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Draft Partnership Form Raises Red Flags, Firm Says

NOV. 7, 2019

Draft Partnership Form Raises Red Flags, Firm Says

DATED NOV. 7, 2019
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November 7, 2019

Mr. David Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

RE: Partnership Tax Return Information

Dear Sir:

We are writing to voice our sincere and urgent concern as to the new draft 2019 Form 1065, related instructions and Frequently Asked Questions (the "Documents"). Although the Documents are all well-intentioned, we believe the information requested needs refinement to both be useful to the IRS and to provide clear guidance to taxpayers as to what information is to be gathered. Once refined, there also needs to be significant lead time to allow taxpayers to gather the new requested information. The type of data requested in the Documents is unclear and full taxpayer comment is needed for the IRS to understand the scope and impact of the requests relating to tax basis and Section 704(c) tracking.

Without such input, the IRS likely will receive lots of information that will not be useful in tax administration. Moreover, the Documents create newly defined terms, and the exact scope of these defined terms needs to be carefully considered. Once that vetting process is complete, which should only be done after requesting taxpayer comment, a period of additional time will be needed for historical partnerships to gather such complex and never-before tracked data (especially if there has been a lot of change in partner composition or a partnership merger or division). The tax basis requests are much more complicated than the Cost Basis Reporting that became effective in 2011 for stockbrokers, and those rules had a very long comment process and lengthy set of transition rules. For background on those basis reporting rules see: https://www.irs.gov/businesses/small-businesses-self-employed/cost-basis-reporting-faqs.

Although we had a glimpse at a new requirement to track "tax capital" earlier this calendar year, confusion began right out of the gate with uncertainty as to what information the IRS was even asking for. Although the IRS gave a very short and limited penalty reprieve in Notice 2019-20, no further guidance was given until a month ago with a draft Form 1065 that was vague at best, and it was not until just a few days ago that practitioners got any hint at what the IRS was asking for as a result of the publication of the draft instructions to the Form 1065. These instructions, unclear in their own right, show how the IRS continues to be confused and unclear in its definition of what a negative tax capital account is. Moreover, the instructions add a material number of additional informational requests that further need vetting, with the most important being exactly how taxpayers should compute the new Section 704(c) information requested. The IRS knows that Section 704(c) is one of the most uncertain areas of partnership tax law after the responses it received to Notice 2009-70, for which IRS guidance was never even published. This is simply a road that cannot be dealt with in procedural guidance without a clear set of rules that fully defines the term "tax capital" and answers the critical Section 704(c) tracking questions covered in Notice 2009-70. Otherwise, the IRS will simply receive reams of information from partnerships that will not be useful in tax administration.

In our personal experience in this area, the term "tax capital", which is not defined in any governmental guidance, is what accountants use to define a partner's outside tax basis related to a partner's equity, meaning that "tax capital" is equal to a partner's gross outside basis less a partner's share of partnership debt. This number can then be used to determine the minimum amount of debt a partner needs allocated to avoid trigging gain under Section 731(a). This simple definition would then not need to get into the question of whether Section 743(b) adjustments are relevant and does not get into a partner's share of "inside" tax capital, which is something that the Documents seems to be trying to define. We recognize that others may view tax capital as instead more akin to a partner's inside basis similar to the previously taxed capital concept used in computing Section 743(b) adjustments. We further acknowledge that an outside tax capital definition may not be something the partnership can provide given that the partnership may not know a partner's outside basis, but if the IRS is trying to use the same terminology to define a different "inside tax capital" concept, we believe this distinction needs to be set forth more clearly in the Documents.

We cannot emphasize enough how this is a complex set of questions and the determination of the answers will not be easy for many partnerships. For partnerships which need to start working on their 2019 tax returns in a few short months, the IRS's draft Documents are nowhere close to being usable at this time. Many partnerships currently do not even have, on a readily accessible basis, the information that is being requested because although a partnership has the option to track a balance sheet on a "tax basis", a partnership also has the option to track such information on a GAAP or a Section 704(b) basis. As a result, there is no uniformity in the information maintained by partnerships because there is a wide variance in the tracking methods used by various partnerships. Moreover, even if partnerships tracked tax basis, the lack of a clear definition of "tax capital" means that the tax basis some partnerships have been tracking could be inconsistent with the IRS's final definition of tax capital. When Section 704(c) concepts are added to this mix, the process will be difficult and the information derived may not be helpful to the IRS. Taxpayer input and comments will be needed to make sure this project progresses in a reasonable and fruitful manner.

We are happy to speak by phone and/or meet with you in person to discuss at your convenience.

Best regards,

Steven R. Schneider
Baker & McKenzie LLP

Richard M. Lipton
Baker & McKenzie LLP

cc:
Mr. Jeffrey Van Hove, Senior Advisor for Tax Policy
Mr. Bryan Rimmke, Attorney Advisor, Office of Tax Policy
Ms. Holly Porter, Associate Chief Counsel, Passthroughs & Special Industries
Mr. Cliff Warren, Special Counsel, Passthroughs & Special Industries

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