Draft 2020 Form 1065 instructions reflect change in reporting partner capital accounts

October 23, 2020

Article provided by Thomson Reuters

IR 2020-240, 10/22/2020

IRS has issued draft instructions for 2020 Form 1065, U.S. Return of Partnership Income, that include revised instructions for partnerships required to report capital accounts to partners on Schedule K-1 (Form 1065).

Background. For all recent past years, the Form 1065 instructions to Item L of Schedule K-1 to Form 1065, and Item F of Schedule K-1 to Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships), required reporting of a partner's capital account. See, for example, 2019 Form 1065 Instructions.

On April 5, 2019, IRS released Form 1065 Frequently Asked Questions explaining how a partnership should determine a partner's capital account and providing a safe harbor approach based on a partner's outside basis in its partnership interest. Thereafter, early releases of drafts of the 2019 Form 1065 and the 2019 Form 8865 required all partnerships and certain other persons who file Form 8865 to report all partners' capital accounts using the tax basis method.

However, after receiving comments that many partnerships could not comply with the tax basis method requirement in time to file their 2019 returns, IRS did not make this change for 2019. See IRS delays tax basis reporting of capital accounts to 2020.

The 2019 Form 1065 instructions to Item L of Schedule K-1 to Form 1065, and Item F of Schedule K-1 to Form 8865, required reporting of a partner's capital account. A partnership could report capital accounts using tax basis, Code Sec. 704(b), GAAP, or any other method. A partnership had to attach a statement titled “Item L. Partner's Capital Account Analysis” to Schedule K-1 identifying the method used. (2019 Instructions to Form 1065)

In Notice 2020-43, 2020-27 IRB, IRS again announced its intention to require tax basis methods for computing partner capital accounts. It proposed two methods, the Modified Outside Basis Method and the Modified Previously Taxed Capital Method, for doing so and said that it anticipated that the two proposed methods would be the only methods that would be acceptable for partnership tax years ending on or after December 31, 2020.

Notice 2020-43 said that a third method of computing partner capital accounts, the transactional approach, could not be used. See IRS proposes methods for reporting partner capital accounts.

IRS draft instructions take a different approach. IRS's newly-issued draft instructions to 2020 Form 1065 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 that method, as 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.

Partnerships that did not prepare Schedules K-1 under the tax basis method for 2019 or otherwise maintain tax basis capital accounts in their books and records (e.g., 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 Code Sec. 704(b) Method, as described in the instructions, including special rules for publicly traded partnerships.

IRS intends 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), 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.

IRS plans similar revisions, as applicable, to Form 8865.

Reference: For partnership returns, see FTC 2d/FIN ¶S-2701.