The IRS has released a draft of the Form 1065 instructions for 2020 returns that contains the IRS’s proposed requirement for reporting partners’ capital on the K-1 on the tax basis.[1] The IRS issued a news release on the matter at the same time.[2]

News Release Summary

The news release indicates that the IRS has decided to require partnerships to use the transactional approach in computing partners’ capital on the tax basis, and require tax basis capital reporting on the 2020 Schedules K-1, Form 1065. The release states:

The revised instructions indicate that partnerships filing Form 1065 for tax year 2020 are to calculate partner capital accounts using the transactional approach for the tax basis method. Under the tax basis method outlined in the instructions, partnerships report partner contributions, the partner’s share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax basis principles as opposed to reporting using other methods such as GAAP.

According to IRS data, most partnerships already use the tax basis method although partnerships previously could report capital accounts determined under multiple methods.[3]

This means that partnerships that have always reported on the tax basis for partners’ capital (which is what the IRS refers to as the transactional approach) will not need to use one of the methods proposed in Notice 2020-43 to determine partners’ capital, either initially or on a continuing basis. That notice had proposed barring the use of the transactional approach[4] due to inconsistent use, but many commenters complained about the requirement to force partnerships that had always been reporting on something they felt was tax basis to go through one of the two alternative methods proposed in the Notice.

In the end, it appears the IRS not only relented and will allow continued use of the transactional approach, but has decided that is the only method to be allowed to be used following the computation of beginning partners tax basis capital for 2020 Schedules K-1.

The IRS defined the transactional approach as follows in Notice 2020-43:

Commenters have indicated that many partnerships that currently possess partner tax capital information generally develop and maintain partner tax capital by applying the provisions and principles of subchapter K of chapter 1 of the Code (subchapter K), including those contained in §§ 705, 722, 733, and 742 of the Code, to relevant partnership and partner events. In such a situation, commenters have indicated that partnerships maintaining tax capital (i) increase 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 (ii) decrease 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 (Transactional Approach).[5]

The IRS will reserve the two methods discussed in Notice 2020-43 solely for partnerships that have not been reporting partners’ capital on the tax basis. They can use these methods, among others, to compute their partners’ beginning tax basis capital.

Partnerships that did not prepare Schedules K-1 under the tax capital method for 2019 or otherwise maintain tax basis capital accounts in their books and records (for example, for purposes of reporting negative capital accounts) may determine each partner’s beginning tax basis capital account balance for 2020 using one of the following methods: the Modified Outside Basis Method, the Modified Previously Taxed Capital Method, or the Section 704(b) Method, as described in the instructions, including special rules for publicly traded partnerships.[6]

The news release also indicates the IRS plans to publish a notice granting penalty relief for partnerships in this year of transition to tax basis capital account reporting:

To promote compliance with using the tax basis method described in the revised instructions, the Treasury Department and the IRS intend to issue a notice providing additional penalty relief for the transition in tax year 2020. The notice will provide that solely for tax year 2020 (for partnership returns due in 2021), the IRS will not assess a partnership a penalty for any errors in reporting its partners’ beginning capital account balances on Schedules K-1 if the partnership takes ordinary and prudent business care in following the form instructions to calculate and report the beginning capital account balances. This penalty relief will be in addition to the reasonable cause exception to penalties for any incorrect reporting of a beginning capital account balance.[7]

Likely the IRS has decided that the objections to date have primarily been related to the conversion of a minority of existing partnerships to the tax basis capital account reporting rather than the use of it on a continuing basis. So the agency has decided to be lenient in what will be allowed to compute the converted beginning tax basis capital account for partners, but then be strict regarding changes to those accounts being made only on the tax basis.

Instructions for Tax Basis Capital Accounts

The draft instructions begin by reminding taxpayers that the use of the tax basis is mandatory for 2020 partnership tax returns:

Tax basis method. Figure each partner’s capital account for the partnership’s tax year using the transactional approach, discussed below, for the tax basis method. If you reported the partner’s capital account last year using any other method (for example, GAAP, section 704(b), or other), you must use the tax basis method this year.[8]

Basic Transactional Method Approach

The IRS begins by describing a standard rule taxpayers should use to report partnership events or transactions:

If you are uncertain how to report a partnership event or transaction, you should account for the event or transaction in a manner generally consistent with figuring the partner’s adjusted tax basis in its partnership interest (without regard to partnership liabilities), taking into account the rules and principles of sections 705, 722, 733, and 742 and by reporting the amount on the line for other increase (decrease). The partner’s ending capital account as reported using the tax basis method in item L might not equal the partner’s adjusted tax basis in its partnership interest. (emphasis added) Generally, this is because a partner’s adjusted tax basis in its partnership interest includes the partner’s share of partnership liabilities, as well as partner specific adjustments. Each partner is responsible for maintaining a record of the adjusted tax basis in its partnership interest.[9]

