Partners’ Capital Accounts – What Story do the Numbers Tell?

If you are a real estate investor, or even if your business owns its own real estate, providing your partnership tax return to your banker to satisfy reporting requirements may not be enough anymore. Partnership tax returns (Form 1065) for the 2020 tax year are in the midst of a reporting change that may leave taxpayers and lenders who use tax return information scratching their heads.

Prior to 2020, partners’ capital accounts could be reported based on several accounting methods, such as tax basis and Generally Accepted Accounting Principles (GAAP). This generally meant that the amounts for partners’ capital accounts on the “Balance Sheets per Books” on Schedule L, the “Analysis of Partners’ Capital Accounts” on Schedule M-2, and each partner’s capital account analysis on their respective Schedule K-1 would all equal and were typically in-sync with the business’ books and records.

New for 2020, the IRS took away the taxpayer’s choice in reporting partners’ capital accounts. The balance sheet can still be reported in whatever manner the taxpayer’s books and records are kept, but each partner’s Schedule K-1 must be reported using the tax basis method.

The head-scratching will stem from how numerous taxpayers use their tax returns; many taxpayers provide their tax returns to lenders and financial institutions to satisfy their borrower’s reporting requirements. Those lenders often look to the partners’ capital accounts to determine the borrower’s fiscal health and ability to repay loans. It will cause confusion if a lender is accustomed to seeing certain numbers in sync but those numbers now tell (sometimes drastically) different stories.

Consider the following example:

Capital contributed: 1,500,000
Net (loss) per books: (200,000)
Partners’ capital – book basis: 1,300,000

Capital contributed: 1,500,000
Net (loss) per tax return: (1,600,000)
Partners’ capital – tax basis: (100,000)

In the above example, a business may have a book-to-tax depreciation difference of 1,400,000 as a result of a Cost Segregation Study, which would result in a negative capital account balance on the tax basis but result in a 1,300,000 capital account on the book basis. Lenders may mistakenly choose to only look at the Schedule M-2 amount, which will convey a taxpayer with no ability to pay, as opposed to the Schedule L amount, which will tell an entirely different story. One option to clear any confusion may be to provide lenders with GAAP financial statements, which convey a more accurate accounting of a business’ fiscal health than a tax return, especially when there are book to tax timing differences.