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Tax Basis Reporting Calculations and Analysis

This article originally appeared in the April 2022 TaxStringer, a publication of the New York State Society of Certified Public Accountants.

The IRS directed partnerships to report capital accounts on the tax basis starting in 2020. In this article, author Dean L. Surkin, JD, LLM addresses the prior rule, why the IRS wasn’t happy, the change they wanted, how to process the transition, and the need to maintain both the former capital account and the IRS-prescribed method.

Overview

The partnership agreement determines each partner’s share of partnership items, provided it meets two requirements— the agreement must provide for allocation, and the allocation must have substantive economic effect. If the partnership agreement fails to meet either of these two, a partner’s “interest in the partnership” determines his share of partnership items. Code §704(b). A partner’s interest in the partnership is measured by his capital account. Furthermore, the Regulations measure substantive economic effect in great part by reference to the partners’ capital accounts [see, for example, Treas. Reg. 1.704-1(b)(2)(iv)].

Typical language in a partnership agreement may include the following:

Allocations of Profits and Losses. After giving effect to the special allocations provisions [relating to appreciated contributed property] and allocations equal to the distribution of cash flow, the Profits and Losses for each Fiscal Year (or portion thereof) shall be allocated to the Members in proportion to their capital accounts.

Limitation on Allocation of Losses. Notwithstanding [the preceding paragraph], the Losses allocated to any Member pursuant to this Article shall not exceed the maximum amount of Losses that can be allocated to that Member without causing or increasing an Adjusted Capital Account Deficit for such Member at the end of any Fiscal Year. All Losses in excess of the amount that may be allocated to that Member shall be re-allocated to any Member that would not have an Adjusted Capital Account Deficit as a result of the allocation, in proportion to their respective Percentage Interests, or, if no such Members exist, then to the Members in accordance with their respective Percentage Interests.

Capital Accounts. A Capital Account shall be established and maintained for each Member in accordance with Treasury Regulations Section 1.704-1(b)(2)(iv).

Here is an example that shows how that partnership agreement could be applied.

Lou and Bud are partners in Third Base Associations. Their capital accounts are $20 and $50 respectively, and they have agreed to share profits and losses equally. The partnership agreement specifies that if the allocated loss exceeds the capital account, it shall be allocated to the partner or partners will positive capital account.

Third Base incurs a loss of $80 in Year 1, and the preliminary allocation is $40 to Lou and $40 to Bud. However, the loss is first limited to capital accounts.

• Lou gets $20 of loss, reducing his capital to zero – $20 excess
• Bud gets all $40 of loss, reducing capital to $10

Of the $20 excess, $10 is allocated to Bud, and now Bud’s capital is also zero; there is $10 loss remaining. The remaining loss is allocated according to the agreement of 50-50, or $5 each

Total losses allocated to each partner are:

• Lou – $20 in the first step and $5 in the last step = $25
• Bud – $40 in the first step, $10 in the second step and $5 in the last step = $55

Practitioners are well aware that a partner’s basis can and often does differ from the partner’s capital account. Of particular relevance to this discussion is the treatment of contributed property. A partner’s basis in the partnership is increased by the partner’s basis in contributed property (Code §722). On the other hand, a partner’s capital account in the partnership is increased by the fair market value of contributed property [Treas. Reg. §1.704-1(b)(2)(iv)(b)(2)]. If the partnership fails to follow the Regulations regarding capital accounts, it runs the risk that the allocation of partnership items will not have economic effect and not be deemed to accord with a partner’s interest in the partnership [Treas. Reg. §1.704-1(b)(2)(iv)(a)].

Example: Kubelsky and Anderson agreed to be equal partners in JB Productions. Anderson contributed $1,000 cash and Kubelsky contributed a vintage Maxwell automobile that cost him $50 and had a fair market value of $1,000. Pursuant to the Regs, their capital accounts each amount to $1,000.

Why the IRS cares about tax-basis capital

A partner can only deduct his share of partnership losses to the extent of his basis in the partnership [Code §704(d]. The partner uses his end-of-year basis to make this calculation [Treas. Reg. §1.704-1(d)(2)]. The IRS has long been concerned that partners were deducting losses in excess of basis, but it was difficult to identify these situations because a partnership not only did not necessarily know the true amount of a partner’s basis; the basis also was not reflected on Form 1065 or Schedule K-1.

The IRS realizes that using GAAP capital – valued at fair market value (FMV) – could easily lead to loss allocations in excess of basis. The IRS decided that it would focus its compliance efforts on situations where one or more partners has negative capital, because negative capital may mean insufficient basis to deduct the entire allocated loss (2021 NYU Institute on State & Local Taxation §4.05[1]; FY 2022-2025 Department of the Treasury Learning Agenda, p. 9).

