Congress overhauled the U.S. tax system when it passed the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) two years ago, and the IRS is still trying to catch up. Last year, the IRS updated a few tax forms to reflect the new laws, and this year, the agency is at it again. It recently released draft versions of the 2019 Form 1065, U.S. Return of Partnership Income and its associated Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. The draft Schedule K-1 includes substantial changes to information reporting that could be time-consuming to implement for partnerships.
The extent of the changes recently prompted the “Big Four” accounting firms to submit a letter to David Kautter, Assistant Secretary for Tax Policy at the U.S. Department of Treasury, asking for a one-year reprieve on certain new information reporting requirements. There is no indication about whether such a delay will be coming, so in the interim, partnerships should work off of the premise that the draft forms will be adopted unchanged. Here’s a closer look at what partnerships, including private equity and venture capital funds can expect.
Tax Basis Capital Accounts
The draft version of the 2019 form Schedule K-1 shows that each partner’s capital accounts will be required to be reported in Item L of Schedule K-1 on the tax basis rather than one of the other methods previously permitted.
A partner’s capital account has always been reported in item L of Schedule K-1, but most partnerships have traditionally elected to report this item on the basis of U.S. Generally Accepted Accounting Principles (GAAP) and therefore tied to equity numbers on the books. Other partnerships calculated their partners’ capital accounts using IRC Section 704(b) book basis or another hybrid basis, often related to the accounting method they followed for financial reporting purposes. Few partnerships have historically reported this item on a tax basis.
Last year, the IRS required partnerships to report on line 20 of the Schedule K-1 using code AH partners’ capital accounts on a tax basis only if their tax basis was negative at the beginning or end of the year. This year, tax basis reporting is compulsory. Tax professionals believe that the IRS is trying to sniff out negative capital balances, either from allocation of partnership liabilities or distributions in excess of basis, to ensure partners aren’t making “bottom-dollar guarantees” of debt they never expect to pay back.
Uncertainties remain about the appropriate method to determine a partner’s “tax basis capital” to be reported on Schedule K-1. The draft Schedule K-1 instructions provide a definition that has changed from the 2018 version of the instructions by excluding Section 743(b) adjustments from the calculation of tax basis capital, but other items are not addressed, such as Section 734 basis adjustments, allocated shares of partnership liabilities, or Section 704(b) revaluations.
Built-In Gains or Losses
Section 704(c) gains or losses exist when partners contribute appreciated or depreciated property to a partnership. The IRS wants to keep an eye on Section 704(c) gains and losses to prevent taxpayers from transferring built-in gains or losses to other partners in a partnership. Net unrecognized Section 704(c) gains and losses, calculated both at the beginning and end of the year, must now be reported on Schedule K-1.
The draft version of the form shows that partnerships should identify whether a partner contributed property with built-in gains or losses by checking a box in Item M of Schedule K-1. If the answer is yes, their portion of net unrecognized 704(c) gains and losses will be reported in Item N.
Section 743(b) Adjustments
When a partnership interest is sold and the selling partner’s tax basis in the partnership’s assets differs from the purchase price, the new partner will need to step up (or step down) their tax basis by the difference if the partnership has made a Section 754 election. This Section 743(b) basis adjustment is a way for the partnership to attribute tax basis in partnership assets fairly to partnerships entering the partnership. Depending on the purchase price and the partnership assets’ tax basis, Section 743(b) basis adjustments can be negative or positive.
In the draft version of Schedule K-1, both negative and positive adjustments must be reported for each partner. Positive Section 743(b) basis adjustments allocated to a partner are reported on Line 11F of Schedule K-1 and negative Section 743(b) basis adjustments on Line 13V.
Section 751 assets are often referred to as “hot assets” because they are assets that produce ordinary income rather than tax-favored capital gains. The IRS wants to see gains and losses from hot assets (like unrealized receivables, appreciated inventory, and LIFO reserves) broken out by partner.
The draft version of the form shows that partnerships should report the net Section 751 gains or losses allocated to each partner on Line 20AB of Schedule K-1.
The TCJA puts a cap on how much interest expense from business debt taxpayers can deduct. For partnerships, this Section 163(j) limitation is calculated and applied at the partnership level. This amount is generally capped at the total of business interest income plus 30% of the partnership’s adjusted taxable income, which is akin to company earnings before interest, taxes, depreciation, and amortization (EBITDA). Guaranteed payments that compensate a partner for contributing capital are likely to be considered business interest expense and thus could be limited as well. This provision was included in a set of proposed regulations released at the end of last year. The new disclosure requirement may also pertain to the excess business loss limitation under Section 461(l), where guaranteed payments for services likely count as trade or business income in measuring whether there is an overall excess business loss.
To help calculate this business debt interest expense limitation, the Schedule K-1 now breaks out guaranteed payments for services and guaranteed payments for capital, to be reported on lines 4a and 4b, respectively. Even though the proposed regulations under Section 163(j) are not finalized, the fact that the IRS included this breakout on the draft Schedule K-1 points to the likelihood that this provision will be preserved in the final regulations.
The new Schedule K-1 also would require partnerships to report informational items like the following:
- Whether the partner is a disregarded entity, and to specify the name of the beneficial owner if so (Box H). This requirement is curious in that the IRS historically provided that the beneficial owner of a disregarded entity should be listed directly on the Schedule K-1 along with the beneficial owner’s taxpayer identification number.
- Whether the partner’s decrease in profit and loss percentages is a result of a sale or exchange of their partnership interest (Item J)
- Whether the partner’s share of liabilities includes amounts from lower tier partnerships (Item K)
- Whether the partnership has more than one “at-risk” activity (Line 21)
- Whether the partnership has more than one passive activity (Line 22)
These reporting changes will almost certainly complicate the reporting process, so taxpayers should be prepared for additional compliance costs and allot additional time to collect this information. If you have any questions about these Schedule K-1 reporting changes, please contact us.
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