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Attorney Discourages IRS From Issuing Partner Tax Capital Account Regs

NOV. 26, 2019

Attorney Discourages IRS From Issuing Partner Tax Capital Account Regs

DATED NOV. 26, 2019
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November 26, 2019

The Honorable Charles P. Rettig, Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

Re: Areas of Partnership Tax That Require Reform, Part 4: Draft Form 1065; Partner Tax Capital Accounts.

Dear Commissioner Rettig:

This fourth letter supplements my three previous submissions addressing ideas to improve partnership tax and partnership tax compliance. This letter addresses the pending Internal Revenue Service proposal to include partner tax capital account reporting on Internal Revenue Service Form 1065, U.S. Return of Partnership Income.

Uncertainty exists concerning the meaning of “partner tax capital accounts” in this context. I submit that Internal Revenue Service Form 1065 should use partner tax capital accounts based on the current capital account accounting rules of Treasury Regulations Section 1.704-1(b)(2)(iv) (with modification as required to eliminate book-tax differences) unless there is a compelling reason to do otherwise.

The Internal Revenue Service might embark on a large project to provide a detailed definition of “partner tax capital accounts.” I discourage this effort. The project could turn out to be a major project that would require years of effort. The project would exhaust significant personnel resources.

I discourage a proliferation of different capital account accounting rules and different capital account accounting systems. I also do not see a need to comply with the notice and comment rules of the Administrative Procedure Act in publishing Form 1065 and its instructions. To the best of my knowledge, notice and comment is not required for tax reporting rules (as opposed to substantive tax rules). Subjecting routine changes in tax return reporting rules to notice and comment would impose a substantial burden that would slow the responsiveness of the Internal Revenue Service. I, however, am not expert in the Administrative Procedure Act.

I am writing this letter on my own behalf and not on behalf of any other person or organization. No other person or organization shares responsibility for my comments.

I do represent partnerships that file tax returns on Form 1065, but I do not believe that their interests in the issues discussed in this letter are differentiated from the interests of any other partnerships filing Form 1065. I am not writing this letter on behalf of any partnership that I represent.

I do not prepare tax returns professionally. I have never prepared nor filed a Form 1065.

A heated controversy (among partnership tax practitioners, at least) exists concerning (i) whether partnerships have the ability to report partner tax capital accounts on Form 1065, and (ii) what does “partner tax capital account” mean?

I do not have useful comments on issue (i).

I am reasonably familiar with partnerships and partnership capital accounts as maintained for federal income tax purposes. I also have general knowledge of partnership taxation. My comments are limited to issue (ii).

You have received various comments from many wise tax practitioners concerning the ambiguity of the definition of “partner tax capital account.” This ambiguity is unfortunate. This ambiguity should be resolved and clarified.

One of my favorite books begins with the line: “Call me Ishmael.” The book tells a story of a man by the name of Ahab who scours the ocean in search of a whale — a white whale. Captain Ahab proposed to “chase him round Good Hope, and round the Horn, and round the Norway Maelstrom, and round perdition's flames before I give him up. And this is what ye have shipped for, men! to chase that white whale on both sides of land, and over all sides of earth, till he spouts black blood and rolls fin out.”

The search did not end well for Captain Ahab.

I learned from the book that time spent chasing white whales over all the oceans and around perdition's flames is not time well spent. A project of developing new rules for capital account maintenance of tax capital accounts could prove to be an enormous and fundamentally wrong-minded project that would waste scarce resources of the Internal Revenue Service. The project could turn out to be a search for a white whale.

One of the major regulations projects at Treasury and the Internal Revenue Service in the first half of the 1980's produced extensive regulations concerning substantial economic effect and capital account maintenance, with capital account maintenance rules now contained in Treasury Regulations Section 1.704-1(b)(2)(iv). These regulations included detailed rules concerning capital account maintenance that go on for many pages and that deal with many capital accounting issues. On the whole, Treasury and the Internal Revenue Service did a good job in designing capital account maintenance rules.

Both Treasury and the Internal Revenue Service devoted some of their best talent in the 1980's to this project. The authors of the capital account maintenance rules struggled over many examples of how to account for capital accounts. The regulations required the expenditure of an enormous number of hours in research, reflection, drafting, and explanation. The rules appeared as proposed regulations, were subjected to full notice and comment, and were published in final regulations.

Practitioners have spent many hours learning how to apply these capital account maintenance rules.

The capital account maintenance rules in the regulations are not perfect. Few tax rules are perfect.

Some ambiguities exist in the capital account maintenance rules, but at least we have final regulations, those regulations have been subjected to notice and comment, and we have substantial experience with capital account maintenance under the Section 704(b) regulations.

I discourage the Internal Revenue Service from embarking on a major project to develop new rules concerning partner tax capital accounts.

The Internal Revenue Service should look to the existing capital account maintenance rules contained in Treasury Regulations Section 1.704-1(b)(2)(iv). These rules would require only minor adjustment to produce “partner tax capital accounts.” The rules would be based on pure tax accounting. Assets would initially be debited with the adjusted tax basis of contributed assets rather than fair market value of contributed assets. Capital accounts similarly would initially be credited with adjusted tax basis of contributed assets. After this, capital accounts would be adjusted by taxable income, gain, depreciation, depletion, deduction, and losses and adjusted tax basis of distributions as provided in the Section 704(b) regulations' capital account rules (with modification to apply pure tax accounting principles). Computations would be based purely on federal income tax accounting items. All “book” adjustments and book-tax differences would be ignored. The rules would be based on pure tax accounting.

