A partnership capital account shows the equity in a partnership that is owned by each partner. The account typically records and reports the partner’s initial and subsequent contributions to the partnership, their proportional share of the partnership’s profits and losses, and any distributions, earnings, or payments made to the partners. Partnerships and certain people are required to file Schedule K-1 for either Form 1065 or Form 8865 to satisfy the IRS’ “Tax Capital Reporting Requirement.” Small partnerships (generally <$250,000 in total receipts and <$1 million in total assets) are exempt from capital account reporting requirements.
Under the “Transactional Approach” (also known as the “Tax Basis Approach”) to tax capital reporting, a partner’s capital account increases with contributions and share of partnership net income and decreases with withdrawals, distributions, and share of partnership net loss as calculated and reported using tax basis rules and principles.
IRS Notice 2020-43
About a year ago, the IRS issued Notice 2020-43, offering partners two alternative methods of reporting their tax capital – The Modified Outside Basis Method and The Modified Previously Taxed Capital Method (including the 704(b) Method). Partnerships were instructed to use one of these two methods, which must be used across all partners. The notice explicitly disallowed the use of the Tax Basis (Transactional Approach) as a method to achieve compliance.
The IRS requested comments from practitioners concerning whether Notice 2020-43 should be modified or adopted. Clearly, the response to the alternative methods was overwhelmingly negative. After reviewing the comments, the IRS changed course and recanted its earlier guidance, issuing draft instructions in October 2020 for completing 2020 Form 1065 using the Transactional Approach.
Consequently, the Modified Outside Basis and Modified Previously Taxed Capital Method (including the 704(b) Method), are now only offered as alternatives in determining partners’ beginning tax basis capital accounts only for 2020 if the tax basis method was not previously used. The two alternative methods are applicable for tax year 2020 only. The Transactional Approach must be used for all subsequent taxable years.