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IRS to Target Partnership Basis Shifting Abuses

On the heels of a significant boost in funding brought by the August 2022 passage of the Inflation Reduction Act (“IRA”), the IRS this week announced new efforts to combat what it sees as abusive transactions and strategies utilized by businesses that are taxed as partnerships. This is another IRS and Treasury initiative targeting high-earning and high-net-worth taxpayers.  Over the past few months, the IRS has announced various enforcement efforts targeting high-end taxpayers. These efforts include an initiative to pursue high-income non-filers and those with large unpaid balances, warnings about exaggerated art donation deductions, and efforts to pursue taxpayers who improperly deduct corporate or private jet expenses incurred for personal use. These and other initiatives are all part of a broader effort by the IRS to allocate more attention and resources to auditing high-earning taxpayers and large businesses.

The most recent announcement focuses on what the IRS sees as inappropriate basis shifting strategies that are used by partnerships to create favorable tax results without adequate underlying economic activity. While these transactions generally comply with the letter of the law and existing regulations, the IRS believes that certain taxpayers are abusing the existing rules in a manner that generates unintended tax benefits. The IRS announcement noted that:

[th]e new guidance is designed to stop the use of “basis shifting” transactions that use related-party partnerships to avoid taxes. In these complex moves, high-income taxpayers and corporations strip basis from assets they own where the basis is not generating tax benefits and then move the basis to assets they own where it will generate tax benefits without causing any meaningful change to the economics of their businesses. These basis shifting transactions allow closely related parties to avoid taxes.

To combat possible abuse of basis shifting strategies, the IRS released three new pieces of guidance on the subject:

  • Notice 2024-54, which announces two sets of upcoming regulations: one set of regulations to limit certain basis adjustments so that they don’t allow inappropriate tax benefits and a second set of regulations intended to require clear reflection of taxable income and resulting tax liability in the context of certain consolidated corporate taxpayers that own interests in partnerships.
  • Proposed Regulations that identify certain basis-shifting transactions as Transactions of Interest. This designation, if finalized, would require taxpayers and their professionals to comply with additional reporting and record-keeping requirements with respect to such transactions, which would make it easier for the IRS to identify and challenge such transactions.
  • Revenue Ruling 2024-14, which indicates that the IRS intends to apply the codified economic substance doctrine to such transactions.

Perhaps most importantly, the IRS Office of Chief Counsel also announced the formation of a new Associate Office that will focus exclusively on partnerships, S-corporations, trusts and estates. This is in addition to a new unit recently announced within the IRS’s Large Business and International group that will also focus on partnerships.

This new emphasis on partnerships is the result of an increase in partnerships and other pass-through filings over the past 10 years that has been accompanied by a decline in the audit rates of such entities. These latest developments make clear that the IRS intends to use the IRA funding to reverse years of under-enforcement in the partnership space. Taxpayers who invest in or operate through partnerships should expect additional scrutiny of their tax-favorable transactions and more of a fight from the IRS over where to draw the line with respect to such transactions.

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