Firm Criticizes Partnership Tax Capital Reporting Approach

June 5, 2020

David Kautter, Department of the Treasury
Michael Desmond, Chief Counsel, Internal Revenue Service
Charles Rettig, Commissioner, Internal Revenue Service
Holly Porter, Assistant Chief Counsel (PSI), Internal Revenue Service
Robert Crnkovich, Special Counsel, Assistant Chief Counsel (PSI), Internal Revenue Service
Clifford Warren, Senior Special Counsel, Assistant Chief Counsel (PSI), Internal Revenue Service

Commenst on IRS Notice 2020-43

Dear Messrs Kautter, Desmond, Rettig, Porter, Crnkovich and Warren:

Thank you for providing us with this opportunity to comment on IRS Notice 2020-43, which was released earlier today. Although we recognize and appreciate the government's very legitimate effort to capture information relating to partner capital account balances, we believe that the authorized approaches outlined in the Notice fail to take into account practical business considerations, and would lead not only to significant administrative costs relating to partnership tax compliance, but will also lead to the presentation of misleading information that would frustrate the governmental interest in requiring this information to be provided. Specifically, we believe that most partnerships would be unable to provide accurate “outside basis” tax capital information without making extensive inquiries of their partners, who may or may not actually be in a position to even provide such information. As a result, most partnerships would be required to apply the “inside basis” tax capital method, referred to as the “modified previously taxed capital approach” (the “modified PTC approach”), as provided in the Notice. As noted in the Notice, partnerships that report tax capital on an “inside tax basis” historically have determined such amounts by taking a starting point, based on the basis of property, net of liabilities, or the amount of cash, contributed to the partnership, and “rolling such amounts forward” by adding the partner's distributive share of income (including items that are exempt from tax) and subtracting the partner's distributive share of losses (including certain nondeductible expenditures) and distributions (the “transactional method”)

Being required to use the modified PTC approach in determining inside tax capital would create undue hardships for many partnerships, including any partnership that uses the traditional method in performing 704(c ) or reverse 704(c ) allocations. The traditional method is used by hundreds of our Firm's clients, and is undoubtedly thought of as the “go-to method” throughout the partnership tax community. Under the traditional method, a partner's inside tax capital account starts out being equal to previously taxed capital, but over time, as the built-in gain associated with contributed or revalued partnership property “burns off”, the partners' PTC amounts diverge from the inside capital amounts that they have historically been reporting using the transactional method. For example, assume a piece of 10 year depreciable property is contributed by a 10% partner at a time that it has a FMV of 100 and a tax basis of 40. The contributing partner will not be allocated any tax depreciation expense relating to this property, nor will it recognize any remedial or curative allocations as long as the partnership is using the traditional method. Instead, the other partner(s) in the partnership, who would bear the economic burden of 90 of book depreciation (90%* 100) would be allocated only 40 of available tax depreciation — with the remaining 50 of book depreciation being “ceiling limited”. Because it is allocated 0 tax depreciation, after 10 years, when the property is fully depreciated, and assuming no other income or loss is allocated to the contributing partner during such time, the contributing partner's capital account will remain at 40 under the transactional method. However, by such time, the built-in gain associated with the property will have “burned off” under section 704(c ). As a result, if the property holds its value until the end of its depreciable life, and is sold in the hypothetical transaction envisioned by the PTC rules, the contributing partner would be allocated only 10 of gain (i.e. 10% of the difference between the property's value [100] and its basis [0]). Thus, under the modified PTC approach, the partner's tax capital account would be 90 (i.e. 100 value less its 10 distributive share of gain upon the hypothetical disposition). Not only is this result inconsistent with the amount the partnership would determine using the transactional method, it also is an illogical and meaningless data point for all practical purposes. In fact, if the government's intention is to identify situations in which a partner has a negative tax capital account, the use of the PTC approach may have the undesired consequence of obscuring such a situation. For example, assume in the hypothetical fact pattern presented above, that the property had been subject to 80 of debt at the time it was contributed to the partnership. In that situation, the partner would have initially had a negative tax capital account of 40, but over time, as the built-in gain on the property was burned off, the partner's tax capital account would turn positive under the modified PTC approach, ending at positive 10 at the time the property is fully depreciated (net proceeds of 20 under the hypothetical sale construct reduced by 10 of gain allocable to the contributing partner, as described above). For these reasons, we strongly urge the IRS and Treasury to adopt an “any reasonable method” approach, or otherwise allow partnerships to use the “transactional method” in determining the partners' share of inside tax capital.

In fairness, to avoid this situation, the partnership could utilize the traditional method with “backend curative allocations”. Under that 704( c) method, the built-in gain would not just ”disappear” over time, as it does under the traditional method, but would, instead, be preserved to be allocated to the contributing partner at the time of the hypothetical sale transaction under the modified PTC approach, thereby making the 40 amount determined under the transactional method the correct amount to be reported. However, under Treas. Reg. 1.704-3(c ), a partnership is permitted to use this 704(c ) method only if it is provided for in the partnership agreement at the time the property is contributed ( or revalued). If the IRS and Treasury actually believe that some governmental interest is served by adopting the modified PTC method, rather than the transactional method employed by partnerships universally, we believe that at a minimum, any forthcoming guidance should allow partnerships that do not currently qualify to use this 704(c ) method to have a “one-time only” opportunity to adopt the traditional method with back-end curative allocations in connection with such guidance becoming effective. Such an “election” could be deemed to be made by using the transactional method in preparing the partnership tax return for the first year after such guidance goes into effect.

Again, we appreciate the opportunity to comment on this matter, and look forward to having the opportunity to work together to meet the needs of both the partnership tax community and the government's tax administrators.

Sincerely,

Glenn E. Dance, Partner, HCVT, LLP