Draft Form 1065 Instructions Require Tax Basis Capital Account Reporting

Draft Form 1065 instructions for tax year 2020 direct taxpayers to calculate partner capital accounts using a tax basis method.  Previously, partnerships could report capital accounts to their partners on Form 1065, Schedule K-1 using other methods such as generally accepted accounting principles (GAAP). The proposal to require the tax basis method has been in the works for some time and, according to the IRS, most partnerships already use it.

Transition Methods Available in Certain Cases

According to the draft instructions, partnerships that did not use the tax basis method for 2019 but maintain books and records using the tax basis for capital accounts must use the tax basis method for 2020.

Partnerships that did not prepare Schedules K-1 under the tax basis method for 2019 or maintain tax basis capital accounts in their books and records may determine each partner’s beginning tax basis capital account balance for 2020 using one of the following methods, as described in the instructions:

  • the modified outside basis method;
  • the modified previously taxed capital method; or
  • the Section 704(b) method.

There are special rules for publicly traded partnerships.

Modified Outside Basis Method

A partner’s beginning capital account under the modified outside basis method is the partner’s adjusted tax basis in its partnership interest as determined under the principles of subchapter K, and subtracting from that basis (1) the partner’s share of partnership liabilities under Code Sec. 752, and (2) the sum of partner’s Code Sec. 743(b) adjustments.

The partnership may rely on the adjusted tax basis information provided by its partners in establishing a partner’s beginning capital account.

Modified Previously Taxed Capital Method

A partner’s beginning capital account under the modified previously taxed capital method is the amount of cash the partner would receive if the partnership liquidated after selling all of its assets in a fully taxable transaction for cash, equal to the fair market value of the assets, and adjusted as follows:

  1. increased by the amount of tax loss determined without taking into account any section 743(b) basis adjustments (including any remedial allocations under Reg. §1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse); and
  2. decreased by the amount of tax gain determined without taking into account any section 743(b) basis adjustments (including any remedial allocations under Reg. §1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse).

Instead of using the assets’ fair market value, the partnership may determine its net liquidity value, and gain or loss, by using the assets’ bases as determined under Code Sec. 704(b), as determined for financial accounting purposes, or on the basis set forth in the partnership agreement for determining what each partner would receive if the partnership were to liquidate, as determined by partnership management.

Section 704(b) Method

A partner’s beginning capital account under the section 704(b) method is the partner’s section 704(b)  capital account, minus the partner’s share of Code Sec. 704(c) built-in gain in the partnership’s assets, plus the partner’s share of section 704(c) built-in loss in the partnership’s assets.

Property contributed to a partnership is section 704(c) property if, at the time of the contribution, its fair market value differs from its adjusted tax basis. Section 704(c) property also includes property with differences resulting from revaluations (reverse section 704(c) allocations).

Penalty Relief Planned for 2020 Reporting Errors

The IRS plans to issue a notice providing additional penalty relief for the transition to the tax basis method in tax year 2020. The notice will provide that solely for tax year 2020 (for partnership returns due in 2021), the IRS will not assess a penalty for a partnership’s errors in reporting its partners’ beginning capital account balances on Schedules K-1. To be eligible for penalty relief, the partnership must take ordinary and prudent business care in following the form instructions to calculate and report the beginning capital account balances. This penalty relief will be in addition to the reasonable cause exception to penalties for any incorrect reporting of a beginning capital account balance.

Robert Recchia, J.D., M.B.A., C.P.A.

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CCHTaxGroup

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