Tax Basis Method for Partnerships: The Transactional Approach

At the end of 2020, the IRS announced important changes to their compliance rules for partnerships. Starting with tax year 2020, partnerships must report their capital accounts using the tax basis method. Capital accounts show the equity in a partnership owned by each partner, including items like initial contributions made by each partner, business profits and losses assigned to each partner, and distributions made to each partner.

The tax basis method is a transactional approach. Since this approach is based on tax basis principles, each contribution or partnership net income increases a partner’s capital account, and each distribution or shares of loss decrease the capital account. Previously, taxpayers were allowed to use several different methods to calculate their capital accounts, such as GAAP or Section 704(b)—businesses who favored these methods will need to be aware of the differences in tax calculation.

Once you have calculated the basis using the tax basis method, you will also subtract the partner share of the partnership liabilities (per Code Section 752). So let’s say you’re contributing property to the partnership that is subject to a liability. We most commonly see this with real estate: investors will have a mortgage out on their property, but they then want to contribute that property to the partnership. When this is the case, you need to subtract the liability that now the partnership is assuming it. You will also need to allocate any income and gain on that property to each partner.

Why the change to the tax basis method? The IRS observed that most partnerships are already using the transactional method, so many businesses will not be overly burdened by this new requirement. To ease the transition, the IRS is also waiving any penalties for errors in calculating and reporting these balances as long as partnerships take “ordinary and prudent business care” in following their instructions. So the new requirement will actually be fully effective starting in 2021.

As another allowance, if a partnership did not use the tax basis method in previous years, they can calculate each partner’s beginning capital balance for 2020 by using the modified outside basis method, the modified previously taxed capital method, or the 704(b) method (read more about these methods here). Of course, if the partnership was previously using the transactional method, they should already have everything they need to accurately report the items of income or deduction to the capital account.

A few important notes on filing: On the return of partnership income (Form 1065), taxpayers will fill out Schedule M-2, which does an analysis of the partner’s capital accounts each year and shows what caused the changes during that year. This includes increases to capital, such as contributions or distributions, and how the partners are sharing in income or other items within the partnership. The values entered on this form should match the partnerships, books, and records.

Another key item is that the amounts on Schedule M-2 should equal the total amounts reported on item L on Schedule K-1, the tax form issued for investment in a partnership. If the beginning and the ending capital accounts on Schedule M-2 are different from the amounts reported on the K-1, the taxpayer will need to attach a schedule that reconciles those differences. If they do not attach details showing why they don’t match, they can be subject to penalties under the new reporting rules.

Tax professionals will want to be well-versed on the implications of these compliance changes to best serve their clients. Improve your ability to plan ahead and secure maximum savings for your clients by becoming a Certified Tax Planner.

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