History of recent reporting changes

Over the past few years, the IRS has issued, revised, withdrawn, revised again, and reissued new reporting requirements that it believes will help enforce the loss limitations of Code §704(d).

The IRS derives its authority to issue reporting requirements from Code §6031(b) which says that taxpayer must provide the information “as may be required by regulations.” The Regulations include the comment:

“to the extent provided by form or the accompanying instructions, [taxpayer must provide] any additional information that may be required to apply particular provisions of subtitle A of the Code to the partner with respect to items related to the partnership”

[Treas. Reg. §1.6031(b)-1T(a)(3)(ii)]

Capital accounts are reported on Item L of Schedule K-1 (Form 1065) and Item F of Schedule K-1 (8865 relating to foreign partnerships).

Prior to 2018, capital accounts could be reported using one of these methods:

• Tax basis;
• GAAP;
• Section 704(b) book; or
• Other

Then in 2018, two new paragraphs appeared in the instructions for Item L, Schedule K-1 (1065).

If a partnership reports other than tax basis capital accounts (i.e., GAAP, section 704(b), book, or other) to its partners in Item L, and tax basis capital, if reported on any partner’s Schedule K-1 at the beginning or end of the tax year would be negative, the partnership must report on line 20 of Schedule K-1, using code AH, such partner’s beginning and ending shares of tax basis capital. This is in addition to the required reporting in Item L.

For Item L, “tax basis capital” means (i) the amount of cash plus the tax basis of property contributed to a partnership by a partner minus the amount of cash plus the tax basis of property distributed to a partner by the partnership, net of any liabilities assumed or taken subject to, in connection with such contribution or distribution; plus (ii) the partner’s cumulative share of taxable loss and nondeductible, noncapital expenditures.

That definition of “tax basis capital” looks a lot like the basis calculation required by Code §705 without regard to Code §752, which treats increases or decreases in liabilities as cash contributions or distributions.

These instructions bear some of the indicia of a first draft: they have potential ambiguity and they do not completely address the issues. The phrase “shares of tax basis capital” implies that the partnership calculates capital on an aggregate basis and then apportions it among the partners. This does not follow partnership law, because capital accounts should be computed independently for each partner. The following example illustrates the potential for incorrect interpretation:

Fred and Ginger form the Heels and Backwards partnership. The operating agreement states that they are equal partners, with respective shares of capital, profits, and loss 50% each. Fred contributes cash in the amount of $100 and Ginger contributes a building with a basis $40 and fair market value of $100.

The tax basis capital of the partnership is $100 cash + $40 adjusted basis of contributed property = $140.

If we use the percentages in the operating agreement, Ginger’s share of tax basis capital is 50% of $140, or $70. Fred’s share of tax basis capital is also $70.

But if we look at Fred’s and Ginger’s bases, the actual numbers are $100 for Fred and $40 for Ginger. The instructions do not provide for differences among the partners.

Having issued the new instructions for Schedule K-1, the IRS needed a way to encourage practitioners to follow them. As a practical matter, it also had to address situations where partnerships filed the returns before IRS guidance clarified the potential ambiguities. The IRS issued Notice 2019-20, which styled itself a waiver of penalties.

The Notice states that the IRS will impose penalties for failure to include information about partners’ negative tax basis capital accounts for taxable years beginning after 12/31/2017 and before 01/01/2019 (i.e., returns filed using the 2018 Form 1065). The contemplated penalties are:

sections 6722 (failure to furnish correct payee statements); 6698 (failure to file partnership return); section 6038(b) and (c) (failure to furnish information with respect to certain partnerships)

These penalties can be significant for larger partnerships.

• §6722: $250 per statement to a maximum of $3 million (lower limits for smaller partnerships), adjusted for inflation to $290 for 2022
• §6698: $195 per partner per month, adjusted for inflation to $220 for 2022
• §6038: $10,000 per annual accounting period

Notice 2019-20 waives the penalty if the partnership files a notice within one year after original, unextended due date, a statement captioned “Filed Under Notice 2019-20.” The statement should be sent by mail to an IRS office in Ogden, UT. (We now know that the IRS has accumulated 5.8 million unprocessed pieces of mail since the state of the pandemic, https://www.washingtonpost.com/politics/2022/02/11/irs-returns-backlog/ retrieved 02/21/2022, but that wasn’t a consideration when the IRS issued Notice 2019-20.)

The Notice must contain:

a. the partnership’s name and Employee Identification Number, if any, and Reference ID Number, if any;
b. the partner’s name, address, and taxpayer identification number; and
c. the amount of the partner’s tax basis capital account at the beginning and end of the tax year at issue.