If a zero basis asset were distributed to a partner, no partner's capital account would be adjusted, regardless of the value of the asset. Section 743 and Section 734 adjustments would result in adjustments to capital accounts only as provided in the current capital account maintenance rules.

To the extent that the current regulations on capital account maintenance are not sufficiently clear or otherwise are deficient, those regulations should be amended and the lack of clarity or other deficiency corrected.

The Internal Revenue Service has not shared with the public how it plans to use its concept of “partner tax capital accounts” in examinations. Some have suggested that partner tax capital accounts are a surrogate for a partner's tax basis in his partnership interest. Tax capital accounts are not a good surrogate for a partner's basis in his partnership interest. If the Internal Revenue Service needs partnerships to report partner tax bases in their partnership interests, then the Internal Revenue Service should require reporting of partner tax bases in partnership interests.

The definition of “partner tax capital accounts” for Form 1065 should follow the use that the Internal Revenue Service will make of the information. My comments may be overridden by those considerations if the Section 704(b) regulations do not provide a good foundation for “partner tax capital account.

Otherwise, I discourage an expansion of the tax law by requiring reporting of a new type of capital account not solidly grounded in federal income tax principles and the capital account maintenance rules in the Section 704(b) regulations. Unless there is a compelling reason to introduce a new concept of partner tax capital accounts, that concept should be based on current capital account maintenance rules with adjustments based on federal income tax principles (and only minimal adjustments to eliminate the use of “book” principles provided for in the current regulations). For example, this concept of tax capital account would not permit rebooking of assets, except to the extent currently required for adjustment to capital accounts for basis adjustments under the current regulations.

To introduce a new concept of capital account not based on existing capital account maintenance rules (with minimal modification to base rules on tax inputs) would substantially add to the complexity of partnership taxation and increase the burden of accounting and tax return preparation.

Some feel that implementation of the reporting requirement for partner tax capital accounts should be deferred until it is possible to resolve ambiguities in adjustments under the Section 704(b) capital accounting rules. There always are ambiguities and uncertainties in the tax law. To the extent that the current capital account maintenance rules in regulations are ambiguous, those ambiguities should be corrected by amendment of the regulations.

I believe that, with slight conceptual modification to eliminate book-tax accounting differences, the Section 704(b) capital account adjustment rules provide reasonable guidance for tax capital account maintenance. I encourage Treasury and the Internal Revenue Service to seek to resolve ambiguities and uncertainties in the Section 704(b) capital account adjustment rules, but not as part of the project for Form 1065. I would not delay implementation of reporting of partner tax capital account until all of the ambiguities in the regulations have been resolved. Resolution of all ambiguities in capital account maintenance under the Section 704(b) regulations may take years. It already has taken more than 30 years. It may well take another 30 years — or many more years — before all ambiguities have been resolved.

Someone could spend a career pursuing ambiguities and uncertainties in the capital account maintenance rules and the Section 704(b) rules in general. Others can spend a career chasing a white whale “round Good Hope, and round the Horn, and round the Norway Maelstrom, and round perdition's flames.” It will be a long chase. I do not believe that the chase to find a new concept of partner tax capital accounts is merited. I also discourage adding a new set of capital account maintenance rules not based on existing capital account maintenance rules.

Others may object that partnerships do not currently have the accounting information necessary to report partner tax capital accounts. Some have objected about the administrative cost concerning reporting partner tax basis capital accounts.

I do not advise clients concerning preparing partnership tax returns, nor do I prepare or file any partnership tax returns myself. I do not have specialized information concerning the burden of complying with partner tax capital account reporting requirements.

I can provide no guidance concerning whether partner tax capital account reporting should be delayed — or altogether abandoned — on account of difficulties that partnerships may have in reporting the required information. I leave that issue to those much more knowledgeable than I am.

I do not have any special insight or comments on other issues that have been raised concerning the proposed new Form 1065 and its instructions or the need to delay implementation of the new Form 1065 for other reasons not addressed in this letter.

I am pleased to discuss these issues with your staff. They can call me at 626.441.5404. They can reach me by electronic mail at tcuff@loeb.com.

Very truly yours,

Terence Floyd Cuff
South Pasadena, CA

cc:
The Honorable David J. Kautter,
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Krishna Vallabhaneni,
Acting Treasury Tax Legislative Counsel,
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Michael Novey,
Associate Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue,
N.W. Washington, D.C. 20220

Jeffrey Van Hove,
Senior Advisor for Tax Policy Office of Tax Legislative Counsel,
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Bryan Rimmke, Attorney-Advisor,
Office of Tax Legislative Counsel,
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

The Honorable Michael J. Desmond,
Chief Counsel
Internal Revenue Service
1111 Constitution Ave., NW 3026 IR
Washington, DC 20224

William M. Paul,
Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Holly Porter,
Associate Chief Counsel (Passthroughs & Special Industries),
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

Clifford Warren,
Special Counsel,
Office of the Associate Chief Counsel (Passthroughs and Special Industries)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

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