Reconciling GAAP Basis and Tax Basis in Partnership...

WHO TO CONTACT DURING THE LIVE PROGRAM

For Additional Registrations:

-Call Strafford Customer Service 1-800-926-7926 x1 (or 404-881-1141 x1)

For Assistance During the Live Program:

-On the web, use the chat box at the bottom left of the screen

If you get disconnected during the program, you can simply log in using your original instructions and PIN.

IMPORTANT INFORMATION FOR THE LIVE PROGRAM

This program is approved for 2 CPE credit hours. To earn credit you must:

• Participate in the program on your own computer connection (no sharing) – if you need to register

additional people, please call customer service at 1-800-926-7926 ext. 1 (or 404-881-1141 ext. 1).

Strafford accepts American Express, Visa, MasterCard, Discover.

• Listen on-line via your computer speakers.

• Respond to five prompts during the program plus a single verification code.

• To earn full credit, you must remain connected for the entire program.

Reconciling GAAP Basis and Tax Basis in Partnership

Income Tax Returns and K-1 Schedules

WEDNESDAY, JULY 29, 2020, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

Tips for Optimal Quality FOR LIVE PROGRAM ONLY

Sound Quality

When listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet

connection.

If the sound quality is not satisfactory, please e-mail [email protected]

immediately so we can address the problem.

mailto:[email protected]

July 29, 2020

Reconciling GAAP Basis and Tax Basis in Partnership Income Tax Returns and K-1 Schedules

John Colvin, Partner

Colvin & Hallett

[email protected]

Brian T. Lovett, CPA, JD, Partner

Withum Smith & Brown

[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

WithumSmith+Brown, PC | BE IN A POSITION OF STRENGTH

5

SM

Reconciling GAAP Basis and Tax Basis

Brian T. Lovett, CPA, CGMA, JD, Withum

John Colvin, Colvin + Hallett


6

SM

Agenda

• GAAP, Tax, & 704(b) Capital Account Reporting

• Tax Allocations and Economic Effect

• Detailed Reconciliation Example

• Financial Statement Implications for Partnerships

(ASC 740, FAS 5) Including New Partnership Audit

Rules

• Tax Basis Capital Reporting


7

SM

GAAP, TAX, & 704(B) CAPITAL ACCOUNT REPORTING


8

SM

GAAP, Tax, & 704(b) Capital Accounts

GAAP vs. Tax vs. 704(b)

Partnerships often maintain multiple capital accounts, including:

- Section 704(b) Basis Capital Accounts: Reflect the partner’s

economic interests in the partnership.

- Tax Basis Capital Accounts: Reflects the partner’s interest in

the

partnership based on federal income tax principles.

- GAAP Basis Capital Accounts: Determined in accordance

with various financial accounting principles. Limited

impact on Tax Basis and Section 704(b) Basis capital

accounts.


9

SM

GAAP, Tax, & 704(b) Capital AccountsGAAP vs. Tax vs. 704(b)

(+ / -)

GAAP Basis Capital

GAAP to Tax Differences

(+ / -)

Tax Basis Capital

Sec. 704(c) Adjustments

Sec. 704(b) Basis Capital


10

SM

GAAP, Tax, & 704(b) Capital AccountsTax vs. 704(b)

Section 704(b) Capital Tax Basis Capital

Increases: • FMV of property

contributions,

including money

• Tax basis of property

contributions, including

money

• Partner share of

Section 704(b) income

• Partner share of taxable income

• Positive Section 704(b)

revaluations (book-ups)

• No change due to Section 704(b)

revaluations (book-ups)

Decreases: • FMV of property

distributions,

including money

• Tax basis of property

distributions, including

money

• Partner share of Section

704(b) losses

• Partner share of tax losses

• Negative Section 704(b)

revaluations (book-

downs)

• No change due to Section

704(b) revaluations (book-

downs)


11

SM

GAAP, Tax, & 704(b) Capital AccountsEffect of Liabilities on Section 704(b) Capital

• Assumption of partner liability by partnership treated as cash

distribution. Includes contribution of property subject to

liability

• Assumption of partnership liability by partner treated as cash

contribution. Includes distribution of property subject to

liability

• Changes to allocable share of partnership liabilities is not

an assumption and has no effect on capital


12

SM

AB

Example:

Building

Mortgage

Value

$100

($ 60)

Basis

$50

($60)

$120 of AB’s liabilities are allocable to

A after the contribution.

A


What is A’s CapitalAccount?

What is A’s Basis inAB?


13

SM

AB

A


Value Basis

Building $100 $50Mortgage ($ 60) ($60)

$120 of AB’s liabilities are allocable toA

after the contribution.

Capital = $100 Building Value - $60 Mortgage assumed by AB = $40

Basis = $50 Building Basis - $60 Mortgage + $120 Liability Allocation =

$110


14

SM

• No increase for contribution of a partners’ own note until the

note is sold or as principal payments are made.

• No decrease for distribution of the partnership’s own note until

the note is sold or as principal payments are made.

• If note is readily tradable on an established securities market

the forgoing rules are inapplicable.