For the following year, the IRS issued draft instructions for 2019 requiring a partnership to report capital accounts on Schedule K-1 using tax-basis capital. This was a huge administrative burden, and when tax professionals explained the situation to the IRS, the IRS issued Notice 2019-66 to delay this to 2020.

The following year, Notice 2020-43 proposed two methods for complying with tax capital reporting. The IRS explained their concerns leading to this proposal. Considering partnerships that have been reporting capital accounts on the tax basis, using the transactional approach, the IRS anticipated that the transactional approach may not have been consistently applied.

The IRS described the transactional approach as having two steps.

• Increase tax capital account by amounts of money and tax basis of property contributed (less any liabilities assumed by the partnership or encumbering the property), plus partnership income or gain; and
• Decrease by amount of money distributed and tax basis of property distributed (less any liabilities assumed by the partner or encumbering the property), plus loss or deductions

The Notice proposed two methods to comply with tax-basis capital—the Modified Outside Basis method, or the Modified Previously Taxed Capital method.

Under the Modified Outside Basis method, the partnership determines, or the partner provides, the partner’s adjusted basis in the partnership interest, and subtracts the partner’s share of partnership liabilities. The partner must notify the partnership of any change in basis (other than contributions or distributions, etc., of which the partnership would have records). The partner must notify the partnership within 30 days or by end of partnership’s taxable year, whichever is later. The partnership may rely upon information provided by partner unless it has knowledge of facts indicating that the information is clearly erroneous.

Under the Modified Previously Taxed capital method, which refers to the definition of previously taxed capital that appears in Treas. Reg. §1.743-1(d)(1), the tax-basis capital account equals:

• The amount of cash the partner would receive on liquidation of the partnership following a hypothetical transaction, increased by
• The amount of tax loss (including any remedial allocation under Treas. Reg. §1.704-3(d) that would be allocated upon a hypothetical transaction]; decreased by
• The amount of tax gain [(including any remedial allocation under §1.704-3(d) that would be allocated upon a hypothetical transaction].

For purposes of this calculation, “hypothetical transaction” means the disposition by the partnership of all its assets in a fully taxable transaction for cash equal to their FMV. If the partnership can’t determine the FMV, it can use a consistent measurement such as GAAP basis or Code §704(b) basis. All liabilities are treated as nonrecourse.

The Notice provides an example of how this works. Although it skips a number of steps in its logical structure, it does provide some guidance. The partnership in the example has the following assets and liability:

Cash	$500
Inventory	$1,000
Equipment	$500
Land	$1,000
Total assets	$3,000
Long-term loan		$5,000

Every asset’s book basis equals its tax basis. The IRS example did not include a balanced balance sheet; presumably the partners’ capital account is a deficit in the amount of $2,000.

The IRS concludes that the partners receive no cash, because it has to be used to pay the loan, and that the partnership has $2,000 of hypothetical gain. Thus, IRS seems to say that all the assets are sold for the amount of the loan and the proceeds are used to pay off the loan. In other words, $5,000 amount realized exceeds $3,000 basis by $2,000, so gain equals $2,000.

Applying this to the three steps described above:

Amount of cash = zero; plus

Amount of tax loss = zero; minus

Amount of tax gain = $2,000

Total = ($2,000)

The two equal partners each have a negative capital account of $1,000.

A partnership that is just starting to use tax basis capital accounts can use either of the two methods or may use the §704(b) method to determine the beginning-of-year (BOY) capital account. For 2020, if a partnership is using tax basis capital accounts for the first time, it must attach a statement showing which method was used to compute the BOY capital account. Note that the Modified outside basis method, which requires information about the partners’ outside basis, would require partnerships to maintain records that they never previously had to maintain.

The IRS planned similar revisions, as applicable, to Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships. https://www.irs.gov/newsroom/irs-releases-draft-form-1065-instructions-on-partner-tax-basis-capital-reporting Retrieved 11/12/2021.

Considering the novelty and complexity of these rules, the IRS issued Notice 2021-13, which gives penalty relief for partnerships if they took ordinary and prudent business care in following the Form 1065 instructions for 2020.

Ramifications and examples

Code §704(b) regulations permit (and many operating agreements require) capital accounts to be revalued to fair market value upon trigger events (e.g., entry of new partner). See Treas. Reg. §1.704-1(b)(2)(iv)(f). These revaluations do not affect the tax basis capital account

Example: Kubelsky and Anderson are equal partners. Anderson contributed $1,000 cash and Kubelsky contributed a vintage Maxwell automobile that cost him $50 and had an FMV of $1,000. The operating agreement contains a provision that capital accounts shall be determined according to FMV.

