In Notice 2021-13[1] the IRS has provided for relief from penalties for certain incorrect reporting related to partners’ tax basis capital accounts on Schedules K-1s.

The Notice describes the changes to K-1 capital account reporting that are effective for 2020 filings:

Prior to the 2020 taxable year, partnerships could report their partners’ capital accounts for the taxable year on Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., using one of a variety of methods that are based on different principles (for example, tax basis, generally accepted accounting principles (GAAP), section 704(b) book, or any other method). Starting in the 2018 taxable year, however, the instructions for Form 1065 required partnerships that did not report tax basis capital accounts to their partners to report separately the beginning and ending tax basis capital account balance of any partner that would have a negative beginning or ending tax basis capital account balance.

Beginning in the 2020 taxable year, the 2020 Form 1065 Instructions require partnerships to calculate and report their partners’ capital accounts using the transactional approach for the tax basis method, irrespective of whether the beginning or ending balance is negative for a partner. The instructions for Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships, refer to the Form 1065 Instructions for reporting partners’ capital accounts. Under the transactional approach outlined in the 2020 Form 1065 Instructions, partnerships report partner contributions, each partner’s share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax basis principles, instead of methods based on other principles such as GAAP. The 2020 Form 1065 Instructions explain that if a partnership did not report its partners’ capital accounts using the tax basis method in the 2019 taxable year and did not maintain its partners’ capital accounts under the tax basis method in its books and records, the partnership may determine its partners’ beginning capital accounts for the 2020 taxable year using any one of the following methods: the tax basis method, modified outside basis method, modified previously taxed capital method, or section 704(b) method (each as described in the 2020 Form 1065 Instructions).[2]

Penalties that Potentially Could Apply

The Notice also details the various penalties that can apply when these forms are properly completed by the partnership. The notice points out that a failure to properly complete the K-1 can trigger penalty for failure to timely file the partnership return (Form 1065) under IRC §6698:

‘Section 6698 imposes a penalty for failing to file a return or report at the time prescribed therefor, or for filing a return or a report that fails to show the information required under section 6031. A return required under section 6031 includes Form 1065 and each Schedule K-1. A failure to file a partnership return that shows information required under section 6031 would generally subject a partnership to the section 6698 penalty. A section 6698 penalty will not be imposed if it is shown that the failure is due to reasonable cause.[3]

A separate penalty applies to the failure to timely file the information return—and the Schedule K-1 is such an information return. Thus, a penalty under §6721 would also potentially apply if the form is not properly completed:

Section 6721 imposes a penalty for any failure to file an information return on or before the required filing date, and for any failure to include all of the information required to be shown on the return or the inclusion of incorrect information. When regulations under section 6011 require a partnership to file a partnership return electronically, each Schedule K-1 required to be included with the return with respect to each partner is treated as a separate information return subject to the section 6721 penalty. See section 6724(e) of the Code. Failure to electronically file a correct Schedule K-1 when required would generally subject a partnership to a section 6721 penalty.[4]

A similar penalty will apply for failing to provide the partner with a properly completed statement in a timely fashion under IRC §6722:

Section 6722 imposes a penalty for any failure to furnish a payee statement on or before the date prescribed therefor to the person to whom such statement is required to be furnished, and for any failure to include all of the information required to be shown on a payee statement or the inclusion of incorrect information. Section 6724(d)(2) provides a definition for “payee statement” that applies to section 6722. Under section 6724(d)(2)(A), a Schedule K-1 furnished to each partner is considered a payee statement. A failure to furnish a correct Schedule K-1 as required under section 6031 would generally subject a partnership to the section 6722 penalty.[5]

The Notice points out that the penalties for failing to file and provide the information returns can be escaped if the partnership shows reasonable cause for the failure and that it was not due to willful neglect:

Section 6724 provides an exception to a penalty for any failure under sections 6721 and 6722 if it is shown that the failure is due to reasonable cause and not to willful neglect. Under § 301.6724-1 of the Procedure and Administration Regulations, a penalty is waived for reasonable cause only if the filer establishes that either there are significant mitigating factors with respect to the failure or the failure arose from events beyond the filer’s control. In addition, the filer must establish that the filer acted in a responsible manner both before and after the failure occurred.[6]

Finally, the Notice points out that the improper reporting could lead to an assessment of tax against the partnership under the BBA 2015 partnership audit rules, and that examination assessment could lead to an accuracy related penalty under §6662.