15

SM

GAAP, Tax, & 704(b) Capital AccountsRevaluations

• Partnership may periodically revalue Section 704(b)

capital accounts

• Regulations provide for Mandatory and Optional revaluations

• Revaluations must reflect fair market value of partnership

property at the date of revaluation

• Allocation of book-up or book-down adjustment must

reflect the way the unrealized gain or loss would be

allocated if recognized


16

SM


Revaluations

• Revaluations have no impact on tax basis of assets therefore

create additional Section 704(c) layers

• Revaluations generally have no GAAP impact, but transactions

that trigger purchase accounting rules may have a similar

impact (i.e. partnership merger)


17

SM

GAAP, Tax, & 704(b) Capital AccountsRevaluations

Mandatory Revaluations

• Partnership is required to revalue distributed assets immediately

before the partnership distributes property to any partner

• Partnership is required to revalue capital accounts immediately after

an exercise of a noncompensatory option


18

SM


Revaluations

Optional Revaluations

• Partnership may choose to revalue capital accounts upon certain

events:

- Contributions of money or property for a partnership interest

- Liquidation or distribution as consideration for a partnershipinterest

- Grant of a partnership interest as consideration for servicesrendered

- Issuance by the partnership of a noncompensatory option, or

- Generally accepted industry accounting practices (hedge funds)


19

SM

GAAP, Tax, & 704(b) Capital AccountsDetermination of Section 704(b) Income

• GAAP Income is the typical starting point

• Determine Taxable Income by adjusting for “M-1” items

• Determine Section 704(b) Income (economic income) by

adjusting for differences between tax basis and Section 704(b)

basis

• Section 704(b) basis may not equal tax basis as a result of

property contributed with values different than tax basis and

Section 704(b) revaluations

• Differences between Section 704(b) and Tax basis are

addressed through 704(c) allocations


20

SM

GAAP, Tax, & 704(b) Capital AccountsImpact of Section 704(c)

• Section 704(c): Income items with respect to property

contributed to the partnership by a partner shall be shared

among the partners so as to take account of the variation

between the basis of the property to the partnership and its

fair market value at the time of contribution.

- Built-in gain or loss on the sale of contributed property must be allocated back to the contributing partner

- Tax depreciation/amortization on contributed property is allocated first to the non-contributing partner in an

amount equal to the partner’s Section 704(b)

depreciation


21

SM


Impact of Section 704(c)

Section 704(c) rules apply to:

- Contributions of property where the Section 704(b) value (FMV) is not equal to the tax basis (“Forward Section 704(c)

Layers”)

- Book up or down adjustments caused by Section 704(b)revaluations (“Reverse Section 704(c) Layers”)

- Possible to have multiple Forward and Reverse Section704(c) Layers


22

SM

GAAP, Tax, & 704(b) CapitalSection 704(c) Depreciation Allocation Methods

• Traditional Method

• Allocations are limited to the tax items associated with the

contributed property.

• Ceiling rule limitations are not fixed, and the built-in gain shifts to

noncontributing partners.

• Traditional Method with Curative Allocations

• Start with the traditional method

• Reallocate other partnership items to overcome ceiling rule

• Other items must generally have the same effect as depreciation.

• Remedial Method

• Provide correct amount to non-contributing partners.

• If figure that exceeds total tax items, contributing partner picks up

offsetting income.


23

SM

TAX ALLOCATIONS & ECONOMICEFFECT


24

SM

Tax Allocations & Economic EffectGeneral Rules

Section 704(a): Except as otherwise provided in the Code, a

partner’s share of partnership income items is determined by the

partnership agreement.

Section 704(b): A partner’s share of income items is determined in

accordance with the partner’s interest in the partnership (“PIP”) if

the allocations per the partnership agreement do not have

Economic Effect. Regulations provide that the allocations must

also be Substantial.

Section 704(c): Income items with respect to property

contributed to the partnership by a partner shall be shared among

the partners so as to take account of the variation between the

basis of the property to the partnership and its fair market value

at the time of contribution.


25

SM

Tax Allocations & Economic EffectSafe-Harbor Allocations

Economic Effect

• An allocation must be consistent with the underlying economic

arrangement of the partners.

• Partners that are allocated income or loss must ultimately

bear the economic benefit or burden associated with the

allocations

• Regulatory Safe-Harbors

- General Test for Economic Effect

- Alternate Test for Economic Effect

- Economic Effect Equivalence

• Allocations that do not meet a regulatory safe-harbor are allocated

based on the partner’s interest in the partnership (“PIP”)


26

SM


General Test for Economic Effect

1. Partnership maintains Section

704(b) Capital Accounts;

2. Liquidating distributions made in

accordance with positive Section

704(b) Capital Accounts; and

3. Partners have obligation to restore

any negative capital account

balance (a “Deficit Restoration

Obligation” or “DRO”)

Alternate Test for Economic Effect

1. Partnership maintains Section

704(b) Capital Accounts;

2. Liquidating distributions made in

accordance with positive Section

704(b) Capital Accounts; and

3. In lieu of a DRO, the partnership

agreement contains a Qualified

Income Offset (“QIO”) provision

Economic Effect Equivalence Partnership agreement does not satisfy the General

or Alternate Test of economic effect. However, allocations are deemed to have

economic effect if, as of the end of each partnership taxable year, a liquidation of

the partnership at the end of such year or at the end of any future year would

produce the same economic results to the partners as would occur if the General

Test of economic effect had been satisfied.


27

SM


Substantiality

• The economic effect of an allocation is substantial if there is a

reasonable possibility that the allocation will affect substantially the

dollar amounts to be received by the partners from the partnership,

independent of tax consequences.

- Overall Tax Effect Rule: One partner benefits at the expense of another

- Shifting Tax Consequences: The net increases/decreases in the partners'

respective capital accounts won’t differ substantially from the baseline

allocations and the aggregate tax liability of the partners will be reduced

- Transitory Allocations: There is a possibility that original allocations will

be largely offset by offsetting allocations, providing there is a strong

likelihood that the net increases/decreases in the partners' capital

accounts won’t differ substantially from the baseline allocations and the

total tax liability of the partners will be reduced in present value terms


28

SM

Tax Allocations & Economic EffectTargeted or PIP Allocations

In General

• Liquidating distributions are not based solely on the partner’s

Section 704(b) Capital Accounts

• General and Alternate Test of Economic Effect cannot apply

• Targeted Allocations may have Economic Effect Equivalence or

maybe in accordance with PIP

• Profits & loss allocations (including gross income) are generally

made in the amounts necessary to ensure ending Section 704(b)

