IRS Proposes Additional Guidance on Partnership Tax Capital Reporting Requirement
The IRS recently issued Notice 2020-43 (the Notice) to seek public comment on a proposed requirement for partnerships to use only certain specified methods to satisfy the tax capital reporting requirement with respect to partnership taxable years that end on or after Dec. 31, 2020. Changes to the tax capital disclosure requirement had initially been slated for all partnerships beginning with the 2019 tax year, but the IRS delayed the requirement until the 2020 tax year, and retained the 2019 requirement only for partnerships that have partners with negative tax basis capital balances.
After the IRS had initially unveiled the change for mandatory reporting of tax capital, uncertainties surfaced about the appropriate method to determine tax capital. In response to previous comments, the Notice proposes two methods that partnerships must use to determine a partner’s tax capital for disclosure purposes:
- Modified outside basis method, or
- Modified previously taxed capital method.
Partnerships must use one of these two methods to satisfy the tax capital reporting requirements and will no longer be able to report partner capital accounts using Section 704(b), GAAP, or other methods. The method selected must be used for all partners during a given year. Partnerships may elect to switch between these two methods during a subsequent year by attaching a disclosure to all Schedule K-1s.
Modified Outside Basis Method
The modified outside basis method starts with each of the partner’s adjusted tax basis in their respective partnership interest, as determined by the principles and provisions of subchapter K (including those contained in Sections 705, 722, 733, and 742). Then each partner’s share of partnership liabilities under Section 752 that were included in the partner’s adjusted tax basis are subtracted.
Partners may be required to provide adjusted tax basis information to the partnership for purposes of applying the modified outside basis method, and must inform the partnership of any changes in their respective adjusted tax basis that occur outside the partnership (i.e., from transactions not reported on their respective Schedule K-1). Partners must provide this information to the partnership within 30 days of such changes or by the tax year-end of the partnership — whichever is later. Partnerships are entitled to rely on such partner basis information provided by their partners unless the partnership has reason to know that such information is clearly erroneous.
Modified Previously Taxed Capital Method
For purposes of the tax capital reporting requirement, the modified previously taxed capital method builds upon the method described in Regulations Section 1.743-1(d)(2). Partners ordinarily reference this regulation when computing the amount of a basis “step-up” adjustment that occurs when a partnership interest is purchased from another partner. The calculation of previously taxed capital for that purpose is based on the amount of cash the partner would receive upon a hypothetical liquidation of the partnership, increased by the amount of tax loss that would be allocated to the partner from the hypothetical liquidation, and decreased by the amount of tax gain that would be allocated to the partner from the hypothetical liquidation.
The hypothetical liquidation transaction is 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, followed by payment from the partnership for all of its liabilities, and followed finally by the distribution of the remaining proceeds to its partners.
The modified previously taxed capital method modifies the above approach as follows:
- The amount of cash a partner would receive upon a hypothetical liquidation and the calculations of gains or losses from the transaction would be based on the fair market value of the assets, if readily available. If not readily available, the partnership may determine its net liquidity value and gains and losses using such asset bases as calculated under Section 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; and
- All liabilities are treated as nonrecourse for purposes of the calculation of gain or loss, respectively.
As noted above, the IRS is seeking comments on the following topics:
- Whether the methods used to satisfy the tax capital reporting requirement described in the Notice should be modified or adopted;
- Whether an ordering rule should apply to the basis used in determining the partnership’s net liquidity value;
- How, if at all, the tax capital reporting requirement should be modified to apply to partnerships that are treated as publicly-traded partnerships under Section 7704 of the Internal Revenue Code;
- Whether other methods should be permitted for purposes of meeting the tax capital reporting requirement and, if recommended, what additional guidance would be necessary; and
- Whether, and in what circumstances, limitations should be imposed on partnerships to change from one method to another, including compliance with such rules in the case of the merger of partnerships using different methods.
Written or electronic comments must be received by Aug. 4, 2020 and should contain reference to Notice 2020-43.
Partnerships may be in the midst of preparations for the new tax capital reporting requirements. This latest IRS proposed guidance is an indication of the IRS’s thoughts on what the reporting could look like, but also serves as a reminder that the guidance may still shift before the reporting for the 2020 tax year begins in earnest. Partnerships should review Notice 2020-43 and consider how the currently proposed methods for computing tax capital accounts will impact data gathering and compliance processes, and potential further changes to the acceptable tax capital account tracking methodologies might impact these planning activities. For more information, please contact us.
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