The Internal Revenue Service has proposed changes to Form 1065, the partnership income tax return, as part of its continuing focus on transparency and compliance risk. These proposed changes include the addition of new and revised forms seeking additional information about the partnership and its partners. These new and revised forms will be in use for tax years ending on or after Dec. 31, 2008.

The IRS revised Schedule B seeking additional information concerning the partnership’s partners, partnership cancelled debt, and partnership transactions related to like-kind exchanges. For example, the revised Schedule B now seeks information concerning the existence of the partnership’s passthrough partners, in addition to detailed information concerning any passthrough partner that owns a greater than 50 percent interest in partnership profit, loss or capital. Measuring a partner’s interest in partnership profits and losses is a difficult task because there is no set guidance on how to undertake the measurement when the partner does not own a fixed percentage of profits and losses. An example of this is determining the partners’ interests in partnership profits and losses when a partner receives a “promote,” or “carried” interest. The proposed instructions offer little help, stating that the partnership should use “a reasonable method” that is “consistent with the partnership agreement,” and “applied consistently from year to year.”  Similar to revised Schedule B, the IRS issued proposed instructions for Item J on Schedule K-1 requiring detailed partnership interest information for all partners as of the beginning and end of the tax year. This additional scrutiny dovetails with the increasing amount of partnership regulations that depend on the status of the partnership’s partners, such as the section 752 debt allocation regulations and the section 704(b) substantiality regulations. 

Revised Schedule B also asks questions about partnership debt cancellations or modifications. The partnership debt modification and cancellation rules contain many traps for the unwary. Thus, checking this box next to this question on the return may cause increased IRS scrutiny of the partnership’s transactions.

Similarly, the revised Schedule B asks two questions relating to like-kind exchanges. The first requires the partnership to check the box if it distributed any property received in a like-kind exchange, or contributed any property received in a like-kind exchange to another entity, including a disregarded entity. The revised Schedule B and proposed instructions are silent as to the application of this question to a partnership that engages in a like-kind exchange where the property received is legally owned by a disregarded entity. In addition, revised Schedule B asks whether the partnership distributed a tenancy-in-common interest or other undivided interest to any partner. Many tax issues arise from a transaction in which a partnership partitions partnership property and distributes those partitions to its partners in order for the partners to engage in like-kind exchanges. It appears the IRS is looking to learn more about the prevalence of those transactions as well.

Finally, the new proposed Schedule C will require filers of Schedule M-3 (generally, a partnership with over $10 million in assets or “total adjusted assets” (a defined term on the form), a partnership with $35 million or more in gross receipts, or a partnership with a 50 percent or greater partner that itself is subject to the M-3 filing rules) to provide additional information. This proposed Schedule C specifically targets partnership special allocations, related person transactions concerning intangibles, and partnership accounting method changes. The IRS hopes these additional disclosures will allow it to analyze better large partnerships.

While most of the revisions impose additional burdens on taxpayers, some small partnerships will see a reduced burden. These proposals raise the asset threshold for filing certain schedules with Form 1065 from $600,000 to $1,000,000. However, even those partnerships with assets less than $1,000,000 will still be required to disclose additional information on Schedule B.

If you have any questions or comments on this Legal Alert, please do not hesitate to contact the Arent Fox attorneys listed below.

John C. McCoy
mccoy.john@arentfox.com
202.857.6175

Joseph A. Rieser
rieser.joseph@arentfox.com
202.857.8964

Robert G. Honigman
honigman.robert@arentfox.com
202.857.6041

Kenneth K. Yoon
yoon.kenneth@arentfox.com
212.484.3981

Elizabeth A. Mullen
mullen.elizabeth@arentfox.com
202.775.5704

Melanie L. Bartlett
bartlett.melanie@arentfox.com
202.715.8571