Capital Accounts reflect the partner’s liquidating distribution

rights


29

SM

Tax Allocations & Economic EffectTargeted Allocations

Safe-Harbor Allocations

Capital Account

Beginning $50

Income/(Loss) $100

Ending Capital

Calculated

Targeted Allocations

Capital Account

Beginning $50

Income/(Loss) Calculated

Distribution Rights

$150


30

SM

Targeted Capital Account Provisions

▪ Generally, there are three steps to making targeted allocations

• First, determine partially adjusted capital accounts

• Second, determine the targeted capital account based on liquidation at book value

• Third, allocate profit or loss to bring partially adjusted capital account to target amount


31

SM


▪ Basic example:

• Partner A contributes $600 to Partnership, and Partner B contributes $400. The distribution waterfall provides that cash is paid first to return capital contributions and then split 80% to A and 20% to B. Partnership earned $500 in income during tax year


32

SM


▪ First, we need to determine partially adjusted capital account:

• Initial year return, so each partner starts with $0

• Adjust for contributions and distributions made during the year

• Partially adjusted capital accounts are:

Partner A = $600

Partner B = $400


33

SM


Description Partner A Partner B Total

Return capital $600 $400 $1,000

Residual allocation $400 $100 $500

Target amount $1,000 $500 $1,500

Less: partially adj. $600 $400 $1,000

Income allocation $400 $100 $500

Next, we need to determine the target amount. Once determined,

subtract partially adjusted capital account from target amount in order to

determine income/loss amounts.


34

SM

GAAP, Tax, & 704(b) Capital AccountsGAAP Capital In Summary

• Client financial data generally comes as GAAP financial

statements, so you will already have total GAAP capital to begin

• The GAAP amounts by partner are generally presented on the

schedule K-1s as the partner’s ending section 704(b) capital

ratio times total ending GAAP capital

• Difference between GAAP and 704(b) capital will result based

on the schedule M-1/M-3 differences as well as any 704(c)

amounts. Additional differences may result from liabilities that

exist for GAAP purposes but not for tax or 704(b) purposes

• The same event may give rise to GAAP/704(b) differences

(i.e. a purchase accounting transaction for GAAP purposes

treated as a carryover basis transaction for tax purposes,

partnership consolidated for GAAP purposes but stand alone

for tax purposes, etc.)


35

SM

ASC 740 for Partnerships

▪ Accounting for uncertainty in income taxes

▪ Generally, minimal impact on pass-through entities like partnerships• State taxes that are deemed to be income taxes

need to be considered

▪ Changes in partnership audit rules raised some questions

▪ Guidance confirms that collection from the partnership remains a tax on the partners and ASC 740 will not apply


37

SM

DETAILED RECONCILIATION EXAMPLE


38

SM

Exercise 1, Part 1

Individuals A, B and C form equal partnership ABC. A contributes

depreciable equipment worth $18,000 with a basis of $9,000

subject to an $8,000 liability. B contributes land with a basis of

$7,200 and value of $10,000. C contributes $10,000 cash. In the

first year of operations,ABC earns GAAP net income of $10,000. In

the first-year tax and GAAP depreciation are $3,000 and $5,000,

respectively. The traditional method is chosen to apply section

704(c).

• Determine the section 704(b) and tax basis capital accounts.

GAAP, Tax, & 704(b) CapitalExercise


39

SM

704(b) Book A B C

Contribution

Income

Depreciation


Tax Basis A B C

Contribution

Income

Depreciation


40

SM

704(b) Book A B C

Contribution 10,000.

Income

Depreciation

GAAP, Tax, & 704(b) Capital

Tax Basis A B C

Contribution 1,000.

Income

Depreciation

ExerciseA contributes depreciable equipment worth $18,000 with abasis

of $9,000 subject to a $8,000 liability.


41

SM

704(b) Book A B C

Contribution 10,000. 10,000.

Income

Depreciation


Tax Basis A B C

Contribution 1,000. 7,200.

Income

Depreciation

ExerciseB contributes land with a basis of $7,200 and value of $10,000.


42

SM

704(b) Book A B C

Contribution 10,000. 10,000. 10,000.

Income

Depreciation


Tax Basis A B C

Contribution 1,000. 7,200. 10,000.

Income

Depreciation

ExerciseC contributes $10,000 cash.


43

SM


GAAP to Tax Income Conversion:

GAAP Net Income 10,000

GAAP Depreciation 5,000

Taxable Income Before Depreciation 15,000

Tax Depreciation -3,000

Taxable Income 12,000

Tax to 704(b) Income Conversion:

Taxable Income Before Depreciation

704(b) Depreciation (Tax depr. on $18,000 of basis)

704(b) Net Income

15,000

-6,000

9,000


44

SM

704(b) Book A B C

Contribution 10,000. 10,000. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation


Tax Basis A B C

Contribution 1,000. 7,200. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation

ExerciseIn the first year of operations, ABC earns taxable incomeof

$15,000 before tax depreciation on the equipment of $3,000.


45

SM

704(b) Book A B C

Contribution 10,000. 10,000. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation (2,000) (2,000) (2,000)

13,000. 13,000. 13,000.


Tax Basis A B C

Contribution 1,000. 7,200. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation

Exercise704(b) Depreciation is proportionate to tax depreciation:

Equipment Tax Depr./ Tax Basis = $3,000 / $9,000 = 1/3rd

Equipment 704(b) Depr. = 1/3 x $18,000 = $6,000


46

SM

704(b) Book A B C

Contribution 10,000. 10,000. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation (2,000) (2,000) (2,000)

13,000. 13,000. 13,000.


Tax Basis A B C

Contribution 1,000. 7,200. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation (0) (1,500) (1,500)

6,000. 10,700. 13,500.

ExerciseUnder the traditional method, tax depreciation is allocated first to the non-

contributing partners to match 704(b) depreciation, but only to the extent of tax

depreciation


47

SM

704(b) Book A B C

Contribution 10,000. 10,000. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation (2,000) (2,000) (2,000)

13,000. 13,000. 13,000.


Tax Basis A B C

Contribution 1,000. 7,200. 10,000.

