Retain Transactional Method for Tax Capital Reporting, CPA Says

July 27, 2020

Internal Revenue Service
CC:PA LPD (Notice 2020-43)
Room 5207
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

RE: Comments on Notice 2020-43

Dear Sirs:

I appreciate the Internal Revenue Service proposals set forth in Notice 2020-43 to simplify the partner Tax Capital Account Reporting Requirements. I am submitting this letter in response to the Internal Revenue Service's request to provide comments concerning the two alternative methods of Tax Capital Reporting Requirements that will be permitted in partnership tax returns for taxable years that end on or after December 31, 2020.

As explained more fully below, my comments deal with the need to permit the continued use of the Transactional Approach for purposes of meeting the Tax Capital Reporting Requirement.

By way of background, I am a semi-retired CPA who has prepared partnership tax returns since 1976. During my 40+ year career with a Big 4 CPA firm, I signed thousands of partnership tax returns. From 1988 through 1991, I served as an appointed member of the AICPA Partnership Taxation Subcommittee. I currently prepare approximately twenty partnership tax returns, many of which historically reported capital accounts on a basis consistent with Generally Accepted Accounting Principles (“GAAP”). In 2020, I prepared those partnerships' 2019 returns reporting tax basis capital accounts that were calculated using the Transactional Approach.

According to information provided by the IRS, partnerships filed more than 3.9 million returns that included more than 27 million Schedules K-1 for 2017.¹ Based on my experience, I believe that the vast majority of those partnerships presented partner's capital accounts using a tax basis that was calculated using the Transactional Approach.

I understand that a large number of partnerships (but probably not a majority of the partnership returns filed) are finding it difficult, perhaps impossible, to convert from another method of presentation (usually GAAP) to the tax basis, which was initially required for the 2019 tax returns.

The reasons for those difficulties are briefly described in Notice 2020-43, but based on my experience the principal reasons are either:

In response to these situations, in Notice 2020-43 the IRS proposed two methods of reconstructing tax basis capital accounts that meet the Tax Capital Reporting Requirement.² Both methods are generally well conceived and potentially provide relief for those partnerships that find the conversion to Tax Capital Account Reporting otherwise difficult or even impossible. Partnerships experiencing these difficulties should be allowed to utilize either approach.

Continued use of Transactional Approach should be permitted

Although Notice 2020-43 provides requested relief for partnerships that were unable to use the Transactional Approach, it precludes the use of the Transactional Approach for years ending on or after December 31, 2020.³

The Transactional Approach is consistent with the methodology set forth in § 705(a) and Reg. § 1.705-1(a).⁴ Congress considered the possibility that not all partners or partnerships would be able to adopt the § 705(a) methodology (z.e., the Transactional Approach) when enacting § 705(b) which states:

“The Secretary shall prescribe by regulations the circumstances under which the adjusted basis of a partner's interest in a partnership may be determined by reference to his proportionate share of the adjusted basis of partnership property upon a termination of the partnership.” (Emphasis added.)

The use of the word “may” instead of an alternative term such as “shall” or “must” indicates that Congress intended to allow for alternatives to the Transactional Approach, rather than replacing the Transactional Approach altogether.

Reg. § 1.705-1(b) clearly states that alternative rules may be applied when a partner (or partnership) cannot practicably apply the general rules contained in § 705(a) and Reg. § 1.705-1(a):

“The alternative rule may be used to determine the adjusted basis of a partner's interest where circumstances are such that the partner cannot practicably apply the general rule set forth in section 705(a) and paragraph (a) of this section, or where, from a consideration of all the facts, it is, in the opinion of the Commissioner, reasonable to conclude that the result produced will not vary substantially from the result obtainable under the general rule.”

Notice 2020-43 apparently exceeds the authority granted to the Commissioner because it mandates the use of an alternative method rather the general rule setting forth the Transactional Approach.

If Notice 2020-43 is adopted, partnerships that successfully use the Transactional Approach to properly compute their capital accounts in accordance with the Tax Capital Reporting Requirement are placed in the unfortunate position of having to use a new, more time consuming method to meet the new requirements set forth in Notice 2020-43. Therefore, to ameliorate these concerns, the use of the Transactional Approach method should continue to be allowed.

