By Julia Taylor, CPA, Tax Manager | Financial Services Industry Team
Update: The requirement to report partners’ shares of partnership capital on the tax basis method will not be effective for partnership tax years beginning in 2019 but will be effective for partnership tax years beginning on or after January 1, 2020.
IRS drafts changes to Form 1065 and Schedule K-1
As anyone with partners or LLC investors knows, the Tax Cuts and Jobs Act added layers of complexity to tax reporting, pushing the delivery of K-1s to investors later than ever before. For the 2019 forms, changes have been drafted by the IRS to Form 1065 and Schedule K-1 which may further add to reporting complexities and compliance burdens in the coming year. Investor communications about the changes are key in ensuring they have an understanding of how the K-1 changes will affect them.
NEW TAX BASIS CAPITAL ACCOUNT REPORTING – deferred to 2020
The biggest factor for many partnerships will be the new tax basis capital account reporting. Previously we have had options to use GAAP, Tax, 704(b) or Other. The IRS indicated their intent was not only to improve the quality of the information reported to investors, but also to “aid the IRS in assessing compliance risk and identifying noncompliance”. Partnerships that had been reporting on any method other than tax basis may need to dig back into the archives to recreate tax basis capital accounts. That may mean going back to the beginning and gathering data on all of the partnerships investments. Fund or partnership structure (fund of funds, tiered partnership) can have a significant impact on the effort needed to track tax basis. Luckily, this requirement has been postponed to apply to tax years that begin on or after January 1, 2020 to allow partnerships time to gather the information needed to comply. Our recommendation is to move forward now to the extent practicable in order to get ahead of the compliance needs of 2020.
U.S Fund Managers and K-1
If all of your fund managers are U.S. based, and provide a K-1, their tax provider is going to have to recreate accounts. Even in this case, you may still want to discuss with your service provider whether you will use the amounts reported on the K-1 you receive from the manager, or use a separate calculation. Differences can exist for various reasons including purchasing the interest from another partner and suspended losses.
Offshore Funds without a K-1
If you are invested in offshore vehicles where no K-1 is provided, your tax advisor will have to calculate it – likely going back to the year you bought the investment. Hedge funds employing reverse 704(c) tax allocations will likely have an easier time as it is tracked, but every partnership will have to go through this process, hopefully prior to the heights of the filing season.
While you may wonder what this has to do with investor communications, the answer is advance notice.
Proactively Communicate with Investors about the K-1 Changes
Consider letting investors know that their 2019 or 2020 K-1 will have important presentation changes and new information. If you have been historically reporting capital accounts on GAAP, 704(b) or “other”, you may want to let the investors know that their capital account balances may appear different on the 2019 K-1s, and will appear different on the 2020 K-1 if not. The balance reported in the capital section will now be on an income tax basis and it is unlikely to match the investment value statements provided by their financial advisors.
Other partnership tax compliance changes include
- Reporting a partner’s share of IRS Section 704(c) gain or loss at the beginning and ending of the year. This is the amount of built in gain or loss on contributed property or revaluations to FMV, and will reflect the special allocation to the contributing partner during the year.
- Disregarded entities are no longer permitted to “stand in” for the beneficial owner. The taxpayer ID for the beneficial owner must be used, and the beneficial owner’s name reported.
- Whether a decrease in a partner’s profit, loss or capital is due to a sale or exchange.
- If liabilities allocation includes amounts from lower tiered partnerships.
- If the partnership has aggregated more than one activity for purposes of at-risk or passive activities.
The 2019 and 2020 partnership tax compliance changes are going to require time, effort, planning and communication. Chances are they will affect your fund in some way, and proactive communication about the changes will help get ahead of investor questions when they receive their K-1s in 2020.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.