Partnerships and Practitioners Wrestle with New Outside Basis Reporting Requirement

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. 

Urgent EFIN Scam Alert to Tax Professionals

The IRS and its Security Summit partners are warning the tax community of a new scam email that impersonates the IRS and attempts to steal Electronic Filing Identification Numbers (EFINs).

The latest scam email says it is from “IRS Tax E-Filing” and carries the subject line, “Verify your EFIN before e-filing.” The IRS warns tax professionals not to take any of the steps outlined in the email, especially responding to the email. Instead, send the email as an attachment to phishing@irs.gov and notify TIGTA.

View an example of the bogus email:

https://www.irs.gov/newsroom/irs-summit-partners-issue-urgent-efin-scam-alert-to-tax-professionals

Educators Can Now Deduct Out-of-Pocket Expenses for COVID-19 Protective Items

Eligible educators can deduct unreimbursed expenses for COVID-19 protective items to stop the spread of the virus in the classroom. The protective items include, but are not limited to:

• Face masks,
• Disinfectant for use against COVID-19,
• Hand soap,
• Disposable gloves,
• Tape, paint or chalk to guide social distancing,
• Physical barriers (e.g., clear plexiglass),
• Air purifiers, and
• Other items recommended by the CDC to be used for the prevention of the spread of COVID-19.

The new law clarifies that unreimbursed expenses paid or incurred after March 12, 2020, by eligible educators qualify.

https://www.irs.gov/pub/irs-drop/rp-21-15.pdf

Rough Tax Season Ahead for the Resource-Starved IRS!

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

 

The IRS budget has been reduced over the last 10 years while legislation and circumstances, including the pandemic, have added greatly to its workload. The IRS seems stretched and this may result in a rough tax season ahead. It is still backlogged from last year and is about to start this year’s filing season while it is likely to be tasked with a third round of COVID-19 relief and stimulus payments.

This article makes the case for increased funding for the IRS for the upcoming filing season and the future and also provides a link to tell practitioners the timing and what to do for various backlogged interactions with the IRS from last year. The IRS is critical to implementing various aspects of relief and stimulus programs, is critical to raising much needed revenue, and is probably the closest link most individual citizens have with the government – a smooth operation is important to restoring faith in government service during this difficult time.

IRS Needs More Funds to Address 2021 Tax Season Issues and to Deliver COVID Relief and Stimulus Payments

Because additional coronavirus relief legislation was enacted at the end of the year, the IRS has had to reprogram computers and modify tax forms, causing a delayed start to the tax filing season. The IRS normally allows tax returns to be filed late in January each year, but for the current filing season, the IRS announced that it cannot receive returns until Feb. 12 (returns can be prepared earlier but cannot be received until then). This delayed start will be particularly harmful to low-income families who rely on refunds from the Earned Income Tax Credit and Additional Child Tax Credit that will not be received until early March.  

Commissioner Charles Rettig stated: “Planning for the nation's filing season process is a massive undertaking, and IRS teams have been working nonstop to prepare for this as well as delivering economic impact payments in record time. Given the pandemic, this is one of the nation's most important filing seasons ever. This start date will ensure that people get their needed tax refunds quickly while also making sure they receive any remaining stimulus payments they are eligible for as quickly as possible."

The IRS has processed two stimulus payments, sending out approximately 300 million checks or direct deposits to provide relief for families and a stimulus to the economy. It will likely be tasked with delivering a third round of stimulus payments in the coming months. Just as the filing season is starting, the IRS will require substantial resources to reprogram computers, handle taxpayer inquiries and correct errors that are inevitable in sending out so many payments. Taxpayers do not need glitches in our tax system as they cope with other issues related to the pandemic. The IRS needs additional funding immediately to make the upcoming tax season go smoothly. 