Beginning Capital Account for Partnerships Previously Reporting on the Tax Basis

The IRS gives some information first for the majority of partnerships already purporting to report partners’ capital on the tax basis about the beginning capital account reporting for 2020. The IRS starts by noting that taxpayers should, in this case, report the beginning capital account as the same number reported as the ending capital account on the prior year’s Form 1065:

If you figured the partner’s capital account for last year using the tax basis method, enter the partner’s ending capital account as determined for last year on the line for beginning capital account.[10]

Some taxpayers, now understanding that the IRS is looking to focus on negative capital accounts, may decide to recalculate their tax basis capital accounts. The IRS indicates that if they do so, some additional information will be necessary for partners whose capital account was negative on the prior return, but now shows a positive beginning balance:

If you reported a negative ending capital account to a partner last year and a different amount is figured for the partner’s beginning capital account using the tax basis method this year, provide an explanation for the difference.[11]

As well, the IRS provides guidance for dealing with partners who did not hold a partnership interest in the prior year:

If a partner joined the partnership through a contribution to the partnership this year, enter zero as the partner’s beginning capital account. If a new partner acquired its interest in the partnership from another partner in a purchase, exchange, gift, inheritance, or as the result of death this year, enter an amount for beginning capital account that is equal to the transferor partner’s ending capital account with respect to the interest transferred immediately before the transfer figured using the tax basis method.[12]

Contributions of Capital

The IRS gives the following instructions for properly reporting contributions of capital for tax basis capital account reporting:

On the line for capital contributed during the year, enter the amount of cash plus the adjusted tax basis of all property contributed by the partner to the partnership during the year. The amount you enter on this line should be reduced by any liabilities assumed by the partnership in connection with, or liabilities to which the property is subject immediately before, the contribution. This amount might be negative.[13]

Note that final sentence—if a taxpayer’s capital contribution included liabilities in excess of the basis of the property contributed, the capital contribution should be a negative number.

Current Year Net Income (Loss)

The income or loss line should be filled in as follows per the instructions:

On the line for current year net income (loss), enter the partner’s distributive share of partnership income and gain (including tax-exempt income) as figured for tax purposes for the year, minus the partner’s distributive share of partnership loss and deductions (including nondeductible, noncapital expenditures) as figured for tax purposes for the year.[14]

Other Increases (Decreases)

The IRS goes on to describe the items that would be found in the other increases (decreases) box, with certain specific examples:

On the line for other increase (decrease), enter the sum of all other increases or decreases that affected the partner’s capital account for tax purposes during the year and attach a statement explaining each adjustment. For example, include increases for the following.

The partner’s distributive share of the excess of the tax deductions for depletion (other than oil and gas depletion) over the adjusted tax basis of the property subject to depletion.
The partner’s share of any increase to the adjusted tax basis of partnership property under section 734(b).

Include decreases for the following.

The partner’s distributive share of tax deductions for depletion of any partnership oil and gas property, but not exceeding the partner’s share of the adjusted tax basis of that property.
The partner’s share of any decreases to the adjusted tax basis of partnership property under section 734(b).

While §734 adjustments do affect partners tax basis capital accounts under the IRS system, the other adjustment triggered by an election under §754 does not affect partners tax basis capital accounts. §734 adjustments are internal to the partnership and affect all partners, while the §743 adjustment only affects the partner acquiring an interest. The IRS not only warns about this, but requires partnerships that have recorded a §743 adjustment in a manner that causes it to be included in a partner’s purported tax basis capital account to remove that net adjustment on the 2020 return:

Note: Section 743(b) basis adjustments are not taken into account in calculating a partner’s capital account under the tax basis method. If section 743(b) adjustments are included in a partner’s beginning capital account balance (because they were included in last year’s ending capital account), those section 743(b) adjustments, whether positive or negative adjustments, should be removed from the partner’s capital account in the 2020 tax year and reported as a 2020 tax year other increase(decrease) item.[15]

Withdrawals and Distributions

The box that contains withdrawals and distributions should be computed for tax basis capital accounts as follows per the IRS instructions:

On the line for withdrawals and distributions, enter the amount of cash plus the adjusted tax basis of all property distributed by the partnership to the partner during the year. The amount you enter on this line should be reduced by any liabilities assumed by the partner in connection with, or liabilities to which the property is subject immediately before, the distribution. This amount might be negative.[16]

Note that, as was true for capital contributions, distributions with liabilities in excess of basis may cause this number to properly be negative.

