However, for those that have used an alternative capital account method, such as 704(b), GAAP, or other, and for those partnerships that have errors in their tax capital accounts, this can present a challenge. įor the many partnerships that have used the TBM, this is not a change or an issue. Notice 2021-13, provides broad penalty relief for 2020 and thereafter, should the 2020 beginning capital accounts include incorrect information, provided the partnership can establish “that it took ordinary and prudent business care in following the 2020 Form 1065 instructions…”. At this time, the IRS has not finalized those instructions, but Notice 2021-13’s recent publication suggests that they will not again delay TBM reporting. This reverses the IRS previous position, that the transactional approach could not be used. On Octoand January 14, 2021, the IRS released Form 1065 draft instructions that would require, for the tax year 2020, taxpayers to calculate partner capital using a transactional approach for the TBM. Reporting on the tax basis allows the IRS to determine if a partner has distributions in excess of basis and estimate the basis on sale of partnership units. In prior years, taxpayers were permitted to use a number of methods to report partner’s capital including tax basis, GAAP, Section 704(b) or other. On June 5, 2020, the IRS issued Notice 2020-43, requesting comments on the proposed-required methods for reporting partner’s capital under the tax basis method (TBM). The IRS then delayed this reporting for tax years 20. To provide some history, the IRS unexpectedly launched the tax capital reporting requirement in 2018 via the 2018 Form 1065 instructions. The Current Ratio (also known as the Working Capital Ratio) may be more appropriate for businesses not relying on inventory to generate income.Ĭurrent Ratio = current assets ÷ current liabilitiesįor either ratio, a result of one or greater is generally sufficient to confirm adequate business liquidity to support the withdrawal of earnings.Tax professionals have been waiting for the IRS to provide guidance with regard to partnership capital account reporting. Quick Ratio = (current assets - inventory) ÷ current liabilities This test excludes inventory from current assets in calculating the proportion of current assets available to meet current liabilities. The Quick Ratio (also known as the Acid Test Ratio) is appropriate for businesses that rely heavily on inventory to generate income. It is important that the lender select a business liquidity formula based on how the business operates. When business tax returns are provided, for example, the lender may calculate a ratio using a generally accepted formula that measures business liquidity by deriving the proportion of current assets available to meet current liabilities. The lender may use discretion in selecting the method to confirm that the business has adequate liquidity to support the withdrawal of earnings. If business tax returns are required, then the lender must consider the type of business structure and analyze the business returns, according to the requirements described in B3-3.2-01, Underwriting Factors and Documentation for a Self-Employed Borrower. But if the Schedule K-1 does not reflect a documented, stable history, then the lender must confirm adequate business liquidity, as discussed below.
If the Schedule K-1 reflects a documented, stable history of receiving cash distributions of income from the business consistent with the level of business income being used to qualify, then no further documentation of access to the income or adequate business liquidity is required.
If the borrower has a two-year history of receiving “guaranteed payments to the partner” from a partnership or an LLC, these payments can be added to the borrower’s cash flow. Ordinary income, net rental real estate income, and other net rental income reported on Schedule K-1 may be included in the borrower’s cash flow provided the lender can confirm that the business has adequate liquidity to support the withdrawal of earnings, as described below: The lender must use caution when including income that the borrower draws from the borrower’s partnership or S corporation as qualifying income. LLC - reported on either IRS Form 1065 or IRS Form 1120S, Schedule K-1, depending on how the federal income tax returns are filed for the LLC. S corporation - reported on IRS Form 1120S, Schedule K-1 and Partnership - reported on IRS Form 1065, Schedule K-1 The version of Schedule K-1 that is utilized to report a borrower’s share of income (or loss) is based on how the business reports earnings for tax purposes:
Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1