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Firm Objects to Premature Implementation of Tax Capital Account Rules

AUG. 3, 2020

Firm Objects to Premature Implementation of Tax Capital Account 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, D.C. 20044

Re: Comments in Response to Notice 2020-43, Tax Capital Reporting — Notice Requesting Comments

Dear Ms. Altman:

On behalf of Crowe, LLP, we respectfully submit the below comments in response to the request for comments in Notice 2020-43. Specifically, Notice 2020-43 proposes to require that partnerships report partners' tax capital accounts using one of two prescribed methodologies effective for the 2020 partnership taxable year. We recommend that partnerships should not be required to use any new prescribed method for reporting partners' tax capital before the partnership taxable year beginning after the calendar year in which the rules requiring the prescribed method are finalized. Our other comments and recommendations are set forth below.

A. Background

A partnership communicates its accounting of each partner's tax capital account to the partner on Line L of the Schedule K-1.1 Until a change in form instructions for the 2018 tax year, the law, including regulations, governing the federal tax treatment of partnerships and their partners did not prescribe a particular method for how a partnership is required to track each partner's interest in the partnership. Most partnerships maintain partner tax capital accounts based on section 704(b), GAAP accounting, allocations resulting from transactions engaged in by the partnership, or some combination of these methods.

Generally, there is no tax law requirement that a partner provide information it maintains about its basis to the partnership, although partners are required to provide certain information to the partnership when it transfers or acquires its interest. This is consistent with the general information flow of tax-related information between the partners and the partnership, which is almost always from the partnership to the partners, and not the other way around. Affirmative obligations of the partners to provide the partnership with information related to federal tax treatment or federal tax consequences is almost exclusively established by statute or the partnership agreement.

In early 2019, the IRS revised the 2018 Form 1065 instructions to require that partnerships reporting partner tax basis on Line L of the Schedule K-1 using either the 704(b) book, the GAAP, or some other method other than “Tax Basis” must report when a partner has a negative tax basis at the beginning or end of the year. Because of questions relating to the definition of these terms and the fact that this new reporting requirement could potentially require partnerships to capture and calculate additional information in a new way, the IRS published Notice 2019-20 to provide information reporting penalty relief and delay the negative basis reporting requirement for partnership tax year 2018 until March 15, 2020. Subsequent to the notice, the IRS issued Frequently Asked Questions (FAQs) on its website to mandate particular rules for partnerships to use to determine a partner's Tax Basis for purposes of reporting the partner's tax capital account on the Schedule K-1. The FAQs also included a safe harbor method for determining a partner's Tax Basis for purposes of tax capital account reporting. These FAQs have been updated since being published.

Early drafts of the 2019 Form 1065 instructions released in September 2019 would have made “Tax Basis” the exclusive method to report all partners' tax capital accounts on the Schedule K-1. In December 2019, the IRS issued Notice 2019-66 to delay mandatory use of Tax Basis as described in the FAQs for purposes of reporting tax capital accounts until the 2020 tax year. Notice 2019-66 also extended negative basis reporting to the 2019 tax year.

On June 5, 2020, the IRS released Notice 2020-43 to prescribe the precise method for computing Tax Basis for tax capital account reporting on the 2020 Schedule K-1. The notice proposes two alternative methods for computing Tax Basis, and prohibits the use of a “Transactional Approach” as a permissible method for partnerships to compute a partner's tax capital account reported on Line L of the Schedule K-1. The notice describes the Transactional Approach for partnerships to maintain their record of partners' tax capital accounts as applying the provisions of subchapter K to 1) increase a partner's tax capital account by money and capital contributed by the partner to the partnership (less liabilities assumed by the partnership) plus a partner's allocable share of income and gain and decrease a partner's tax capital account by money and basis of property distributed to the partner (less liabilities assumed by the partner) plus the partner's allocable share of losses and deductions.