Income 6,000. 4,500. 4,500.

Depreciation* 0. (1,500) (1,500)

7,000. 10,200. 13,000.

Under the traditional method with curative allocations, tax depreciation is

allocated first to the non- contributing partners using the traditional method,

and other items are reallocated to make up for any shortfall

Exercise


48

SM

704(b) Book A B C

Contribution 10,000. 10,000. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation (2,000) (2,000) (2,000)

13,000. 13,000. 13,000.


Tax Basis A B C

Contribution 1,000. 7,200. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation* 1,000. (2,000) (2,000)

7,000. 10,200. 13,000.

ExerciseUnder the remedial method, tax depreciation is allocated first to the non-

contributing partners to match 704(b) depreciation whether or not there is

enough tax depreciation


49

SM

GAAP Books A B C

Contribution 10,000. 10,000. 10,000.

Income 5,000. 5,000. 5,000.

Depreciation (1,667) (1,667) (1,666)

13,333. 13,333. 13,334.

GAAP, Tax, & 704(b) CapitalExerciseAssuming the GAAP contributions were equal to fair market value, the same as

704(b) capital, the GAAP capital should be as follows

• In this example income and depreciation are broken out for

consistent presentation, the full net income would be

allocated in proportion to ownership in this case


50

SM

Exercise 1, Part 2

On the first day of year 2, the value of land has increased to

$16,000 and the company has created goodwill value of $30,000.

Partner D is admitted as an equal partner in exchange for a

$25,000 cash contribution.

What are the 704(b) capital accounts immediately after D’s

admission…

• If the partnership agreement calls for revaluations?

• If the partnership agreement does not call for revaluations?



51

SM

With Revaluation A B C D

Beginning 13,000. 13,000. 13,000. 0.

Revaluation Gain

Contribution


Without Reval. A B C D

Beginning 13,000. 13,000. 13,000. 0.

Revaluation Gain

Contribution


52

SM


Beginning 13,000. 13,000. 13,000. 0.

Revaluation Gain 12,000. 12,000. 12,000. 0.

Contribution



Beginning 13,000. 13,000. 13,000. 0.

Revaluation Gain0. 0. 0. 0.

Contribution

ExerciseThe value of land has increased by $6,000 to $16,000 and the company

has created goodwill value of $30,000 ($36,000 unrealized gain)


53

SM


Beginning 13,000. 13,000. 13,000. 0.

Revaluation Gain 12,000. 12,000. 12,000. 0.


25,000. 25,000. 25,000. 25,000.



Beginning 13,000. 13,000. 13,000. 0.

Revaluation Gain 0. 0. 0. 0.


13,000. 13,000. 13,000. 25,000.

ExercisePartner D is admitted as an equal partner in exchange for a $25,000 cash

contribution.


54

SM


Beginning 25,000. 25,000. 25,000. 25,000.

704(b) Gain on Sale

Final Distribution



Beginning 13,000. 13,000. 13,000. 25,000.

704(b) Gain on Sale

Final Distribution

ExerciseThe partnership sells all its property shortly after D’s admission for $100,000 and

distributes the proceeds in accordance with the Capital Accounts (ignoring pre-sale

activity in year of sale)


55

SM


Beginning 25,000. 25,000. 25,000. 25,000.

704(b) Gain on Sale 0. 0. 0. 0.

Final Distribution



Beginning 13,000. 13,000. 13,000. 25,000.

704(b) Gain on Sale9,000. 9,000. 9,000. 9,000.

Final Distribution

Exercise

The partnership sells all its property shortly after D’s admission for $100,000

and distributes the proceeds in accordance with the Capital Accounts (ignore

pre-sale activity)


56

SM


Beginning 25,000. 25,000. 25,000. 25,000.

704(b) Gain on Sale 0. 0. 0. 0.

Final Distribution 25,000. 25,000. 25,000. 25,000.



Beginning 13,000. 13,000. 13,000. 25,000.

704(b) Gain on Sale9,000. 9,000. 9,000. 9,000.

Final Distribution 22,000. 22,000. 22,000. 34,000.

Exercise

The partnership sells all its property shortly after D’s admission for $100,000

and distributes the proceeds in accordance with the Capital Accounts (ignore

pre-sale activity)

J O H N M . C O L V I N

C O L V I N + H A L L E T T , P . S .

Revised Partnership Audit RulesUnder the BBA

57

Overview

The Bipartisan Budget Act of 2015, P.L. 114-74, § 1101 (enacting new §§ 6221-6241).

Repealed and replaced the TEFRA partnership rules and the (seldom used) electing large partnership (ELP) rules for tax years beginning after December 31, 2017.

The goal of the changes was to shift the burden of making adjustmentsfrom the IRS to partnerships and their partners.

58

Why the Change?

After making substantive adjustments at the partnership level, the IRS spent months or years locating partners and collected little or no tax.

The trouble with tiered partnerships - GAO and TIGTA reports.

Given these frustrations, It was clear that Congress was going to revise the rules in order to assess and collect tax at the entity level.

In October 2015, the Real Estate Roundtable Tax Policy Advisory Committee suggested modifications, many of which were ultimately incorporated, including the alternative K-1 “push‐out” procedures.

BBA applies to all partnerships and entities filing partnership returns (even if it’s later determined that the entity is not a partnership) (§6241(1) and (8)).

59

TEFRA vs. BBA

60

Opting Out of the BBA Audit Rules

Make election on timely filed return. § 6221(b)(1)(D)(i).

Only available if partnership has 100 or fewer partners, all of whom are eligible partners

Eligible partners: individuals, C corporations (including foreign entities that would be taxed as C corporations), S corporations (but counting each S corporation shareholder as a partner for purposes of the 100-partner limit), or estates of deceased partners. § 6221(b)(1)(B) & (C). 100-partner limit based on the number of Forms K-1 required to be filed (not actually filed).

See § 6221(b)(1)(B).

