The Internal Revenue Service (“IRS”) has recently released guidance regarding methods for reporting partnership tax capital accounts. Partnerships & limited liability companies filing Form 1065 for tax year 2020 must calculate partner capital accounts using the transactional approach for the tax-basis method. According to IRS data, most partnerships already use the tax basis method, but previously partnerships could report capital accounts determined under multiple methods. Starting in tax year 2020, partnerships will only be able to report under one method. Reporting using only one method assists the IRS in assessing compliance risk, and identifying potential noncompliance, while ensuring that compliant taxpayers’ returns are less likely to be examined. The method partnerships will be required to use depends on whether or not they prepared Schedules K-1s under the tax basis method in 2019.
On June 5, 2020, the IRS released an advance version of Notice 2020-43 (the “Notice”) to seek public comment on a proposed requirement for partnerships. Then on October 22, 2020, the IRS released an early draft of the instructions for Form 1065, U.S. Return of Partnership Income which incorporated these proposed requirements. The IRS plans to issue final instructions in December.
Changes under Notice 2020-43 & the Updated Form 1065 Instructions
Partnerships that did not prepare Schedules K-1 under the tax basis method for 2019 or otherwise maintain tax basis capital accounts in their books and records (for example, for purposes of reporting negative capital accounts) will need to calculate partner’s tax basis capital accounts using one of the two alternative methods provided for in the Notice. These taxpayers will need to use either the Modified Outside Basis Method or the Modified Previously Taxed Capital Method to calculate their beginning tax basis capital accounts for tax year 2020. Starting in tax year 2021 these taxpayers will need to report tax basis capital accounts using the tax basis method. Partnerships that have always reported using the tax basis method for partners’ capital will not need to use one of the alternative methods proposed in the Notice.
In order to promote compliance with the tax-basis method, the IRS intends to grant penalty relief for the transition to the new rules in 2020. The relief will provide that solely for the 2020 tax year, the IRS will not assess a penalty for any errors in reporting a partnership’s partners’ beginning capital account balances on Schedules K-1 if the partnership takes ordinary and prudent business care in following the form instructions to calculate and report the beginning capital account balances.
Individuals who are members of partnerships or limited liability companies that normally file a Form 1065 will want to check with their accountant to make sure that their partner capital account is being calculated correctly under the new reporting requirements. If you or your CPA have any questions regarding reporting requirements for partnership tax capital accounts, please feel free to give us a call at (404) 365-5682.