Impact of ASC 842 on Liability Reporting and Partner Tax Basis

ASC 842 introduced significant changes in the accounting for leases, particularly in the capitalization of right-of-use assets and associated liabilities. The standard established a divergence between book and tax treatment, as the right-of-use asset and related lease liability recorded for financial statement purposes do not have tax basis.

Understanding the implications of reporting partnership liabilities on a tax basis is crucial, as it directly impacts a partner’s outside tax basis in the partnership. This, in turn, plays a vital role in the ability of a partner to take non-taxable distributions and to deduct tax losses, as well as the calculation of potential income or loss recognition events.

Defining tax basis liabilities

Under Internal Revenue Code Section 752, partners include their share of the partnership’s liabilities in their outside basis. A partnership reports each partner’s share of the partnership liabilities in item K1 of Schedule K-1.

Partnership liabilities reported to partners on Schedule K-1 can only include liabilities which have tax basis. To provide tax basis, a liability must:

1. Create or increase the basis of the partnership’s assets,
2. Give rise to an immediate tax deduction, or
3. Give rise to an expense that is not deductible in computing taxable income, such as non-deductible expenses.

For example, a cash basis taxpayer would not include accounts payable reported for financial statement purposes since the deduction created by the liability has not been recognized yet for tax purposes.

It is fairly common for financial statement liabilities to not reconcile with the amount reported on the K-1. In fact, it is often the exception, not the standard, that the liabilities for financial statement purposes would equal the liabilities for tax basis.

Understanding the impact of ASC 842

ASC 842 requires all leases (with limited exceptions) to be reported on the balance sheet for financial statement purposes. For non-capital leases, this requires the creation of a right-of-use asset, and an associated lease liability. However, this entry for non-capital leases is recorded for financial statement purposes only.

For tax purposes, the lease payments are recognized based on the taxpayer's method of accounting. No asset or corresponding liability is created on the tax basis balance sheet. When allocating liabilities to the partners on Schedule K-1, it is important to remember that the GAAP liability is not included in the total amount of partnership liabilities allocated to the partners. This does not mean that all liabilities associated with leases are disregarded for tax purposes.

There are situations where lease-associated liabilities do have a tax basis and, therefore, should be reported on Schedule K-1 and included in the partner’s outside basis.

True tax lease (operating lease)

A true tax lease is not capitalized by the lessee for tax purposes and there is no corresponding liability. Lease payments are deducted when payment is made by cash basis taxpayers and deducted when the expense is incurred by accrual basis taxpayers.

However, for accrual basis taxpayers, if the payment has not been made by the end of the tax year, an accrued expense liability will exist for tax purposes at year end. Under the second qualification of determining if a liability exists, the liability did give rise to an immediate deduction (i.e., rent expense) and thus is included as a tax basis liability on the K-1.

Sale/financing arrangement (capital lease)

If a purported lease agreement is treated as a sale for tax purposes, the lessee will capitalize the basis of the property and recognize a corresponding liability for the future payment amounts under the lease. This liability is treated as a partnership liability meeting the first condition (creates or increases basis in a partnership asset) and thus is treated as a liability on Schedule K-1.

Significance of reporting liabilities on a tax basis

It is important to report partnership liabilities on a tax basis, as opposed to a financial statement basis, due to the impact of liabilities on a partner’s outside tax basis in the partnership. This is because outside tax basis is used in determining taxability of distributions, deductibility of losses, and gain or loss on sale of partnership interests.

Incorrect reporting of a partner’s share of partnership liabilities could result in the over or underreporting of a partner’s taxable income. Both the character and timing of recognition could be impacted.

Due to the importance of accurate tax basis reporting, liabilities should be analyzed carefully on the partnership tax return and Schedule K-1 reporting. It is recommended that a reconciliation of book and tax basis differences be documented in the file for accurate reporting.

Thank you to our National Tax Office for their assistance with this blog post.

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CLA can help you navigate the impact of ASC 842 on liability reporting and partner tax basis. Our team uses deep industry knowledge to identify financial, tax, operational, and strategic opportunities across all phases of the real estate investment life cycle.