IRS Provides Penalty Relief for Failure to Include “Negative Basis” Info on 2018 Partnership Returns

For 2018 partnership tax returns due in 2019, partnerships must report negative “tax basis” capital accounts on the Schedules K-1 for their partners. Perhaps recognizing that it may be difficult for some partnerships to timely comply with these new requirements, the IRS issued Notice 2019-20 on March 7, 2019, providing penalty relief under certain circumstances, discussed below.

Background

Capital accounts ensure the proper allocation of income and loss among partners. Partnerships have long been required to report partners’ capital accounts on Schedule K-1 to Form 1065, and many report on the same basis that they track the capital account balances of their partners. Many partnerships maintain their capital accounts on a section 704(b) book basis or GAAP basis, rather than on a tax basis. Reporting on book or GAAP basis allows the partnership to better track the economic agreement between the partners by measuring the value of assets contributed to a partnership at the time of contribution (rather than by their historical, pre-contribution tax basis), but also requires taxpayers to make adjustments at tax time. Capital accounts maintained on a section 704(b) book basis (or on a GAAP basis) may differ substantially from capital accounts maintained on a tax basis.

It is permissible for a partner to have a negative capital account balance, usually in tandem with an allocation of partnership debt, or a deficit restoration obligation. Negative capital accounts can result if the partner has taken a distribution or losses financed by partnership debt. Whether a distribution is taxable depends on whether it exceeds a partner’s tax basis in his partnership interest (plus his share of partnership liabilities). Similarly, partners cannot take losses in excess of their tax basis (including their share of partnership liabilities.) Because partnerships did not previously have to report capital accounts on a tax basis, the IRS could not readily determine if distributions or losses exceeded basis. Prior to the current filing season, the information presented to the IRS on tax returns was a mix of book and tax basis, without an easy way to move from one to the other.

New K-1 Reporting Requirement

The instructions to Schedule K-1 to Form 1065 now require larger partnerships (with assets of more than $1 million or gross receipts of more than $250,000) and late filing partnerships, who do not otherwise report capital accounts on a tax basis, to now report on line 20 of Schedule K-1 using code AH, the amount of every partners’ “tax basis capital” at the beginning and end of the year if either amount is negative. As set out in the instructions to Form 1065, “tax basis capital” is essentially the partner’s tax basis in his partnership interest (not including the partner’s share of partnership liabilities which is reported elsewhere on the Form K-1). This information will make it much easier for the IRS to determine if a partner may have received a distribution or claimed losses in excess of basis.

Penalty Relief Related to Failures To Report Using The New Rules During this Filing Season

Given that it may be necessary to review many years’ worth of historical data to determine partner tax basis, this is truly a Herculean task (comparable to the cleaning of the Augean stables), and one that some return preparers may have difficulty accomplishing before the due date of 2018 returns, especially given the rigors of the filing season and the complexity introduced by the new TCJA provisions. The worry for many partnerships and their tax preparers was that, if the 2018 returns were not filed correctly, the IRS could assert penalties under Sections 6698 or 6722 for failures to file correct partnership returns and/or Forms K-1 information returns.

Fortunately, the IRS announced yesterday (March 7, 2019) in Notice 2019-20, which will be included in IRB 2019-13, that these penalties would not be imposed so long as the required information is supplied in a separate schedule by March 15, 2020 (this date is adjusted to the date six months after the extended due date if the partnership is a fiscal year filer). The IRS will provide additional information as to how to obtain this penalty relief in the coming weeks.

The IRS has recently announced an LB&I campaign focusing on S corporation distributions. This new partnership reporting requirement could lead to similar audit scrutiny of partnership distributions.

For those partners who may not have correctly characterized current or prior distributions or who have taken losses in excess of basis, it may be possible to file a qualified amended return, , prior to the time that the IRS receives information from the partnership about the negative basis problem. If the partner files an amended return before the IRS initiates an audit, the partner can eliminate the threat that the IRS will impose accuracy penalties.