The IRS recently issued Notice 2020-43 (the Notice) to seek public comment on a proposed requirement for partnerships to use only certain accepted methods to satisfy the tax capital reporting requirement with respect to partnership taxable years that end on or after Dec. 31, 2020. Changes to the tax capital disclosure requirement had initially been slated for the 2019 tax year, but the IRS had delayed the requirement until the 2020 tax years for partnerships except those with negative tax basis capital balances.
After the IRS had initially unveiled the change to the tax basis reporting, uncertainties had surfaced about the appropriate method to determine tax basis capital. The Notice reacts to previous comments and now proposes two such methods that would be available for partnerships to use:
- Modified Outside Basis Method, or
- Modified Previously Tax Capital Method.
Partnerships must use one of these two methods to satisfy the tax capital reporting requirements and will no longer be able to report partner capital accounts using Section 704(b), GAAP, or other methods. The method selected must be used for all partners and for tax years after 2020, partnerships may elect to switch between these two methods by attaching a disclosure to all Schedule K-1s.
Modified Outside Basis Method
The modified outside basis method starts with each of the partner’s adjusted tax basis in their respective partnership interest, as determined by the principles and provisions of subchapter K (including those contained in Sections 705, 722, 733, and 742) and subtracting from this amount each partner’s share of partnership liabilities under Section 752.
Partners may be required to provide adjusted tax basis information to the partnership for purposes of applying the modified outside basis method and must inform the partnership of any changes in their respective adjusted tax basis that occur outside the partnership (i.e., from transactions not reported on their respective Schedule K-1). Partners must provide this information to the partnership within 30 days of such changes or by the tax year-end of the partnership—whichever is later. Partnerships are entitled to rely on such partner basis information provided by its partners unless the partnership has reason to know that such information is clearly erroneous.
Modified Previously Taxed Capital Method
For purposes of the tax capital reporting requirement, the modified previously taxed capital method modifies the calculation of previously taxed capital described in Regs. Section 1.743-1(d)(2). The original calculation of previously taxed capital is based on the following:
- The amount of cash the partner would receive upon a hypothetical liquidation of the partnership; increased by
- The amount of tax loss that would be allocated to the partner from the hypothetical liquidation; decreased by
- The amount of tax gain that would be allocated to the partner from the hypothetical liquidation.
The hypothetical liquidation 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, subsequent payment by the partnership of all of its liabilities, followed finally by the distribution of the remaining proceeds to its partners.
The modified previously taxed capital method modifies the above approach as follows:
- The amount of cash a partner would receive upon a hypothetical liquidation and the calculations of gains or losses from the transaction would be based on the fair market value of the assets, if readily available. If not readily available, the partnership may determine its net liquidity value and gains and losses using such asset bases as calculated under Section 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; and
- All liabilities are treated as nonrecourse for purposes of the second and third bullet points related to the calculation of gain or loss, respectively.
As noted above, the IRS is seeking comments on the following topics:
- Whether the methods used to satisfy the tax capital reporting requirement described in the Notice should be modified or adopted;
- Whether an ordering rule should apply to the basis used in determining the partnership’s net liquidity value;
- How, if at all, the tax capital reporting requirement should be modified to apply to partnerships that are treated as publicly-traded partnerships under Section 7704 of the Internal Revenue Code;
- Whether other methods 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, including compliance with such rules in the case of the merger of partnerships using different methods.
Written or electronic comments must be received by Aug. 4, 2020 and should contain reference to Notice 2020-43.
Next Steps for Private Equity & Venture Capital Firms
Private equity and venture capital funds and their flow-through portfolio companies may be in the midst of preparing for the new tax capital reporting requirements. This latest Notice is an indication of the IRS’s thoughts on what the reporting could look like, but also serves as a reminder that the guidance may still shift before the reporting for the 2020 tax year begins in earnest.
Private equity and venture capital funds should review the Notice and consider how the currently proposed methods of tracking tax capital accounts will impact their efforts of preparing their compliance processes and how they might be able to adjust to potential further changes to the acceptable tax capital account tracking methodologies. For more information, please contact us.
Rob Kerr is a Tax Managing Director and a Member of the Private Equity & Venture Capital Practice. He can be reached at 401.626.3228 or email@example.com.
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