Draft 2021 Form 1065 Instructions Clarify Several Partnership Issues

An early-release draft version of the 2021 Instructions for Form 1065, U.S. Return of Partnership Income, lets practitioners familiarize themselves with the expected changes from the 2020 form and instructions. The instructions clarify reporting for:

• self-employment taxes
• family and sick leave payroll credits
• tax shelter elections
• schedule changes for foreign partners
• business meal deductions.

Self-Employment Tax and Limited Partners in Draft Form 1065 Instructions

The 2021 Form 1065 draft instructions expand the explanation for limited partners, in order to help partners determine if they are limited partners for purposes of the self-employment tax. A limited partner’s self-employment earnings from the partnership generally include only partnership payments for services rendered to or on behalf of the partnership.

The expanded explanation in the draft instructions clarifies that status as a limited partner is determined under IRC §1402(a)(13) without regard for whether the partner may qualify as a limited partner under state law.

Family and Sick Leave Payroll Credit in Draft Form 1065 Instructions

An eligible employer may take a credit against payroll taxes owed for amounts paid before October 1 for family leave or qualified sick leave during 2021. A partnership must include the full amount (both the refundable and nonrefundable portions) of the credit in its gross income for the tax year, but no double tax benefit is allowed.

The partnership includes the credit in the calculation of “Other income (loss)” on line 7 of Form 1065.

Tax Shelter Election in Draft 1065 Instructions

If more than 35% of a partnership’s losses during a tax year are allocated to limited partners, the partnership is a syndicate. A syndicate is considered a tax shelter that cannot use the cash method of accounting.

However, new regulations under IRC §448 allow a partnership to make an annual election

to substitute its allocations from the immediately preceding tax year when determining whether it is a syndicate. The election is valid only for the year in which it is made and cannot be revoked. The regulations explain how a partnership makes the election.

Schedule Changes and Foreign Partners

On Schedule B, a question has been added to line 26 requiring the number of foreign partners subject to the effectively-connected income provisions of IRC §864(c)(8) because of transferring some or all of their partnership interest, or receiving a partnership distribution.

The codes for Schedule K-1 are now included within the Instructions for Form 1065 instead of on page two of Schedule K-1 where they’ve been listed in prior years.

Line 21 on Schedules K and K-1, “Total foreign taxes paid or accrued,” replaces line 16p in regards to basis adjustments and income reconciliation. Foreign taxes paid or accrued must also be reported on the new Schedules K-2 and K-3, which replace lines 16 and 20 from prior years’ Form 1065 schedules K and K-1 for certain international codes. The change is intended to provide additional clarity for partners regarding the computation of the U.S. income tax liability due to international tax items.

Business Meal Deduction in Draft Form 1065 Instructions

The Form 1065 draft instructions clarify that partnerships may deduct 100% of certain business meal expenses incurred after 2020 and before 2023. This is an increase from the usual 50 percent limitation.

Deductible meals must not be lavish or extravagant, and a partner or employee of the partnership must be present. Entertainment-related meals generally are not deductible.

Draft Forms and Instructions May Change

The IRS release draft forms and instructions only when it believes that all appropriate changes have been included. However, this does not guarantee there will not be subsequent changes. Thus, taxpayer should wait for the IRS to release final versions before filing forms for 2021.