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Tax Capital Reporting Proposal Falls Short, Accounting Firm Says

AUG. 3, 2020

Tax Capital Reporting Proposal Falls Short, Accounting Firm Says

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 20044

RE: Notice 2020-43 Comments

BDO USA, LLP is pleased to submit comments on Notice 2020-43 regarding Tax Capital Reporting. We appreciate that the IRS is attempting to provide guidance related to the computation of partner's tax basis capital accounts. While a significant step forward, we believe the proposed approaches fall short in several critical areas and may not be practical for many partnerships.

We intend to address the following topics and have included specific recommendations:

1. Timing of Notice and inconsistency with prior delayed requirements. Since early guidance from the IRS suggested a Transactional Approach would be available to partnerships for maintaining tax basis capital accounts, we recommend that partnerships be permitted to use the Transactional Approach to satisfy the Tax Capital Reporting requirement in addition to the other methods described in Notice 2020-43.

2. Potential to reach different conclusions under the proposed methods. In order to maximize the usefulness of information provided we recommend changing the Modified Previously Taxed Capital Method to require use of the current section 704(b) capital account balance as reflective of current fair market value. This will minimize potential variances in amounts reported under the available Tax Capital Reporting methods. If the Modified Previously Taxed Capital method is maintained as currently proposed, we respectfully request the IRS provide examples of ideal situations in which each method would be used and the IRS' goals in collecting the information.

3. Situations where partners do not provide outside basis information. We request that the IRS provide guidance on situations where the partner does not notify its partnership, in writing, of any changes to the partner's basis in its partnership interest during each partnership taxable year. Of particular concern is whether the partnership is allowed to report a tax basis of zero, adjusted for partnership income or loss, until the information is provided. If such zero assumption is not permitted, we respectfully request guidance as to how to determine this information in the absence of the timely provision of data by each of the partners.

4. Timing of information provided. We respectfully request guidance regarding specific steps partnerships should take in situations where partners fail to provide information as required under the Modified Outside Basis Approach. For example, where partner information is provided subsequent to the filing of a tax return, we do not believe an amended return to correct the reported tax capital balances should be required. Rather, we recommend allowing this information to be included in the subsequent year's tax return with a tax capital rollforward reconciliation.

5. Application to Publicly-Traded Partnerships. As described in more detail below, we recommend Notice 2020-43 be modified to exempt publicly-traded partnerships (PTPs) from the Modified Previously Taxed Capital Method and instead allow for the application of the Transactional Approach to tax capital reporting. Further, unless modification to the Modified Outside Basis Method is made to not require a purchaser of units on a secondary exchange to provide a written statement, we recommend Notice 2020-43 be modified to exempt PTPs from the Modified Outside Basis Method.

Timing of Notice and inconsistency with prior delayed requirements

For tax year 2018, partnerships were required to report whether any partner had a negative tax capital account at the beginning or end of the 2018 tax year. Detailed FAQs were published by the IRS in April 2019 to clarify how to compute tax capital for this purpose. Many practitioners were confused by the guidance and have questioned whether the IRS was trying to track a partner's outside tax basis or a partner's share of the partnership's inside tax basis. Due to the confusion created by this new reporting requirement, and the fact that many commentators communicated to the IRS that information was not readily available, relief was granted through Notice 2019-20.

In September and October 2019, the IRS released draft forms and instructions, respectively, for tax year 2019 that included a mandate to report partner capital accounts on Schedule K-1 (Form 1065) solely on the tax basis thereby eliminating the additional previous options of GAAP, Section 704(b) book, and “Other”.

In response to the change requiring all partnerships to report their partners' tax capital on a tax basis method, commenters stated that some partnerships might be unable to comply, either in a timely manner or ever. These commenters explained that partnerships that have not historically maintained partner tax capital accounts may face difficulties in calculating their partners' tax capital by means of a historical transactional analysis of events. In response to these comments, on December 9, 2019, the IRS issued Notice 2019-66 and provided a one-year delay in requiring the reporting of partner capital on the tax basis method.

The 2019 instructions for Form 1065 and Partner's Instructions for Schedule K-1 (Form 1065), like the 2018 instructions for these forms, require that a partnership reporting its partners' capital on a method other than the tax basis method report a partner's tax capital account at both the beginning and the end of the partnership's taxable year if either amount is negative with respect to the partner.

