The coronavirus pandemic forced many rapid changes to the Internal Revenue Code to assist American taxpayers in economic recovery. However, some changes for 2020 were already in the making prior to the pandemic. One such change was the new IRS requirement for partnerships to report their partners’ capital accounts on a tax basis.
It used to be that partners had options when reporting their capital accounts to the IRS, and this resulted in a variety of computational methods. To create uniformity, the IRS now requires all partnerships to report their capital accounts on a tax basis starting with the 2020 tax year. While capital accounts aren’t always top of mind and don’t necessarily have a direct effect on taxable income, they can have far-reaching tax implications.
If a taxpayer historically had been computing capital accounts on a tax basis, then he or she will not need to change the way capital is reported on Schedule K-1 of the tax return. However, if a taxpayer had been using any other method to compute and report capital accounts, there are a few options for calculating starting tax basis capital accounts for 2020.
The first alternative method the IRS offers is the modified outside basis method. This method starts with the outside basis of each partner, provided either by the individuals or tracked by the partnership itself. Each person’s share of partnership debt and the net tax value of any Section 743(b) adjustments will then be backed out of the outside basis to arrive at that partner’s beginning tax basis capital.
The second method the IRS has prescribed for calculating beginning tax basis capital is determined by calculating what a partner would receive in a hypothetical liquidation of the partnership. This is known as the modified previously taxed capital method. Essentially, this method determines what each partner would receive if all partnership assets were sold, debts settled, and proceeds distributed to the partners. Because fair market value would be difficult to calculate for a hypothetical liquidation, the IRS allows a partnership to use one of the following alternatives: asset basis under Section 704(b), Generally Accepted Accounting Principles (GAAP), or the basis set forth in the partnership agreement for purposes of determining what each partner would receive in a liquidation. Note that partnerships that have not tracked the amount of historic Section 704(c) gain would have a difficult time applying this approach.
The third and final method for calculating beginning tax basis capital is the Section 704(b) method. The calculation under this method begins with each partner’s capital account as calculated under Section 704(b), then increases that amount by that partner’s share of built-in loss and/or reduces by that partner’s share of built-in gain in the partnership’s assets, should such built-in gain or loss exist. If a partnership has not been tracking its 704(b) capital accounts, this method would be difficult to implement.
While partnerships that have historically tracked their tax basis should have a relatively easy time calculating their beginning tax basis capital, partnerships that have not may have some more legwork to do before filing their 2020 return. The calculations above are complex and prone to errors, and an experienced tax professional should be engaged to ensure the accuracy of what will be a foundation for years of future returns.
If you would like to speak with a tax professional about filing taxes as a partnership, or if you would like assistance with any matter involving tax planning and strategy or business advisory, contact a PYA executive below at (800) 270-9629.