In Notice 2020-43, the IRS expressed a concern that partnerships and other persons using the Transactional Approach may not have been adjusting partner tax capital accounts in the same way under similar fact patterns. The notice does not further elaborate as to whether the IRS is concerned about the existence of abuses because some partnerships do not treat similar transactions consistently or whether there is an overall concern that different partnerships account for partnership transactions differently. If the IRS is concerned about the former, perhaps it should consider establishing a consistency requirement. If the concern involves the use of different accounting methods by different partnerships, there commonly are multiple acceptable methods to account for a transaction. The IRS should consider allowing multiple approaches, as long as they are reasonable, are consistent with the intent of Subchapter K and are consistently applied by each partnership.

An overwhelming majority of partnerships are relatively simple enterprises that do not employ elaborate allocations of partnership items. The Transactional Approach has served them well. Compliance with either of the two suggested approaches in Notice 2020-43 requires additional analysis and time. The time period for completing partnership returns has been accelerated in recent years (partnership returns must now be completed by March 15^th instead of April 15^th). Imposing additional work on practitioners during peak periods will result in more extensions of partnership returns and delays in the partners' receipt of their Schedules K-1. With the exception of certain complex partnerships, partnerships using targeted capital accounts or older partnerships with incomplete records, most partnerships have successfully used the Transactional Approach and should be allowed to continue using it.

Transactional Approach is more consistent with partners' basis calculations

I suspect that many partnerships implementing the Modified Previously Taxed Capital Method, will use GAAP basis as a surrogate for fair market value. In such circumstances, the method will not work properly unless the partnership has accurately accounted for all of its cumulative GAAP/tax differences. Based on my recent experience converting capital account reporting from a GAAP to a Tax Basis, many partnerships do not have an accurate accounting of cumulative GAAP/tax differences — particularly if the partnership has been in existence for a long time.

Last tax season, when preparing several partnership returns I used the Transactional Approach to reconstruct partners' tax capital accounts. In each instance, the partnership had all of its returns since inception. I calculated the amount of partner capital using the information from Form 1065 Schedules K and M-2 for each year which showed the actual contributions/distributions, income and expense from inception through December 31, 2018. The amount of tax capital computed using this method is consistent with the amounts partners would have used when calculating the basis of their partnership interests because it is consistent with the information reported on the Schedules K-1 that they received.

In order to verify the correctness of this approach, I then undertook an analysis using an approach similar to what is mandated by the Modified Previously Taxed Capital Method. The GAAP basis balance sheet was adjusted to account for the GAAP/Tax balance sheet differences.⁵ When the analysis was completed, the resulting tax basis capital accounts differed from the amounts calculated using the Transactional Approach. In these situations, the tax capital computed differed from the amounts that the partners would have used in computing the tax basis of their partnership interests. After giving this matter considerable thought, and after discussing the situation with the client and several colleagues, we decided to report the capital accounts using the Transactional Approach because we believed it to be more accurate (i.e., the amounts used were consistent with what was previously reported to the partners on their Schedules K-1). Clearly, if we change from the Transactional Approach to either method contained in Notice 2020-43, the Tax Capital Reporting amounts reported in the Schedules K-1 will be inconsistent with the partners' calculations of the basis of their partnership interest.

In order to prevent these inconsistencies, continued use of the Transactional Method should be allowed.

Modified Outside Basis Method

One of the principal problems with the Modified Outside Basis Method, is the burden it places on partnerships that have had transfers of interest, but have not made a Section 754 election. It requires the partnership to request information from a partner who purchased or inherited his partnership interest. Once that information is compiled, the partnership must then determine the basis of each partner's interest and subtract that partner's distributive share of partnership liabilities. Unless the partnership has a Section 754 election in effect or has a substantial built-in loss, implementing the Modified Outside Basis Method is a considerable amount of extra work that many partnerships will choose to avoid.

Many practitioners will not understand the proposed methods

Notice 2020-43 is directed at sophisticated practitioners possessing a working knowledge of Subchapter K. Unfortunately, many tax return preparers lack such sophistication and will not have the technical understanding needed to implement any method other than the Transactional Method.⁶

In conclusion, Notice 2020-43 presents two worthwhile alternatives for partnerships that cannot otherwise use the Transactional Method to accurately comply with the Tax Capital Reporting Requirements and those methods should be made available to partnerships who cannot otherwise comply with those requirements. However, partnerships that are able to comply with the Tax Capital Reporting Requirements using the Transactional Method should be allowed to continue using that method.

I appreciate your consideration of these comments and welcome the opportunity to discuss these issues further. If you have any questions, please contact me by phone at (661) 210-6912 or via email at jdebree11@gmail.com.

Respectfully submitted,

James P. de Bree, Jr.
Certified Public Accountant
Valencia, CA