January 25, 2021
Partnerships get penalty relief related to reporting of partners' capital account balances; updates to Form 1065 reporting
In Notice 2021-13 (the Notice), the IRS has announced transitional penalty relief for partnerships incorrectly reporting their partners' beginning capital account balances on 2020 Schedules K-1 (Form 1065) and the Schedules K-1 (Form 8865), following changes to the reporting requirements included in the 2020 Form 1065 instructions. The Notice also includes relief from accuracy-related penalties for any tax year for the portion of an imputed underpayment attributable to the inclusion of incorrect information in a partner's beginning capital account balance reported by a partnership for the 2020 tax year.
In addition, the IRS has released updated 2020 Form 1065 draft instructions (dated January 14, 2021) that include some new reporting changes beyond those included in the prior draft. The IRS has not yet published the final instructions for the 2020 Form 1065.
Form 1065 instructions
Draft instructions for the 2020 Form 1065, U.S. Return of Partnership Income, released in October 2020 included revised guidance requiring partnerships to use the transactional approach for the tax basis method for purposes of reporting tax capital accounts to partners on Schedule K-1 (Form 1065). For prior tax years, partnerships could report their partners' capital accounts on Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., using one of a variety of methods based on different principles (e.g., tax basis, generally accepted accounting principles (GAAP), IRC Section 704(b) book). The draft instructions included transitional guidance for partnerships that did not use the tax basis method for tax years prior to 2020. For a discussion of the change in the draft instructions, see Tax Alert 2020-2623.
The updated 2020 Form 1065 draft instructions released by the IRS in January 2021 retain the approach to partner capital account reporting adopted in the draft instructions released in October 2020. However, the updated instructions include some other new revisions, discussed below.
Various penalties may apply for failing to file, or filing incomplete or incorrect, Forms 1065 and Schedule K-1 reporting, including:
In addition, IRC Section 6662 imposes an accuracy-related penalty on portions of an underpayment attributable to one or more types of misconduct, such as negligence or substantial understatement of income tax.
The Notice provides relief from the penalties under IRC Sections 6698, 6721 and 6722 for partnerships that include incorrect information in reporting their partners' beginning capital account balances on 2020 Schedules K-1. The relief is available only if the partnership can show that it took "ordinary and prudent business care" in following the 2020 Form 1065 Instructions to report its partners' beginning capital account balances using one of the following methods (as outlined in the instructions): the tax basis method, modified outside basis method, modified previously taxed capital method, or IRC Section 704(b) method. The Notice clarified that "ordinary and prudent business care" for this purpose means the standard of care that a reasonably prudent person would use under the circumstances in the course of its business in handling account information.
In addition, the Notice includes penalty relief under IRC Sections 6698, 6721 and 6722 for partnerships that include incorrect information in reporting (1) their partners' ending capital account balances on Schedules K-1 in tax year 2020 or (2) their partners' beginning or ending capital account balances on Schedules K-1 in tax years after 2020. This additional relief is available to the extent that such incorrect information is attributable solely to the incorrect information reported as the beginning capital account balance on the 2020 Schedule K-1 for which relief under the Notice is available.
Partnerships are not eligible for the relief in the Notice if (1) they fail to timely file their 2020 Form 1065, Form 8865 and Schedules K-1, or (2) they fail to include a partner's beginning capital account balance on the Schedule K-1.
The Notice also includes relief with respect to accuracy-related penalties under IRC Section 6662. The IRS will waive such penalties for any tax year for the portion of an imputed underpayment attributable to an adjustment to a partner's beginning capital account balance reported by the partnership for the 2020 tax year, to the extent the adjustment arises from the inclusion of incorrect information for which the partnership otherwise qualifies for relief under the Notice.
Updated Form 1065 draft instructions
The January 2021 update to the Form 1065 draft instructions include a couple notable changes from the version released in October 2020.
First, the January 2021 instructions clarify that transfers of partnership interest now go on the "other increase (decrease)" line, rather than beginning capital, which was the requirement in the October 2020 instructions.
Second, while the October 2020 instructions reserved on Box 20 Code N regarding interest expense for corporate partners (the former description with the 2019 tax year Form 1065), the January 2021 instructions changed Box 20 Code N to be "business interest expense," requiring a partnership to attach a statement providing the allocation of the deductible business interest expense included within other lines of Schedule K. This change is meant to aid the tracking of business interest expense for IRC Section 704(d) purposes since business interest expenses (allowed and disallowed) are treated as the same loss class for IRC Section 704(d) purposes.
The Notice helpfully clarified both the type of penalty relief provided to taxpayers and the definition of "ordinary and prudent business care" that is required to be eligible for the penalty relief. Furthermore, as the Form 1065 instructions remain in draft form, partnerships and their advisors should continue to monitor the release of the final instructions for any further changes as they prepare for the 2020 compliance season.