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In Notice 2020-43, the IRS requests public comment on a proposed requirement for partnerships to use one of two methods to report partner capital accounts for tax years ending on or after December 31, 2020.

Background

The 2019 Form 1065 and Schedule K-1 (Form 1065) instructions require partnerships to report partners' tax basis capital account information for partners with negative tax basis capital accounts at the beginning and end of the tax year. The 2019 Form 8865 and Schedule K-1 (Form 8865) instructions incorporate that requirement by reference to the 2019 Form 1065 instructions.

Draft 2019 forms and instructions had proposed requiring partner tax basis capital reporting for 2019 regardless of whether a partner's tax basis capital account is positive or negative (see Tax Alerts 2019-1832 and 2019-2011). On December 11, 2019, the IRS released Notice 2019-66 (see Tax Alert 2019-2184), which postponed by one year the requirement to report partners' shares of partnership capital on the tax-basis method to tax years beginning on or after January 1, 2020, rather than for 2019 tax years. Notice 2019-66 also announced that the IRS would issue additional guidance defining partner tax basis capital for this purpose. The IRS, however, decided to issue guidance proposing two methods for reporting partner tax basis capital accounts, instead of providing guidance on how partner tax basis capital is defined.

Notice 2020-43

Notice 2020-43 would require partnerships to report partner tax basis capital accounts under two alternative methods:

1. The partner's basis in its partnership interest, reduced by the partner's allocable share of partnership liabilities, as determined under IRC Section 752 (Modified Outside Basis Method)
or
2. The partner's share of previously taxed capital, as calculated under a modified version of Treas. Reg. Section 1.743-1(d) (Modified Previously Taxed Capital Method)

Partnerships would be required to use one of these two methods to satisfy the reporting requirements for all partners. Notice 2020-43 would allow partnerships to change their method from the Modified Outside Basis Method to the Modified Previously Taxed Capital Method, or vice versa, for reporting the partner tax basis capital accounts for tax years after 2020. To change the method, a partnership would be required to attach a disclosure to each Schedule K-1 that describes the change to the amount of each partner's beginning and year-end balances, as well as the reason for the change. The Notice would prohibit the use of the "Transactional Method," under which tax capital is maintained by:

1. Increasing a partner's tax capital account by the amount of money and the tax basis of property contributed by the partner to the partnership (less any liabilities assumed by the partnership or to which the property is subject), as well as allocations of income or gain made by the partnership to the partner
and
2. Decreasing a partner's tax capital account by the amount of money and the tax basis of property distributed by the partnership to the partner (less any liabilities assumed by the partner or to which the property is subject), as well as allocations of loss or deduction made by the partnership to the partner

Modified Outside Basis Method

Under Notice 2020-43, if a partnership uses the Modified Outside Basis Method to report partner capital accounts, a partner would have to notify the partnership of any changes to the partner's basis in its partnership interest during the tax year. An example of a non-partnership change to a partner's basis in its partnership interest would be when a partner purchases an interest in a partnership that has chosen to use the Modified Outside Basis Method to report partner tax basis capital accounts, regardless of whether that partnership has an IRC Section 754 election in effect. The partner would have to provide written notification of the change to the partnership within 30 days or by the partnership's tax year-end, whichever is later. The partner would not have to notify the partnership of any changes related to contributions to and distributions from the partnership and the partner's share of income, gain, loss or deduction that is reflected on the partnership's Schedule K-1.

Notice 2020-43 would allow the partnership to rely on the partner basis information supplied by the partners unless the partnership has knowledge that the information is incorrect.

Modified Previously Taxed Capital Method

If a partnership does not use the Modified Outside Basis Method, the partnership would have to use the Modified Previously Taxed Capital Method to report the partner capital accounts.

For purposes of satisfying the partner tax basis capital reporting requirements, the Modified Previously Taxed Capital Method would adopt the approach for computing a partner's "previously taxed capital" typically used to determine a partner's IRC Section 743 adjustment, as described in Treas. Reg. Section 1.743-1(d)(1), but revises, for this purpose, the "hypothetical transaction" concept described in Treas. Reg. Section 1.743-1(d)(2).

