Four million businesses should pay attention to this.  That’s how many entities filed Form 1065, Partnership Tax Returns  last year.  About 70% of them are filed by Limited Liability Companies (LLC’s).

I know, I know. I’m probably one of the very few that examine draft tax forms.  But, y’all should at least glance at them.  So, you can determine what the IRS is thinking- and if those thoughts are going to ruin (or make) you year.

Case in point- page 30 of the Form 1065 instructions.

I’ve highlighted the change (in the above image) for us to discuss.  Item L, Partner’s Capital Account Analysis.  (In case that print is too small for you to read- here’s what it says… Tax basis method.  Figure each partner’s capital account for the partnership’s tax year using the transactions approach, discussed below, for the tax basis method.  If you reported the partner’s capital account last year using any other method (for example, GAAP, section 704(b), or other), you must use the tax basis method this year.)

Let’s make something perfectly clear.  More than one person or entity that operates a business that is NOT a corporation and divides profits is by definition a partnership.   That is not necessarily state law- but we are talking about federal taxes here.

And, that Section 704(b)…Let’s assume Tom gave some property to the partnership.  That provides the partnership’s 704(b) capital account with the fair market value of that property. However, the basis of the property to the partner- and the partner’s basis in the partnership- is solely based on Tom’s basis in the asset.  So, as the partnership depreciated Tom’s donated asset, there is a difference between book income and taxable income.  And, that had to be allocated among the partners to account for those differences.  These would follow the partnership agreement that governed the business.

Um… I’ll bet you figured out by now that most entities didn’t track those differences or allocate them among the partners.  Oh, yeah. It gets better.  You see most folks form LLC’s because they are told that the paperwork requirements are among the lightest requirements- and that means they often don’t have a partnership agreement.  So, allocating the differences have no governing rules.

And, since 1985 (the date the IRS tried to impose rules on partnerships and failed in said attempt with ‘new’ regulations), the IRS didn’t worry about this discrepancy.  Until now!

Consider this…

Partners recognize income from the pass-through of the entity’s income.  But, they also have losses or gains when capital assets are disposed.  So, one’s basis in the partnership is increased by income and by contributions, decreased by distributions, and… one’s share of partnership liabilities.  Any distribution that exceeds your basis means the partner must recognize that as a gain. Any decrease in the partner’s share of liabilities means that there was a distribution to the partner.

So, one’s capital account can actually be negative.  Either too much distributions were effected or there was significant business losses.  And, if that capital account (in absolute numbers) exceeds the partner’s share of liabilities, then somewhere a gain should have been recognized on a tax submission.

But, until now (assuming the draft instructions become permanent), the capital accounting could follow a slew of different protocols- so the IRS wouldn’t (or couldn’t) track it.  That is true no more!

Why is this change being instituted?  Because lots and lots of partnership gains have not gone recognized.  Until now.

Let’s consider one of my clients.  He and a bunch of others bought some commercial property on excellent terms.  And, they managed (for a while) to improve the rented percentage, cut their operating costs, and radically improved its profitability.  Instead of selling the property, they borrowed some money (on a non-recourse basis [this means they are not personally liable]) and distributed those funds.

Oops. That means there was a large deficit capital account.

And, then, along comes Mary.  Oh, no.  Not Mary.  The pandemic.  Tenants stop paying rent.  The money to pay the mortgage isn’t there.  The owners decide to dissolve the partnership and turn the property over the mortgage lender.

There will be no big gain to bring those capital accounts to zero on the final partnership return.  And, the partners are assuming they had a loss in their partnership for this last year.  Don’t forget that the partners got money without recognizing any income.

That final return is going to show them with gains- not losses.  But…some of the partners may try to not file that final return. Banking on the previous years’ (or decade’s) IRS practices.

But, given that proposed change in definition, I’m betting that the IRS IS going to search out for that return.  And, collect on that tax bill!

 

 

Happy birthday,  “baby” brother.  Hope your day is grand, Neil!