ALBUQUERQUE, N.M. — Partnerships and S corporations are called pass-through entities or flow-through entities because they essentially serve as a conduit for reporting income and loss to their owners. The entity files a return but reports each owner’s share of income and loss on a schedule K-1.
Losses that pass through from such an entity may not be claimed on the owner’s return if the owner lacks tax basis in their interest. Pass through entity tax returns are information returns. The returns show the IRS the operations of the entity and also show the owners’ shares of each reported item.
The pass-through entity’s return should then be informative. Each owner needs to know how to report their share of the income or loss reported by the entity. The IRS also thinks the return should be informative.
Sometimes IRS may want to know information that the owners do not consider important. In 2008 partnership returns added questions to identify aggressive tax-deferred like-kind exchanges using strategies commonly called “drop and swap” or “swap and drop.”
If the IRS decides that it needs additional information, it does not need to ask taxpayer permission to gather the information. The 2008 changes I mentioned just popped up on the returns for the year.
The 2008 question popping did not cause the tax preparer industry to have a cow, or even a smaller barnyard animal. The question could be easily answered. Sometimes people don’t want to answer the question, but it’s not hard to answer.
Ten years later, for the 2018 tax return, a new question popped up. This one did cause some cow having. Some of the cows are still stuck on the way out. The question? If a partner has a negative tax basis capital account, IRS wants to know what the amount is.
Some partnerships report these tax basis capital accounts on each partner’s schedule K-1. Those partnerships need not worry about this question because they already provide the information.
So the question is new only for partnerships that do not report tax basis capital. Partners’ capital must be reported, but there are three common alternatives used to report this item.
Partnerships that choose something other than tax basis still confront the new rules only if one or more partners has a negative balance at the beginning or end of a tax year. There are penalties for not reporting this.
Partnerships that have not previously reported tax basis capital may not know what the numbers are for each partner. The partnership may have been around for a long time. The 2018 question was a shocker for those partnerships.
IRS had to issue a Notice that waived penalties for 2018 returns that did not report negative tax basis capital. But the information must still be reported by March 15, 2020, and perhaps earlier if the partnership did not take full advantage of filing extensions.
Some partnerships are still scrambling to find this information. Getting the numbers right will likely raise professional fees for such a partnership. A tax preparer cannot simply accept whatever the partnership says the negative tax basis capital is — particularly if the preparer know this has never been tracked.
There are, of course exceptions. There are always exceptions. Partnerships with both less than $250,000 of gross receipts and $1 million of total assets are exempt from the reporting. But they must provide schedule K-1 forms to the partners on a timely basis to preserve the exemption.
The IRS has also released guidance regarding the computation of a tax basis capital account. The guidance says you can include special adjustments allowed by Sections 734 or 743 of the tax law in the tax basis capital. This is not normally done.
So even partnerships that have maintained tax basis capital accounts may need to tweak them a bit before reporting to the IRS.
Partnership taxation can be very complex. Sometimes for little benefit. A partnership tax expert described one such provision as “building a bear trap to catch a very small mouse.”
For many partnerships, the 2018 and beyond reporting obligation will cause construction of expensive bear traps for little critters. This will cause many preparers to have a cow. Ew.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.