On June 5, 2020, the IRS issued Notice 2020-43 seeking public comments on proposed requirement for partnerships to use only one of two alternative methods to satisfy the Tax Capital Reporting Requirement with respect to partnership taxable years that end on or after December 31, 2020. Of note is that neither of the proposed methods follows a transactional approach to computing inside tax capital that has historical widespread use within the practice community (the “Transactional Approach”)1. Additionally, neither of the proposed methods is consistent with the method for computing tax basis capital as originally provided by the IRS in the April 2019 FAQs. While recognizing that in some part these proposed methods are designed to address the concerns of commentators who stated that historical transactional information may not be readily available in order to “roll forward” tax basis capital accounts, they are also punitive to partnerships who have been diligent in maintaining inside tax basis capital accounts utilizing a Transactional Approach. Partnerships that have either been maintaining tax basis capital accounts under the Transactional Approach or have begun to do so in anticipation of expected required reporting for tax year 2020 are now being asked to “start over” and compute partners' inside tax basis capital in a new and unexpected manner. For this reason, we believe it would be prudent to allow use of the Transactional Approach to satisfy the Tax Capital Reporting Requirement.

Potential to reach different conclusions under the proposed methods

The two proposed methods may, under certain and very common circumstances, yield different results. This may not allow the IRS to capture the useful information it intends via enhanced reporting. Consider the following facts:

In the formation of AB, LLC, a limited liability company taxed as a partnership, Partner A contributes depreciable appreciated property valued at $1,000 with a tax basis of $400. Partner B contributes cash of $1,000. The AB, LLC operating agreement provides that net profits and net losses are to be allocated equally between Partner A and Partner B. The partners have agreed to apply the Traditional method to Section 704(c) property. Assume the partnership does not have liabilities.

Assume the asset when placed in-service had a 10-year depreciable life, straight-line depreciation and that it is contributed to the partnership at the beginning of the sixth year of its depreciable life. Tax depreciation to the partnership for year 1 in this example is therefore $80. Section 704(b) depreciation is $200. AB, LLC has no other profit/gain or items of deduction/loss in year 1.

Section 704(b) depreciation for the year is allocated $100 to Partner A and $100 to Partner B. Partner B, as the noncontributor of the section 704(c) property, is allocated tax depreciation of $80. Application of the ceiling limitation rule under Reg. 1.704-3 creates a $20 shortfall in the allocation of tax depreciation to Partner B. Partner A is allocated $0 of tax depreciation.

At the conclusion of year 1, Partner A's section 704(b) capital account is $900. Likewise, Partner B's section 704(b) capital account is $900.

Under the proposed Modified Outside Basis Method, upon contribution, Partner A has a tax basis capital account of $400 and Partner B has a tax basis capital account of $1,000. At the conclusion of year 1, Partner A has a tax basis capital account of $400 and Partner B has a tax basis capital account of $920.

Under the proposed Modified Previously Taxed Capital Method, upon contribution, Partner A has a tax basis capital account of $400 and Partner B has a tax basis capital account of $1,000. At the conclusion of year 1, (depending on the particular assumptions used) Partner A has modified previously taxed capital of $420 and Partner B has modified previously taxed capital of $900. These amounts are determined assuming the fair market value of AB, LLC's assets is equal to the existing section 704(b) balance.

In this example, the variance between tax capital determined under the Modified Outside Basis Method and the Modified Previously Tax Capital Method is equal to the impact of the cumulative ceiling limitation. Additional variances could be caused by incorrect prior income or loss allocations as well as certain distributions of partnership property.

In addition to the forgoing, the fair market value assumption used in determining tax capital under the Modified Previously Taxed Capital Method can create anomalous differences that significantly impact the usefulness of the data reported. Consider the previous example but assume the fair market value of the partnership property is equal to the total adjusted tax basis of such property, i.e., $1,320. Under this assumption the partnership would recognize $0 gain or loss for tax purposes. Further, because the available cash on liquidation would equal $1,320, both Partner A and Partner B would be entitled to receive $660. Under the Modified Previously Tax Method formula, Partner A and Partner B would report a $660 tax capital balance.

Since each method may produce a different result, we question the usefulness of the information that the IRS is requesting. We recommend changing the Modified Previously Taxed Capital Method to require use of the current section 704(b) capital account balance as reflective of current fair market value. This will ensure the only variances between reported capital equal common differences, e.g., cumulative ceiling limitation amounts. We further recommend allowing for the use of the Transactional Method. If the Modified Previously Taxed Capital method is maintained as currently proposed, we respectfully request the IRS provide examples of ideal situations in which each method would be used and the IRS' goals in collecting the information.