The IRS instructions explain how this should be reflected on Form 1065, Schedule L – Balance Sheet per Books.

The balance sheets should agree with the partnership’s books and records. Attach a statement explaining any differences. There are additional requirements for completing Schedule L for partnerships that are required to file Schedule M-3. [See the Instructions for Schedule M-3 (Form 1065) for details.]

***

For partnerships required to file Schedule M-3, the amounts reported on Schedule L must be amounts from financial statements used to complete Schedule M-3.

Here is the balance sheet for Schedule L:

Cash	$1,000
Maxwell	$50
Unrealized gain on Maxwell	$950
Total assets	$2,000
Capital – Kubelsky		$1,000
Capital – Anderson		$1,000
Total capital		$2,000

BOY tax-basis capital accounts are Kubelsky, $50 and Anderson, $1,000.

A partner who purchases partnership interest from another partner takes carryover tax-basis capital account. The tax-basis capital account will no longer have any connection to the partner’s outside basis in their partnership interest.

Example: Moe, Larry, and Curly are equal partners. Their bases equal their capital accounts of $15K each. The partnership has been successful and has $15K of unrecorded good will. Curly retires for health reasons and sells his partnership interest to Shemp for $20K. Shemp’s tax-basis capital account is $15K, but his basis in the partnership is $20K.

This partnership has a provision in the operating agreement that capital accounts shall be revalued to FMV upon the entrance of a new partner. The balance sheet looks like this:

	Assets	Liabilities & Capital
Miscellaneous assets	$45
Unrecorded goodwill	$15
Total assets	$60
FMV capital		$60

The revaluation to FMV gives each partner a capital account of $20, but the tax-basis capital account remains $15 each.

The next example illustrates the reporting on Schedule K-1.

Example: Stan and Ollie have a partnership, Sons of the Desert, that was formed in prior to the 2018 instructions on tax-basis capital account (the partnership was formed in 1927). They maintained capital accounts on the GAAP basis; the balance sheet for 2019 looks like this:

	Assets	Liabilities & Capital
Cash	$300
Accumulated depreciation	$1,000
Total assets	($600)
Total assets	$700
Liabilities		$300
Capital – Stan		$200
Capital – Ollie		$200
Total liabilities & capital		$700

Stan’s 2019 Schedule K-1, Part L:

Beginning capital account
Capital contributed during the year
Current year net income (loss)
Other increase (decrease)
Withdrawals and distributions
Ending capital account	$200

Prior to the tax-basis capital account rules, we would expect the 2020 BOY capital to equal the end-of-year (EOY) 2019 capital.

Stan’s 2020 Schedule K-1, Part L

Beginning capital account	$200
Capital contributed during the year
Current year net income (loss)
Other increase (decrease)
Withdrawals and distributions
Ending capital account

For 2020, the Sons of the Desert decides to use the modified outside basis method. Stan discloses that his outside basis is $250, and his share of the liabilities is $150. Stan’s tax-basis capital account is $250 less his share of liabilities = $100.

Stan’s 2020 Schedule K-1, Part L

Beginning capital account	$100
Capital contributed during the year
Current year net income (loss)
Other increase (decrease)
Withdrawals and distributions
Ending capital account

The partnership should include an attachment to Schedule K-1 that explains the discrepancy between EOY 2019 and BOY 2020 (i.e., one of the statements attached to explain details of the various lines). Here’s a sample I pulled from a client’s files:

Due to changes in partnership reporting requirements for Form 1065, Schedule k-1, the beginning capital reported under item l of your 2020 Schedule k-1 may differ from the ending capital reported under item L of your 2019 Schedule k-1. The capital account information on your Schedule k-1 is now presented using the tax basis capital method. The tax capital amounts reflected under item L of your Schedule k-1 do not represent your adjusted tax basis (“outside basis”) and should not be used to determine your adjusted tax basis (“outside basis”). Please consult your tax advisor.

Summary

Although the 2020 tax season has passed, the issue of properly transitioning from book basis capital accounts to tax basis capital accounts is still relevant, as we may be required to file amended returns for our clients.

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Dean L. Surkin, JD, LLM, is a tax director at Gettry Marcus CPA, P.C. He is a tax attorney with broad-based experience in tax planning and research, has litigated major cases in the fields of taxation, probate, and general commercial matters, and has been peer-reviewed by Martindale-Hubbell. He is admitted to the New York State Bar, the Federal District Courts of the Southern and Eastern Districts of New York, the Second Circuit Court of Appeals, and the U.S. Tax Court. Mr. Surkin holds the faculty appointment of Professor (Adjunct) at Pace University Graduate School of Business where he teaches taxation of entities. He was recently honored for 35 years of service to Pace.

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