New Section 1061 reporting guidance for passthrough entities: PwC

New Section 1061 reporting guidance: Observations and impacts on passthrough entities

November 2021

In brief

On November 3, the IRS released reporting guidance in the form of FAQs for partnership interests held in connection with the performance of services (i.e., Section 1061). The FAQs contain sample worksheets (the Worksheets) for passthrough entities (hereinafter referred to as partnerships) to attach to each investor’s Schedule K-1 (Worksheet A) and for individual taxpayers (Owner Taxpayers) to use for purposes of preparing Form 1040s (Worksheet B and Tables 1 and 2). Below are some initial observations regarding the FAQs, with a particular focus on Worksheet A, which is provided by the partnership to its partners holding applicable partnership interests (APIs).

In detail

Same information as required for 2022 - While the Worksheets may appear daunting, they generally require the same information and level of detail that must be provided under the final regulations under Section 1061 (the Final Regulations) beginning with the 2022 tax year (for calendar-year taxpayers). Rather than requiring more detail, the Worksheets seek to provide a consistent format of reporting for taxpayers which is intended to be helpful for taxpayers and their tax preparers in complying with Section 1061.

Effective date includes 2021 - Partnerships applying the Final Regulations in 2021 must use Worksheet A. The FAQs state that, even if the taxpayer is not applying the Final Regulations for the 2021 tax year, the partnership must provide similar information to that required by Worksheet A.

Format of 2021 reporting - A partnership’s existing Schedule K-1 footnotes already may provide sufficient detail required to comply with the FAQs’ information reporting requirements, but Worksheet A presents this in a different format. If a partnership is not adopting the Final Regulations in 2021, it may consider continuing to use its existing footnotes, instead of providing Worksheet A. However, it should be noted that Worksheet A generally follows the same terminology and categories that Owner Taxpayers will need when completing Worksheet B and associated Tables. Accordingly, individual preparers may request information that mirrors Worksheet B for ease of reporting. The FAQs also require a partnership that is not relying on the Final Regulations for 2021 to disclose whether the information provided was determined under the proposed regulations or another method.

Information required to be provided on Worksheet A - There are seven components of Worksheet A.

Net long-term capital gain (loss) - This will represent total long-term capital gain reported on line 9a of the Schedule K-1, without any adjustments for Section 1061.

Capital gains or (losses) that are not subject to Section 1061 under Treas. Reg. sec. 1.1061-4(b)(7) - Capital gains and losses excluded under this section are typically those from Section 1256 contracts, Section 1231 property, etc. To the extent they are included on line 9a of the Schedule K-1, they should be reported here so they are removed. Some of these items, such as Section 1256 items, typically are not reported on line 9a; therefore, presumably they would not need to be reported here to be removed.

Capital Interest Gains or (losses) under Treas. Reg. sec. 1.1061-3(c)(2) - This would represent gains/losses that meet the capital interest exception of the rules.

API One Year Distributive Share Amount - Subtraction of lines 2 and 3 from 1. This removes capital interest gains and losses that are not subject to Section 1061 from the calculation.

Amounts included in line 4 that would not be treated as long-term gain or (loss) if greater than three years is substituted for greater than one year - This typically will be the amount that is recharacterized as short-term gain (after being netted with other API interests by the Owner Taxpayer).

Any Lookthrough Rule adjustment applicable to the disposition of an API by the passthrough entity - Because the lookthrough rule is not part of the statute and only included in the regulations, if a taxpayer is not adopting the proposed or Final Regulations for the 2021 tax year, this presumably would be marked N/A or left blank for the 2021 tax year.

API Three Year Distributive Share Amount - Subtraction of lines 5 and 6 from 4.

Observation: While the substance of the information may be the same, the ordering and bucketing of the information on Worksheet A does not necessarily line up with the way many partnerships have been reporting information to investors. It closely follows the exact language in the Final Regulations, as compared with a more intuitive approach.

In the most basic example, assume an API holder (who holds no interest eligible for the capital interest exception) has $100 of capital gain from property held for one to three years and $60 of capital gain from property held more than three years, for a total capital gain on line 9 of $160. In Worksheet A, line 1, Net Capital Gain/Loss, would be $160; line 4, API One Year Distributive Share, also would be $160; line 5 would be $100 (i.e., the recharacterization amount); and line 7, the API Three Year Distributive Share Amount, would be $60. In other words, the API One Year Distributive Share amount actually is the total long-term capital gain from property held in excess of one year (including the property held in excess of three years). This matches the definition of the API One Year Distributive Share Amount in the Final Regulations. This should not be confused with the amount of gain from property held one to three years, when in actuality, gain from property held one to three years is reported on line 5 and is typically the amount that will be recharacterized as short term capital gain under Section 1061.

PFICs - The reporting guidance states that if a passive foreign investment company (PFIC) with a qualified electing fund (QEF) election provides information to the shareholder to determine the amount of the shareholder's inclusion that would be included in the API One Year Distributive Share Amount and the API Three Year Distributive Share Amount, the shareholder must retain a copy of this information. Other than this information retention requirement, the FAQs do not provide additional guidance with respect to PFICs. As a result, taxpayers should discuss with their advisors reporting options for the 2021 tax year.

API v. capital - While most partnerships have been providing the requisite information to partners on their share of gains/losses from property held one to three years, property held for more than three years, and gain from Section 1256 contracts and Section 1231 property, some partnerships have not taken an affirmative position on the Schedule K-1 as to whether such partnership interest, or portion thereof, is an API or a capital interest. This should be discussed in more detail with the taxpayer and the individual’s tax advisor, to the extent applicable, in order to determine the appropriate presentation for 2021.

Action items:

Perform a gap analysis with your existing disclosures to partners and the information required by the new IRS guidance.

To the extent there is information or level of detail required that currently is not provided, a partnership should discuss with its tax preparer to determine the approach for 2021.

Consider coordinating with an API holder’s individual tax advisor regarding the format of information being disclosed for purposes of preparing the API holder’s Form 1040.