Ending Capital Account

Finally, the instructions discuss the ending capital account on the tax basis—and, not surprisingly, the IRS insists the column must add down to come up with the ending capital line:

The sum of the amounts shown on the lines in item L above the line for ending capital account must equal the amount reported on the line for ending capital account. A partner’s ending capital account determined under the tax basis method may be negative if the sum of a partner’s losses and distributions exceeds the sum of the partner’s contributions and share of income.[17]

Reconciliation with Schedule L (Balance Sheet) Partners’ Capital Accounts

So must the capital accounts on the Schedule K-1s in total agree with the partners’ capital accounts reported on Schedule L (Balance Sheet)? The answer is no, but only if Schedule L is not prepared on the tax basis.

The instructions to Schedule M-2 indicate that it the reconciliation of partners capital accounts is always prepared on the tax basis.[18]

Show what caused the changes during the tax year in the partners’ capital accounts as reflected on the partnership’s books and records used in figuring the partnership’s net income or loss for tax purposes, the amount of any contributions and distributions of money or property made by the partnership to its partners, and any other increases or decreases to the partners’ capital accounts determined in a manner generally consistent with calculating the partners’ adjusted tax bases in their partnership interests (without regard to partnership liabilities), taking into account the rules and principles of sections 705, 722, 733, and 742.[19]

But the instructions note that while you must reconcile Schedule L capital to the totals on partner’s K-1 capital account balances if the Schedule L balance sheet is presented on the tax basis, the reconciliation is not required if the Schedule L balance sheet is not reported on the tax basis:

The balance at the beginning of the year should equal the total of the amounts reported as the partners’ beginning tax basis capital accounts in item L of all the partners’ Schedules K-1. If not, the partnership should attach an explanation of the difference. Generally, the balance at the beginning of the year should equal the adjusted tax basis of the partnership’s assets at the beginning of the year reduced by the partnership’s liabilities at the beginning of the year. If the partnership’s balance sheet (Schedule L) is reported on the tax basis and if the aggregate of the partners’ beginning and ending capital accounts differ from the amounts reported on Schedule L, attach a statement reconciling any differences. No such reconciliation is required if Schedule L is not reported on the tax basis.[20]

But Schedule M-2 will remain on the tax basis, as is clear in the instructions related to the balance at the end of the year section for Schedule M-2.

The balance at the end of the year should equal the total of the amounts reported as the partners’ ending capital accounts in item L of all the partners’ Schedules K-1.

Partnerships Previously Reporting on a Method Other than Tax Basis for Partners’ Capital

Those partnerships that, in prior years, used a method other than tax basis to report partners capital are given special instructions for this year. As was noted earlier, these partners will have to report partners’ capital on Schedule K-1 on the tax basis this year per the draft Form 1065 instructions.

Last year partnerships that reported on a basis other than tax basis for partner’s capital accounts did have to report negative tax basis capital accounts for any partners with such accounts. Thus, such partnerships may already have complete schedules of partners tax basis capital accounts calculated in which case those numbers should be used:

If you reported partners’ capital accounts using a method other than the tax basis method last year, but also maintained capital accounts in your books and records using the tax basis method (for example, for purposes of meeting the requirement to report partner negative tax capital accounts), you must report each partner’s beginning capital account using the tax basis method.[21]

If the partnership did not maintain such tax basis records the IRS provides that such partnerships may refigure each partner’s beginning capital account using one of the following methods, with the same method being used for each partner:

Tax basis method;
Modified outside basis method;
Modified previously taxed capital method; or
§704(b) method.[22]

The partnership must use the standard tax basis methods described previously to report all other items on Schedule L aside from the beginning partners’ capital balances, so this represents a one-time only calculation to obtain a starting point for a partner’s tax basis capital account.[23]

The following disclosures must also be made to each partner in this case as a statement attached to Schedule K-1:

You must also attach a statement to the partners’ Schedules K-1 indicating the method used to determine each partner’s beginning capital account.[24]

The three methods aside from reconstructing the transaction tax basis capital accounts are described in the following sections.

Modified Outside Basis Method

The first method for computing the partners’ beginning tax basis capital accounts for the transition is the modified outside basis method. This method looks at the outside basis of each partner’s capital account as a starting point.

The instructions describe the method as follows:

The amount to report as a partner’s beginning capital account under the modified outside basis method is equal to the partner’s adjusted tax basis in its partnership interest as determined under the principles and provisions of subchapter K including, for example, sections 705, 722, 733, and 742; and subtracting from that basis (1) the partner’s share of partnership liabilities under section 752 and (2) the sum of partner’s section 743(b) adjustments (that is, net section 743(b) adjustments). For purposes of establishing a partner’s beginning capital account, you may rely on the adjusted tax basis information provided by your partners.[25]

Assuming each partner can provide the partnership with this information, or the partnership has maintained such information for each partner, this provides a relatively simple method to make the conversion.

