While the 2020 tax prep season is well underway, accountants are still waiting on the IRS for one piece of the puzzle: the final instructions for calculating and reporting partners’ capital accounts on Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc.
Clarity from the IRS is expected soon, but it is a good idea for partnerships to get started on compliance now to allow for plenty of time and minimal disruption once the instructions are announced. As long as a partnership “takes ordinary and prudent business care in following the form instructions,” the IRS will provide penalty relief.
The Basics: What’s Changed
Historically, partnerships could use any reasonable method—including generally accepted accounting principles (GAAP), Section 704(b) book, or the tax-basis method—to report partners’ shares of partnership capital. This started to change in 2018 when the IRS launched a new rule that required partnerships to use only the tax-basis method for reporting some partners’ capital account information.
This requirement initially applied only to partners with negative tax capital balances, but in 2019 the IRS proposed expanding the rule to require disclosure of tax-basis capital amounts for all partners. After a backlash from the tax and business communities, the IRS delayed the expanded requirements for one year, but as of the 2020 tax year, partnerships must now calculate and disclose tax-basis capital information for all partners.
The only exception to the new rule is for small partnerships that meet all of the following requirements:
- The partnership’s total receipts for the tax year are less than $250,000.
- The partnership’s total assets at the end of the tax year are less than $1 million.
- Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return.
- The partnership is not required to file Schedule M-3.
Any partnership that does not meet all four of these conditions must disclose partners’ capital account information using the tax-basis method.
Making the Transition
To guide partnerships in transitioning to the new standard, the IRS issued Notice 2020-43 in June 2020. The notice spelled out two proposed methods for calculating partners’ tax-based capital accounts to satisfy the new requirements: the modified outside basis method and the modified previously taxed capital method. These methods were intended to replace the commonly accepted transactional approach. This represented a significant and abrupt change in policy, as prior IRS guidance said that the only permissible method was the transactional method.
Once again, the tax and business communities responded, and the IRS reversed its proposals. The most recent draft instructions once again state that partnerships filing Form 1065 for tax year 2020 must calculate partners’ tax-based capital accounts using the standard transactional approach.
For partnerships that already used the tax-basis method to calculate their partners’ capital accounts for 2019, the partner’s ending capital account balance for 2019 is entered as the beginning capital account balance for 2020. The ending balance for 2020 is then calculated by recording various 2020 transactions—such as additional capital contributions, withdrawals, distributions, and the partner’s share of net income or loss—using tax-basis principles.
For partnerships that have not been using the tax-basis method, the transition is more complicated. Such partnerships often do not have access to the many years of historical data that would be needed to reconstruct each partner’s capital account using a transactional approach.
These partnerships will need to recalculate their partners’ beginning capital account balance for 2020 using one of three permissible methods: the modified outside basis method, the modified previously taxed capital method, or the Section 704(b) method. The complex processes for applying these transition methods are described in the pending draft instructions. The ending balance for 2020 is then calculated using the standard transactional approach.
It’s not ideal to be awaiting instructions from the IRS at this date. However, the new rules bring benefits for both the IRS and partnerships. The IRS will receive improved data from partnerships, and partners will see greater transparency and clarity when it comes to calculating their capital via a single method.
New instructions for Form 1065 are one of many changes partnerships must navigate in what is already a tax season like no other. Contact Dembo Jones today for insight and assistance in complying with the new standard.