The two approaches described in the notice are the Modified Outside Basis Method and, if unable to satisfy the Modified Outside Basis Method, the Modified Previously Taxed Capital Method. Under the Modified Outside Basis Method, the partner's tax capital account is determined under the guidelines of IRC Section 705 before subtracting the partner's share of liabilities under IRC Section 752. If the partnership uses this method, partners are required to notify the partnership in writing within 30 days after the partnership year end of any changes to the partner's basis in its partnership interest other than changes resulting from a contribution to or distribution from the partnership and the partners' share of income, gain, loss or deduction that are otherwise reflected on the partnership's schedule K-1. For example, if John purchases Paul's interest in a partnership that uses this method, John must notify the partnership in writing within 30 days after the partnership year end of the purchase price of the partnership interest. Partnerships using the Modified Outside Basis method may rely on the information provided by the partner unless it is clearly erroneous.

Under the Modified Previously Taxed Capital Method, the partnership is required to calculate a hypothetical liquidation of the partnership using fair market value, GAAP or section 704(b). This method reports the tax capital accounts of the partners as the amount equal to their interest as a partner in the partnership's previously taxed capital, plus the partner's share of partnership liabilities. Generally, previously taxed capital for this purpose appears to be capital determined under section 743(b) and Treas. Reg. § 1.743-1, with some modifications.

The notice states that these two methods are “in lieu of providing a definition of tax basis capital.” The notice also requests comments from the public.

B. Comments

1. Partnerships should only have to report the information they know

Federal tax information reporting requirements do not require filers to report information they do not have. Information reporting to partners under IRC Section 6031(b) is no exception. Accordingly, partnership reporting to its partners should not require a partnership to obtain information from third parties, including partners, unless the law requires the third party to provide the information to the partnership. Accordingly, a partnership's reporting obligation should be limited to reporting information the partnership itself is required to maintain and, if required by law, information others are required to provide to the partnership. Unless Congress changes the law to require partners to provide information regarding their basis in the partnership to the partnership and to require the partnership to obtain such information from partners, the IRS is not permitted to require the partnership to obtain, maintain, or track information from any third party, including partners, that the partnership does not know or have a legal requirement to know. Even regulations requiring this would be beyond Treasury and the IRS's authority under the law.

2. Regulations are required to impose new requirements for how partnerships determine and maintain partners' tax capital accounts

Treasury and the IRS have broad authority under Subchapter K to prescribe rules for how partnerships determine and maintain partners' tax capital accounts. There is similar broad authority under IRC Section 6031 to prescribe reporting of that information. However, the APA rules for notice and comment must be followed to exercise that broad authority and impose a new requirement that has penalties and other negative consequences in the case of non-compliance. Further, when taxpayer rights or obligations are at stake, as is the case with the rules set forth in Notice 2020-43, Treasury policy provides that regulations, not sub-regulatory guidance, should be used.2 As the Treasury policy states:

After weighing relevant factors, if the intended interpretation or position would have the effect of modifying existing legislative rules or creating new legislative rules on matters not addressed in existing regulations, the interpretation or position will generally be issued through notice-and-comment rulemaking, absent exceptional circumstances.

Accordingly, any new requirements imposed on partnerships for precisely how they are required to determine and maintain partners' tax capital accounts should be prescribed by regulations, not a notice, form instructions, and FAQs. It is not clear what exceptional circumstances exist to warrant foregoing regulations in this case.

3. Partnerships need sufficient time before new rules are effective

Any new prescribed rule for precisely how a partnership is to determine and maintain partner tax capital accounts should provide sufficient time for partnerships to comply. As the notice identifies, partnerships currently use a variety of methods to maintain partner tax capital accounts. Conforming historic records to a prescribed method will be costly and time consuming. New requirements imposed during a partnership tax year cannot easily be implemented within that year because systems and procedures are not established to capture information for transactions that have already occurred or are already occurring. Accordingly, partnerships will need at least 18 months, similar to the lead time the IRS requires for its computer changes, before the tax year for which any new partnership tax capital account requirements are effective.