IRS Needs More Funds to Address Its Work Backlog from Last Year

While the new tax season is here, the IRS is still working on issues backlogged from the last tax season. Because of the pandemic, the IRS had to delay the tax filing due dates in 2020. IRS offices were closed for much of the year, mail processing was delayed for many months and much important work had to be placed on hold. Many IRS employees are still not in offices and although the IRS has now opened its mail and processed payments, many substantive taxpayer issues from the 2019 filing season have not been addressed. Incorrect notices were sent to many taxpayers because the taxpayer’s mail responses were not properly received and processed by the IRS due to pandemic closures, including:

• If a taxpayer e-filed a return and sent a check in the mail, the check may not have been received until much later, causing the IRS to issue erroneous notices to collect taxes, interest and penalties. Although the IRS has ceased sending some notices, many substantive issues remain.
• Some taxpayers received notices of default on installment agreements for checks that were mailed but not timely received because of mail delays, and this has resulted in some notices cancelling the installment agreements and proposing charges to reinstate the agreement.
• Many returns cannot be filed electronically and the paper returns have not been processed with refunds delayed.
• Taxpayers who have not received refunds from last year’s returns often cannot reach an IRS assistor to explain the problem and have generally been told not to file again or call to ask about their refunds.
• Offers-in-compromise are not being entered by the IRS because agents do not have time to process them.
• In addition to erroneous notices that were sent, in many instances the IRS has not sent notices to properly inform the taxpayer of the error.

The IRS has listed specific transactions that are currently delayed and provided information on how long they are delayed and what taxpayers or their representatives should do.

IRS Needs More Funds to Improve Taxpayer Service

Although the lack of adequate taxpayer communications was exasperated by the COVID pandemic, this was also a significant problem in prior years. The IRS serves taxpayers as they comply with the tax law, but without adequate resources the IRS is unable to effectively serve this function. The IRS has tried to address taxpayer-service problems, but the problems are continuing and may become worse with the added issues of this tax season relating to stimulus payments, delayed credits and refunds, catching up its workload, etc.

The National Taxpayer Advocate indicated in her 2021 Purple Book that the IRS received over 100 million telephone calls in fiscal 2020, but was only able to answer 24%. With 150 million stimulus checks going out, even if there is just a 2% error rate from things like changed addresses or bank accounts, that means 3 million unhappy citizens calling the IRS with questions that will require research and response. Often, taxpayers who call the IRS to try to comply with our complex tax law spend hours on hold and sometimes end up with a “courtesy disconnect.” Taxpayers are told that lines are busy and to call back later. This undermines taxpayer faith in the tax system and reduces the level of taxpayer compliance.

IRS Needs More Funds to Interact with Tax Professionals

In our complex tax system, many taxpayers engage professionals to assist with compliance issues and, like taxpayers, preparers have serious problems engaging with the IRS on substantive issues. Although practitioners have a “hotline,” due to underfunding it is understaffed. Practitioners should not have to spend hours of scarce professional time on the telephone or trying to reach understaffed departments. Clients and professionals who bear the cost of this inefficiency are badly served by our tax system, and the IRS needs immediate funding to be able to work more efficiently and effectively with taxpayer professional representatives.    

IRS Needs More Funds for Its Increasing Workload

In the past 10 years, funding of the IRS has been reduced by $11.5 billion or a reduction of 20% after adjusting for inflation. In this same period, more returns are being filed, resulting in additional work being placed on the IRS with no additional resources, such as:

• Reprogramming of computers and developing new or changed tax forms for law changes;
• Issuing stimulus checks or making direct deposits to taxpayer bank accounts—timely payments are essential to help citizens and to achieve the intended stimulus to the economy;
• Implementing COVID relief measures such as deductions of expenses covered by the Payroll Protection Program (PPP) and forgiveness of indebtedness income for PPP loans; and
• Preventing or dealing with the national problem of identity theft, particularly attempts to steal taxpayer refunds—the IRS must quickly verify the identity of taxpayers to avoid delaying these refunds. This function requires additional human capital.  

Some of the current issues relate to the IRS’ inability to update its information systems because of lack of funding. The Taxpayer First Act of 2019 identifies improvements to be made, but these are to be phased in through 2025.