Treas. Reg. Section 1.743-1(d)(1) computes a partnership interest transferee's share of the adjusted basis of partnership property as "the sum of the transferee's interest as a partner in the partnership's previously taxed capital, plus the transferee's share of partnership liabilities." Previously taxed capital is:

1. The amount of cash the partner would receive if the partnership were liquidated in a hypothetical transaction, increased by
2. The amount of tax loss that would be allocated to the partner from the hypothetical transaction, decreased by
3. The amount of tax gain that would be allocated to the partner from the hypothetical transaction

The "hypothetical transaction" described in Treas. Reg. Section 1.743-1(d)(2) is a partnership's disposition of its assets in a fully taxable transaction for cash, equal to the fair market value of the assets.

Recognizing that all partnerships might not have the fair market value of their assets readily available, the Modified Previously Taxed Capital Method would simplify the calculation for previously taxed capital. Thus, the Modified Previously Taxed Capital Method would allow a partnership to use the cash a partner would receive from a liquidation in the calculation if the assets' fair market value were readily available. If the fair market value is not readily available, a partnership could determine its net liquidity value and gain and loss by using the assets' bases as determined under IRC Section 704(b), generally accepted accounting principles (GAAP) or the basis established in the partnership agreement for purposes of determining how much each partner would receive in a liquidation. For determining a partner's share of previously taxed capital for this purpose, all liabilities would be treated as nonrecourse (which avoids the burden of requiring partnerships to characterize the underlying debt and simplifies the computation).

Partnerships using the Modified Previously Taxed Method must attach a statement indicating that the Modified Previously Taxed Capital Method is being used and the method used to determine their net liquidity value.

Request for comments

The IRS requests comments on whether:

1. The proposed methods should be modified or adopted
2. An ordering rule should apply to the basis used in determining the net liquidity value
3. The partner capital accounts reporting requirement should be modified to apply to publicly traded partnerships
4. The transactional approach, or similar method, should be allowed for satisfying the partner capital accounts reporting requirement and, if so, what additional guidance is necessary
5. Limits should be placed on a partnership's ability to change from one method to the another

Written or electronic comments must be submitted by August 4, 2020. Electronic comments may be submitted through the Federal eRulemaking Portal at www.regulations.gov. Comments also may be mailed to Internal Revenue Service, CC:PPA:LPD (Notice 2020-43), Room 5207, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044.

Implications

Notice 2020-43 is helpful in providing detailed guidance for how partnerships should satisfy the reporting requirement for partner tax basis capital accounts, if such guidance is adopted. Taking earlier comments into account, the IRS has provided alternative methods for determining partner tax basis capital accounts, particularly for partnerships that have not historically maintained partner tax basis capital accounts or that do not possess the information necessary to determine partner tax basis capital accounts for satisfying the reporting requirements.

While the flexibility afforded by the IRS for satisfying the requirement to report partner tax basis capital accounts under two alternative methods is helpful, partnerships should carefully consider which method is most appropriate based on their respective circumstances.

Under the Modified Outside Basis Method, as all partners must timely provide written notification to the partnership of any non-partnership changes to their outside basis within 30 days of such changes or, if later, by tax year-end of the partnership, partnerships might consider amending their partnership agreements to include a requirement for their partners to timely provide the information necessary to apply this method. Under the Modified Previously Taxed Capital Method, partnerships would be required to apply a complex hypothetical sale approach, similar to the computation of an IRC Section 743(b) basis adjustment, that could significantly increase the compliance and administrative burden for partnerships with a large number of partners and/or assets and complex IRC Section 704(c) allocations.

It is common for many partnerships to compute tax basis capital accounts using the Transactional Approach, which is similar to a tax capital rollforward and currently required for negative tax basis capital reporting. Many partnerships may be surprised to learn that the Notice would not allow using this approach. That means partnerships using the Transactional Approach as part of its normal accounting will have to conduct additional tax capital computations in order to satisfy the reporting requirements in this Notice, even though the partnerships might have otherwise believed the Transactional Approach ought to satisfy the current reporting requirements for negative tax basis capital reporting.

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