There are approximately 4 million partnership tax returns filed annually, reporting income and loss to almost 30 million partners. Partnership tax entities, which include LLCs, are the fastest growing business form in the U.S.
The growth in number – and perhaps more importantly, in share of reported business income – of partnerships has piqued the interest of the IRS. Advance planning for future tax audits includes a focus on the partnership form.
Partnerships do not pay tax. But the partnership reports tax information to the 30 million partners who do pay tax. The growth in this form of operation has caused the IRS to ask for more information when partnerships file tax returns.
In 2018 IRS started to ask for more detail about partnership “capital accounts.” A partner’s share of capital often reflects how much of the partnership assets that partner owns.
Often is not always. One problem is that partnerships have many ways to report capital accounts. Up through the 2019 tax year there were three common ways to report: (1) Tax basis capital; (2) Section 704(b) capital; or, (3) GAAP basis capital.
Most partnerships chose (1) or (2). Number (2) is quite complicated with detailed rules spelled out in regulations. Number (1) has no rules. Beginning in 2018 IRS required tax basis capital for any partner who had a negative capital balance.
Beginning in 2020 IRS will require tax basis capital reporting for all partners. It is not clear why. The most likely reason is that IRS wants to know the tax basis of partners’ interests. That basis may help identify audit issues.
If IRS wants to know the basis of partners’ interests they could just ask for that information. In theory the basis of the interest is the sum of the partner’s tax basis capital and the partner’s share of partnership liabilities.
Partners’ shares of liabilities have long been reported on the partnership filings. So, again in theory, knowing the tax basis capital would allow a reconciliation to the basis of the interest.
The problem is that there are no rules as to how one computes tax basis capital, only theory and common practice. But different people adopt different practices, so that “common” may exist but “identical” and “consistent” do not.
So when IRS said it wanted tax basis capital the professional tax community went into shock. IRS implied it expected a specific way of reporting. No one knew what this way was.
IRS twice delayed the reporting requirement. Now it has issued a notice that discusses three ways of computing tax basis capital. One, called the “transactional approach,” adjusts capital for reported transactions.
Transactions are things like contributions, distributions, income and loss. It is what most tax preparers do. IRS says this approach is not allowed for 2020.
IRS says one of two ways may be accepted. But they are also asking for input from professionals. This input includes – should we stick with these two methods, should we amend the methods, and should we allows the transactional approach?
Method 1 is called the “modified outside basis method.” It requires the partnership to know, or for each partner to tell the partnership, the basis of each interest in the partnership. The capital account is then this known basis minus that partner’s share of liabilities.
Partners must inform the partnership of changes in their basis not reported by the partnership. Changes might be from a purchase, gift or inheritance of an interest. If the partnerships lacks this information it must use Method 2.
Method 2 is called the “modified previously taxed capital method.” It requires a hypothetical sale of partnership properties at the end of each year. The sale is at fair market value (FMV). If FMV is unknown the sale may be at Section 704(b) basis or GAAP basis. Often none of these numbers is known.
Method 2 computes tax basis capital as the cash received from the hypothetical sale, minus the gain allocated to the partner from the hypothetical sale, plus any loss allocated to the partner from the hypothetical sale.
Non-hypothetically speaking, I’ll bet you don’t understand this. Maybe your tax professional doesn’t either. But 4 million tax returns, for 30 million partners, will be affected by this.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.