IRS Needs More Funds to Collect Unpaid Taxes

The IRS is incredibly efficient in collecting revenue, having collected $3.5 trillion in fiscal year 2020 when the government had a budget of $11.5 billion, a revenue/expense ratio of 300:1. Revenue collection is particularly important in a time of record debt and deficits to fund government relief and other programs, to stimulate the economy and to keep government borrowing as low as possible. Our self-assessment system of taxation relies on voluntary compliance by taxpayers, but this has to be backed up by a credible audit potential. In recent years, the audit rate has declined to around .5% of tax returns filed and for 2019 returns, this rate of audit has likely declined even more. Having a chance of being audited every 200 years on average does not provide much of a credible audit potential.

The most recent report of the tax gap (the amount of taxes that should have been paid but were not) was published in 2019, and for tax years 2011-2013 they averaged a net (after later collections) of $381 billion dollars or about 14% of total tax liability. This level of noncompliance is unacceptable when revenue is so badly needed. If the IRS is unable to collect taxes fairly due, compliant taxpayers may have to pay more than they should fairly have to pay. This may lead to disrespect for the tax system, growing noncompliance and lack of faith in our government.

IRS Immediate Needs

The IRS needs funds for:

• the current tax season and COVID-19 relief implementation,
• catching up on last season’s backlog,
• service to taxpayers,
• efficiently working with tax professionals,
• properly collecting taxes owed, and
• other new unfunded missions.

The IRS is one of the most important points of contact between the federal government and its citizens. Effective, efficient and fair administration are critical to maintaining faith in government during a time of crisis. 

Adios to California? Here’s What You Need to Know

By Torakichi Jesús Oba, EA, CPA

I apologize in advance to my CPA colleagues in Texas for the sudden influx of new clients who have entire conversations consisting of the word ”dude,” as leaving California for Texas has become quite popular of late. However, I urge a certain measure of caution with these monosyllabic types because breaking California tax residency brings to mind the famous line from Hotel California, ”You can check out anytime you’d like, but you can never leave.”

California tax residency entails worldwide taxation of one’s income to its state treasury. For purposes of California income tax, a tax resident is someone who is present in California for other than a temporary or transitory purpose, or someone who is domiciled in California but outside of the state for a temporary or transitory purpose. To successfully cease to be a tax resident, one must successfully establish a domicile outside of California and have their closest ties shift to their new jurisdiction of residence. These close ties are the specifics of day-to-day life that include, but are not limited to, where one’s spouse/children are located, location of principal residence, state where taxpayers are registered to vote and other criteria that give substance to the daily life led by any taxpayer. The State of California Franchise Tax Board (FTB) Publication 1031 gives a great overview to the subject and provides specific examples that are of use when determining tax residency.

However, just because someone successfully breaks tax residency does not mean they are done paying California tax, as nonresidents are taxed on income from California sources. California nonresidents are generally subject to withholding on sales of California real estate, income allocations or distributions from CA S-Corporations and CA partnerships. These withholding requirements are addressed in FTB Publications 1016, Real Estate Withholding Guidelines and 1017, Resident and Nonresident Withholding Guidelines.

I would boil all this down to the following key concepts and reinforce it with the specifics in the FTB publications:

1. Breaking CA residency – Make sure that a taxpayer really does live and go about their day-to-day life in Texas and does not go back to California with any regularity.

2. California sourced income = California tax due with the potential of backup withholding.

2020 Publication 1031 Guidelines for Determining Resident Status

Withholding on nonresidents | FTB.ca.gov

FTB Publication 1016 | FTB.ca.gov

T. Jesús Oba, EA, CPA, is an accountant based in San Diego, CA, who specializes in international taxation matters. He has written for Tax Notes International and CalCPAs and works collaboratively with TXCPA’s Federal Tax Policy Committee. When not in his office, Jesús is looking for delicious burritos.

Final Revenue Recognition Regulations

The Tax Cuts and Jobs Act of 2017 (TCJA) included an amendment to Section 451(b) that requires accrual method businesses to recognize income no later than it is recognized in their financial statements. For many taxpayers, this accelerates taxable income that historically would not have been reported for tax purposes until the “all events test” was satisfied. Furthermore, the proposed regulations generally did not permit a reduction in this accelerated portion of the income for any costs.

Released late December, the final revenue recognition regulations (TD 9941) reflect legislative changes made by the TCJA and finalize regulations that were proposed in September 2019.

