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Monday, August 18, 2014
Chief Counsel Warning -Watch the Detail on Form K-1
Originally Published on forbes.com on October 3rd,2011
I review a lot of partnership K-1s that my firm prepares. I also see a lot of partnership K-1′s that are prepared by other firms. Now nobody is perfect, but I have a pretty high level of confidence in the technical compliance of the ones that go out of our office. The ones that come into our office – maybe not so much. I see a lot of carelessness. One area that gets frequently blown is the allocation of liabilities. It is in Box K of Part II. It gives that particular partners share of the partnership’s liabilities broken down among recourse, non-recourse and qualified non-recourse. I will sometimes see K-1s where the partner is being allocated a loss, which is increasing a deficit capital account, which according to the box checked is on the tax basis, with nothing entered in the liability section. I can probably dream up a scenario where that would be valid, but it is usually a mistake. Either the loss allocation was wrong or, more likely, the return preparer just forgot to allocate liabilities.
Why is this so important ?
If your cumulative losses and distributions from the partnership are less than the cumulative contributions and income allocations, it is not very important. If the losses and distributions are greater it is very important. It is possible to receive tax-free distributions and be allocated losses in excess of income allocations and contributions in a partnership. Many people, including tax practitioners, will then say that you have “negative basis”. Although, if you abandon such a partnership interest it will end up feeling a lot like you had “negative basis”, you really didn’t. Your basis in your partnership interest includes your share of the partnership’s liabilities. This is one of the most important differences between partnerships (which include most LLCs) and S corporations. Sometimes preparers of partnership returns do the loss allocations correctly and then just forget to put the liabilities on the K-1. When you get a K-1 like that you need to inquire and figure out what is going on.
The breakdown in the liabilities can also be very important. The allocation of the liabilities will give you basis but if the liabilities are the “wrong flavour” you will not be “at-risk”. Recouse liabilities add to your amount at-risk. “Qualified non-recourse” liabilities are deemed “at-risk” in the case of real estate. Nonrecourse liabilities do not count for purposes of at-risk.
Are You Stuck with the K-1s?
Two recent rulings indicate that if you believe that liabilities have been wrongly allocated you should try to get the general partner to straighten it out before you file. They are fairly short:
From: —————————- Sent: Tuesday, July 26, 2011 11:32:18 AM To: —————————— Cc: ————————————————— Subject: RE: TEFRA question.
Yes. The determination that “qualified nonrecourse financing” is non-qualified non-recourse financing is a partnership item whose determination or recharacterization must be made at the partnership level. See Dakotah Hills v. Commissioner, T.C. Memo. 1996-35 and Treas. Reg. 301.6231(a)(3)-1(a)(1)(v) and -1(a)(1)(vi)(C)(amounts enabling partner to compute at risk under section 465).
From: —————————- Sent: Monday, July 11, 2011 8:31:09 AM To: —————————————— Cc: —————- Subject: RE: TEFRA affected item
Under Roberts v. Commissioner, 94 T.C. 853, 860 (1990) we may assert the section 465(e) recapture as an affected item without conducting a prior TEFRA proceeding. For purposes of computing the affected item recapture the parties will be bound by the partnership’s reporting of the change from recourse debt to nonrecourse debt.
What Happened ?
As best I can determine partners in a partnership were allocated losses in excess of their investment in the partnership. The liabilities supporting the loss allocation were designated recourse so they also created an amount at-risk. In a subsequent year the liabilities were designated non-recourse which triggers recapture of the losses. In my experience it is a pretty rare event. What the Chief Counsel is saying is that the IRS does not have to make any inquiries about the partnership in order to assert the recapture. The taxpayers are stuck with what is on the K-1s or at the least are facing an uphill battle.
Things like this should not come popping up in an IRS audit. If the liabilities really did go from being recourse to non-recourse somebody should have been paying attention and warned the partners about the possible effect. It is also quite conceivable that nothing about the liabilities changed but that somebody just changed what line they were on without giving it much thought. Return preparers need to look at K1s with a critical eye to avert disasters like this one.