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IRSAC Chair Criticizes Complexity of Tax Capital Reporting Rules

AUG. 3, 2020

IRSAC Chair Criticizes Complexity of Tax Capital Reporting Rules

DATED AUG. 3, 2020
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August 3, 2020

Internal Revenue Service
CC:PA: LPD (Notice 2020-43)
Room 5207
P.O. Box 7604
Ben Franklin Station
Washington, DC 22044

The IRSAC appreciates the opportunity to provide comments on Notice 2020-43 Tax Capital Reporting-Notice Requesting Comments (the Notice).

Background

The Notice is intended to provide a consistent framework for all partnerships to comply with the tax capital account requirement and to reduce complexity of preparing partnership tax returns. The Notice allows two methods of calculating partner tax capital accounts: the Modified Outside Basis Method and the Modified Previously Taxed Capital Method. These methods are described in detail in the Notice. The proposal is for these changes to be effective for tax years ending on or after December 31, 2020. The Notice also eliminates the reporting of tax capital accounts using the Transactional Approach. Below, we provide feedback with regard to the Notice, including those topics with regard to which comments were specifically requested.

Whether the methods used to satisfy the Tax Capital Reporting Requirement described in section iii of the Notice should be modified or adopted:

Small Partnerships

Using either of the two methods provided in the Notice will add complexity to preparing tax returns rather than simplifying the preparation of partnership tax returns. For many small partnerships, this added complexity will be exceptionally burdensome given their limited resources.

With regard to the Modified Outside Basis Method, a partnership will now be required to obtain information from the partners if there has been a transaction outside the partnership such as basis changes in acquired interest or inheritance. Partners may be reluctant to share the basis in the acquired interest or the inherited interest. The Notice allows the partnership to rely on the partner basis information provided by the partners to avoid penalties on providing incomplete or inaccurate information. We appreciate this relief. However, even with a partnership making every effort to comply, no matter how administratively burdensome, not all partners will comply with the requirement to provide the information to accurately report the tax capital account using the Modified Outside Basis Method, which would result in the partnership not accurately reporting the tax capital account, which would frustrate the stated purpose of the Notice.

If the Modified Previously Taxed Capital Method is selected the partnership will to have make an annual calculation of the tax capital account assuming the partnership liquidated which will increase the cost of compliance with the provision and likely not be realistic for small partnerships.

Many small partnerships will find these methods administratively extraordinarily burdensome and costly to implement due to their limited resources. We believe that relief for small partnerships should be considered in the form of an exemption for small businesses to comply with the tax capital account reporting requirements (once a partnership no longer meets the definition of a small partnership, the partnership would be required to report the tax capital account), There is precedent for allowing an exemption from reporting tax capital accounts. Indeed, the Form 1065 Frequently Asked Questions (FAQ) Question 7 provides relief from reporting negative tax capital accounts for small partnerships that meet the following requirements:

  • The partnership total receipts for the tax year were less than $250,000

  • The total partnership assets at the end of the year were less than $1 million

  • Schedules K-1 were all furnished to the partners and filed with the return by the due date (including extensions) for the partnership return and

  • The partnership is not filing and doesn't have to file Schedule M-3.

In the experience of those members of the IRSAC whose practice provides perspective in this area, the threshold for exemption under FAQ 7 for reporting negative tax capital accounts is too low to capture many small partnerships. Listed below are three alternative options for defining a small partnership eligible for an exemption:

a. A partnership that meets the gross receipts test of Code Section 448(c) without treating a syndicate as a tax shelter as defined in Code Section 448(c)(3)(C) and 1256(e)(3)(B) (the syndicate provision). The syndicate provision treats as tax shelters, among others — (i) Many real estate entities which are heavily financed and create losses from interest expense and bonus depreciation (ii) Other small businesses that experience operating losses due to the accelerated depreciation methods, including bonus depreciation and (iii) Some start-up businesses. These business partnerships should not automatically be excluded from a small partnership exemption.

b. A partnership that is not required to file Schedule M-3. Schedule M-3 is required when total assets are $10 million or more or total receipts are $35 million or more.

c. A partnership that has fewer than 25 partners.

Effective Date for Implementation

The current due date is for capital account changes to be made for partnership returns beginning with year-end December 31, 2020. The proposed requirement for partnerships to change the methods available for reporting the tax capital account differs significantly from the current reporting methods and is going to involve a lot of time and effort collecting information to meet the new reporting options. Converting to the Modified Outside Basis Method will require the partnership to contact each partner for the outside basis. Not all partners may respond on the first request and partnerships must follow up with each nonresponding partner. Current business economic and matters due to COVID-19, never seen before or expect to be seen again, have disrupted partners and tax practitioners' operations. The focus has been on 2019 tax compliance, implementing recently enacted legislation, and business operations.

The effective date for reporting tax capital should be delayed. Some options to consider are:

1. Delay reporting the requirement to partnership tax returns beginning with year-end December 31, 2022. This gives the partners and tax practitioners time to meet the administrative task of collecting and reporting the information to the IRS.

2. Require the partnership to report the information formed for partnerships as of a certain date. This option would reduce the compliance burden of reconstructing existing partnership capital accounts. This option is similar to the way the IRS implemented the basis reporting requirements for stock and security transactions.

3. Phase in the tax capital account reporting requirements starting with large partnership for tax year 2022. Other partnerships would be phased in over a subsequent two-year period. A large partnership could be defined as one required to file Schedule M-3 or based on the number of partners in the partnership.

