How Partnerships Can Account For Startup Costs For Tax And Partner Basis
How Partnerships Can Account For Startup Costs For Tax And Partner Basis
The tax treatment of costs incurred by taxpayers when a new partnership is formed is complicated. Often these costs cannot be deducted, but even so, they have to be appropriately reflected in the capital accounts and tax bases in their partnership interests.
In respect of Section 709 and others, deductions for partnership organizational expenses and syndication costs are denied. It includes syndication costs like brokerage, registration, legal, and accounting fees incurred during the issuance and marketing of interests in a partnership.
The partnership may amortize its original expenses under Sec. 709 (b), but no election is available for syndication costs, which must be capitalized.
Although the regulations require the capitalization of syndication costs, limited guidance is provided on how these costs impact partner’s capital accounts and tax bases in their partnership interests when a partner pays it instead of the partnership.
Also, the impact of tax accounting on syndication costs depends on who bears the ultimate economic burden for the costs following the agreement between the parties.
Tracking The Cost
When a partner pays the syndication costs on behalf of a partnership, as a rule, the partnership is designated as the payer for federal income tax purposes. In respect of Rev. Rul. 81-153 the IRS indicated that no investor could deduct syndication costs paid on behalf or in connection with the acquisition of a partnership interest. This ruling was made after a partnership agreed to pay various advisers to assist in the sale of the partnership interests to their clients. In terms of the rules above, the advisors can be paid for their services in two ways.
- The partnership can rebate a portion of the cash received from investors in exchange for the partnership interest to the investor who then paid the advisor. This payment represented a syndication cost, so the partnership was not allowed any deduction.
- The investor can pay the advisor’s fee directly, and the partnership can then reduce the amount that the investor has to pay for the partnership interest commensurately. Although the investor remitted the cash to the advisor, the IRS ruled that partnership made the payment for federal income tax purposes. Neither the investor nor the partnership was allowed to make any deductions for the syndication costs.
In Egolf, 87 TC 34 (1986), the partnership agreement required one of the partners to bear the expenses for partnership syndication. In return, the partnership paid the partner a management fee for which they claimed a deduction. In turn, the partner reported the management fee as an income, and he claimed offsetting deductions for the syndication costs incurred on behalf of the partnership.
The court concluded that this arrangement was an attempt to circumvent Sec. 709 at the partnership level by transforming the syndication costs into a deductible management fee. The court denied the deduction for the portion of the management fee that represented a reimbursement to the partner for the syndication costs paid on behalf of the partnership. In contrast, the amount of the management fee recognized by the partner was reduced by the same amount.
In Rev. Rul. 89-11, the IRS considered a case similar to Egolf. A corporation was a general partner in a partnership and incurred syndication costs for an offering of the partnership interests. The IRS concluded that the corporation should be treated as making a capital contribution to the partnership in the amount of the syndication cost. The partnership was treated as if it paid the syndication cost and was required to record the syndication expenditure as an intangible asset on the balance sheet.
Therefore, in many situations where a partner incurs syndication costs on behalf of a partnership, the partnership will be treated as paying the expenses for federal income tax purposes and the partner will be treated as making a capital contribution to the partnership in an amount equal to the syndication costs incurred on the partnership’s behalf.
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Outside Basis And Capital Accounts
From the partnership’s side, it receives cash from a partner as a capital contribution and pays the syndication costs, which is capitalized as an intangible asset on the balance sheet. The question is, what effect does the capital contribution and partnership-level expenditure have on the partner’s basis in its partnership interest and the partnership’s Sec. 704 (b) capital accounts?
In terms of Sec. 722, the partner increases its tax basis in its partnership interest by the amount of capital it is deemed to contribute to the partnership by paying the syndication costs on behalf of the partnership.
In Rev.Rul. 81-153, the IRS confirmed this position. A partnership that maintains capital accounts per Sec. 704(b) would credit the amount of the supposed contribution to the partner’s capital account.
LP 1 and LP 2 both contribute $1,000 to partnership PRS upon formation, and both receive an equal limit partnership interest. Both partner’s limited partner’s initial capital account and outside basis in its PRS interest equal $1,000.
GP is a general partner in PRS.
GP incurs $150 of syndication costs on behalf of the partnership. Immediately, after formation, PRS reimburses GP for the syndication costs incurred. In terms of PRS’s partnership agreement, LP1 and LP2 are entitled to a return of their $1,000 capital contributions before GP is entitled to any distributions.
