Comment Letter

Comment letter on tax capital reporting for partnerships

July 24, 2020

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Dear Mr. Kautter:

Baker Tilly Virchow Krause, LLP, on behalf of our clients, offers the following comments on IRS Notice 2020-43, Tax Capital Reporting. While we recognize the government’s goal to create a consistent framework for all partnerships to comply with the tax capital reporting requirement, we believe the previously taxed capital method proposed in the Notice as a reporting alternative is flawed, will lead to misinformation and is unduly costly and burdensome. Rather than creating an entirely new framework, we recommend that as an alternative to the proposed Modified Outside Basis Method, partnership capital reporting should be done in accordance with the already-established rules provided under IRC § 704(b).

The Purpose for Tax Capital Reporting

We agree with the need for the IRS to have access to information that provides it the ability to efficiently and accurately administer the tax rules. In this regard, there are really only two broad measures that are pertinent for this purpose. The tax basis for a partner’s interest in the partnership, as governed by the rules outlined in IRC § 705, and the economic structure of the partner’s deal, as memorialized in the Capital Account rules outlined in Reg. § 1.704-1(b)(2)(iv). These two measures of capital are the only ones needed to determine the elements critical to the income tax compliance system: A taxpayer/partner’s economic rights in a partnership and the taxpayer/partner’s tax basis against which the ultimate tax treatment is measured. The former is governed by the principles outlined in the regulations promulgated under IRC § 704(b), and the latter governed by the rules outlined in IRC § 705 and related authority.

Modified Outside Basis Method

We believe this method, as outlined in Notice 2020-43, ultimately provides information necessary for the determination of gain or loss recognized on the sale or exchange of an interest, the proper tax treatment for distributions from the partnership, and the deductibility of allocated losses. Unfortunately, there may be many partnerships that will be unable to utilize this method, for two reasons. First, this method is dependent upon receiving timely information from the partners with respect to transactions that occur outside of the partnership. For large partnerships and, especially, entities organized in tiered structures, it will likely be extremely burdensome, costly and time-consuming to gather this information. Second, and more importantly, use of this method will be dependent upon a partner’s willingness to share outside basis information with the partnership (assuming the partners even have their basis readily available). Other than for small closely held partnerships, the end result is that many partnerships will only be able to report an incomplete picture of partnership tax capital in any given year. For those partnerships unable to properly comply with the Modified Outside Basis Method, the only reasonable alternative method for capital reporting should rely upon the already established rules under IRC § 704(b) — we believe this should be the required method for all partnership capital reporting.

Modified Previously Taxed Capital Method

As acknowledged in the Notice, most partnerships that track and/or report using tax capital do so utilizing the “transactional approach.” This method basically reports “inside” tax basis by reflecting contributions, distributions and allocable shares of income or loss to each partner over time. Under existing code and regulations, partnerships are not required to track partner tax capital or a partner’s basis.

"Reg. § 1.705-1 (a) General Rule. (1) Section § 705 and this section provides rules for determining the adjusted basis of a partner's interest in a partnership. A partner (emphasis added) is required to determine the adjusted basis of his interest in a partnership only when necessary for the determination of his tax liability (emphasis added) or that of any other person."

Since neither the code nor regulations require allocations in accordance with tax capital and as they do not require that a partnership track, compute or report each partner’s tax capital, we question whether the IRS has the authority to mandate such reporting via a change to the instructions to Form 1065. Form instructions are not authority, nor have instructions gone through a regulatory review process.

We are also concerned about the Notice’s dismissal of the transaction approach, which can at least reflect inside basis. The modified previously taxed capital method utilizes a hypothetical liquidation approach, which may be difficult and impractical to implement. This method essentially relies on fair market value of assets, yet it does not utilize the principles of § 704(b) on which the partner’s economic deal is constructed. Depending upon the § 704(c) method selected by the partnership, there may be divergent results between this estimated approach versus actual allocations that are being recognized for tax purposes.

