By Miranda Aavatsmark
Who has not frantically awoken from a bad dream in the middle of the night and been relieved to realize that it was not real? I have a reoccurring dream (nightmare) that I either have to go back to college and retake classes or sit for the CPA exam again. I used to dream I had to go back to high school, but thankfully my unconscious self has progressed beyond this fear.
Now and then, though, something comes up in the tax world that CPAs have had bad dreams about for years, basis tracking. But instead of waking up relieved that all basis schedules are neatly tucked away in a spreadsheet at the office, dread floods in as they realize this daunting task is not complete for many clients. Although there are many basis issues that keep CPAs up at night, (like attaching basis schedules to 1040s with S-corporation losses, distributions, loan repayments, etc…), the focus of this article is on some recent changes to partnership related basis reporting.
The Internal Revenue Service (IRS) is very concerned about basis tracking because it largely determines whether a taxpayer is “at-risk” in an activity. A taxpayer can only deduct losses to the extent they are at risk. For this reason, the IRS made a few changes to the 2018 Form 1065 instructions, particularly new requirements to report negative tax basis capital accounts on the respective partners’ K-1s. If a partnership reports partners’ capital accounts on a basis other than the tax basis (GAAP, 704 (b) book or other), then the beginning and ending amounts (if either is negative) must be reported on line 20, code AH starting with 2018 taxable years.
A negative tax basis capital account does not necessarily indicate a partner is not at-risk; they could have an “outside” basis, as well as recourse debt available to deduct losses. Nevertheless, this new reporting requirement may help the IRS pinpoint where to look as they begin to match K-1s to individual income tax returns.
However, since this change was not included in the Tax Cuts and Jobs Act of 2017 (TCJA) and was not as highly publicized, the IRS offered some relief through Notice 2019-20. Under two conditions, the notice offers a waiver of penalties to taxpayers who fail to include negative tax basis information. The two conditions are:
- The Schedule K-1 is timely filed with the IRS (including extensions), timely furnished to the partner and includes all other applicable information
- A schedule is filed with the IRS no later than one year after the unextended due date
(March 15, 2020, for the calendar year taxpayers) that lists the partner’s name, identification number, address and the amount of beginning and ending tax basis capital account
Note that the penalty relief outlined in Notice 2019-20 only applies to tax years beginning after December 31, 2017, and before January 1, 2019. See the notice for additional details and requirements for penalty relief. Now on to the related reporting requirements for tax years starting in 2019 and beyond, spelled out in Notice 2019-66.
In late 2019, the IRS released Notice 2019-66 detailing updates to partnership capital accounts for the 2019 taxable year and beyond. The notice addressed the following issues:
Reporting of positive tax basis
As discussed above, starting with the filing of the 2018 partnership income tax returns, negative tax basis capital accounts were required to be reported. Draft 2019 1065 forms and instructions, released in the fall of 2019, proposed that partnerships begin reporting capital accounts using the tax basis exclusively. Prohibited under the proposal and draft instructions are all other methods of reporting capital accounts (GAAP, 704(b) book and other). Since the IRS received comments that some taxpayers would be unable to comply with this new rule timely, the reporting requirement will not begin until the 2020 taxable year. Nevertheless, reporting negative tax basis capital accounts will continue to be required with the filing of the 2019 taxable year. Any method available for reporting the capital account will remain acceptable. Also, Notice 2019-66 refers to “Frequently Asked Questions” that are posted on the IRS website to provide additional clarity and guidance on how to calculate tax basis capital accounts.
Net unrecognized 704(c) gain or loss requirements
Proposed requirements to report partners’ share of net unrecognized 704(c) gain or loss at the beginning and end of the 2019 taxable year are also included in the draft 2019 1065 forms and instructions. The IRS received comments that the definition of “net unrecognized 704(c) gain or loss” was not included in the draft instructions. The notice defines of the aforementioned as follows, “the partner’s share of the net (net means aggregate or sum) of all unrecognized gains or losses under Section 704(c) of the Code (Section 704(c)) in partnership property, including Section 704(c) gains and losses arising from revaluations of partnership property.” Excluded from this reporting requirement are publicly traded partnerships.
Section 704(c) refers to the section of partnership tax laws that deals with contributions of appreciated property to a partnership. In the simplest of terms, this section provides for specific allocations of gain or loss upon the sale of property contributed by a partner. Allocating the gain or loss in this way may not shift gains and losses unfairly to other partners. Based on the information in Notice 2019-66 and the draft instructions, these built-in gains and losses will need to be reported to each applicable partner, starting with the 2019 taxable year.
**An in-depth discussion of Section 704(c) is beyond the scope of this article as there are many specific matters of the law to consider.
At-risk activity reporting
Another reporting requirement mentioned in the draft 2019 1065 forms and instructions relates to at-risk activities. The proposal would require partnerships with multiple activities, which may be subject to limitations under Section 465 at the partner level, to report certain information separately. The separately stated information would include a description of the at-risk activity, the items of income, loss or deduction for the activity, other items of income, loss, or deduction, partnership liabilities and any other information that relates to the activity, such as distributions and partner loans. Activities aggregated for purposes of Section 465 are required to be indicated by the partnership.
Again, the IRS received comments that some taxpayers would not be able to comply with these changes timely. As a result, the requirement to report at-risk activities separately will not start until the 2020 taxable year. For purposes of the 2019 taxable year, partnerships must indicate the aggregated at-risk activities.
Section 465 of the tax law refers to a taxpayer’s amount they are “at-risk” for purposes of deducting losses from an activity, as mentioned above. In other words, a taxpayer is at-risk to the extent they have contributed property to the activity or borrowed money with respect to the activity.
**An in-depth discussion of Section 465 is beyond the scope of this article as there are many specific matters of the law to consider.
If taxpayers follow the provisions outlined in Notice 2019-66, then they will not be subject to penalties (per Notice 2019-66).
There are many reasons why maintaining accurate capital accounts and basis schedules are important (deducting losses, sale of ownership interest, etc.). There are just as many reasons why doing so is easier said than done. Losing basis information or the availability of historical data is often an issue when taxpayers switch CPA firms. Even so, with these extensive new reporting requirements and the IRS on the hunt for losses to disallow, the days of kicking this can down the road are over. The 2020 busy season will be a prime time for CPAs and their clients to get into compliance in this area. Despite that, I am confident that my accounting colleagues and I will wake up multiple times between now and April 15, panicked and sweating over many issues and deadlines. Hopefully, though, fears of basis tracking begin to fade like those of repeating high school, calculus classes, and exams.
This article was originally published in The Kentucky CPA Journal.