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On October 29, 2019, the IRS released draft instructions for 2019 Form 1065, U.S. Return of Partnership Income, and Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. (the Draft Instructions). The Draft Instructions address some of the questions raised by the October 2019 release of an amended draft Form 1065 and an amended draft Schedule K-1 (See Tax Alert 2019-1832). However, the Draft Instructions raise other questions.

The proposed changes to the Form 1065, Schedule K-1 and associated instructions, if adopted, will likely add significant time and complexity to the partnership tax reporting process.

Tax basis capital accounts

Before release of the 2018 Form 1065 instructions, partnerships had the option of reporting their partners' capital accounts under any one of several different methods (e.g., tax basis, GAAP or IRC Section 704(b) book). The 2018 Form 1065 instructions, however, required partnerships to report partners' tax basis capital account information for partners with negative tax basis capital accounts at the beginning or end of the tax year (see Tax Alerts 2019-0396 and 2019-0509). The draft 2019 Schedule K-1 goes further and requires the reporting of each partner's tax basis capital account, regardless of whether a partner's tax basis capital account is positive or negative.

The Draft Instructions define tax basis capital for purposes of the amended capital account reporting requirement. For such purposes, tax basis capital means:

[(Amount of cash + tax basis of property contributed to a partnership by a partner) — (amount of cash + (the tax basis of property distributed to a partner by the partnership - any liabilities connected with the contribution or distribution))] + [the partner's cumulative share of partnership taxable income and tax-exempt income - the partner's cumulative share of taxable loss and nondeductible, noncapital expenditures]

Insight: The definition of tax basis capital is noteworthy in several regards. First, it mandates that partnerships use a historic approach to compute their partners' tax basis capital accounts and does not provide a safe harbor. To the extent partnerships have not historically maintained tax basis capital accounts, significant work may be required to prepare such capital accounts in anticipation of 2019 tax filings, because the partnership's activities since its formation need to be rolled forward using the income tax rules. Furthermore, the Draft Instructions' definition of tax basis capital implicitly indicates that IRC Section 743(b) adjustments do not affect transferee partners' tax basis capital accounts. This is arguably inconsistent with IRS FAQs (released in April of this year) addressing the negative tax basis capital account reporting requirement. These FAQs indicate that an IRC Section 743(b) basis adjustment affects a transferee partner's tax basis capital account.

The Draft Instruction's approach also raises the possibility that the sum of all partners' tax basis capital accounts reported on the Schedule K-1s would not equal a total tax basis equity amount that would balance on a tax basis balance sheet (e.g., if a partnership had made a prior liquidating distribution to a partner and the basis of the distributed property did not equal the distributee partner's tax basis capital account and the partnership did not have a IRC Section 754 election in effect).

Net unrecognized Section 704(c) gain or loss

The draft 2019 Schedule K-1 includes a new item (Part II, Item N) for reporting a partner's beginning and ending share of "net unrecognized IRC Section 704(c) gain or (loss)." The Draft Instructions do not provide guidance on how to compute net unrecognized IRC Section 704(c) gain or loss.

Insight:This new item requires disclosures regarding IRC Section 704(c) items on an ongoing basis — not merely when built-in-gain or built-in-loss property is contributed by a partner to a partnership. Furthermore, this new requirement appears to implicate "reverse" IRC Section 704(c) layers. Thus, it appears that this new item may result in a significantly increased compliance burden if a partnership holds IRC Section 704(c) property and total remaining IRC Section 704(c) balances have not been tracked historically.

The Draft Instructions do not provide an exception to the requirement to report the partners' shares of net unrecognized IRC Section 704(c) gain or loss for publicly-traded partnerships (PTPs).

