The IRS, in releasing the drafts for the 2019 Form 1065 and related instructions, indicated that all partnerships would have to provide information on tax basis capital accounts on Schedules K-1 prepared for 2019 and later years.  The IRS in the end decided to remove the requirement from the 2019 Form 1065 Schedule K-1s after receiving a number of comments indicating that providing that information would be very difficult or impossible for many partnerships.  The agency indicated that it would be providing additional information on the calculation of partner tax capital.

In Notice 2020-43[1] the IRS indicated the agency had decided that, in lieu of providing that information the agency would propose to offer two proposed methods for partnerships to comply with the tax capital reporting requirement.  The agency is using the notice to request comments on these proposed methods.

The two methods the IRS proposes in this Notice are:

• The partner’s basis in its partnership interest, reduced by the partner’s allocable share of partnership liabilities, as determined under § 752 of the Code (Modified Outside Basis Method) or

• The partner’s share of previously taxed capital, as calculated under a modified version of § 1.743-1(d) of the Income Tax Regulations (Modified Previously Taxed Capital Method).[2]

Issues Faced in Computing Partner Tax Capital

While the IRS may have initially believed providing partners’ capital on a tax basis would not create issues for partnerships, the agency found that many commenters did not agree.  As the Notice indicates:

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).

The Treasury Department and the IRS understand that many partnerships and other persons have maintained partner tax capital accounts according to the Transactional Approach, but due to the array of transactions that might affect partner tax capital, it is possible that partnerships and other persons that have been using the Transactional Approach may not have been adjusting partner tax capital accounts in the same way under similar fact patterns. Several commenters explained that providing detailed guidance that would make the Transactional Approach consistent in all potential transactions would be a major project that would consume significant IRS resources.[3]

The IRS, taking these comments into account, still believes it’s important to move forward with the Tax Capital Reporting Requirement, as it will “aid the IRS in administering the tax law, and consistency will ultimately reduce complexity of the preparation of partnership returns.”[4]

The IRS notes that the agency intends to require partnerships to use one of the two methods described in this notice, and that “[c]apital account amounts based on the Transactional Approach will not satisfy the Tax Capital Reporting Requirement.”[5]  Rather, the Notice provides:

It is intended that a partnership must use one of these two methods for purposes of satisfying the Tax Capital Reporting Requirement and the method selected must be used with respect to all of the partnership’s partners.[6]

The partnership will not be required to use the same method each year, so the selection for 2020 would not bind the partnership into the future.  But the IRS would demand certain disclosures if a change takes place:

For taxable years after 2020, a partnership may change its Tax Capital Reporting Requirement method from the Modified Outside Basis Method to the Modified Previously Taxed Capital Method, or vice versa, by attaching a disclosure to each Schedule K-1 describing the change, if any, to the amount attributable to each partner’s beginning and end of year balances, and the reason for the change.[7]

Proposed Modified Outside Basis Method

The first method looks to use the partners’ outside basis (that is, the partner’s basis in his interest in the partnership) after adjustment for debt allocated to the partner to determine the partner’s tax basis capital.

Per the Notice, under the modified outside basis method the partnership can determine each partners’ tax basis capital in the following manner:

A partnership may satisfy the Tax Capital Reporting Requirement by determining, or being provided by its partners, the partner’s adjusted basis in its partnership interest, determined under the principles and provisions of subchapter K (including those contained in §§ 705, 722, 733, and 742), and subtracting from that basis the partner’s share of partnership liabilities under § 752.[8]

If a partnership uses this method, notification requirements are imposed on the partner regarding basis adjustments that the partnership would not generally be aware of from its books:

If the partnership is satisfying the Tax Capital Reporting Requirement by using the Modified Outside Basis Method, a partner must notify its partnership, in writing, of any changes to the partner’s basis in its partnership interest during each partnership taxable year other than changes attributable to contributions to and distributions from the partnership and the partner’s share of income, gain, loss, or deduction that are otherwise reflected on the partnership’s schedule K-1. The partner must provide such written notification of such changes to the partner’s basis within thirty days or by the taxable year-end of the partnership, whichever is later.[9]

The notice uses the following example of such a notification event:

Example (Based on Notice 2020-43, Section III(1))

If a person purchases an interest in a partnership that has chosen to use the Modified Outside Basis Method, the purchasing partner must notify the partnership of its basis in the acquired partnership interest, regardless of whether the partnership has an election under § 754 of the Code in effect or has a substantial built-in loss, as defined in § 743(d) of the Code, at the time of such interest purchase.