Further, while the Notice does not mandate appraisals, it must be recognized that determining fair value can be highly subjective. Even though the Notice allows taxpayers to use GAAP as fair value, not every taxpayer maintains records on a GAAP basis. Even if every partnership employed GAAP basis, such amounts are by definition irrelevant for income tax purposes. We also believe that this computation may be time-consuming and burdensome for many partnerships and result in duplicative efforts for taxpayers using separate hypothetical liquidations under § 704(b) in order to make tax allocations.

Tiered Partnerships

The rules of Subchapter K are either silent in regard to tiered partnerships or contain rules that have limited application. All of which will make the application of tax capital reporting extremely difficult and often subjective to apply in a tiered context. While the formulaic approach for calculating a partner’s share of previous tax capital is relatively clear under the § 743 regulations, questions remain in numerous contexts. One example is how the calculation works when an interest in an upper-tier partnership (UTP) is transferred. Does the UTP have to drill down through all tiers with underlying computations at each level?

Should the UTP calculate its share of previously tax capital (PTC) with respect to each of its lower-tier partnership interests, and then factor this amount into the UTP PTC? While this approach would appear simpler, it would likely create distortions when inside and outside basis differences exit with regard to the lower-tiered partnerships. Alternatively, is an entity theory approach required where detailed computations would need to be made on a tier-by-tier level?

Broadly speaking, this is the same entity versus aggregate theory issue that has been grappled with for years regarding partnership taxation. This also came up in Notice 2009-70 where the IRS requested comments regarding § 704(c) and revaluations in UTP.

In Notice 2019-16, the IRS acknowledged Notice 2009-70 (for which subsequent guidance has yet to be issued), and stated: “For purposes of reporting for 2019, partnerships and other persons should generally resolve these issues in a reasonable manner, consistent with prior years’ practice for purposes of applying Section 704(c) to partners.” While this quote relates to a partner’s share of built-in gain, the issues are similarly analogous to those involved in computing PTC in a tiered entity structure. By leaving the approach to each partnership, the end results will be inconsistent reporting and inherently meaningless information.

Summary and Recommendation:

We do not believe that adding rules and concepts to compute what amounts to a projected partner tax capital accounts is merited. We also believe adding rules that are not based on the existing capital account maintenance rules creates an undue hardship upon partnerships that is both costly and time-consuming and will lead to inconsistent and inaccurate results. The cost of additional compliance with a new set of rules in the current economy is unwarranted at best and fails to acknowledge the tremendous financial burdens many taxpayers are experiencing due to the coronavirus pandemic.

If uniformity in capital account maintenance is desired, we agree with such a goal. We support the elimination of reporting capital accounts on a GAAP basis, which serves no useful purpose to either the government or the taxpayers. Rather, we recommend that capital account reporting be based upon the existing framework of rules under the § 704(b) regulations. This would help ensure that the capital account maintenance rules are being complied with, that allocations are being made in accordance with the economic arrangement of the partners, and that tax capital and basis computations are left where they belong, at the individual partner level.

We appreciate your time and consideration. If you would like to discuss or have any questions, please do not hesitate to contact me at my direct dial below.

Baker Tilly Virchow Krause, LLP, trading as Baker Tilly, is a member of the global network of Baker Tilly International Ltd., the members of which are separate and independent legal entities.

Very truly yours,

BAKER TILLY VIRCHOW KRAUSE, LLP

Paul H. Dillon
Director, Washington national tax
Direct dial: +1 (703) 923 8489
paul.dillon@bakertilly.com

PHD/

cc:

Krishna Vallabhaneni
Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Michael Novey
Associate Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Jeffrey Van Hove
Senior Advisor for Tax Policy Office of Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Bryan Rimmke, Attorney-Advisor
Office of Tax Legislative Counsel, Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Michael J. Desmond, Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW, Room 3026 IR
Washington, DC 20224

William M. Paul
Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Holly Porter
Associate Chief Counsel (Passthroughs & Special Industries)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

Clifford Warren, Senior Counsel
Office of the Associate Chief Counsel (Passthroughs & Special Industries)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

Robert Crnkovich, Special Counsel
Office of the Associate Chief Counsel (Passthroughs & Special Industries)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024