Form 1065, U.S. Return of Partnership Income, is an information return used to report the income, gains, losses, deductions, credits and other information from the operation of a partnership. As many professionals know, a partnership does not pay tax on its income but “passes through” any profits or losses to its partners. Partners must then include partnership items on their tax or information returns.

For even the most skilled of professionals, the preparation of the partnership return is a source of frustration partly due to the complexities of Subchapter K of the IRC (Subchapter K governs partnership taxation). A member recently suggested we write a blog on the changes to Form 1065, Schedule M-2, Line 3, net income (loss) per books. Earlier this year, NATP provided a brief overview of the matter in the Government News section of our February 2021 TAXPRO Monthly. Below is a copy of the Schedule M-2 for tax year 2020. The area of discussion is circled.

The Line 3 instructions state to enter on Line 3 the net income (loss) shown on the partnership books used in maintaining the partners’ tax basis capital accounts for purposes of Schedule K-1.

For tax years beginning in 2020, there were tax changes related to the capital account calculation.

Changes to Schedule K-1 for 2020

Notice 2019-66 states that for partnership tax years beginning in 2020, Schedule K-1 must report the partnership’s capital account on the tax basis. It is important to note that the partner’s ending capital account reported using the tax basis method might not equal the partner’s adjusted tax basis in the partnership interest.

Generally, this is because a partner’s adjusted tax basis in the partnership includes the partner’s share of partnership liabilities, as well as partner-specific adjustments, and the partner’s tax basis capital account does not include these items. It is the responsibility of the partner, not the partnership, to maintain a record of the adjusted tax basis of the partnership interest.

This new requirement for 2020 is a change from prior tax years; although as we reported in the Government News article, most partnerships already use the tax basis method. In prior years, a partnership could calculate and report partner’s capital accounts using a variety of methods including:

• GAAP
• §704(b) basis
• Tax basis

According to the instructions for Form 1065 (2020), the transactional approach is the tax basis method. It must be used to determine ending partner capital accounts for 2020, and both beginning and ending capital accounts for future tax years. Under the transactional approach, partnerships report partner contributions, each partner’s share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax basis principles, instead of methods based on other principles such as GAAP.

Beginning capital account if tax basis method was previously used

If the 2019 partner’s capital account was calculated using the tax basis method, the beginning capital account for 2020 will equal the partner’s ending capital account for 2019.

If the partner’s 2019 capital account balance was a negative and a different amount is calculated for the partner’s beginning capital account using the tax basis method in 2020, an explanation of the difference needs to be provided.

Use the following rules when there is a change in partnership ownership:

• If a partner joined the partnership through a contribution to the partnership in 2020, enter zero as the partner’s beginning capital account.
• If a new partner acquired the partnership interest from another partner, enter an amount for the beginning capital account that is equal to the transferor partner’s ending capital account for the interest transferred. The capital account balance is calculated using the tax basis method immediately prior to the transfer. Acquisition of the interest can be due to:
  • Purchase
  • Exchange
  • Gift
  • Inheritance
  • Death in 2020

Beginning capital account balance if tax basis method was not previously used

If the partner’s capital accounts were calculated using a method other than the tax basis method in 2019, but the capital accounts were maintained in the books and records using the tax basis method (for example, for purposes of meeting the requirement to report partner negative tax capital accounts), each partner’s beginning capital account must be reported using the tax basis method.

If the partner’s capital accounts were not reported using the tax basis method in 2019 and the capital accounts were not maintained under the tax basis method in the books and records, a partner’s beginning capital account may be figured using the:

• Tax basis method
• Modified outside basis method
• Modified previously taxed capital method, or
• §704(b) method

The instructions for Form 1065 (2020) has explanations for each method.

Partnerships that have kept partner tax capital information will generally have used the transactional approach and should not have much difficulty with the reporting change. Partnerships that are required to use one of the methods the IRS has provided for restating the beginning tax capital may have more difficulty.

For those practitioners who have extended client 2020 partnership returns still due and have questions, check out NATP’s three upcoming partnership webinars:

• Learning to Set Up a Partnership
• Understanding Partnership Basis and Unreimbursed Expenses
• Preparing Complex Partnership Returns, Including PTPs