Ineligible partners: other partnerships (upper tier), trusts, disregarded entities (SMLLCs, grantor trusts), estates of individuals other than deceased partners, nominee partners

61

Why Opt Out?

Partners would rather trust their own tax advisors to handle audit issues

More cumbersome for the IRS to audit, as IRS will have to deal with multiple parties

If partnership has potential reallocation issues (§704(b) issues)

Preserve personal penalty defenses

This could be especially important in partnerships designed for tax-advantaged transactions

62

Additional Issues Regarding Opting Out

Partnership cannot opt out if partners include disregarded entities (DREs), other partnerships, or trusts (even grantor trusts). See § 6221(b)(1)(C).

If partnership has pass-through entities as partners, may want to have the pass-through entities change status (e.g., have domestic LLC formerly taxed as partnership make an S election) to preserve the ability to opt out.

REITs and RICs are eligible partners for purpose of opting out because these entities are technically C corporations (i.e., all corporations are C corporations if they are not an S corporation pursuant to § 1361(a)(2)).

63

Effective Date

BBA partnership audit rules generally apply to tax years beginning on January 1, 2018.

Partnerships were allowed to elect into application of the BBA provisions for partnership tax years beginning after November 2, 2015 (date BBA was enacted).

64

Partnership Representative - § 6223

Partnership will designate (in manner prescribed by the Secretary) a partner (or other person) with a “substantial presence in the United States” to be the Partnership Representative. § 6223(a).

Partnership Representative has sole authority to act on behalf of partnership for purposes of the BBA partnership audit rules. Id.

If no partnership designation, the IRS “may select any person as the partnership representative” Id. (emphasis added).

Partnership and all of its partners are bound by actions taken by the partnership pursuant to Subchapter 68C (the BBA Partnership Audit rules). § 6223(b)(1).

65

Basic Procedure

IRS sends out Notice of Selection for Examination (Letter 2205-D) (new concept in Regs). IRS sends out Notice of Initiation of Administrative Proceeding. § 6231(a)(1). After audit complete, IRS sends out Notice of Proposed Partnership Adjustment.

§ 6231(a)(2). Partnership provides info supporting modification to IRS within 270-day period after

issuance of Notice of Proposed Adjustment. During this 270-day period, the IRS is barred from issuing a Notice of Final Partnership Adjustment. § 6225(c)(1) and (7); § 6231(b)(2)(A).

IRS sends out Notice of Final Partnership Adjustment. § 6231(a)(3). Like Notices of Deficiency, sent to the “Last Known Address” of Partnership Representative or Partnership.

§ 6231(a) (hanging paragraph).

Unclear, but above steps may also be required if the partnership files an AAR. § 6231(a) (hanging paragraph) (“The first sentence shall apply to any proceeding with respect to an administrative adjustment request filed by a partnership under section 6227.”).

66

BBA Basic Audit Procedure

270 days

Audit60 Day Letter

Appeals NOPPA

“Pull In”/ Partners File Amended

Returns

Options

(1)

Imputed Underpayment Modifications: Reductions to Rate (if p-ship

will pay)

(2)

270 Days After

NOPPA

FPA

“Push Out”/ K-1

Alternative

Partnership Assessment

Petition

90 Days

45

Days

Agree

67

Definitions: Reviewed Year and Adjustment Year

“Reviewed Year”– the partnership taxable year to which the item(s) being adjusted relates. § 6225(d)(1).

“Adjustment Year” – § 6225(d)(2) – the partnership tax year in which either:

A court proceeding under § 6234 becomes final;

An AAR under § 6227 is made; or

If not covered above, the Notice of Final Partnership Adjustment is mailed.

If partnership ceases to exists before an adjustment is made, the former partners of the partnership are required to take the adjustment into account. § 6241(7).

69

“Imputed Underpayment”

“Imputed Underpayment”– net adjustments multiplied by highest rate of tax under section 1 or 11. § 6225(b).

Modifications that may reduce “imputed underpayment”: Take into account any amounts reported on amended returns filed by Reviewed Year

partners (along with payment). § 6225(c)(2).

Disregard portion allocable to tax-exempt partners. § 6225(c)(3).

Make adjustments with respect to amounts allocable to individual partners if such amounts would have been subject to capital gain/qualified dividend rate. § 6225(c)(4)(A)(ii).

Make adjustments with respect to amounts allocable to partners subject to section 11 rate (if lower than section 1 rate) (i.e., C corporations). § 6225(c)(4)(A)(i).

Other factors. § 6225(c)(5) and (6).

70

“Imputed Underpayment” - Character of Adjustments

Regulations attempt to preserve character as much possible in computing “imputed underpayment” through use of grouping procedure. Treas. Reg. § 301.6225-1.

(Net Positive Adjustments x Tax Rate) – Adjusted Credits

Adjustments first grouped: (1) reallocation grouping, (2) credit grouping; and(3) residual grouping

Adjustments within each grouping/subgrouping are netted (excluding the credit grouping). Netted amounts resulting in a non-positive adjustment are disregarded for this purpose

Net adjustment is multiplied by highest rate under section 1 or 11

Product is reduced, but not below zero by net adjustment to credits

71

Example – Simple Adjustments

Audit Adjustment Ordinary Subgroup Capital Subgroup Credit Group

Increase OI $200

Decrease depreciation $40

Increase LTCG $80

Decrease LTCL $40

Increase Tax Credits $8

Total Audit Adj by Group $240 $120 ($8)

Assumed Highest Rate 40% 40%

Imputed Underpayment $96 $48 ($8)

Imputed Underpayment $136

72

Example – Moving LTCG to OI

Audit Adjustment Ordinary Subgroup Capital Subgroup

Increase OI $200

Decrease LTCG ($200)

Total Audit Adjustments $200 ($200)

Assumed Highest Tax Rate 40% 0%


73

Example – Reallocation Between Partners

Audit Adjustment Partner A Subgroup Partner B Subgroup

Reallocate OI $30 ($30)

Reallocate Deprecation ($70) $70

Total Adjustments ($40) $40

Assumed Highest Rate 0% 40%


74

Imputed Underpayment: Reduce by Amending Returns

The net liability of the partnership and its partners in virtually all cases will be minimized if the partners file amended returns within the 270-day period.

