Draft instructions for reporting partnership capital accounts are issued

On Oct. 22, the IRS released an early draft of the instructions for Form 1065, U.S. Return of Partnership Income (IR-2020-240). The IRS accepted comments on the draft instructions for 30 days and had planned to issue final instructions in December.

The revised instructions will apply to the 2020 tax year (i.e., the 2021 filing season) and include revised instructions for partnerships required to report capital accounts to partners on Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc.

Partnerships filing Form 1065 for tax year 2020 must calculate partner capital accounts using the transactional approach for the tax-basis method. Under the tax-basis method, 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 even though multiple methods were permitted. 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 (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 Sec. 704(b) method, as described in the instructions, including special rules for publicly traded partnerships.

Earlier in 2020, the IRS issued Notice 2020-43 asking for comments on other possible methods to report capital accounts to partners and received numerous comments requesting that the tax-basis method approach be retained. The IRS also did not receive practical alternative approaches to partner capital account reporting. The IRS has determined that reporting using only one method assists it in compliance and ensures that compliant taxpayers’ returns are less likely to be examined.

To promote compliance with the tax-basis method, the IRS intends to grant penalty relief for the transition to the new rules in 2020 (see Schreiber, “Partnership Capital Reporting Requirements Postponed Until 2020,” The Tax Adviser (Dec. 10, 2019). The relief will provide that solely for the 2020 tax year (for partnership returns due in 2021), the IRS will not assess a penalty for any errors in reporting a partnership’s 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. According to the IRS, this penalty relief will apply in addition to the reasonable-cause exception.