The IRS has embarked on a campaign to force partnerships to step up their reporting of partner-specific information on Form 1065 in the partnership’s income tax return. Unlike the accepted method for requiring taxpayers to maintain new entries in their books and records, the IRS of late has sought to, in effect, make law not through regulations, rulings and notices, but through the instructions to Form 1065 (usually in draft form) and even in “Frequently Asked Questions” (FAQs).
In Notice 2019-66 (the “Notice”), issued on December 9, 2019, the IRS took a much-needed step back from the burdens imposed upon partnerships. In this update, we highlight the (interim) relief granted, keeping in mind that S Corporations have yet to receive the same relief.
Partners’ Capital Accounts. Draft instructions to the 2019 partnership return would have required the partnership to report all partners’ capital accounts using tax basis (based upon regulations) and not based on GAAP (Generally Accepted Accounting Principles) or another method. Given the large number of partnerships not using tax basis, this shift to reporting tax basis capital accounts would have required a massive amount of effort. For 2019, the Notice allows a partnership to use a method other than tax basis. For 2020, Form 1065 tax basis will be required; the Notice promises to provide guidance on calculating “tax basis” capital accounts, a tacit admission that existing guidance is inadequate.
Negative Capital Accounts. The IRS is especially concerned about partners with “negative capital accounts,” which can result, for example, when allocations of loss and distributions are greater than income allocations and cash and property contributed to the partnership. Unlike calculation of a partner’s basis in its partnership interest (“outside basis”) capital accounts do not reflect a partner’s share of partnership liabilities. The Notice permits a partnership to use any of the methods for computing capital accounts under 2018 rules. IRS will issue more guidance on computing capital accounts with a view to 2020 tax return preparation, which will likely require disclosure of negative capital accounts based on tax basis calculations.
Net Unrecognized Section 704(c) Gain or Loss. The 2019 draft tax forms would have required partnerships to report each partner’s share of the net unrecognized gain or loss at the beginning and the end of the partnership’s tax year. However, the draft forms failed to define this term, leading to confusion. In general, the term means the unrecognized gain or loss resulting from contributions of property as well as revaluations of partnership property. For example, a securities partnership generally revalues all its securities for each break period (when partners enter and leave the partnership, partnership year-end and any interim computation dates). The Notice permits a partnership to compute these often-difficult items using any “reasonable manner” consistent with the approach used in prior years.
At-Risk Activity Reporting. The 2019 draft guidance would have required partnerships to provide detailed reporting on at-risk rules under Section 465 of the tax code. These rules limit a partner’s deductions to items where the partner is at risk economically with respect to the partnership’s activities. The draft rules would have required break outs of each separate activity where a partner could be subject to Section 465. Partners in hedge funds holding solely publicly traded securities and commodities generally are not limited by the at-risk rules, but funds-of-funds and partnerships holding publicly traded partnership interests, oil and gas drilling partnerships and real estate partnerships have issues here. The Notice provides that partnerships may use for 2019 the type of approach used in 2018 but must nonetheless indicate whether they have aggregated their at-risk activities.
Alas, S Corporations have not been so fortunate, and the Notice does not provide relief to S Corporations with respect to the onerous new at-risk rules proposed for 2019. We wait to hear if this is just an oversight that might be corrected promptly.
Good News on Penalties. The Notice states that taxpayers that “follow the provisions of this notice will not be subject to any penalty for reporting in accordance with the guidance provided in this notice,” including penalties relating to payee statements, failure to furnish information on a Schedule K-1 and failure to file a partnership return that shows required information (Form 1065 asks many questions). This is only fair, given the IRS’s shortcomings in establishing these changes.
Bonus Question: Should Service Partners Be Treated as Employees? The IRS ruled in Revenue Ruling 69-184 that a partner cannot also be classified as an employee of the partnership for tax purposes, regardless of what state law may provide. Partners with small partnership interests are economically in the same position as employees; this problem is one that has vexed tax professionals for some time. For example, many partners find it inconvenient to make quarterly estimated tax filings and would prefer wage withholding, which is usually done by an outside service.
Now, the IRS is questioning the wisdom of their 50-year old ruling. In a detailed report issued in December 2019, the American Bar Association Tax Section reviews the ramifications of partners as employees and concludes that among other modernizations, classifying “small” services partners as employees has merit. The report characterizes as a “small” partner one that has a capital or profits of less than 10%.
Effect on 2019 Tax Compliance. First, it is good to see that the IRS responded to the many criticisms regarding its proposed 2019 tax compliance additions. The IRS heard the complaints that many partnerships would not be able to comply with the new rules in time and that the 2019 tax return filing season would be very negatively affected. Although the IRS has been very severely criticized for what is arguably making rules of general application through FAQs, draft tax return instructions and changes to tax forms, it is not clear that the IRS has taken proper heed of its rulemaking failures. Taxpayers do not have the same opportunity to comment on FAQs and tax return instructions that they do with respect to the regulations process. The Service’s haste has led to the retrenchment that the Notice represents. Has the IRS learned its lesson? Watch this space.