Benefit of lower marginal rates, use of partners’ other tax attributes to mitigate the adjustment.

Any penalty at partnership level should be based on aggregate net adjustments. The aggregate net adjustments will ordinarily be lower if partners file amended returns.

Alternative: “pull-in” procedure which allows partnership to submit the relevant information on behalf of the relevant partner (reflecting what would have been owed) as well as make payment.

75

Some But Not All Partners File Amended Returns, AndThe Partnership Pays Some Imputed Adjustment

Considerations:

Partners who do not file amended returns should be treated differently from those who do not file amended returns with respect to the imputed underpayment paid by the partnership.

Partners who file amended returns and pay tax should not have to share in the tax burden remaining at the partnership level.

Logical solution would be to treat portion of imputed adjustments as distribution to the non-paying partners.

76

Imputed Underpayment: Adjustments Relating to Inter‐Partner Allocations

If an adjustment reallocates distributive shares of any item from one partner to another, these are not netted. § 6225(b)(2). Instead, the imputed underpayment is determined by disregarding any decrease in

any item of income or gain and any increase in any item of deduction loss or credit. § 6225(b)(2).

The partnership can avoid the imputed adjustment only if all partners who are subject to the reallocation file amended returns. § 6225(c)(2)(B) & (C).

77

Imputed Underpayment: Assessment and Collection

“Imputed Underpayment” assessed and collected in same manner as if it were a tax imposed for the Adjustment Year. § 6232(a).

If AAR showing tax due is filed, payment of underpayment is due when the AAR is filed.

In tiered partnership setting, failure to comply with consistency requirement is treated like math error. § 6232(d)(2).

Partners not subject to joint and several liability for any liability determined at the partnership level. House 2015 Bipartisan Budget Act Section-by-Section Summary. Possibility that IRS will assert transferee liability if there have been distributions that

leave partnership insolvent and unable to pay tax.

78

Imputed Underpayment:Treat Payment as Distribution to Partner

To the extent that the partnership obligation to pay an imputed underpayment is related to the income/loss of (or distributions to) any partner, the amounts required to be paid by the partnership with respect to such partner (including taxes, penalties and interest) seems to be appropriately treated as a distribution to that partner.

Prop. Reg. § 301.6225-4(c) treats payments of imputed underpayment (and any interest and penalties) as non-deductible, non-capitalizable expenses under §705(a)(2)(B).

To the extent that the items are attributable to persons who were partners in the Reviewed Year, but who are not partners in the Adjustment Year, there is a disconnect.

To the extent that there is no mechanism for recovering from departed partners, this burden will have to be spread across Adjustment Year partners.

79

Partnership Generally Pays Interest and Penalties

The assessment amount is computed for the Adjustment Year by calculating interest accrued from the Reviewed Year to the Adjustment Year, taking into account the effect of changes in the intervening years. § 6233(a)(2).

Regular interest runs from Adjustment Year forward. § 6233(b)(2).

Partnership is liable for penalties (including accuracy and fraud penalties) as if it had been an individual subject to tax on amount of imputed adjustment in Reviewed Year. § 6233(a)(3).

In case of a failure to pay an imputed underpayment for Adjustment Year, the partnership is subject to the delinquency penalties, including failure to pay under § 6651(a)(2). § 6233(b)(3).

80

Alternative to Imputed Underpayment: “Push-Out” Adjustments to Partners in Year of Adjustment – § 6226

Must elect no later than 45 days after issuance of Notice of Final Partnership Adjustment. § 6226(a)(1).

In the Adjustment Year, the partnership issues Form K-1-type statements to those who were partners during the Reviewed Year. § 6226(a)(2).

Partners are required to include a tax amount on their personal tax returns for the Adjustment Year equal to the amount (plus interest) that would have been paid if taken into account in Reviewed Year, plus any adjustments for intervening tax years (years between Reviewed Year and Adjustment Year) where the adjustments made would result in an increase in tax in those years. § 6226(b)(1) and (2). Deficiency procedures do not apply to Reviewed Year partners who do not include K-1 amount on personal

tax return.

Any tax attributes affected had adjustments been taken into account during the Reviewed Year, or any year between Reviewed Year and Adjustment Year, must also be “appropriately adjusted.” § 6226(b)(3). In many cases, additional income in the earlier years would provide basis in later years (shielding

distributions). It is unclear if this can be taken into account. File protective AARs for intervening years?

81

Push-Out/Form K-1 Alternative: Interest and Penalties

Interest is computed at “hot interest” rates (federal short term rate plus 5%) from “due date of return to which the increase is attributable” (Reviewed Year and any later year where tax is “appropriately adjusted”). § 6226(c)(2).

Applicability of penalties determined at partnership level, but those persons who were “partners of the partnership for the reviewed year shall be liable for any such penalty.” § 6226(c)(1). Thus, there is no personal defense to the penalty for the partners who receive Forms K-1.

Even if a partner filed an amended return prior to the issuance of the Final Notice of Partnership Adjustment, eliminating the portion of the partnership imputed understatement attributable to him, if penalties are applicable, the Form K-1 could require the partner to pay his share of the penalty, plus “hot interest” thereon.

82

§ 6225(a)(2) – Situations Where There Is No Imputed Underpayment

To the extent that audit adjustments do not result in an imputed underpayment (e.g., the audit adjustment generates refunds), the adjustment is generally taken into account by the partnership in the Adjustment Year as a reduction in non-separately stated income. § 6225(a)(2).

While the imputed underpayment includes an interest component, there is no statutory mechanism to provide refund interest if the adjustments result in refunds.

