Partnership “tax capital”
Partnerships will have to track another metric called partner “tax capital” starting next year.
The IRS explained what additional calculations will be required in a notice in early June. The notice is Notice 2020-43.
It is the third attempt the IRS has made to explain the new metric. Earlier attempts left the market confused. (For past coverage, see “Deficit restoration obligations” in the December 2019 NewsWire.)
Part of the confusion is the name given to the new metric since it sounds like the capital accounts that partnerships are already required to use to distribute assets among partners when the partnership liquidates, but it is calculated differently.
Partnerships will still be required to maintain capital accounts, but the Form K-1s that are sent each year to partners will no longer tell partners their capital account balances at year end and will report their tax capital amounts instead starting with K-1s delivered in 2022 for payment of 2021 taxes.
The new metric — “tax capital” — is basically a way for the IRS to identify partners who perhaps should report taxable gains to the IRS. Negative tax capital is a sign of a potential gain.
Tax capital must be calculated using one of two methods. Partnerships can change back and forth between methods, but must tell partners the reason for the change and how their beginning and ending tax capital for the year differs as a result when sending partners their K-1s.
One method for calculating tax capital is the “modified outside basis method.” Under this method, a partner’s tax capital is the “outside basis” the partner has in its partnership interest, but with its share of partnership-level debt backed out of the calculation.
Partnerships do not always have the information needed to calculate partner outside bases. Notice 2020-43 requires partners to notify the partnership within 30 days or, if later, by the last day of the partnership tax year of any changes in a partner’s outside basis, other than changes due to capital contributions or distributions and allocations of which the partnership will already be aware.
An example of something the partnership would have to be told is if a partner paid an adviser a fee to buy a partnership interest. The fee must be added to the basis the partner has in its partnership interest since it is a cost of acquiring the partnership interest.
Partnership agreements should require partners to provide partnerships such information.
The other way to calculate partner tax capital is the “modified previously taxed capital method.” The calculation is as follows.
First calculate the amount the partner would be distributed if the partnership sold all of its assets for fair market value and liquidated, using the cash raised in the asset sale to pay all partnership liabilities first before distributing the remaining cash to partners.
Next add back any tax loss the partner would be allocated for the liquidation year.
Alternatively, subtract any tax gain the partner would allocated.
For example, suppose a partnership with two equal partners has assets in which the partnership has an “inside basis” of $3,000. The partnership owes $5,000 to a third party.
Partnerships are assumed for this purpose to be able to sell their assets for at least the amount of debt secured by the assets.
Assuming a sale for $5,000 in this case, the partnership would have no cash to distribute to partners since the cash would all go to repay the debt.
The partnership would have a gain of $2,000 on the sale, or the difference between $5,000 and its tax basis of $3,000 in the assets. Each equal partner would be allocated half this gain. The gain is subtracted from the $0 in cash they would be distributed. Thus, each partner has tax capital of negative $1,000.
In this simple case, each partner has tax capital of negative $1,000 under both methods for calculating tax capital.
However, the two methods produce different numbers in cases where there is no partnership-level debt exceeding the gross asset value.
Partnerships are not required to have appraisals done each year for the calculations. The IRS said to use the fair market values of assets “if readily available.” Otherwise, partnerships can guess at the numbers by using numbers they already track for tax or book purposes or by using some other method spelled out in the partnership agreement for “determining what each partner would receive if the partnership were to liquidate.”
It is still not entirely clear why the IRS feels it needs partnerships to track tax capital. The figures may confuse IRS agents on audit since the actual gain or loss on sale of a partnership interest may be a different number.