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Bumpy tax season ahead for partnerships

Jim HamillALBUQUERQUE, N.M. — As you are enjoying your February, many tax professionals are … probably not.

You probably think they are working on your tax return. More likely they are first pushing out partnership and S corporation returns.

New Mexico has a higher percentage of businesses operated as partnerships than the nation as a whole. This often includes real estate operations, but also many operating businesses formed as limited liability companies taxed as partnerships.

Partnerships are called “pass through” entities because the entity passes its income and deductions on to the owners. The partnership form of operation is growing faster than any other.

The IRS plans to significantly increase the audit rate of partnerships. That’s smart. Partnership-level audit adjustments will cause the partners’ liabilities to increase.

Partnership tax returns provide information to the partners. IRS also gets this information. Beginning last year, IRS started asking for new information items to help it do its job. Tax professionals did not always have this new information.

The information gap will be a growing concern. More information is being requested on 2019 partnership returns and even more will be asked in 2020. Are you are partner in any partnerships? If so, your tax professional will likely need to spend more time to gather information to do your return.

A partner’s equity investment is generally marked by a capital account. There are different types of capital accounts. Some partnership agreements require something called “Section 704(b) book” capital. This type of capital helps decide how to allocate income and loss and how to distribute assets on liquidation.

A “tax basis” capital account can also be maintained. This type is very useful to track a partner’s tax basis in their investment. Tax people like to see this one. The IRS likes to see this one.

Beginning in 2018, IRS required partnerships to report any partners who have a negative tax basis capital. Not all partners, or their tax professionals, knew this information. So IRS said there would be no penalties if this information was provided by March 15, 2020.

Many tax professionals trying to work on 2019 tax returns are also trying to satisfy this March 15 deadline for 2018 partnership returns.

Beginning in 2019, IRS proposed to require all partnerships to report tax basis capital for all partners. Tax professionals howled in protest and this was deferred until 2020 returns. But that makes 2019 a crazy year because the tax basis capital information needs to be pulled together later this year to satisfy the 2020 requirement.

Sometimes partners contribute property to a partnership that has a fair value more or less than its tax basis. Partnerships must track this difference. Tax allocations by the partnership cannot shift this “built-in” gain or loss to anyone but the partner who contributed the property.

Beginning with 2019 tax returns, partnerships must report the amount of each partner’s built-in gain or loss. The easiest way to do this is to compare a partner’s Section 704(b) capital with his or her tax basis capital.

Take the difference between a partner’s Section 704(b) capital and tax capital and, ba-da-bing, ba-da-boom, you’ve got the amount of the built-in gain or loss to report on the 2019 tax return.

But you need to have both types of capital to do this. And we already know, from the previously discussed tax professional howling, that many people do not know the tax basis capital. Many also do not know the Section 704(b) capital.

There is no delay in reporting the dollar amount of each partner’s built-in gain or loss. No amount of howling will get a further delay in providing this information. So expect some wailing instead. Oh, and likely higher fees to prepare partnership returns.

Well, some professionals may say, we’re so busy we’ll just do the best we can and move on. But there’s a reason this information is being asked, and asked now. (See earlier statement about IRS raising the audit rate).

Tax professionals will have to increasingly defend the numbers on these partnership tax filings. What we sow in 2018 to 2020 we shall reap in later years. It’s important for the professional and the partners to understand the value of getting this information right.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at