In particular, the 2020 tax year should not be the first tax year that the IRS requires partnerships to comply with new, prescribed methodologies for determining and reporting partners' tax capital accounts. The IRS has consistently acknowledged the unprecedented economic and logistical challenges taxpayers face as a result of the COVID-19 pandemic. Accordingly, the 2020 taxable year is not the time to require taxpayers to shoulder the additional burden and resources needed to comply with new prescribed methodologies for determining and reporting partners' tax capital accounts.

C. Recommendations

  • No prescribed method for determining and maintaining partners' tax capital accounts should be imposed until after a reasonable implementation period after final regulations are published. Specifically, we recommend that partnerships should not be required to use any new prescribed method for reporting partners' tax capital before the partnership taxable year beginning after the calendar year in which the rules requiring the prescribed method are finalized.

  • The effective date of any new, required methodology for a partnership to determine their partners' tax capital accounts should be prospective only. Prior to this effective date, a partnership should be able to determine partners' tax capital accounts under any method that is consistent with the Code, regulations, forms and other guidance applicable to such determinations at the time the determination is made.

  • Even if the two recommendations above are not adopted, in light of the challenges facing taxpayers as a result of the COVID-19 pandemic, taxpayers should not be required to use a new, prescribed methodology to determine and report partners' tax capital accounts for the 2020 taxable year.

  • Proposed regulations should be published providing one or more methodologies for partnerships to use to determine and maintain each partner's tax capital account.

  • In addition to the alternative methodologies provided in the notice, we recommend that the following criteria and methodologies be included in any rule for maintaining, determining, and reporting partners' tax capital accounts:

    • A Transactional Approach with a foundation in Subchapter K should be allowed once the partnership establishes a base line for all partner tax capital accounts using one or more prescribed methodologies or existing historical transactional approach information maintained by the partnership. Any inconsistency in application of Subchapter K should be addressed through formal and sub-regulatory guidance addressing shortcomings in those rules, not by prohibiting a Transactional Approach. This will allow for consistency between partnerships and remove increased incremental reporting burden for the partnership. A Transactional Approach would also be consistent with how each partner is required to maintain their outside basis, and consistent with how many partnerships currently maintain partner tax capital balances.

    • No method for establishing a base line for tax capital accounts should require the partnership to obtain information from any third party, including partners, unless a statute requires the partnership to collect the information and requires the third party to provide the information. The Modified Outside Basis Method does not fit these criteria and so should not be used.

    • For partnerships that have been in existence for a long period of time, that have not previously maintained books and records that reflect best practices, or that have low turnover, a methodology must be permitted that allows the partnership to establish a base line using the best information available and best efforts. Otherwise, there will be partnerships that may never be able to come into complete compliance. Further, there should be sufficient time given for partnerships, even those described above, to come into compliance.

    • Partnerships that have always maintained their partners' tax capital accounts in accordance with Subchapter K should not be required to compute a base line on a new, prescribed method. For others, a method similar to the Modified Previously Taxed Capital method described in the notice could be required.

Thank you for the opportunity to provide comments with respect to this notice. If you have any questions or need further information, please feel free to call Rochelle Hodes at (202) 552-8028.

Respectfully submitted:

Bruce Belman
TJ Brecht
Steven Driver
Rochelle Hodes
Nick Hollinden
Sharon Jones
Phil Malnar
Tim Trifilo
John Ye

Crowe LLP
Washington, DC

cc:
Holly Porter, Associate Chief Counsel (Passthroughs and Special Industries)
Holly Paz, Director, LB&I Passthroughs Entities Practice Area
Bryan Rimmke, Office of Tax Policy

FOOTNOTES

1These rules also affect the Form 8865 and its Schedule K-1. However, for convenience, this discussion refers only to the Form 1065 and its Schedule K-1, though the comments apply to both.

2Department of the Treasury, Policy Statement on the Tax Regulatory Process (March 5, 2019).

END FOOTNOTES

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