The IRS recently published Notice 2020-43, which proposes two new methods for reporting partner capital accounts on partnership returns (Form 1065 or Form 8865) and requests comments on the proposed methods. For years ending on or after December 31, 2020, the IRS expects that these two proposed methods will be the only methods that meet the tax capital reporting requirements for partnerships.
The IRS originally required reporting of capital accounts on the tax basis method in 2019, but ultimately delayed the requirement to the 2020 tax filing year. The partnership is required to report this information in Box L and Box F on Schedule K-1 for Form 1065 and Form 8865, respectively. The notice provides that one of the two methods proposed must be used; however, the partnership may change between the two proposed methods in Notice 2020-43 by attaching a disclosure to each Schedule K-1 describing the change to each partner’s beginning and end of year capital account balances.
The two available methods are:
Modified Outside Basis Method
A partner or the partnership determines the partner’s basis in their interest in the partnership, as provided in subchapter K, before subtracting from that basis the partner’s share of partnership liabilities under §752. If the partnership is using this method, any partner must notify the partnership, in writing, of any changes to the partner’s basis in its partnership interest during the year other than changes attributable to contributions, distribution, and the partner’s share of income or loss from the partnership. The notification must be provided within 30 days or by the tax year-end of the partnership, whichever is later. For example, if a partner purchases an interest in a partnership that has chosen to use the Modified Outside Basis Method, the purchasing partner must notify the partnership of its basis in the acquired partnership interest. Partnerships may rely on the information provided by partners about their basis unless the information is clearly erroneous. If the Modified Outside Basis Method is chosen, operating agreements may need to be amended to get partners to timely provide this information.
Modified Previously Taxed Capital Method
This method calculates a hypothetical liquidation of the partnership using FMV, GAAP, or §704(b.) This method reports the capital accounts of partners as the amount equal to their interest as a partner in the partnership’s previously taxed capital, plus the transferee’s share of partnership liabilities. A partnership that adopts the Modified Previously Taxed Capital Method would be required, for each taxable year in which the method is used, to attach a statement indicating that the Modified Previously Taxed Capital Method is used and the method it used to determine its partnership net liquidity value.
Previously taxed capital is equal to the sum of the following amounts that would occur upon a disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the fair market value of the assets:
(i) The amount of cash that the partner would receive on a liquidation of the partnership following a hypothetical transaction; increased by
(ii) The amount of tax loss (including any remedial allocations under § 1.704-3(d) of the Income Tax Regulations) that would be allocated to the partner from the hypothetical transaction; and decreased by
(iii) The amount of tax gain (including any remedial allocations under § 1.704-3(d)) that would be allocated to the partner from the hypothetical transaction.
The Notice then modifies the calculation as follows:
- The cash a partner would receive on a partnership liquidation and calculations of gain and loss in the hypothetical transaction would be based on the assets’ fair market value, if readily available. Otherwise, a partnership may determine its partnership net liquidity value and gain or loss by using such assets’ bases as determined under § 704(b), GAAP, or the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management; and
- All liabilities are treated as nonrecourse for purposes of parts (ii) and (iii) of the calculation above referring to gain or loss, respectively. This is to avoid the burden of having to characterize the underlying debt and to simplify the computation.
Example. Facts. A and B are equal partners in AB LLC, a calendar-year partnership. On December 31, 2020, AB LLC’s balance sheet reflects the following assets and liabilities:
- $500 of cash;
- Inventory with a tax and book basis of $1,000;
- Equipment with a tax and book basis of $500;
- Land with a tax and book basis of $1,000; and
- A long-term loan of $5,000.
AB LLC chooses to comply with the Tax Capital Reporting Requirement by using the Previously Taxed Capital Method and calculating liquidation values, gains, and losses, based on the book basis of the assets. Each of A and B’s Previously Taxed Capital under that method would be $(1,000), an amount equal to (i) the cash each would receive after the hypothetical liquidation (zero, because the debt of $5,000 exceeds the $3,000 book basis of the assets), less (ii) gain that would be allocated to each partner on the hypothetical liquidation and sale ($1,000, each partner’s 50% share of the excess of the $5,000 amount realized on a sale of the property for the debt over the tax basis of $3,000), plus (iii) loss that would be allocated to each partner (zero).
In practice, the Modified Outside Basis Method is likely to be more readily determined. The IRS is currently accepting public comments on Notice 2020-43, and RubinBrown will update this guidance as necessary.
By: Tony Nitti, CPA, MST
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