Situations where partners do not provide outside basis information

The first sentence of the Modified Outside Basis Method description states, in part, “A partnership may satisfy the Tax Capital Reporting Requirement by determining, or being provided by its partners, the partner's adjusted basis in its partnership interest. It is also indicated at the end of the description of the Modified Outside Basis method that “a partnership is entitled to rely on the partner basis information that the partnership is provided by its partners unless the partnership has knowledge of facts indicating that the provided information is clearly erroneous.”

We request that the IRS provide guidance on situations where the partner does not notify its partnership, in writing, of any changes to the partner's basis in its partnership interest during each partnership taxable year. Of particular concern is whether the partnership is allowed to report a tax basis of zero, adjusted for partnership income or loss, until the information is provided. If such zero assumption is not permitted, we respectfully request guidance as to how to determine this information in the absence of the timely provision of data by each of the partners.

Timing of information provided

Under the Modified Outside Basis Method, a partner must notify its partnership, in writing, of any changes to the partner's basis in its partnership interest during each partnership taxable year other than changes attributable to contributions to and distributions from the partnership and the partner's share of income, gain, loss, or deduction that are otherwise reflected on the partnership's schedule K-1. Additionally, the partner must provide such written notification of such changes to the partner's basis within thirty days or by the taxable year-end of the partnership, whichever is later.

It is reasonable to assume that situations will arise where partners fail to provide information as prescribed above. We respectfully request guidance regarding specific steps partnerships should take in these situations. For example, where partner information is provided subsequent to the filing of a tax return, we do not believe an amended return to correct the reported tax capital balances should be required. Rather, we recommend allowing this information to be included in the subsequent year's tax return with a tax capital rollforward reconciliation. Further, to the extent such information is contained within a subsequent year tax return, we recommend such reconciling adjustments to be considered in any preceding tax year for purposes of determining imputed underpayment obligations under the centralized partnership audit regime.

Application to Publicly-Traded Partnerships

Notice 2020-43 specifically requests comments on how, if at all, the Tax Capital Reporting Requirement should be modified to apply to partnerships that are treated as PTPs under section 7704 of the Code. As the IRS is already aware, PTPs have thousands of investors who buy and sell regularly on a secondary market. A PTP obtains the majority of its partner investor information through broker data reports, including information on the price paid for units by an investor, and should not have need for written statements from individual partners that report the same information. Additionally, processing written statements from the thousands of transactions that occur throughout the year would be administratively impossible. Unless modification to the Modified Outside Basis Method is made to not require a purchaser of units on a secondary exchange to provide a written statement, we recommend Notice 2020-43 be modified to exempt PTPs from the Modified Outside Basis Method and instead allow for the application of the Transactional Approach to tax capital reporting.

A partner who chooses to liquidate its PTP units will sell the units on a secondary market as opposed to receiving a liquidating distribution of cash as contemplated under the Modified Previously Tax Capital Method. Further, PTPs have in place section 754 elections such that a purchaser who acquires units on a secondary market will always have a section 743(b) adjustment computed according to industry conventions. The convention uses the monthly low price for all purchases on a secondary market during the month. Therefore, if a goal of obtaining a tax basis capital account from the partnership for individual partners is to determine each partners' outside tax basis, most partners will have an outside basis under section 742 and adjusted under section 705 that is higher than what may be computed by adding a partner's section 743(b) adjustment to a partner's tax basis capital account. Thus, the Modified Previously Tax Capital Method will present information that does not reflect reality. For these reasons, we recommend Notice 2020-43 be modified to exempt PTPs from the Modified Previously Taxed Capital Method and instead allow for the application of the Transactional Approach to tax capital reporting.

Conclusion

We thank you in advance for your consideration of our commentary and welcome the opportunity to further discuss any specific questions you may have on our comments. Please do not hesitate to contact Jeff Bilsky at jbilsky@bdo.com or Todd Simmens at tsimmens@bdo.com should you wish to discuss.

FOOTNOTES

1 For purposes of these comments, under the Transactional Approach, a partner's tax capital is determined by means of a historical transactional analysis of events. In particular, partner tax capital is determined by applying the provisions and principles of subchapter K, including sections 705, 722,723, and 742, to relevant partnership and partner events.

END FOOTNOTES

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