IRS Provides Penalty Relief to Partnerships for Form 1065 Reporting Inaccuracies

(Parker Tax Publishing February 2021)

The IRS issued a notice providing partnerships with relief from certain penalties due to the inclusion of incorrect information in reporting their partners' beginning capital account balances on the 2020 Schedules K-1 as outlined in the 2020 instructions for Form 1065, U.S. Return of Partnership Income. The notice also provides relief from accuracy-related penalties for any tax year for the portion of an imputed underpayment attributable to the inclusion of incorrect information in a partner's beginning capital account balance reported by a partnership for the 2020 tax year. Notice 2021-13.

Background

Under Code Sec. 6031, Reg. Sec. 1.6031(a)-1, and Reg. Sec. 1.6031(b)-1T, partnerships generally are required to (1) file annual returns stating the items of its gross income and deductions, and any other information as prescribed by forms and instructions, and (2) furnish partners with statements containing each partner's distributive share of the partnership's items of income, gain, loss, deduction or credit, and any additional information as prescribed by forms and instructions. The IRS has long required the reporting of partner capital account balances under Code Sec. 6031 and the accompanying regulations.

Prior to the 2020 tax year, partnerships could report their partners' capital accounts for the tax year on Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., using one of a variety of methods that are based on different principles (for example, tax basis, generally accepted accounting principles (GAAP), Code Sec. 704(b) book, or any other method). Starting in the 2018 tax year, however, the instructions for Form 1065 required partnerships that did not report tax basis capital accounts to their partners to report separately the beginning and ending tax basis capital account balance of any partner having a negative beginning or ending tax basis capital account balance.

Beginning in the 2020 tax year, the 2020 Form 1065 instructions require partnerships to calculate and report their partners' capital accounts using the transactional approach for the tax basis method, irrespective of whether the beginning or ending balance is negative for a partner. The instructions for Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships, refer to the Form 1065 Instructions for reporting partners' capital accounts. Under the transactional approach outlined in the 2020 Form 1065 instructions, 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. The 2020 Form 1065 instructions explain that, if a partnership did not report its partners' capital accounts using the tax basis method in the 2019 tax year and did not maintain its partners' capital accounts under the tax basis method in its books and records, the partnership may determine its partners' beginning capital accounts for the 2020 tax year using any one of the following methods: the tax basis method, modified outside basis method, modified previously taxed capital method, or Code Sec. 704(b) method (each as described in the 2020 Form 1065 instructions).

Relief Provided in Notice 2021-13

Last week, the IRS issued Notice 2021-13 to provide partnerships with relief from certain penalties due to the inclusion of incorrect information in reporting their partners' beginning capital account balances on their 2020 Schedules K-1. The notice also provides relief from accuracy-related penalties for any tax year for the portion of an imputed underpayment attributable to the inclusion of incorrect information in a partner's beginning capital account balance reported by a partnership for the 2020 tax year.

Specifically, a partnership will not be subject to a penalty under Code Sec. 6698, Code Sec. 6721, or Code Sec. 6722 due to the inclusion of incorrect information in reporting its partners' beginning capital account balances on the 2020 Schedules K-1 if the partnership can show that it took ordinary and prudent business care in following the 2020 Form 1065 instructions to report its partners' beginning capital account balances using any one of the following methods, as outlined in the instructions: the tax basis method, modified outside basis method, modified previously taxed capital method, or Code Sec. 704(b) method. For purposes of Notice 2021-13, "ordinary and prudent business care" means the standard of care that a reasonably prudent person would use under the circumstances in the course of its business in handling account information. The IRS reminded taxpayers that, in demonstrating ordinary and prudent business care, capital account balances are part of a partnership's books and records and must be maintained accordingly.

In addition, a partnership will not be subject to a penalty under Code Sec. 6698, Code Sec. 6721, or Code Sec. 6722 due to the inclusion of incorrect information in reporting its partners' ending capital account balances on Schedules K-1 in tax year 2020 or its partners' beginning or ending capital account balances on Schedules K-1 in tax years after 2020 to the extent the incorrect information is attributable solely to the incorrect information reported as the beginning capital account balance on the 2020 Schedule K-1 for which relief under Notice 2021-13 is available. This penalty relief is in addition to the reasonable cause exception to penalties for failing to properly report the partners' beginning capital account balances.

Caution: A partnership that fails to timely file a 2020 Form 1065, Form 8865, and Schedules K-1 is not eligible for the relief provided by Notice 2021-13. A partnership that fails to include a partner's beginning capital account balance on the Schedule K-1 is also not eligible for relief. Notice 2021-13 does not relieve a partner of its obligation to determine the adjusted basis of its interest in the partnership for purposes of determining its tax liability or that of any other person as prescribed in Code Sec. 705 and Reg. Sec. 1.705-1(a)(1).

Notice 2021-13 also provides that the IRS will waive any accuracy-related penalty under Code Sec. 6662 for any tax year with respect to any portion of an imputed underpayment that is attributable to an adjustment to a partner's beginning capital account balance reported by the partnership for the 2020 tax year to the extent the adjustment arises from the inclusion of incorrect information for which the partnership qualifies for relief under Notice 2021-13. However, Notice 2021-13 does not prevent the IRS from imposing an accuracy-related penalty under Code Sec. 6662 for any other portion of an imputed underpayment related to capital account reporting by the partnership.

For a discussion of the Form 1065 filing requirements, see Parker Tax ¶28,550. For a discussion of information reporting penalties, see Parker Tax ¶262,130. For a discussion of accuracy-related penalties, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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