The final regulations are more favorable to taxpayers, providing that taxpayers with inventory can generally reduce the financial statement income by the cost of the goods sold consistent with Regulation 1.451-3. Additionally, the final regs provide that a taxpayer does not have to report any income that the taxpayer does not have a legal right to recover. Taxpayers with certain goods, as specified in the regulations, can utilize Section 451(c) when reporting the income. And special rules apply where the financial statement income includes advance payments for contracts that are subject to additional obligations.

While the final regulations are effective for tax years beginning after Dec. 31, 2020, they do permit taxpayers to choose to apply them retroactively for any tax year beginning after Dec. 31, 2017, if applied consistently in the intervening years. 

Final regulations Section 1.451-2 also permit taxpayers to elect to defer inclusion of income related to advance payments for goods and services to the year following the taxable year when it is received if the income is deferred in the financials. 

Mailing Address Error for Paper Filing of 2020 Form 1096

It has come to our attention that the Austin area ZIP code of 78741 is incorrect for the paper filings of Form 1096, Annual Summary and Transmittal of U.S. Information Returns. The IRS is aware. At this point, we are watching for the IRS release of a corrected address.

Forms 1099 Changes: What you need to know

By Jim Smith, CPA-Dallas

 

There are many types of 1099 forms. Some of the most common are:

1099-B (Gross Broker Proceeds)

1099-DIV (Dividends)

1099-G (Certain Government Payments)

1099-INT (Interest)

1099-K (Payment Card and Third-Party Network Transactions)

1099-MISC (Miscellaneous)

1099-NEC (Non-employee Compensation)

1099-OID (Original Issue Discount)

1099-PATR (Patronage Dividends)

W-2G (Certain Gambling Winnings)

This discussion will focus on Forms 1099-NEC and 1099-MISC. 

 

Form 1099-NEC (Non-employee Compensation)

This is the biggest change! Amounts that were formerly reported in Box 7 of Form 1099-MISC are now reported in Box 1 of this form. 

Who gets one? 

• Generally, non-employee service providers who are paid $600 or more in the course of a trade or business during a calendar year. 
• ALL legal fees, even if under $600.
• Oil and gas working interest payments.

This is not an all-inclusive list. Additional information can be found in link below, Instructions for Forms 1099-MISC and 1099-NEC.

When are they due? Your 1099-NEC forms must be filed this year by Feb. 1, 2021, accompanied by a transmittal Form 1096.

 

Form 1099-MISC (Miscellaneous)

Who gets one? The following non-employee payees who are paid $600 or more in the course of a trade or business during a calendar year:

• Payees who receive rent, including equipment rental and surface royalties. Exception: If you pay rent to an agent of the owner, such as a management company, they do not prepare a 1099-MISC.
• Payees who receive royalties, such as literary rights, copyrights, licensing fees and mineral royalties.
• Payees who receive other payments. The most common are recipients of prizes and awards (but NOT employees), a deceased employee’s wages paid to an estate or beneficiary, payments for participation in medical research, payments to informants and taxable legal damages/settlements.
• Payees who provided medical services, including veterinary services (NOT equipment, drugs or insurance premiums). This includes things like pre-employment physicals, workers comp review, drug testing, physical exams, MRIs, X-rays, counseling, dental work, etc.
• Gross proceeds paid to attorneys. This category is for payments such as damage awards, which may include contingent fees, but not direct hourly billings for fees which are reported on the 1099-NEC.

Some of these categories are very tricky and this is not an all-inclusive list. Additional information can be found in the link below, Instructions for Forms 1099-MISC and 1099-NEC.

When are they due? Forms 1099-MISC must be filed this year by March 1, 2021, accompanied by a transmittal Form 1096.

 

Are there any payees who are exempt from receiving these forms?

Yes. The most common exempt entities are: 

• Corporations (both C-corporations and S-corporations),
• Government entities, and
• Not-for-profit entities/charitable/tax-exempt entities.

 

How do I know if the payee is an exempt entity?

