Partnerships, including the very popular Limited Liability Company (or LLC for short), continue to be one of the most popular entity choices among farmers. We love partnerships because they are relatively easy to form and less complicated to dissolve in comparison to other entity types. However, the danger of an easy to form entity is that it comes with complexity that is not always identified at formation. The new tax law resulted in a change to the partnership tax return form instructions which require more attention to the equity portion of the balance sheet, specifically partners’ capital accounts. Additionally, with more and more farmers approaching retirement, it is imperative that partners work with their tax accountants to review and understand the value of their ownership in partnerships.
The change to Form 1065 - U.S. Return of Partnership Income instructions for 2018 has impacted reporting of partners’ capital accounts on Schedule K-1. This change is for any partnership reporting partners’ capital accounts using any method other than tax basis. The instructions for Schedule K-1, Item L state the following:
- If a partnership reports capital accounts other than tax basis, and
- If that capital account would be negative at the beginning or end of the tax year, then
- The partnership must report the beginning and ending shares of tax basis capital as Code AH on Line 20 of Schedule K-1
Failure to provide the required information may result in a penalty of $195 per month per partner. Fortunately, there is relief available for noncompliance on 2018 returns, but going forward, the penalty will apply. In the end, all partnerships will be required to maintain some form of tax basis capital accounts for partners.
In addition to compliance with the new tax law and form instructions, knowing and understanding your capital account is step one in selling or transitioning ownership in a partnership. A partner’s capital account, calculated on a tax basis will determine the gain or loss on sale of partnership interest as well as aid in the calculation of the value of a gifted share. There are further complications if a partner has a negative capital account. The negative capital may become taxable income or need to be paid back to the partnership or assumed by an existing partner before a sale or gift can be completed.
If you are thinking about selling or transitioning any ownership in a partnership in the next several years, please consider talking with your local Tax Specialist, as there may be basis issues that you are not aware of. These items can often be worked through with careful planning, but can be very complex and take time to resolve.