The IRS released draft instructions for Form 1065, containing guidance on how partnerships must report partner’s capital accounts beginning with tax year 2020 filings. The approach outlined in the draft instructions would be a welcome change, as the guidance in Notice 2020 43—which proposed two methods to determine partner tax account basis—could be administratively challenging for partnerships.
The IRS is taking steps to enhance overall partnership income tax reporting accuracy, such as expanding required disclosures at the level of the partnership and partners and requiring new disclosures starting with tax returns filed for 2019. When coupled with other information on each partner’s Schedule K-1, the IRS could have enough information to use data analytics to identify potential abnormalities that may lead to inquiries.
If allocation errors are identified, taxpayers and their advisors will need to determine what corrective measures are available. Whichever measures are selected, consideration will need to be given to potential administrative complexity and/or challenges by the IRS.
Taxpayers and their advisors need to evaluate the impact that allocation errors have on a partner’s capital balance, as well as “outside” and “inside” tax bases. How these items are tracked may impact gain on a sale for a transferor, the basis adjustment for the transferee, and future allocations of income or loss and liability.
Accuracy in partnership allocations and capital maintenance is paramount. Given the complexity found in many existing partnership operating agreements, technology-based tools are often critical to ensuring accurate allocations and future transactional computations.