The best way to get the necessary information is to obtain a completed Form W-9 from the payee prior to making payments. The forms should be kept in a file for reference when it is time to prepare 1099 forms. It is acceptable to receive the W-9 information orally. If a payee refuses to provide a taxpayer identification number (TIN), reportable payments are subject to backup withholding at a rate of 24%, which must subsequently be deposited with the IRS. (See IRS instructions.)

A link to Form W-9 is below. The IRS website also has it available in Spanish.

 

Are there any other special rules?

Yes:

• Do not report the purchase of goods or parts unless they are paid for in conjunction with services.
• Do not report the payment of refunds or rebates.
• Do not report payments for telephone, telegram, storage or freight services and similar items.
• Do not report expense reimbursements that meet accountable plan rules.
• If the payee is located in a state with state income tax, you must determine whether the payment must be reported to the state.
• Payments made to sole proprietors and single-member LLCs operating with a name other than that of the owner should be reported to the owner’s name and Social Security number or Employment Identification Number.

Please see the IRS instructions for complete information.

 

Are there penalties for noncompliance?

Please note that the IRS began a compliance campaign in 2019 that focuses on 1099 compliance, including backup withholding. Additionally, the IRS is expanding payroll tax audits to include 1099 compliance.

The most common penalties assessed are:

• Missed filing deadlines,
• Missing TINs,
• Name/TIN mismatches,
• Using a TIN that has not been assigned, and
• Failure to withhold backup withholding.

Additionally, if you are filing over 249 of any type of 1099 form, you must file electronically. For future reference, Congress has given the IRS permission to lower that electronic filing threshold to 100 after 2021. The threshold may drop as low as 10 forms in subsequent years.

https://www.irs.gov/pub/irs-pdf/i1099msc.pdf

https://www.irs.gov/pub/irs-pdf/fw9.pdf

Highlights of the Coronavirus Response and Relief Supplemental Appropriations Act

President Trump has signed the stimulus bill passed by Congress on Dec. 27, 2020.  It includes $1.4 trillion to extend expiring tax measures and $1 trillion for new tax benefits. Some of the more important provisions are the following:

• Permits a tax deduction for expenses paid for by a forgiven Paycheck Protection Program loan (reversing the previous position taken earlier this year by the IRS stating that these expenses were not deductible)
• Extends the employee retention credit for the first two quarters of 2021
• Retroactively permits the employee retention credit for businesses receiving PPP loans
• Permits businesses to deduct 100% of restaurant meals in 2021 and 2022
• Extends and expands the sick pay and paid family leave credits through 2021
• Permits taxpayers who do not itemize to claim up to $600 in charitable contributions on their 2021 returns
• Continues through 2021 the provision that permits corporations to deduct 25% of taxable income for charitable and food inventory contributions
• Provides $600 checks for each taxpayer and their qualified children subject to income limitations

Final Regs Expand Property Eligible for Like-Kind Exchanges

By Tom Ochsenschlager, JD, CPA

Last month, the IRS issued final regulations (TD 9935) explaining the limitations on like-kind exchanges that were imposed in the Tax Cuts and Jobs Act (TCJA). The TCJA limited the ability to qualify for a tax-free exchange under Section 1031 to exchanges of real property. Accordingly, exchanges of personal or intangible property that qualified for tax-free exchange prior to the TCJA no longer do.

In addressing the TCJA limitation, the proposed regulations limited the definition of real property to land, buildings and their permanent structural components and provided a “purpose or use test” that excluded incidental property located within the real property that was unrelated to the use or occupancy of the property such as machinery and equipment.

The final regulations revoke the purpose or use test, thereby expanding the definition of real property to include property held for the productive use in a trade or business. Additionally, the proposed regulations provide that even property not considered real property under state law may qualify based on the facts and circumstances. However, it is clear in the regulations that regardless of state law definition of real property, intangibles such as artwork, patents, intellectual property, stock in a corporation and a partnership interest do not qualify as assets eligible for tax-free exchange.

The final regulations are generally effective for exchanges of real property completed after Dec. 31, 2017. An amended return may be necessary to take advantage of the expanded definition of property now eligible for exchanges that occurred in 2018 and 2019 that did not qualify under the proposed regulations.

https://www.irs.gov/pub/irs-drop/td_9935.pdf