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IRS Takes a Proactive Approach to Partnership Tax Capital Reporting

The past two years have been a series of changing rules for many areas in tax, including capital account reporting for partnerships.

While most of the public doesn’t know that such a topic exists, tax practitioners across the country stare fearfully at the monumental tasks ahead of them. We will discuss the surprisingly proactive steps the IRS is taking to create a new, “simpler” reporting scheme.

Nearing the July 15 deadline of another historic busy season, practitioners find themselves staring at the task of converting partnership capital accounts to tax basis. Expecting that many partnerships had procrastinated on calculating tax basis capital accounts over the past two years, the IRS released Notice 2020-43 to propose two methods of calculating capital accounts. Labeling the typical method of tracing historical capital accounts as the Transactional Method, the notice provides the details of how an Outside Basis Method and Previously Taxed Capital Method operate.

As opposed to forcing new requirements with minimal guidance, it is a welcomed change of pace to have months of time to analyze the proposed methods and provide comments to the IRS. Each of the proposed methods follows similar calculations that accountants are familiar with calculating; outside basis and previously taxed capital. At first glance, both methods seem to provide the desired goal of creating an easy framework for calculating capital accounts while providing the IRS the information they are really seeking; partners’ ability to deduct losses and take distributions tax-free.

If you think your partnership could benefit from this proactive approach from the IRS, please contact a member of Withum’s Tax Group.

Many of the remaining questions in our minds relate to the logistics of accomplishing the reporting change. How will the forms bridge the gap between the 2019 capital accounts on GAAP, 704(b) or hybrid basis to the 2020 tax basis accounts? How will the balance sheet on the tax return tie to the capital account summary schedule, the M-2? Will the states accept the new methodologies of calculating tax basis capital?

The final question that practitioners face is how to convince clients that this is a worthwhile project that requires a number of trips to archived returns and costly fees? Besides providing a complete and accurate return that meets IRS standards, understanding a partner’s tax basis allows practitioners to plan for events that could cause unwanted tax consequences. Such events include disallowed losses, the recapture of losses taken against at-risk basis or capital gains on distributions in excess of basis.

Additionally, understanding tax basis assists in the calculation of gains upon sale of a partnership interest. Such a shift in reporting methods is very logical and probably should have happened a long time ago. At least taxpayers and practitioners are being given the opportunity to pick their poison this time in how they reach the end goal.

Author: Ian Taylor, CPA, MST | itaylor@withum.com

Business Tax Services

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