The Adjustment Year partners (current partners) get the benefit of net taxpayer favorable adjustments (assuming no AAR filed), while the Reviewed Year partners will bear the burden of net underpayment adjustments if the § 6226 push-out method is elected.

83

Administrative Adjustment Request (AAR)

Statute authorizes filing of AAR to adjust one or more items of income, gain, loss, deduction or credit. § 6227(a).

May be filed by partnership (under “rules similar to” § 6225 default rule) or by partnership and partners (under “rules similar to” § 6226 Form K-1 method). § 6227(b)(1) and (2).

If there is no imputed adjustment (e.g., AAR reflects a reduction of income or increase in loss/deduction/credits), must use the § 6226 Form K-1 method. § 6227(b) (hanging paragraph) (“In case of adjustment that would not result in an imputed underpayment, paragraph (1) shall not apply and paragraph (2) shall apply with appropriate adjustments.”) Thus, any refund generated by an AAR will go to the partners.

Must be filed within 3 years of later of: (1) date original return was filed, or (2) due date of return without regard to extensions. § 6227(c).

There is no stand alone “refund jurisdiction” for the courts with respect to an AAR. If a Final Partnership Adjustment is made as a result of an AAR, it appears that the matter may be contested in court. See § 6231(a) (last sentence of hanging paragraph).

84

Observations Regarding AARs

The time limit on an AAR (3 years) makes filing one in the case of potential timing adjustments (i.e., deficiency in one year and refund in later year) absolutely essential.

The AAR provisions make timing adjustments potentially problematic for a partnership. Cash flow mismatch: While the partnership could pay an imputed adjustment in the

Adjustment Year of the year under of the audit, the persons who were partners during the AAR year would get the benefit of any refund.

Complexity increases if a new partner arrives in the middle of a timing adjustment, which increases income in an earlier year and decreases income in a later year. There will be a windfall to the incoming partner who will receive the benefit of a refund, while the outgoing partner could end up paying a deficiency on an amended return or under § 6226 procedures.

85

Other Implications

Financial Statements. Possibility that partnership will incur an entity-level tax means that partnerships may have to reflect a provision for taxes on their financial statements under FASB No. 109 (ASC Topic 740). FIN 48 (“Accounting for Uncertainty in Income Taxes”) may also be applicable.

86

Reporting Tax Basis Capital Accounts87

Background – Part 1

Partnerships have long been required to report capital accounts on the Schedule K-1 to Form 1065 (and 8865).

Many partnerships maintain their capital accounts on a § 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, e.g., § 704(c).

Capital accounts maintained on a § 704(b) book basis or on a GAAP basis may differ substantially from capital accounts maintained on a tax basis.

88

Background – Part 2

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.)

Negative tax basis capital accounts can also result when a partner contributes property to a partnership that is subject to debt in excess of its basis.

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.

89

2018 Returns: IRS Requires Partnerships toReport Negative Tax Basis Capital Accounts

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.

The “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.

90

Penalty Relief Provided for 2018 Tax Returns Wherethe Negative Tax Basis Capital Accounts Were Not Reported

In light of the enormity of the task, return preparers were worried that errors in the computation of tax basis capital accounts could result in the assertion of penalties under §§ 6698 or 6722 for failure to file a correct partnership returns and/or Forms K-1.

In March of 2019, in Notice 2019-20, 2019-13 IRB 1, the IRS announced that penalties would not be imposed so long as the required information was supplied in a separate schedule within one year of the un-extended due date for the partnership tax return (the contents of the schedule are set out in the FAQs discussed below).

In April of 2019, the IRS put out an FAQ on its website regarding “negative tax basis capital.” https://www.irs.gov/businesses/partnerships/form-1065-frequently-asked-questions.

91

https://www.irs.gov/businesses/partnerships/form-1065-frequently-asked-questions

IRS FAQs - Initial Tax Basis Capital Account and Increases

Money contributed to partnership, PLUS

i. The adjusted tax basis of non-cash property contributed by the partner to the partnership, less the liabilities assumed by the partnership (or to which the property is subject) in connection with the contribution;

ii. The sum of the partner’s distributive share for the taxable year and prior taxable years of partnership income or gain (including tax-exempt income);

iii. The partner’s distributive share of the excess of the tax deductions for depletion (other than oil and gas depletion) over the tax basis of the property subject to depletion;

iv. The amount of liabilities of the partnership assumed by the partner, excluding liabilities assumed in connection with a distribution of property; and

v. The partner’s distributive share of any increase to the tax basis of partnership property under § 734(b) or with respect to partnership property under § 743(b).

92

IRS FAQs – Decreases to Tax Basis Capital Account

i. Distributions of money to the partner;

ii. The adjusted tax basis of property distributed to the partner from the partnership, less the liabilities assumed (or to which the property is subject) in connection with the distribution;

iii. The sum of the partner’s distributive share for the taxable year and prior taxable years of partnership losses and deductions (including expenditures which are not deductible in computing partnership taxable income and which are not capital expenditures);

iv. The partner’s distributive share of the tax deductions for depletion of any partnership oil and gas property, not to exceed the partner’s share of the adjusted tax basis of that property;

v. The partner’s distributive share of the adjusted tax basis of charitable property contributions and foreign taxes paid or accrued;

vi. The amount of a partner’s individual liabilities that are assumed by the partnership, excluding liabilities assumed in connection with a contribution of property to the partnership; and

vii. The partner’s distributive share of any decrease to the tax basis of partnership property under § 734(b) or with respect to partnership property under § 743(b).

93

FAQs – Example of Negative Tax Basis Capital Account

Example 1: On January 1, 2019, A and B each contribute $100 in cash to a newly formed partnership. On the same day, the partnership borrows $800 and purchases Asset X, qualified property for purposes of § 168(k), for $1,000. Assume that the partnership properly allocates the $800 liability equally to A and B under § 752. Immediately after the partnership acquires Asset X, both A and B have tax basis capital accounts of $100 and outside bases of $500 ($100 cash contributed, plus $400 share of partnership liabilities under § 752). In 2019, the partnership recognizes $1,000 of tax depreciation under § 168(k) with respect to Asset X; the partnership allocates $500 of the tax depreciation to A and $500 of the tax depreciation to B. On December 31, 2019, A and B both have tax basis capital accounts of negative $400 ($100 cash contributed, less $500 share of tax depreciation) and outside bases of zero ($100 cash contributed, plus $400 share of partnership liabilities under § 752, and less $500 of share tax depreciation).

