NEW YORK (HedgeWorld.com)–In a development that is almost certain to affect hedge fund investors, the Internal Revenue Service is preparing a draft for a new Schedule K-1 that has codes for showing in greater detail income from partnerships and limited liability companies, such as certain types of capital gains.

The new form is expected to be ready for comment by interested parties in two months or so. It will have numerical codes in its instructions to help the taxpayer identify the nature and type of income or expense encoded in the K-1.

In addition, the IRS is working with software companies to design what are described as two-dimensional bar codes for the schedule. These plans are still at an early stage and are not meant for this year’s tax returns.

“Changing a major form like K-1 is a very serious undertaking, and the Service is very deliberate about it,” said Robert Goldstein, a member of New York State Society of Certified Public Accountants’ tax oversight committee and a partner at accounting firm Leipziger and Bresklin LLP, New York. “They are reaching out to stakeholders and other interested parties for input and advice.”

Complaints

This effort stems from a K-1 matching program the IRS started in 2001 to identify under-reporting by taxpayers. Because of the difficulty in matching certain income flows, many people who had complied with the rules received IRS notices that said they had failed to report taxable income.

For a time, the tax collector stopped sending out notices because of complaints. The United States General Accounting Office prepared a report at the request of the Senate Committee on Finance.

The program has been reinstituted with some precautions to prevent the previous problems, and the tax collector wants to find way for its computer system to match accurately K-1 income data with taxpayer returns.

New York State Society of Certified Public Accountants has proposed a more detailed version of the schedule, to be available in addition to the current one. The NYSSCPA proposal would break out various types of income aggregated as “other” in the current K-1, including non-portfolio short-term and long-term capital gains .

But IRS staffers believe that having two K-1 schedules would be too complicated.

“We felt that for hedge funds and some financial institutions something more comprehensive was required,” explained Mr. Goldstein. “The Service feels that they can achieve that in a simpler form. That is what we hope to see in about 60, plus or minus, days.”

When the new design with numerical codes will come into use is unclear. “They want to get it right first,” Mr. Goldstein said. “I would not anticipate any great modification for the 2003 tax year.”

But other accountants fear that the 2003 K-1 schedules could be delayed anyway. Some modification is taking place in the form for this year. “It will be very late, unless they abandon the idea of making changes,” said Gerald Ranzal of Anchin, Block & Anchin LLP in New York, speaking at a recent conference organized by the Institute for International Research.

A K-1 is issued by pass-through entities, including partnerships, limited liability companies and certain trusts. A copy is mailed to the taxpayers who are partners or beneficiaries, so that they can include the information in their tax returns.

In the current version, much of the income from hedge funds and certain financial organizations tends to be put under a catchall “other” category and explained in footnotes. “This complicates the reporting,” Mr. Goldstein commented. “And the IRS K-1 matching program has made it even more complex.”

CKurdas@HedgeWorld.com