Insight:PTPs generally cannot track who is buying or selling individual units because their units are traded on securities exchanges. PTPs generally rely upon the interaction of the remedial method under Section 704(c) and a special recovery rule for Section 743(b) basis adjustments to make their units fungible . As such, PTPs cannot determine for any individual public partner how much of any IRC Section 704(c) layer relates to that partner. Thus, it is generally impossible for a PTP to compute (and, thus, report) the amount of net unrecognized IRC Section 704(c) gain or loss for its public partners.

Furthermore, the Draft Instructions require the reporting of each partner's share of net IRC Section 704(c) adjustments to current year income or loss. This information is reported in Line 20, Code AA (a code previously used for IRC Section 199A information).

Insight: It is unclear what should be reported on this line (e.g., should this line include the total net taxable income or loss allocated to a partner for items with IRC Section 704(c) layers or the difference between actual allocations and how tax items would have been allocated using IRC Section 704(b) percentages (i.e., an IRC Section 704(c) "shift")). Regardless, it appears this new item may result in a significantly increased compliance burden.

IRC Section 751(a)

Historically, no Form 1065 or Schedule K-1 reporting was required for IRC Section 751(a) gain or loss. Under IRC Section 751(a), partners may recognize ordinary income upon the sale or exchange of a partnership interest. The Draft Instructions, however, require the reporting of certain attributes resulting from a sale or exchange of an interest in a partnership, including the amount of IRC Section 751(a) gain or loss. This IRC Section 751(a) information is reported in Line 20, Code AB (a code previously used for IRC Section 199A information).

IRC Section 743(b) adjustments

Historically, the Form 1065 instructions required partnerships to report the income, deduction, gain or loss resulting from IRC Section 743(b) adjustments using the codes for "Other Income or Other Deductions." The Draft Instructions designated Schedule K-1 Lines 11F and 13V to report a partner's share of IRC Section 743(b) adjustment items. Line 11F (previously used for IRC Section 951A) will now be used to report a partner's share of income or gain resulting from the total net IRC Section 743(b) basis adjustments. The new Line 13V reports a partner's share of deduction or loss resulting from the total net IRC Section 743(b) basis adjustments. If the amount relates to more than one IRC Section 743(b) adjustment, then a statement is required to show the assets to which the IRC Section 743(b) adjustments relate and the computation of the net IRC Section 743(b) basis adjustment.

Insight: Historically, partnerships reported income, deduction, gain or loss resulting from IRC Section 743(b) adjustments in a variety of different manners. This change indicates that IRC Section 743(b) basis adjustments should not be reflected in ordinary business income reported on Line 1 or as a footnote disclosure and will require the consistent reporting of items resulting from IRC Section 743(b) adjustments.

As referenced previously, PTPs generally rely upon the combination of the remedial method and IRC Section 743(b) adjustments to allow for fungible income allocations to their partners. Generally, this combination is used to compute a net cost recovery deduction that is reported on Line 1. PTPs will generally be unable to compute amount of income or deductions related solely to IRC Section 743(b) adjustments, as required by this reporting change.

IRC Section 199A items

The 2018 Form 1065 instructions required partnerships to report each of the IRC Section 199A items under different Schedule K-1, Line 20 codes (e.g., W-2 wages under Code AA and unadjusted basis under Code AB). In contrast, the Draft Instructions condensed the different items into Code Z, instructing partnerships to report partners' distributive shares of each of the IRC Section 199A items as part of a statement attached to the Schedule K-1. The prior line items used to report IRC Section 199A have been repurposed for other reporting items unrelated to IRC Section 199A.

Implications

Although the Draft Instructions clarify certain reporting requirements included in the draft 2019 Form 1065 and draft 2019 Schedule K-1, the Draft Instructions raise certain questions, notably regarding the tax basis capital account reporting requirement and net unrecognized IRC Section 704(c) gain or (loss) reporting requirement. Moreover, uncertainty remains with respect to certain other items.

In all, partnerships and their advisors should carefully consider the recently released Draft Instructions as they prepare for the 2019 compliance seasons. As significant efforts may be necessary to comply, early consideration of the Draft Instructions is warranted.

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