Partnerships Beware: The IRS Wants You to Use Tax Basis Method for Capital Accounts

Partnerships Beware: The IRS Wants You to Use Tax Basis Method for Capital Accounts 

On October 22, 2020, the IRS released an early draft of the 2020 tax year instructions for Form 1065, U.S. Return of Partnership Income. The draft instructions reflect changes on the guidance on how partnerships should report each partner’s capital account on Schedule K-1 Items L, Partner’s Capital Account Analysis.

Draft instructions have some important changes
The draft instructions require that each partner’s capital account for the partnership’s 2020 tax year should be calculated using a transactional approach for the tax basis method. They also provide detailed descriptions of each line item on item L of Schedule K-1, Partner’s Share of Current Year Income, Deductions, Credits, and Other Items.

Since partnerships previously could report capital accounts determined under multiple methods (e.g. GAAP, section 704(b), or other), some partnerships may need to refigure the beginning capital account using the tax basis method for 2020. Therefore, for 2020 only, the IRS provides four alternative methods for partnerships to determine a partner’s beginning capital account – the tax basis method, the modified outside basis method, the modified previously taxes capital method, and the Section 704(b) method. The draft instructions describe these methods and include special rules for publicly traded partnerships to adjust a partner’s beginning capital account to reflect the transferee partner’s purchase price of the interest.

If the tax basis method was previously used, partnerships may simply enter the partner’s 2019 ending capital account on the line for the beginning capital account or provide an explanation if a different amount is reported.

The draft instructions also point out that section 743(b) adjustments are not considered in calculating a partner’s capital account under the tax basis method. If applicable, they should be removed from the partner’s capital account in the 2020 tax year and reported as a 2020 tax year other increase(decrease) item.

Potential Penalty Relief for Certain Errors
In the IRS News Release IR-2020-240 that announced the draft instructions, the IRS indicated that it will not assess a partnership a penalty for any errors in reporting its partners’ beginning capital account balances on Schedule K-1 if the partnership takes ordinary and prudent business care in following the form instructions to calculate and report the beginning capital account balances.

For more information or questions, please contact a member of the Herbein tax team, or email us at info@herbein.com.

Article Prepared By: Ada Zhang