Funds: Are You Ready for New Tax Reporting Requirements?

This blog post was previously published on December 13, 2019. It was updated on January 24, 2020.

Fund managers should be aware of a number of changes in reporting requirements for tax year 2019, while keeping in mind new considerations introduced for 2018 and beyond with the Tax Cuts and Jobs Act.

Tax-basis capital reporting

Starting with 2020 K-1s, funds will no longer have a choice of reporting each partner’s capital account for tax purposes.  You will need to report each partner’s capital account using a tax basis capital method. While investment managers have historically kept track of the necessary info to compute tax basis capital, some have not. If you haven’t tracked this in the past, it’s time to start.

This new reporting requirement was expected to impact 2019 K1s due to a draft Schedule K-1 released in September. Fortunately, an early holiday present came along. Notice 2019-66 provided that the tax basis method will not be effective for 2019. The notice does say that tax basis must still be disclosed (like in previous years) if a partner’s beginning or ending tax basis capital is negative. There are also a number of helpful guidance points and clarifications, including a reference to an IRS FAQ on tax basis capital account calculation.

Schedule K-1 form changes

While the tax basis requirement was delayed, Schedule K-1 (aka Form 1065 “Partner’s Share of Income, Deductions, Credits, etc.) has seen changes for the 2019 tax year. The final Schedule K-1 form (updated December 2019)  made several additions, including:

• Disregarded entity names and Tax Identification Numbers must now be included, along with the individual beneficial owner’s information.
• Your Schedule K-1 may need to disclose the unrecognized balance of any unrealized gain or loss on contributed securities, as well as unrealized gain or loss on investments purchased by the partnership.
• Instead of a single line for qualified business income (QBI), there is now guidance to report all “QBI/Qualified PTP Items Subject to Taxpayer-Specific Determinations.” (See below for more information on this.)

Calculate QBI on new worksheet

Many investment companies are structured as pass-through entities, such as subchapter S corporations, partnerships and limited liability companies. The Tax Cuts and Jobs Act included a QBI deduction break for owners of certain pass-through entities that may reduce your maximum effective tax rate.

A new worksheet for the individual taxpayer, Form 8995, must now be used to calculate QBI reporting on Schedule K-1. Form 8995’s instructions includes a flowchart for calculating restrictions and limitations on each business that creates QBI. Each business must stand separately and will require its own Form 8995.

QBI deduction limitations and restrictions are set at the owner level. Your conversation with your tax advisor should include a discussion of salaries, timing and distribution of income.

You may want to revisit your capital strategy

Business interest expense deductibility is limited. For net interest expense that exceeds 30% of adjusted taxable income (ATI), deductibility has been limited. Through 2021, ATI is computed without accounting for depreciation, amortization or depletion, but beginning in 2022 those items are included. This could decrease your ATI, and thus limit your interest expense deductibility further.

Highly leveraged portfolio companies should take note and address this issue strategically. A capital strategy relying on more equity and less debt may be advisable.

U.S. withholdings on partnership interest transfers with ECI

When a non-U.S. person engages in a trade or business in the U.S., income from sources within the U.S. connected with the conduct of that trade or business is generally considered to be Effectively Connected Income (ECI). Proposed regulations under IRC Section 1446(f) provide guidance about reporting ECI and the 10% withholding due to the sale, exchange, or distribution when the non-U.S. person is investing through a partnership. IRS filing requirements related to this new withholding include Form 8288. The proposed regulations contain some stringent rules that can adversely impact foreign investors.

Fortunately, there are a good number of exceptions that may allow you to avoid this issue entirely. You should speak with your tax advisor to learn more about these exceptions and how they may impact your tax liability.

Opportunity Zone investments require additional reporting

Opportunity Zones can offer tax benefits for real estate developers, investors and investment funds, by offering the opportunity to defer capital gains by investing in certain economically distressed communities. The longer you hold the property, the greater the benefit. If you defer your gains on opportunity zone investments for 10 years, you’ll pay no tax on the appreciation of your investment.

For 2019, Qualified Opportunity Funds will need to provide more information to the IRS, through a new Form 8996. Funds must report the value of business properties, the census area tract number for each property, the value of investments allocated to each area, each investments’ current valuation and other information.

To learn more about opportunity zones and the recently issued final regulations, read the Treasury Department’s FAQ or consult your Kaufman Rossin tax advisor. Also keep in mind that your tax advisor may need additional information about your Opportunity Zone investments for filing your 2019 taxes.

Don’t forget tax reporting basics

It’s also important to think about the basics of tax preparation and reporting:

• Assess whether you have current W9s and W8s for all of your investors. Some of these forms have expiration dates and need to be filled out and signed again.
• As 1099s start coming in, they need to be reconciled with the fund’s records. Brokers may record transactions differently from the way the fund has recorded them. It’s a good idea to have your tax professional review and resolve these differences early in the tax preparation process.
• Keep in mind January 2020 transactions can impact 2019 wash sales. The Wash Sale rule is triggered if “substantially identical” securities are purchased within 30 days prior to or 30 days after the sale of another security at a loss.
• You may be familiar with the “constructive sale,” which adds unrealized gains into your taxable income. It occurs when a taxpayer is holding at year-end (December 31, 2019) appreciated property (e.g., stock), while also holding a short position with respect to the same or “substantially identical” property. During January and February of 2020, the following circumstances can help you avoid the constructive sale rule.
  • Offsetting position is closed within 30 days after the end of the year,
  • Appreciated financial position is held throughout the 60-day period beginning on the date such transaction is closed, and
  • During that 60-day period the taxpayer does not enter into certain transactions that would diminish the risk of loss during that time on such position.

Contact your Kaufman Rossin tax professional to learn more about new tax reporting requirements and other considerations that may impact your tax liability for 2019.