The Internal Revenue Service (IRS) has made a series of changes to the partnership Schedule K-1 (K-1) for the 2019 tax year, which will result in significantly enhanced disclosures by partnerships, including limited liability companies (LLC) since they are generally regarded as partnerships by the IRS. While the IRS has delayed some of the changes from taking effect until 2020, partnerships and tax professionals should prepare now for the changes taking affect in both 2019 and 2020. While some of these changes are in response to the massive tax overhaul resulting from the 2017 Tax Cuts and Jobs Act (TCJA), most of these changes represent a long-term and ongoing plan by the IRS to enhance transparency in tax reporting.
The most significant change introduced in 2019 is the requirement to show the partner / members’ tax capital basis on the face of the K-1s. This represents a significant change from past practice, as K-1’s have historically reported capital on Generally Accepted Accounting Principles (GAAP) basis, Section 704(b) basis, or other basis instead of tax capital basis. In the past, it has always been the responsibility of the individual partner / member to track his/her tax basis in the partnership, meaning that partnerships not reporting on tax basis have not been in the habit of tracking tax capital. For partnerships that have been in existence for many years and/or have many partners / members, the need to prepare tax basis schedules of the partners may represent a significant and costly undertaking.
Often, tax document retention policies for both companies and tax professionals are limited to seven years. This may make it difficult to determine accurate tax capital balances. It is unclear what will happen in these circumstances, especially when the tax capital on the K-1 is different from calculations made by the individual partner / member. Because of these potential difficulties, the IRS issued Notice 2019-66 which grants a one year stay on this tax capital reporting requirement. This notice allows partnerships to report capital on the 2019 K-1 consistent with 2018 requirements, which only required footnoted disclosure on the K-1 of any partners/members with a negative tax capital. This serves to give partnerships and their accountants additional time to locate and review prior year tax records and the flexibility to work on calculating tax capital during non-peak times.
A second major change is the need to disclose the beneficial owners of disregarded entity partners / members in the partnership. Disregarded entities are those which do not file their own tax return, but instead have their tax information reported directly on the return of the entity owner. Single member limited liability companies and grantor trusts are two of the most common examples of entities that are considered disregarded for tax purposes. While this is a simple disclosure, it will require partnerships to review their list of partners / members and inquire if any of the trusts or LLC’s are disregarded entities. If so, they will need to gather the names and employer identification numbers or social security numbers of the owners of such entities.
Guaranteed payments are another area where additional disclosure will now be required. Under the TCJA, Section 163(j) of the Internal Revenue Code was altered to limit the amount of interest expense a business can deduct. Under the change, the definition of interest expense includes guaranteed payments made to a partner / member for use of capital. Consequently, the K-1 will now break out guaranteed payments between those made for use of capital and those made for providing services to the partnership. For example, a guaranteed payment made to a management company for its services in managing an investment partnership would not be considered interest, but a guaranteed payment made to a partner / member for providing a surety on a partnership loan by the partnership would be considered interest.
Another change is a requirement to disclose any net unrealized Section 704(c) gains or losses. Section 704(c) gains or losses occur when a partner / member contributes property to a partnership instead of cash. This creates a basis difference, because the fair market value (FMV) of the property at contribution and the tax basis of the property at contribution are usually different.
The most common form of Section 704(c) gains or losses in investment companies occur when a partner / member contributes securities to a partnership instead of cash. In these cases, the partnership recognizes the contribution of property at FMV for determining the contribution amount, but it also inherits the partner’s / member’s tax basis in the assets. This results in a built-in gain or loss attributable to the contributing partner / member. As a result, when the securities are sold, the difference between the tax basis and the fair market value at contribution must be specially allocated back to the contributing partner / member, while gains or losses made after the contribution would be allocated based on normal partnership allocations. This prevents a partnership from “passing” built in gains or losses to other partners / members. Because these gains or losses occurred before the assets were inside the partnership, they belong to the contributing partner / member. Going forward, the outstanding amount of these built in gains or losses must be disclosed on the K-1 of the applicable partner / member.
Effective for tax year 2020, partnerships will now be required to disclose if they have more than one at-risk activity and/or more than one passive activity inside the partnership. If the partnership has more than one of either of these, it must attach a statement showing the calculation of the partnership’s at-risk or passive activity limitation, whichever is applicable.
These additional disclosure requirements will require partnerships and their tax advisors to evaluate partnership operations and make a determination about reporting these items.
At-Risk Limitations – At-risk limitations prevent a partner from deducting losses in excess of the amount they have at risk for a given trade or business or income producing activity within the partnership.
Passive Activity Limitation – Passive activities are defined as a trade or business in which the partner does not materially participate and certain rental activities. Passive activity losses are limited to the amount of passive activity income.
Lastly, partnerships will be required to make a check the box disclosure if recourse, qualified non-recourse, or non-recourse debt is being passed through from a higher-tier partnership.
With all of these changes coming in 2019 and 2020, partnerships will need to begin preparations to report this additional information. Partnerships should work with their tax advisors to determine the best and most cost-effective way of implementing these changes.
We can help with:
- Calculating partner/member tax basis,
- Evaluating the activities of the partnership for multiple at-risk and/ or passive activities,
- And calculating net unrealized 704(c) gains or losses.
Contact a member of the Elliott Davis Investment Companies team for assistance.