New Reporting for Partner Negative Capital Account Balances
Partners and members of an LLC taxed as a partnership will often have negative or deficit capital account balances at the end of a taxable year. A negative capital account balance is permissible if supported by proper allocation of partnership debt (or an obligation to restore a deficit). The new instructions to Item L on form 1065 suggest that the Service is going to be looking at partnership returns where partners have negative capital account balances. Their interest would be, and should be, to see that there is a proper allocation of partnership debt to support the deficit capital account since that amount represents future income or gain of the partnership that the partner will likely recognize. The actual target of the new instruction is a partnership return where capital account balances are reported on other than a tax basis, since that reporting may show a positive capital account balance for a partner who actually has a deficit balance if reported on tax basis.
There is really no change to the form itself. Rather, the change appears in the specific instructions for Item L “Partners Capital Account Analysis” on page 30 of the instructions.
The instructions add that if a partnership reports capital accounts on other than the tax basis (for example GAAP or Section 704(b) book basis) and the partners’ tax basis capital accounts at the beginning or end of the year are negative, the partnership must report on line 20 of schedule K-1, using code AH each such partner’s beginning and ending share of tax basis capital.
In other words, the Service wants to know on a tax basis if a partner has a negative capital account balance. If the partnership is already reporting capital account balances on the tax basis, the return will show that. If the partnership reports capital accounts on any other basis, the capital account may not show as negative on the return even though the tax basis capital accounts are negative. This is what the service wants to know.
Be aware of the new rules because there are penalties for failure to properly file under IRC Section 6698(a)(2).