IRS Cracks Down on Partnership Tax Strategies

The IRS has unveiled a new multistage regulatory initiative aimed at addressing what it describes as a "significant tax loophole" often utilized by large, intricate partnerships. This effort stems from the agency's concern that certain partnerships may be leveraging transactions with related parties to significantly reduce their tax liabilities inappropriately.

The key area of concern for the IRS is referred to as basis-shifting transactions. In these arrangements, a single business that operates through many different legal entities enters into a series of transactions. The goal is to leverage partnership tax rules to reduce taxable income, thereby minimizing tax liability. This strategy takes advantage of rules that govern when a partnership can receive a basis step-up in assets that would allow for:

For example, a partnership might shift tax basis from property that doesn't generate tax deductions (for example, stocks or land) to property that does (for example, equipment or machinery). Some taxpayers also use basis-shifting transactions to depreciate the same asset repeatedly.

According to the IRS, these "abusive schemes" have flourished while it was underfunded. Although filings from pass-through businesses with more than $10 million in assets increased 70% from 2010 to 2019, the audit rate for such entities plunged from 3.8% to 0.1% during that time. By using some of its recent funding under the Inflation Reduction Act to crack down on basis shifting, the IRS expects to raise more than $50 billion in revenue over 10 years.

In the first stage of its effort to stop this abusive practice, the IRS announced plans to issue three sets of proposed regulations and provided a new revenue ruling to alert taxpayers about upcoming challenges to certain transactions. The details of its initial phase are as follows:

Proposed regulations will provide rules under the partnership provisions of the tax code on the effects on adjustments resulting from basis-shifting transactions in a related-party partnership. If finalized, the rules would effectively eliminate the "inappropriate" tax benefits from such practices.

A second set of proposed regulations would apply a single-entity approach for interests in a partnership held by members of a consolidated group. If finalized, the regulations would stop members of a consolidated group who are in a partnership from shifting their basis in a way that skews the group's income. If finalized, the regs could affect a significant number of partnership transactions.

The IRS will also publish proposed regulations that would require some partnerships and their advisors to report if they and their clients are participating in certain basis-shifting transactions. The proposed regulations identify the following actions as reportable transactions of interest:

The rules would set a reporting threshold of $5 million or more of positive basis adjustments generated through covered transactions in a single tax year and for which no tax was paid.

If finalized, affected taxpayers and advisors would have 90 days to report existing covered transactions, as well as those that are "substantially similar." Going forward, taxpayers would be required to annually report their cost-recovery allowances and taxable gain and loss attributable to any basis increase from related-party basis-shifting activity undertaken in previous years. Noncompliance could lead to penalties.

The IRS has released Revenue Ruling 2024-14. It provides that three specific types of related-party partnership transactions involving basis shifting lack the requisite economic substance. The ruling will allow the IRS to support its position — in current and future audits and litigation — that many of these practices violate the economic substance doctrine.

The IRS will argue that these transactions create no meaningful change to the parties' economics compared to the tax benefit or have no substantial business purpose — and therefore the associated tax benefits aren't allowable. Moreover, transactions lacking economic substance are subject to a 20% underpayment penalty, which doubles to 40% if the activity isn't reported.

While the verdict is still out on the final impact of the proposed regulations, partnerships should leverage their tax advisors for guidance. A tax professional can help you navigate these changes while ensuring compliance and strategically managing their taxable income. Don’t hesitate to reach out to CSH for professional assistance and stay tuned for updates as they develop.