Starting with tax year 2020, the IRS is requiring partnerships to report their capital accounts using the tax basis method. Capital accounts show the equity in a partnership owned by each partner and often include initial contributions made by each partner, business profits and losses assigned to each partner, and distributions made to each partner. The tax basis method calculates these balances using tax basis principles (read more about this method here).
Tax advisors are likely aware that a partner’s basis in the partnership interest can never be negative. However, a partner’s capital account can be negative. This generally happens when the partnership allocates losses or receives a distribution funded by debt incurred by the partnership. These actions can result in a taxable event for partners, so proactive steps need to be taken to avoid a negative balance.
At the beginning of the year, a capital account cannot begin with a negative balance, but a partner can have a negative capital account after fully accounting for all their distributed shares of losses and distributions. Generally, the partner is going to have to carry forward any losses that have been disallowed because they are higher than outside basis. From a tax planning perspective, our focus is on the outside basis amount, since this will tell us whether the partner is entitled to deduct any losses from the partnership. If there are ways to prevent a loss from being suspended, the taxpayer will want to do that before the end of the year.
In certain situations, a negative capital account balance on a Schedule K-1 (the tax form for a partner’s share of income) may not reflect whether that partner is able to take a deduction. The reason is debt basis. If a partner receives a distribution in excess of their outside basis, the partner might be required to recognize a gain. In this case, that partner may not have sufficient debt basis to claim a deduction. This is where we will likely see the most impact as a result of this IRS compliance change.
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A negative capital account can be problematic for a couple of reasons:
- It’s more likely that the taxpayer will also have a negative outside basis, which jeopardizes their ability to deduct a loss
- If any members of a partnership have a negative capital account, that partner is legally obligated to restore their deficit, also known as a DRO (deficit restoration obligation).
The reasoning behind a DRO is that if an event happens to impact the state of the partnership, say if one of the partners dies or if the company is liquidated, the partner with a negative capital account would need to be able to pay their deficit amount. If one partner dies, the other partner has a legal obligation to make their partner’s heirs whole, so the law requires them to pay the partnership an amount equal to that negative capital account. During the COVID-19 era, we have all seen businesses close unexpectedly, which is why the protection of a DRO exists.
A DRO is calculated by the hypothetical date before liquidation. So if we are looking at reporting for tax year 2020, we might look at the balances on December 30th and say, theoretically if the partnership were to completely liquidate tomorrow, what assets would be left, where would they get distributed, in what percentages, and who would be liable for any debts? If a partner has a negative balance on that hypothetical liquidation date, this will impact their tax liability.
To help taxpayers navigate the risks associated with negative capital accounts, tax advisors need to stay up-to-date on current tax requirements and learn to look into the future to anticipate negative consequences. Learn these skills and more by becoming a Certified Tax Planner.