However, this method will in many cases not result in total partners’ tax basis capital that will reconcile to net tax basis capital for a balance sheet prepared on the tax basis. Thus, the method may require, as a practical matter, that the Schedule L balance sheet continue to be reported on a basis other than tax basis.

Modified Previously Taxed Capital Method

The second method looks to make use of the method found in the regulations under §743 to compute “previously taxed capital” for use in computing a §743(b) adjustment for a partner. The method looks to start with the cash each partner would receive if all partnership assets were sold, and and then adjust that number to take into account the gains and losses that would be reported by each partner related to that sale. Thus, the calculation is meant to determine each partners’ share of the inside net tax basis of partnership property.

The instructions describe this method as follows:

The amount to report as a partner’s beginning capital account under the modified previously taxed capital method is equal to the following.

The amount of cash the partner would receive if you liquidated after selling all of your assets in a fully taxable transaction for cash equal to the fair market value of the assets; increased by
The amount of tax loss determined without taking into account any section 743(b) basis adjustments (including any remedial allocations under Regulations section 1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse); and decreased by
The amount of tax gain determined without taking into account any section 743(b) basis adjustments (including any remedial allocations under Regulations section 1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse).

Instead of using the assets’ fair market value, you may determine the partnership’s net liquidity value, and gain or loss, by using such assets’ bases as determined under section 704(b), as determined for financial accounting purposes, or on the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management.[26]

If this method is used, the following additional information must be provided to the partner:

If the modified previously taxed capital method is used, the statement must also include the method used to determine the partnership’s net liquidity value (fair market value, section 704(b) book value, etc.). The method used to determine the partnership’s net liquidity value must be adopted for all partners in the partnership.[27]

§704(b) Method

While the prior two methods were described by the IRS in Notice 2020-43, the draft instructions add a brand new method based on §704(b) capital accounts, referred to in the §704 regulations as “book capital” accounts.

The IRS describes this method as follows:

The amount to report as a partner’s beginning capital account under the section 704(b) method is equal to the partner’s section 704(b) capital account, minus the partner’s share of section 704(c) built-in gain in the partnership’s assets, plus the partner’s share of section 704(c) built-in loss in the partnership’s assets. Property contributed to a partnership is section 704(c) property if, at the time of the contribution, its fair market value differs from its adjusted tax basis. Section 704(c) property also includes property with differences resulting from revaluations (reverse section 704(c) allocations). For more information see sections 704(b) and 704(c) and Regulations sections 1.704-1 through 1.704-3.

Most partnership agreements drafted by legal counsel will require the maintenance of capital accounts under the §704(b) regulations or, in the case of target capital accounts, will provide what is essentially a yearly computation of that account that is used to determine income/loss allocations. The §704(b) capital accounts are important for a partnership to be able to defend any special allocations in the partnership agreement against an IRS challenge.

Again, this beginning “tax basis” capital account will often result in the total of the individual partner capital accounts not agreeing with the total of net tax basis capital on a balance sheet prepared on the income tax basis. So, again, this would be most appropriate in cases where the partnership plans to continue to report its Schedule L balance sheet on other than the tax basis.

Special Beginning Tax Basis Capital Account Method for Publicly Traded Partnerships

Finally, the instructions conclude with the following special method for computing the partners’ beginning capital account for a publicly traded partnership:

In the case of a sale or exchange of an interest in a publicly traded partnership, you may determine a transferee partner's beginning capital account by adjusting the partner's beginning capital account to reflect the transferee partner's purchase price of the interest rather than entering the transferor partner's ending capital account. In making the adjustments, you may use information required to be reported to you under Regulations section 1.6031(c)-1T, and publicly available trading price information. If you are a publicly traded partnership and adopt the modified previously taxed capital method, you may apply Regulations section 1.743-1(j)(4)(i)(B)(2) in figuring a partner's beginning capital account.[28]

[1] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, https://www.irs.gov/pub/irs-dft/i1065--dft.pdf (retrieved October 22, 2020)

[2] IR-2020-240, October 22, 2020, https://www.irs.gov/newsroom/irs-releases-draft-form-1065-instructions-on-partner-tax-basis-capital-reporting (retrieved October 22, 202)

[3] IR-2020-240, October 22, 2020

[4] Notice 2020-43, Section III (retrieved October 22, 2020)

[5] Notice 2020-43, Section III (retrieved October 22, 2020)

[6] IR-2020-240, October 22, 2020

[7] IR-2020-240, October 22, 2020

[8] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 30

[9] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 30

[10] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 30

[11] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 30

[12] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, pp. 30-31

[13] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[14] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[15] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[16] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[17] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[18] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 55

[19] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 55

[20] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 55

[21] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[22] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[23] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[24] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[25] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[26] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[27] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31

[28] 2020 Instructions for Form 1065 (Draft), U.S. Partnership Return of Income, Draft as of October 21, 2020, p. 31