By Dolly Rajani, Tax Supervisor, CPA
On October 22, 2020, the IRS released draft instructions for Form 1065, US Return of Partnership Income that included revised instructions which require partnerships to report their partner’s capital account on Schedule K-1 using the transactional approach for the tax basis method for tax years beginning 2020.
What is the Transactional Approach for the “Tax Basis” Method?
Tax basis capital accounts are determined by adding a partner’s share of all contributions and items of income/gain and subtracting all distributions and items of losses and deductions. Please note that this straightforward approach referred to as the “transactional approach” did not satisfy the reporting requirements per IRS Notice 2020-43. However, the 1065 instructions that were released on October 22, 2020 contradict the notice.
Prior to this mandate, partnerships could report its partner’s capital accounts determined under multiple methods, e.g., GAAP Basis, Section 704(b) etc. For those partnerships that did not prepare and maintain their Schedule K-1 capital accounts on a tax basis method, may now determine or adjust each partner’s beginning capital account balance for 2020 using any one of the following three methods:
- The modified outside basis is the partner’s adjusted basis in their partnership Interest, determined under the principles of and provisions of Subchapter K and subtracting from that basis the partner’s share of partnership liabilities under S/752 and net tax value of any Section 743(b) basis adjustments. For the purposes of establishing a partner’s beginning capital account, the partnership may rely on the adjusted tax basis provided by the partners.
- The modified previously taxed capital method is determined based on the amount of cash a partner would receive in a fully taxable partnership liquidation and adjusting for the amount of tax gain and/or loss that would be allocated to each partner determined without regard to any Section 743(b) basis adjustments, following a hypothetical transaction.
- The Section 704(b) method is equal to the partner’s Section 704(b) capital accounts adjusted by the net of any built-in gain or loss on property contributed by the partner.
Please note that the partnership must use the same method to determine and adjust the beginning capital accounts for all of its partners as well as attach a statement to each of the partner’s Schedule K-1’s describing the method used to adjust or determine the beginning capital accounts and providing a description of the adjustments made.
Are Penalties Assessed for Incorrect Capital Account Reporting?
To promote compliance with using the tax basis method described in the revised instructions, the Department of the Treasury and the IRS intend to issue a notice providing additional penalty relief for the transition in tax year 2020. The notice intends to provide instructions that solely for tax year 2020 (for partnership returns due in 2021), a penalty will not be assessed for any errors in reporting its partners’ beginning capital account balances on Schedule K-1 if the partnership takes ordinary and prudent business care in following 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.
Partnerships and advisors should carefully consider and review the new mandate to ensure compliance for the 2020 tax season.