IRS Announces Plan to Crack Down on Abuse of Partnership Tax “Loopholes”

In a recent News Release, the Internal Revenue Service (IRS) announced that it plans to crack down on the abuse of partnership tax “loopholes” over the coming years. As the News Release states:

“As part of ongoing efforts to focus more attention on high-income compliance issues, the Internal Revenue Service announced today a new series of steps to combat abusive partnership transactions that allow wealthy taxpayers to avoid paying what they owe. . . . Using [Inflation Reduction Act] funds, the IRS is increasing audits on complex partnerships, and the issues covered in this guidance will emerge as an important focus area.”

This could have substantial implications for many high-income and high-net-worth taxpayers. As Texas tax attorney Lawrence Brown explains, the IRS is focusing specifically on basis shifting transactions that allow taxpayers to avoid recognizing gain through the use of related-party partnerships. Despite being permissible under the Internal Revenue Code, the IRS considers these transactions to be abusive, and it is now seeking to close the “loopholes” that currently allow for tax mitigation through basis shifting through new guidance and regulations.

New IRS Guidance Focuses on Basis Shifting Transactions

Along with its News Release, the IRS also issued new guidance on partnership basis shifting transactions. The new guidance identifies three specific types of transactions on which the IRS intends to focus its enforcement efforts going forward:

• Transferring a Partnership Interest to a Related Party – “[A] partner with a low share of the partnership’s ‘inside’ tax basis and a high ‘outside’ tax basis transfers the interest in a tax-free transaction to a related person or to a person who is related to other partners in the partnership. This related-party transfer generates a tax-free basis increase to the transferee partner’s share of “inside” basis.”
• Distributing Partnership Property to a Related Party – “[A] partnership . . . distributes a high-basis asset to one of [its] related partners that has a low outside basis . . . [and] the distributee partner reduces the basis of the distributed asset [while] the partnership increases the basis of its remaining assets. The . . . reduced tax basis of the distributed asset [does] not adversely impact the related partners, while the basis increase to the partnership’s retained assets . . . produce[s] tax savings for the related parties.”
• Liquidating a Related Partner or Partnership – “[A] partnership with related partners liquidates and distributes (1) a low-basis asset that is subject to accelerated cost recovery or for which the parties intend to sell to a partner with a high outside basis and (2) a high-basis property that is subject to longer cost recovery (or no cost recovery at all) or for which the parties intend to hold to a partner with a low outside basis. . . . [T]he first related partner increases the basis of the property with a shorter life or which is held for sale while the second related partner decreases the basis of the long-lived or non-depreciable property, with the result that the related parties generate or accelerate tax benefits.”

To be clear, all three of these transactions are permissible under the Internal Revenue Code and the IRS’scurrent regulations. However, the IRS is seeking to change this with new regulations that are currently pending.

New Regulations Would Allow the IRS to Challenge Basis Shifting (or Basis Stripping) Transactions Going Forward

To close the basis shifting “loopholes,” the IRS has proposed two new sets of regulations that focus specifically on transactions involving partnerships and related partners. The first set of regulations would prevent taxpayers from realizing “inappropriate” tax benefits from basis shifting transactions involving related partners and partnerships. The second would make clear that these transactions involve basis adjustments under Sections 732, 734 and 743 of the Internal Revenue Code and impose additional reporting requirements.

The IRS plans to take action as soon as its new regulations become enforceable. Along with increasing its efforts to audit complex partnerships, the IRS states in its News Release that it is also working to “equip examiners to identify these issues on other partnership returns identified for examination as part of either the Large Partnership Compliance (LPC) program, partnership audit campaigns or other selection methods.” As a result, high-income and high-net-worth taxpayers who currently rely on basis shifting transactions to mitigate their federal tax liability may need to consider alternate strategies; and, in any case, they will need to be prepared to affirmatively demonstrate compliance to the IRS if they face scrutiny.

Basis Shifting Transactions May Become Transactions of Interest (TOI)

Through its proposed regulations, the IRS is also seeking to label basis shifting transactions as Transactions of Interest (TOI). A TOI is a transaction that the IRS “believe[s] . . . has the potential for tax avoidance or evasion, but lack[s] sufficient information to determine whether the transaction should be identified specifically as a tax avoidance transaction.” Transactions of Interest are subject to reporting—which means that they present an increased risk of triggering invasive IRS audits.

What Does This Mean for High-Income and High-Net-Worth Taxpayers Who Rely on Basis Stripping Transactions?

So, what does all of this mean for high-income and high-net-worth taxpayers who rely on basis stripping transactions to mitigate their federal tax liability? Under the IRS’s proposed regulations, not only will many types of basis shifting transactions be prohibited, but these transactions will become reportable as TOIs as well. As a result, continuing to utilize basis shifting transactions will present new—and enhanced—risks, and high-income and high-net-worth taxpayers will need to reconsider their tax mitigation strategies accordingly.

Request an Appointment with Texas Tax Attorney Lawrence Brown

If you have concerns about the IRS’s new regulations governing basis shifting transactions or its enhanced efforts to target partnerships in high-risk audits, we invite you to get in touch. To request an appointment with Texas tax attorney Lawrence Brown, give us a call at 888-870-0025 or tell us how we can get in touch online today.