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. Under section 6221, the applicability of any penalties, additions to tax, or additional amounts that relate to an adjustment to a partnership-related item must be determined at the partnership level for partnerships subject to the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015, Pub. L. 114-74, 129 Stat. 584. Section 6233 makes partnerships subject to the centralized audit regime liable for the section 6662 penalties calculated on the imputed underpayment.[7]

As should be clear, at least in theory a failure to properly determine and report partners’ tax basis capital accounts could expose a partnership to a rather significant amount of penalties.

Late Filing Penalty Relief (§§6698, 6721 and 6722)

Relief for the various late filing penalties is provided in Section 3 of the Notice.

The notice deals with relief when issues arise with the proper reporting and computation of the partners’ beginning capital account balance on the tax basis, providing:

A partnership will not be subject to a penalty under sections 6698, 6721, or 6722 due to the inclusion of incorrect information in reporting its partners’ beginning capital account balances on the 2020 Schedules K-1 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 any one of the following methods, as outlined in the instructions: the tax basis method, modified outside basis method, modified previously taxed capital method, or section 704(b) method.[8]

The Notice goes on to describe ordinary and prudent business care for these purposes:

For purposes of this notice, “ordinary and prudent business care” 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 demonstrating ordinary and prudent business care, taxpayers are reminded that capital account balances are part of a partnership's books and records and must be maintained accordingly.[9]

The notice also provides relief from issues with ending capital account balances, but only to the extent the error arises due to errors in the beginning capital account:

In addition, a partnership will not be subject to a penalty under sections 6698, 6721, or 6722 due to the inclusion of incorrect information in reporting its partners’ ending capital account balances on Schedules K-1 in taxable year 2020 or its partners’ beginning or ending capital account balances on Schedules K-1 in taxable years after 2020 to the extent the 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 this notice is available.[10]

Although this relief is limited in a way that may trouble advisers, the Notice reminds taxpayers that reasonable cause exceptions to these penalties are still available if this Notice doesn’t deal with the issue:

The penalty relief provided in this notice is in addition to the reasonable cause exception to penalties for failing to properly report the partners’ beginning capital account balances, as described in section 2 of this notice.[11]

The late filing relief for errors in capital accounts concludes by providing that this relief will not apply to returns that are simply not filed, even with these errors, in a timely fashion:

A partnership that fails to timely file a 2020 Form 1065, Form 8865, and Schedules K-1 is not eligible for the relief provided by this notice. A partnership that fails to include a partner’s beginning capital account balance on the Schedule K-1 is also not eligible for relief.[12]

As well, this relief does not impact the requirement that a partner needs to have maintained accurate records for his/her basis in the partnership interest.

This notice does not relieve a partner of its obligation to determine the adjusted basis of its interest in the partnership for purposes of determining its tax liability or that of any other person as prescribed in section 705 of the Code and § 1.705-1(a)(1) of the Income Tax Regulations.[13]

Relief for Accuracy Related Penalty Under §6662 in BBA Exams

If a partnership has an error that is eligible for relief under the “late filing” relief provisions of this ruling, the IRS Notice provides that the accuracy related penalty under IRC §6662 will not be asserted by the Service on that part of the understatement:

The IRS will waive any accuracy-related penalty under section 6662 for any taxable year with respect to any portion of an imputed underpayment that is attributable to an adjustment to a partner’s beginning capital account balance reported by the partnership for the 2020 taxable year to the extent the adjustment arises from the inclusion of incorrect information for which the partnership qualifies for relief under section 3 of this notice.[14]

However, the Notice provides that relief is strictly limited to those partnerships that meet the conditions for relief under the late filing section of the Notice:

This notice does not prevent the IRS from imposing an accuracy-related penalty under section 6662 for any portion of an imputed underpayment related to capital account reporting by the partnership that is not described in the previous sentence.[15]

[1] Notice 2021-13, January 20, 2021, https://www.taxnotes.com/tax-notes-today-federal/information-reporting/partnerships-given-penalty-relief-some-incorrect-reporting/2021/01/21/2l6n5 (retrieved January 22, 2021)

[2] Notice 2021-13, Section 2

[3] Notice 2021-13, Section 2

[4] Notice 2021-13, Section 2

[5] Notice 2021-13, Section 2

[6] Notice 2021-13, Section 2

[7] Notice 2021-13, Section 2

[8] Notice 2021-13, Section 3

[9] Notice 2021-13, Section 3

[10] Notice 2021-13, Section 3

[11] Notice 2021-13, Section 3

[12] Notice 2021-13, Section 3

[13] Notice 2021-13, Section 3

[14] Notice 2021-13, Section 4

[15] Notice 2021-13, Section 4