Partnerships using this method will generally be able to rely on information given to the partnership by a partner:

For purposes of the Modified Outside Basis Method, a partnership is entitled to rely on the partner basis information that the partnership is provided by its partners unless the partnership has knowledge of facts indicating that the provided information is clearly erroneous.[10]

Proposed Modified Previously Taxed Capital Method

The second method borrows from the regulations found at Reg. §1.743-1(d)(1).  As the Notice provides:

Section 1.743-1(d)(1) generally provides that a partnership interest transferee’s (transferee’s) share of the adjusted basis of partnership property is equal to 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. [11]

Previously taxed capital is defined as an amount equal to:

• (i) The amount of cash that the partner would receive on a liquidation of the partnership following a hypothetical transaction; increased by

• (ii) The amount of tax loss (including any remedial allocations under § 1.704-3(d) of the Income Tax Regulations) that would be allocated to the partner from the hypothetical transaction; and decreased by

• (iii) The amount of tax gain (including any remedial allocations under § 1.704-3(d)) that would be allocated to the partner from the hypothetical transaction.[12]

The notice indicates that “[t]he hypothetical transaction is a disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the fair market value of the assets.”[13] 

Of course, partnerships will not generally be able to quickly discover the amount to be received from that hypothetical sale:

Part (i) of the above calculation is intended to quantify, for each partner, the partner’s economic right to a share of the distributable proceeds of the partnership immediately after the hypothetical transaction and the payment by the partnership of all of its liabilities (partnership net liquidity value). The Treasury Department and the IRS understand that although some partnerships may be able to determine the fair market value of their assets for each taxable period, such information will not be readily available for all partnerships.[14]

The IRS notes that in many cases the exact amount of the sale proceeds won’t change the ultimate calculation, since the second and third steps remove the gains and losses inherent in the deemed sale, leaving in place what is essentially the partner’s share of the basis in each asset.  So for purposes of the Modified Previously Taxed Capital Method, the traditional §1.743-1(d)(2) calculation is modified as follows:

• The cash a partner would receive on a partnership liquidation and calculations of gain and loss in the hypothetical transaction would be based on the assets’ fair market value, if readily available. Otherwise, a partnership may determine its partnership net liquidity value and gain or loss by using such assets’ bases as determined under § 704(b), GAAP, or 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; and

• All liabilities are treated as nonrecourse for purposes of parts (ii) and (iii) of the calculation referring to gain or loss, respectively. This is to avoid the burden of having to characterize the underlying debt and to simplify the computation.[15]

The Notice provides the following example of applying this method:

Example (from Notice 2020-23, Section III(2))

Facts. A and B are equal partners in AB LLC, a calendar-year partnership. On December 31, 2020, AB LLC’s balance sheet reflects the following assets and liabilities:

• $500 of cash;

• Inventory with a tax and book basis of $1,000;

• Equipment with a tax and book basis of $500;

• Land with a tax and book basis of $1,000; and

• A long-term loan of $5,000.

AB LLC chooses to comply with the Tax Capital Reporting Requirement by using the Previously Taxed Capital Method and calculating liquidation values, gains, and losses, based on the book basis of the assets. Each of A and B’s Previously Taxed Capital under that method would be $(1,000), an amount equal to (i) the cash each would receive after the hypothetical liquidation (zero, because the debt of $5,000 exceeds the $3,000 book basis of the assets), less (ii) gain that would be allocated to each partner on the hypothetical liquidation and sale ($1,000, each partner’s 50% share of the excess of the $5,000 amount realized on a sale of the property for the debt over the tax basis of $3,000), plus (iii) loss that would be allocated to each partner (zero).