94

FAQs – Tax Capital Account Where Partner AcquiresInterest in Partnership from Another Partner

A partner that acquired its partnership interest by transfer from another partner, for example, by purchase or in a non-recognition transaction, has a tax capital account immediately after the transfer equal to the transferring partner’s tax capital account immediately before the transfer with respect to the portion of the interest transferred, except no portion of any § 743(b) basis adjustment the transferring partner may have is transferred to the partner acquiring the interest as part of the transaction.

If the partnership has a § 754 election in effect, the partnership increases or decreases the tax capital account acquired by the transferee partner by an amount equal to the positive or negative adjustment to the tax basis of partnership property under § 743(b) as a result of the transfer.

95

FAQs – Safe Harbor For Determining Whether Or Not A Partner Has A Negative Tax Basis Capital Account

Partnerships may calculate a partner’s tax basis capital account by subtracting the partner’s share of partnership liabilities under § 752 from the partner’s outside basis (safe harbor approach).

If a partnership elects to use the safe harbor approach, the partnership must report the negative tax basis capital account information as equal to the excess, if any, of the partner’s share of partnership liabilities under § 752 over the partner’s outside basis.

96

FAQs – Certain Partnerships Not Required to ReportNegative Tax Basis Capital Account Information

A partnership that satisfies all four of the conditions provided in question 4 on Schedule B to the Form 1065 does not have to comply with the requirement to report negative tax basis capital account information. The conditions are:

a. The partnership’s total receipts for the tax year were less than $250,000;

b. The partnership’s total assets at the end of the tax year were less than $1 million;

c. Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return; and

d. The partnership is not filing and is not required to file Schedule M-3.

97

2020 Partnership Tax Returns Changes

Some draft 2019 partnership forms and instructions (Forms 1065 and 8865) required most partnerships to report all partner capital accounts on a tax basis. Predictably, there was an outcry.

In Notice 2019-66, 2019-52 IRB 1509, the IRS delayed this requirement until 2020.

The Notice indicates that further guidance on the definition of partner tax basis capital accounts will be published, and comments requested.

98

Notice 2020-43, 2020-27 I.R.B. 1

IRS provides two alternative methods for determining tax basis capital accounts Modified Outside Basis Method

Modified Previously Taxed Capital Method

Methodology set out in FAQs discussed above (transactional approach) would not be permitted (IRS believes providing guidance would be too burdensome)

For years after 2020

Unless something changes, these will be the only two methods available to compute tax basis capital accounts

Comments requested

99

Notice 2020-43Modified Outside Basis Method

Either the partnership or a partner will determine the partner’s outside basis in the partnership interest

Subtract from the partner’s outside basis the partner’s share of liabilities under §752; the difference is the tax basis capital account number

Partners may provide their own outside basis to the partnership, in writing within 30 days of year-end

Partnership can rely on partner provided information unless it is clearly erroneous

100

Notice 2020-43Modified Previously Taxed Capital Method

Must calculate a hypothetical liquidation of the partnership using FMV, GAAP or §704(b)

Previously taxed capital is equal to: The amount of cash the partner would receive on liquidation, plus

The amount of tax loss allocated to the partner from the hypothetical sale, less

The amount of tax gain that would be allocated to the partner from the hypothetical sale

Must include a statement that a partnership is using this method and the method used to determine net liquidity value of partnership

101

Notice 2020-43Modified Previously Taxed Capital Method - Example

Account Book Tax

Cash $500 $500

Inventory $1,000 $1,000

Equipment $500 $500

Land $1,000 $1,000

Total Assets $3,000 $3,000

Debt $5,000 $5,000

Partner A (50%) ($1,000) ($1,000)

Partner B (50%) ($1,000) ($1,000)

102

Notice 2020-43Modified Previously Taxed Capital Method – Example (cont.)

Under the Modified Previously Taxed Capital Method, tax capital would be equal to: The amount of cash a partner would receive - $0 in this case since the debt exceeds

the book basis of the assets

Plus the loss allocated to each partner - $0

Less the gain that would be allocated to each partner – $1,000 ($5,000 amount realized de to the debt, less $3,000 book basis in the assets, split between the 2 partners)

$0 + $0 - $1,000 = ($1,000) tax capital for each partner

103

Other Reporting Change – Unrecognized § 704(c) Gain/Loss

For 2019 partnership tax returns, the IRS imposed a requirement that taxpayers report the partners’ shares of unrecognized § 704(c) gain or loss. Form 1065 , Schedule K-1, Item N.

The instructions did not provide a definition of “unrecognized § 704(c) gain or loss.”

Commenters requested additional guidance, especially with respect to multiple layers of forward and reverse § 704(c) gain & loss, tiered partnerships, and partnership mergers and divisions.

Notice 2009-70, 2009 IRB 255, requested comment on these issues prior to the imposition of the reporting requirement.

Notice 2019-66, 2019-52 IRB 1509, provided a stopgap definition of “unrecognized §704(c) gain or loss” for 2019 reporting, defining it as “the partner's share of the net (“net” means aggregate or sum) of all unrecognized gains or losses under § 704(c) in partnership property, including § 704(c) gains and losses arising from revaluations of partnership property.”

Additional guidance is likely forthcoming.

Notice 2019-66 also clarified that this requirement will not apply to publicly-traded partnerships until further notice.

104

Reconciling GAAP Basis and Tax Basis in Partnership...

Documents

Transcript of Reconciling GAAP Basis and Tax Basis in Partnership...