The Internal Revenue Service’s announcement last month delaying a requirement for reporting partners’ share of partnership capital offers some extra time to busy tax practitioners, but the issue still isn’t going away and may lead to some other problems.
“The best news we just got about filing season is the IRS delayed for a year the tax basis capital reporting requirements,” said Bill Smith, managing director of CBIZ MHM’s National Tax Office.
For 2019, partnerships and other persons must report partner capital accounts consistent with the reporting requirements in the 2018 forms and instructions, including the requirement to report negative tax basis capital accounts on a partner-by-partner basis. The notice also clarifies the 2019 requirement for partnerships and other persons to report a partner’s share of net unrecognized Section 704(c) gain or loss by defining this term for purposes of the reporting requirement. In addition, the notice exempts publicly traded partnerships from the requirement to report their partners’ shares of net unrecognized Section 704(c) gain or loss until further notice. But the reprieve may not go far enough, especially for the many partnerships that aren’t publicly traded.
“The delay of tax basis capital is a welcome change,” said Nick Passini, senior manager of pass-through tax consulting at RSM US LLP. “There was a lot of push from tax preparers and taxpayers to say this is something we needed more time with, to make sure it was reported properly. But when you go back to the request, in addition to delaying this, there was a requirement to report unrecognized section 704(c) gain or loss, but the delay notice did not offer a delay in that part of the reporting. There will be a large group of taxpayers who will still need to compute tax basis capital, even though there is a delay in the reporting of tax basis capital.”
In the past, partnerships weren’t required to keep track of a running balance of 704(c) adjustments, but many of them — particularly in the middle market — decided to defer the calculations until they affected the allocation of taxable income. Now, however, partnerships will be required to report unrecognized section 704(c) gain and loss in 2019. Due to the volume of information that may need to be gathered, partnerships may have to act right away to determine whether the additional calculations are needed to accurately prepare their 704(c) records for the 2019 tax year. On top of that, even though the IRS is providing a one-year delay in tax capital reporting, many partnerships may still need to calculate tax capital for the 2019 tax year. That’s because the calculation of section 704(c) attributes involves the computation of tax capital.
“There will be some partnerships that do benefit, but the group of partnerships that do benefit will probably be more limited than you might imagine,” said Passini. “When you look at this concept of 704(c), it’s a lot more common than you might realize. A lot more of them may create this adjustment that aren’t always contemplated at the time. The most common is the contribution of cash for an existing partnership. If a partner is admitted, there’s a strong possibility that the admission of the new partner will create a reverse layer. It may have an impact years down the road, and the work may not have been done at the time. Now that it needs to be reported. to determine if there is a 704(c), you have to do a calculation of tax basis capital.”
He believes many partnerships will have to do the reporting early no matter what. “I think there’s going to be quite a few taxpayers who will early report it because they have to do the work anyway,” said Passini. “They have to make sure it’s not negative. We had that in 2018, and it still exists in 2019.”
The delay will help some partnerships, but far from all of them. “The delay will help some, but I think the group that the delay benefits is a lot more limited,” said Passini. “To clarify, the 704(c) calculation was always a requirement. It’s not necessarily that the calculation itself is new, but the calculation is occurring earlier and we have to do the tax capital basis in many cases.”
Another problem could occur with engagement letters to clients. Smith noted that many firms have already sent out their engagement letters listing the fees in them before the IRS provided notice of the delay. “Then we get dropped the instructions that say you’ve got to calculate tax basis capital,” he said. “The IRS doesn’t even have a solution for what happens. We have partnerships that go back to the 1980s where nobody’s been tracking basis. What are we supposed to do about that? We can ask our clients for the information, but they’ll go, ‘We don’t have that information. What are you talking about?’ Luckily, they’ve pushed back the most strenuous requirements for a year. In 2018, we had to report negative tax basis capital, and that stays for 2019, but we were very struggling with what we were going to do with our clients in terms of this tax basis capital reporting.”
The informal nature of the IRS announcement may take some practitioners unawares. “It’s like a new rule that they just dropped on a line on the form in the instructions,” said Smith.
He believes the change could have a far-reaching impact for many firms. “For us, it’s very big,” said Smith. “And part of the reason for that is they’re now getting pushback on unbilled work that they’re trying to bill for all the Tax Cuts and Jobs Act extra work they had to do. The fee is kind of an estimate for non-complex issues based on the Tax Cuts and Jobs Act. It’s going to cost more when we have to do that. But nobody wants to upset their clients. So the WIP would go unbilled and they would try to bill it before the end of the year and the clients go, ‘We’re not paying for that!” So now they’re seeing the effects of that and thinking, ‘Now we’re going to have the exact same thing with this tax basis capital. Clients aren’t going to want to pay for it.’ There’s no question there’s going to be a lot of extra work. I think that’s one of the reasons they’re highly sensitive to it. It was a big win for us to at least get a year of delay on that.”
The change could have an impact related to the IRS’s new partnership audit regime, which is supposed to streamline the audit process for large partnerships. “I think there’s probably a connection that can be drawn to the IRS’s expanded ability to audit partnerships,” said Passini. “They’re asking for more information and that may have been driven by the fact that the audits aren’t as difficult as they were in the past.”
The new partnership audit regime could lead to other problems for tax and accounting firms. “Now the firms want to just make the representation on the 1065 that so and so is the partnership representative because he used to be the tax matters partner,” said Smith. “There’s nothing that says the partnership representative is the former tax matters partner. The partnership representative has much broader power than the tax matters partner used to have — night and day — and you’re making the representation that this person is the partnership representative. You don’t want the accountants being the ones to do that because guess who’s going to be getting sued as a result of writing that down and not getting confirmation from the client when the so-called partnership representative who never got elected by the partnership does something dumb under the partnership audit rules? That’s a huge problem.”
