Partnership tax filings are pushing 4 million per year. They are the fastest-growing form of business entity. Approximately 70% of partnerships are limited liability companies, and 50% are real estate entities.
Partnerships do not pay tax. They instead pass their income and losses through to their owners, who are called partners or members. The partnership tax return, IRS Form 1065, is simply an information-reporting document.
Partners receive a Schedule K-1 that reports their share of entity income or loss and reports other information that the partner may need to properly report his or her share of the partnership’s income.
Over the years, the volume of information reported on a K-1 form has dramatically increased. What used to be shown on lines on the form has now expanded to include boxes. Boxes can convey more information because the number in the box may be accompanied by a lettered code that identifies what it is.
The IRS wants to know certain details about the partnership’s information filings. So the expanded reporting on the K-1 form has been motivated by things the IRS wants to know about.
One thing that catches the IRS’ attention is the partner’s tax basis in his or her interest. This basis limits the amount of losses that the partner may deduct and also determines whether cash distributions are taxable in the year received.
Each partner’s tax basis has not been required to be reported on the K-1 form. IRS decided it really wanted to know if a partner might have a current year tax effect (limited loss or taxable cash distribution) from not having enough basis.
Partner K-1 forms include an annual reconciliation (beginning to end) of the partner’s “capital account.” I placed that term in quotation marks because there are multiple ways of calculating a capital account. So the K-1 form asks, how are you determining this capital account you report?
Capital accounts can be tax basis, GAAP (generally accepted accounting principles), Section 704(b) (book), or simply “other.” The most useful capital accounts for tax purposes are – drum roll – tax basis. The second most useful are Section 704b book basis – these are economic-based.
Up through 2017 any of the four methods (really infinite with “other”) were acceptable for inclusion on the K-1. Partnerships could keep multiple capital accounts – the IRS just wanted to know which method was reported on the K-1.
Tax experts would tell partners that it is useful to have both tax basis and Section 704b basis capital. One reflects the tax effects of partnership transactions, the other the economic effects.
Partnership tax law allows allocations of profit and loss to be made by agreement among the partners, but only if the allocations have “economic effect.” The Section 704b (economic) capital reflects the economic effect.
Allocations that match the Section 704(b) capital entries have economic effect and will be respected by the IRS. Tax items that differ from the economics cannot be allocated by agreement. Instead they relate to gains and losses that existed before the partnership was formed or before one of the partners joined an existing partnership.
These “built-in” items could arise because a partner contributed property with a fair value in excess of its tax basis. The inherent gain is shifted to the partnership but it really belongs to the partner who brought that property to the partnership. It creates a Section 704b book and tax difference.
Beginning in 2018, IRS required that a partnership report any negative tax basis capital account of a partner. This surprised people, and IRS had to allow a delayed reporting date. In 2019 the draft K-1 form required tax basis capital, whether positive or negative, for all partners. Big surprise.
Well, now IRS has had to delay the 2019 tax basis reporting for all partners. Negative capital still must be reported. But the reporting for positive capital is delayed until 2020.
So you’re saying, “Blah, blah, blah, Hamill.” Don’t deny it – I heard you. But any partnership you may be involved with – and New Mexicans love partnerships – will need to gather and report tax basis capital data. This may raise the time to prepare a partnership return – and the fees.
Now you’re listening.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.