The IRS plans to require the following disclosures to be made when a partnership uses the Modified Previously Taxed Capital Method:

A partnership that adopts the Modified Previously Taxed Capital Method would be required, for each taxable year in which the method is used, to attach a statement indicating that the Modified Previously Taxed Capital Method is used and the method it used to determine its partnership net liquidity value (for example, fair market value, §704(b) book basis, etc.).[16]

Request for Comments

For the moment this is only proposed guidance.  The IRS is looking for comments on the following topics related to this Notice:

• Whether the methods used to satisfy the Tax Capital Reporting Requirement described in section III of this notice should be modified or adopted;

• Whether an ordering rule should apply to the basis used in determining the partnership’s net liquidity value; for example, use of fair market value is required, but if not readily available, §704(b) book basis is required, and, if the partnership does not maintain § 704(b) capital, GAAP is required, etc.;

• How, if at all, the Tax Capital Reporting Requirement should be modified to apply to partnerships that are treated as publicly traded partnerships under § 7704 of the Code;

• Whether the Transactional Approach, or similar method, should be permitted for purposes of meeting the Tax Capital Reporting Requirement and, if recommended, what additional guidance would be necessary; and

• Whether and in what circumstances limitations should be imposed on partnerships to change from one method to another (for example, whether there should be a limit on how many times the method can be changed over a period of years), including compliance with such rules in the case of the merger of partnerships using different methods.[17]

Comments are due by August 4, 2020 and should contain a reference to Notice 2020-43.  The IRS is encouraging commenters to use the electronic submission option rather than sending comments by mail, as the IRS notes that access to mail may be limited.[18]

Electronic comments are to be submitted “via the Federal eRulemaking Portal at www.regulations.gov (type IRS Notice 2020-43 in the search field on the regulations.gov homepage to find the docket for this notice and submit comments).”[19]

Those who insist on sending comments by mail can do so, though the IRS is likely correct to caution that doing so is not the best course.  There is more than an outside possibility that these comments may not be available to those making the final decisions on this guidance at the time those decisions are made.  Mailed comments are sent “to Internal Revenue Service, CC:PA: LPD (Notice 2020- 43), Room 5207, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044.”[20]

Comments received are going to be subject to public inspection and copying.[21]

[1] Notice 2020-43, June 5, 2020, https://www.irs.gov/pub/irs-drop/n-20-43.pdf (retrieved June 5, 2020)

[2] Notice 2020-43, June 5, 2020, Section III

[3] Notice 2020-43, June 5, 2020, Section III

[4] Notice 2020-43, June 5, 2020, Section III

[5] Notice 2020-43, June 5, 2020, Section III

[6] Notice 2020-43, June 5, 2020, Section III

[7] Notice 2020-43, June 5, 2020, Section III

[8] Notice 2020-43, June 5, 2020, Section III(1)

[9] Notice 2020-43, June 5, 2020, Section III(1)

[10] Notice 2020-43, June 5, 2020, Section III(1)

[11] Notice 2020-43, June 5, 2020, Section III(2)

[12] Notice 2020-43, June 5, 2020, Section III(2)

[13] Notice 2020-43, June 5, 2020, Section IV(2)

[14] Notice 2020-43, June 5, 2020, Section IV(2)

[15] Notice 2020-43, June 5, 2020, Section IV(2)

[16] Notice 2020-43, June 5, 2020, Section III(2)

[17] Notice 2020-43, June 5, 2020, Section IV

[18] Notice 2020-43, June 5, 2020, Section IV

[19] Notice 2020-43, June 5, 2020, Section IV

[20] Notice 2020-43, June 5, 2020, Section IV

[21] Notice 2020-43, June 5, 2020, Section IV