IRS Targeting Partnership Basis-Shifting Transaction Schemes

The Internal Revenue Service (“IRS,” or the “Service”) issued guidance on June 17, proposing new regulations and releasing a revenue ruling to challenge the use of basis-shifting transactions by complex partnerships. In making its announcement, IRS officials stated that closing this loophole could result in over $50 billion in new tax revenue for the U.S. over the next decade.

To utilize this scheme, a partnership typically shifts tax basis from a property that does not generate tax deductions, such as stocks or land, to a property that does, such as equipment, Deputy Treasury Secretary Wally Adeyemo said on a recent call with reporters. Businesses also use the technique to depreciate the same asset repeatedly, he noted.

These basis shifts occur in one of three ways, per an IRS fact sheet released on June 17 :

1. 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.
2. A partnership with related partners distributes a high-basis asset to one of the related partners that has a low outside basis. After this, the distributee partner reduces the basis of the distributed asset and the partnership increases the basis of its remaining assets.
3. 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 sell to a partner with a low outside basis. Under the partnership liquidation rules, the 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.

“In essence, basis shifting amounts to a shell game, where sophisticated tax maneuvers take place by shifting the basis of assets between closely related entities, ultimately allowing the high-income taxpayers to hide from a tax bill,” IRS Commissioner Danny Werfel said on a call with reporters on June 14, ahead of the IRS’ June 17 announcement. “These complicated maneuvers take time and resources for the IRS to uncover. They’re not easy to spot on the surface of the tax return. The new guidance is aimed at telling the tax community that the IRS considers these transactions inappropriate.” “These tax shelters allow wealthy taxpayers to avoid paying what they owe,” added Werfel. The IRS said in a statement announcing the new guidance that there is an estimated $160 billion gap between what the top 1% of earners likely owe in taxes and what they actually pay.

The IRS also announced that it plans to bring in outside experts with private sector experience to help root out the use of what it described as “abusive partnership transactions” and set up new teams so it can focus on these issues, IRS leaders said on the June 14 call. Werfel noted, “The outside experience will be critical, helping give the IRS an inside look at some of the maneuvers taking place with partnerships.”

Due to previous years of underfunding, the IRS had cut back on the auditing of wealthy individuals, and the shifting of assets among partnerships and companies grew more common. The officials said the additional IRS funding provided through the 2022 Inflation Reduction Act has enabled increased oversight and greater awareness of the practice, and it has provided critical resources for the IRS to combat these “abusive partnership transactions” going forward.

As a result of the additional awareness and funding, the IRS Office of Chief Counsel is creating a new associate office to focus exclusively on partnerships, S corporations, trusts, and estates. “This new office will allow the Chief Counsel organization to focus more directly on these troubled areas and provide additional attention to legal guidance and other priorities involving partnerships,” Werfel said.

Accordingly, the IRS issued the following guidance on June 17:

• Notice 2024-54 announced two sets of upcoming regulations. One set would require partnerships to treat basis adjustments from covered transactions in a way restricting them from deriving inappropriate tax benefits from those adjustments. The other set of regulations would provide rules to ensure clear reflection of the taxable income and tax liability of a consolidated group of corporations when members of the group own interest in partnerships. These covered transactions would involve basis adjustments under Sections 732, 734(b) and/or 743(b) of the Internal Revenue Code of 1986, as amended (the “Code”).
• The IRS also issued a notice of proposed rulemaking (“NPRM”) identifying certain basis shifting transactions by partnerships as transactions of interest (“TOI”). These TOIs include positive basis adjustments of $5 million or more under the above Code sections where no corresponding tax is paid.
• Finally, the Service issued Revenue Ruling 2024-14, which announced that the IRS would apply the codified economic substance doctrine in Code section 7701(o) to challenge the transactions where related parties:
  • Create inside/outside basis disparities through various methods, including the use of certain partnership allocations and distributions,
  • Capitalize on the disparity by either transferring a partnership interest in a nonrecognition transaction or making a current or liquidating distribution of partnership property to a partner, and
  • Claim a basis adjustment under Code sections 732(b), 734(b), or 743(b) resulting from the nonrecognition transaction or distribution.

The IRS says filings for large pass-through businesses used for the type of tax avoidance in the guidance increased 70% from 174,100 in 2010 to 297,400 in 2019. However, audit rates for these businesses fell from 3.8% to 0.1% in the same time frame.

The IRS plans to raise audit rates on companies with assets above $250 million to 22.6% in 2026, from an 8.8% rate in the tax year 2019. It also plans to increase audit rates on large complex partnerships with assets over $10 billion, including hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms and other industries.

Although these very large partnerships will be studying the recently issued guidance closely, all partnerships with substantial assets, particularly those that have engaged in the basis-shifting transactions described above, should pay attention as well. While the proposed regulations themselves will not be effective until the publication of a Treasury Decision adopting them as final regulations in the Federal Register, the NPRM takes pains to point out that material advisors have disclosure obligations for transactions occurring in prior years, if they have made a tax statement on or after six years before the date of this Treasury Decision.

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