- GP pays the syndication costs, but it does not bear the economic burden of the costs due to its rights of reimbursement from PRS.
- The reimbursement of the syndication costs incurred by GP deletes PRS’s assets by $150.
- Directly after the reimbursement payments to GP, LP1 and LP2 are both entitled to receive only $925 of their initial capital contributions upon PRS’s liquidation.
- Despite GP’s cash payment to the provider PRS is deemed the payer of the syndication costs.
- The impact of these expenditures must be reflected in the limited partners’ capital accounts.
Careful analysis of the partnership agreement or other relevant documents is necessary to identify the partner who bears the economic burden of the syndication costs paid by or on behalf of a partnership.
The impact on the basis is different from a capital account. Unlike a capital account, a partner’s basis in its interest is not affected when the partnership is treated as the payer of the syndication costs.
Sec. 705(a)(2)(B) does require a partner to reduce its basis in its partnership interest for its distributive share of nondeductible expenditures, but that impacts only those costs that are not adequately chargeable to capital the capital account. Syndication costs must be capitalized, so partners are not required to reduce their outside basis by their shares of the partnership’s syndication costs.
In terms of Sec. 704(b), the results are different. Regs. Sec. 1.704-1(b)(2)(iv)(1)(2) treats syndication costs as Sec. 705(a)(2)(B) expenditures for purposes of maintenance of the partnership’s capital accounts. A partner’s Sec. 704(b) capital account is reduced by its share of a partnership’s syndication costs. Therefore Sec. 704(b) takes into account that the syndication cost as an expenditure of the partnership in the tax year will reduce the amount the partners will receive on liquidation. The partner who pays the syndication cost will recognize less capital gain (or more capital loss) upon disposition of its interest. Hence, there is a permanent difference between a partner’s basis in its partnership interest and its Sec. 704(b) capital account equal to the amount of the syndication cost.
Above, each limited partner would still have a basis of $1,000 in partnership interest after taking its share of the $150 syndication cost into account. Each limited partner’s capital account will, however, be reduced to $925.
New Capital Basis requirements For Partnerships: Penalties
The IRS quietly made significant changes to Form 1065, US Return of Partnership Income, effective for the tax year 2020.
- If a partnership reports other than tax basis capital accounts to its partners on Schedule K-1 item L (that is, GAAP, 704(b) book or other), and tax basis capital, if reported on a partner’s Schedule K-1 at the beginning or end of the tax year would be negative, the partnership must report on line 20 of Schedule K-1, using code AH, such partner’s beginning and ending shares of tax basis capital. This is in addition to the required reporting on item of Schedule K-1.
- For the tax year 2020 any partnerships where GAAP,704(b) or Other is checked in Item L of the Schedule K-1, or any partnership return where tax capital basis is checked (but the tax capital basis was not properly calculated), practitioners are required to report on a partner’s Schedule K-1 for any partner who has negative tax capital basis at the beginning or end of the year. These reporting should be in box 20 on the Schedule K-1 and coded AH.
Let’s start with what is meant with a tax capital base
|The amount of cash contributed t a partnership by a partner|
|PLUS||The tax basis of the property contributed to a partnership by a partner|
|MINUS||The amount of cash distributed to a partner by the partnership|
|MINUS||The tax basis of the property distributed to a partner by the partnership|
|PLUS||The partner’s cumulative share of taxable partnership income and tax-exempt income|
|MINUS||The partner’s cumulative share of taxable loss and nondeductible noncapital expenditures|
|EQUALS||TAX CAPITAL BASIS|
This calculation is entirely different from the better-known calculation of an inside or outside basis, and if this has not been done, it must be done now. The instructions for Form 1065 and the draft Form 1065 Schedule K-1 is clear:
So, even if the 2018 rules with a negative tax capital basis no longer apply, the calculations must still be completed to comply with 2019 filing requirements.
For 2018, the penalty for failure to include this reporting is $195 per partner per month in which the filing is not correct. The IRS noticed that many partnerships were noncompliant and subsequently released notice 2019-20, Penalty Relief for Missing Negative Tax Basis Capital Account Information.
The following further information is required on the Schedule:
- Partner’s Name
- Partner’s Employee Identification Number (if any)
- Reference ID Number (if any)
- For any partner with a negative tax capital basis at the beginning or the end of the year:
- Taxpayer Identification Number
- The amount of the partner’s tax basis capital account at the beginning and the end of the tax year in question.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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