Administrative Issues

The partnership tax return includes a balance sheet that may be prepared using a nontax basis methodology. Currently, Form 1065, Schedule M-2 and the Schedules K-1 capital account balances reconcile to the capital balance on the balance sheet. Changing the Schedule K-1 capital account reporting to tax capital will require the partnership to prepare a reconciliation between the balance sheet and the Schedules K-1 which would change Schedule M-2. By using different methodologies to report the capital account on the various schedules, the result may lead to more reporting errors. The tax return preparer is confident the information reported on the Schedules K-1 is accurate if the capital accounts on the Schedules K-1 reconcile to the balance sheet. This procedure will no longer be available if the Schedules K-1 uses a different reporting methodology for capital.

Partnership capital accounts on the Schedule K-1 start with the ending balance from the prior year. The prior year ending capital account balance may not be the tax capital account which will add confusion.

There is a tremendous amount of information reported on the Schedule K-1 line 20. We encourage the IRS to consider the proposals below to address some of the administrative complexities associated with Tax Capital Reporting:

1. Initial Basis Tax Capital Account Reporting: Allowing partnerships to determine the initial tax basis capital account as of the beginning of the effective date year by converting the balance sheet (which is presumably reported in accordance with Generally Accepted Accounting Principles (GAAP)) to tax basis by adjusting it for tax adjustments reported on Schedule M-1 or Schedule K-1 could facilitate the reporting changes.

2. Supplemental Information Reporting for Tax Capital Accounts. Leaving the capital account procedures in place permit the Schedule K-1 and balance sheet to be reconciled with the use of Schedule M-2 and report the tax capital as:

a. supplemental information on the Schedule K-1, adding a code to line 18 to indicate the difference between the balance sheet capital account and the Schedule K-1 capital account,

b. use item J of the Schedule K-1 if the information reported there doesn't provide information used by the IRS

c. use the space in the bottom right hand portion of the first page of the Schedule K-1 or

d. have the Schedule K-1 include a reconciliation of the balance sheet capital account and the Schedule K-1 capital account.

3. Expanding the Schedule K-1 to two pages with specific lines for many items reported on Line 20 would simplify reporting and correspond to the draft Form 1065 Schedule K-3 Partner's Share of Income, Deductions, Credits, etc. — International released on July 8, 2020, which moves many of the international related Schedule K-1 line 20 footnotes to a separate schedule.

4. Guidance should be provided on how to report the beginning capital account on Schedule K-1 when it differs from the ending balance from the prior year. The guidance may be that the beginning balance agrees with the prior year ending balance and a line is added to convert the opening balance to the tax capital balance.

5. Partner Reporting Changes: Having the partner report the initial purchase price or the fair market value of inherited interests on their filed tax return that included the transaction may encourage partners to inform the partnership to allow the partnership to properly use the Modified Outside Basis method.

6. New Basis Form: The 2019 instructions to Form 1065 Schedule K-1 include a worksheet for adjusting the basis of a partner's interest in a partnership. This worksheet could be used as a starting point to create a new form for the partner to calculate basis, include which would reporting the allowable deductible loss, taxable distributions and gain on sale or other disposition of the partnership interest. The form can be similar to Form 6198, At-Risk Limitations. The partner would use the tax capital account using the Transactional Approach provided by the partnership in completing the appropriate parts of the new form. The new basis form and Form 6198 can be linked to improve compliance with partner's obligation to keep track of basis and to properly apply the loss limitation rules and taxation of distributions. Placing the responsibility on the partner for keeping track of their basis would reduce the burden on the partnership to report transactions that happen outside the partnership. When a taxpayer has an investment in a partnership, this new form would assist the taxpayer with complying with the requirement to report basis. Taxpayers would need to be educated on use of the form. Form 1040 Schedule E Part II includes a note that if a taxpayer reports a loss, receives a distribution, disposes of stock, or receives a loan repayment from an S corporation, the basis computation is required to be attached to the tax return.

Whether the Transactional Approach, or similar method should be permitted for purposes of meeting the Tax Capital Reporting Requirement and, if recommended, what additional guidance would be necessary

We understand many commenters provided reasons not to use the Transactional Approach such as: partnerships may not have the information needed to comply, it would be costly to reconstruct the tax capital accounts using this approach, or that it would consume significant IRS resources to provide detailed guidance on how to modify the Transactional Approach for special situations. However, other commenters indicated many partnerships, including many small partnerships, maintain their capital accounts using the Transactional Approach

Many partnerships currently use the Transactional Approach in calculating tax capital accounts. The administrative burden and the cost of compliance capital for tax account reporting using the Transactional Approach is therefore reduced. Therefore, given that neither of the other methods is without infirmities (such as reliance on partner reporting and the difficulties in addressing transactions outside the partnership), to the extent it is possible reliability to ensure and consistency, it would be advisable to permit use of the Transactional Approach for all partnerships, including publicly traded partnerships. If small partnerships are required to report capital tax accounts, those partnership should have the options to use the Transactional Approach.

Conclusion

We appreciate your consideration of our feedback and welcome the opportunity to discuss these topics further. If you have questions, please contact me or Ben Deneka.

Sincerely,

Diana L. Erbsen
Chair, IRSAC
DLA Piper LLP (US)
New York, NY

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