IRS Targets Partnership Tax Schemes
IRS Targets Basis-Shifting Transactions to Reclaim Lost Revenue
The IRS has initiated a multi-phase regulatory effort to address a significant tax loophole exploited by large, complex partnerships. These partnerships are allegedly manipulating transactions with related parties to artificially lower their tax liabilities.
Tactic in the IRS Crosshairs
The IRS is concerned about basis-shifting transactions, a strategy employed by some partnerships to minimize their tax liability. By structuring complex deals involving multiple entities, these partnerships aim to increase the basis of their assets. This allows them to claim larger depreciation deductions or reduce capital gains when selling assets.
For example, a partnership might transfer tax basis from assets that don’t generate depreciation deductions, such as stocks or land, to assets that do, like equipment or machinery. This allows the partnership to claim larger depreciation deductions. In some cases, taxpayers use these transactions to depreciate the same asset multiple times, further reducing their tax liability.
Underfunded, the IRS has struggled to combat “abusive schemes” used by large, complex partnerships. Despite a surge in filings from these entities, audit rates plummeted. With new funding, the IRS aims to recoup over $50 billion by targeting basis-shifting transactions.
Multipronged Attack
As a first step in its initiative to curb abusive basis-shifting transactions, the IRS has announced plans to release three sets of proposed regulations and has issued a new revenue ruling. The revenue ruling serves as a warning to taxpayers that certain transactions may be subject to increased scrutiny. The details of its initial phase are as follows:
Proposed rules to block basis shifting
The IRS is proposing new regulations to address tax avoidance strategies involving basis-shifting transactions in related-party partnerships. These regulations would eliminate the ability to artificially inflate asset bases and claim excessive deductions. Additionally, the IRS is proposing a single-entity approach for consolidated groups to prevent members from shifting basis within the group to manipulate income allocation. If finalized, these regulations could have a substantial impact on a wide range of partnership transactions.
“The IRS is targeting basis-shifting transactions, a strategy employed by some partnerships to minimize their tax liability.”
Proposed rules to require reporting.
The IRS plans to require certain partnerships and their advisors to report if they engage in specific basis-shifting transactions. These reportable transactions include:
- Current or liquidating distributions to a related partner that result in a basis increase in the partnership’s remaining assets
- Liquidating distributions to a related partner that result in a basis increase in distributed assets
- A partner’s transfer of an interest to a related partner that results in a basis increase in partnership assets
- Distributions to a related partner that would increase the basis of distributed assets if a Section 754 election had been in place at the time of acquiring the partnership interest. A Sec. 754 election generally allows a basis adjustment within a partnership
The reporting requirement will apply to transactions that generate $5 million or more in basis adjustments without incurring any tax liability in a single year.
If finalized, taxpayers and advisors will have 90 days to report existing and similar basis-shifting transactions. Going forward, annual reporting of cost-recovery allowances and taxable gains/losses from previous basis-shifting activities will be required. Failure to comply could result in penalties.
Revenue Ruling on transactions to be challenged.
The IRS has issued Revenue Ruling 2024-14, which identifies three specific types of related-party partnership transactions that lack economic substance. This ruling will bolster the IRS’s position in audits and litigation that such transactions violate the economic substance doctrine.
The IRS argues that these transactions offer no meaningful economic benefit beyond the tax advantage and lack a substantial business purpose. As a result, the associated tax benefits may be disallowed. Furthermore, transactions lacking economic substance are subject to a 20% underpayment penalty, which increases to 40% if not reported.
Tread Carefully
The final impact of these proposed regulations will depend on public feedback and potential challenges. Until then, partnerships should consult with their tax advisors to optimize their tax strategies while complying with the evolving tax laws.
Questions?
Adam manages a variety of tax and accounting engagements for business clients in numerous industries, including manufacturing, real estate, construction, alternative investments, and professional services. He has experience in federal tax, multi-state corporate income and franchise tax, and municipal income tax. In addition to his tax compliance background, Adam specializes in preparing and managing complex partnership engagements.