Partnership reporting has undergone some drastic changes in the past few years. In 2018, the IRS required that if a partnership tracked capital accounts on a nontax basis, the partnership must report on the Schedule K-1 if a partner had a negative tax basis capital account.
Starting in 2020, the IRS is requiring that all capital accounts be reported on tax basis. There are still some questions on how exactly the IRS wants tax basis capital accounts reported, but this is a sign that they have become aware of the abuses that have been occurring for years.
Many of you are reading this and thinking “so what?” Let’s take a step back and see what a capital account is. Simply put, a capital account is your investment in the partnership. The capital account starts with the initial investment and increases through contributions or cash, or property and allocations of profits.
It decreases due to distributions and share of losses. I affectionately call it a piggy bank. It tracks what goes in and out of the partnership.
To make things more confusing, there is another important concept: outside basis. Outside basis measures the adjusted basis in the partnership. Since this is a very complex concept, I’m going to oversimplify. If you start a partnership without contributing $0 basis or depreciated property, capital account plus debt assumed by the partner should equal outside basis.
NEGATIVE CAPITAL ACCOUNTS
One question I often get is how the capital account goes negative. Simple: accelerated depreciation and living beyond your means. Accelerated depreciation reduces taxable income, at least on paper.
Couple that with an ever-increasing standard of living, farmers take out more in distributions than they report as taxable income. Over a period of time, this creates negative capital accounts.
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Although negative capital accounts may be reflective of an economic cycle, it is a cause for concern. As previously mentioned, if the negative capital account plus debt assumed by the partner is negative, the partner must be allocated income to get the outside basis back to $0.
This concept often shocks many farm clients. I try to explain it as the partnership has overdepreciated assets or taken out debt in order to distribute money.
When the outside basis goes negative (which is not possible because you can’t have negative basis), the negative portion is treated as compensation in order to get the outside basis back to $0.
In other words, overdepreciating assets and pulling out too much money ate up all your positive tax attributes, and now you must pay the price. Unfortunately, this often occurs during poor economic times, making it hard for the farmer to come up with money to pay the tax on phantom income.
To bring it full circle, the IRS is requiring taxpayers to report capital accounts on a tax basis. It will be very easy to determine who has negative outside basis and needed to be allocated income to get it back to $0. If you misapplied the concepts of capital account and outside basis, be prepared for an unexpected and costly notice.
Editor’s Note: DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota. Read Rod’s “Ask the Taxman” column at about.dtnpf.com/tax. You may email Rod at email@example.com.