partnership can show that it took ordinary and prudent business care in following the 2020 Form 1065 instructions to report its partners’ beginning capital account balances using any one of the following methods, as outlined in the instructions: the tax basis method, modified outside basis method, modified previously taxed capital method or Section 704(b) method.”
Some Possible Actions for This Year
Some practitioners are recommending that their partnership clients extend their returns. The determination of basis may be time consuming at a busy time of the year, including possible correspondence with individual partners. An extension could allow a partnership to better understand and comply with the new requirement and to correct any errors that might be made in the rush to March 15. If a partnership is subject to the partnership audit regime and an error is discovered after the return is submitted, the return cannot be amended and must go through a more complex administrative adjustment process.
Extending would not keep the partnership from filing earlier but allows it to file or correct a return later. The extension must be filed before the return. A superseded return is a return filed after the original return but before the extended due date of the return.
Practitioners should also consider alerting clients about possible increased fees, extended returns and the possible need to contact individual partners.