IRS Targets Partnership Tax-Reduction Tactic

The IRS has recently announced a multistage regulatory initiative designed to close what it calls a "major tax loophole" exploited by large, complex partnerships. This move comes after the IRS noticed some partnerships using transactions with related parties to reduce their tax bills improperly.

Tactic in the IRS Crosshairs

The IRS is particularly concerned about a tactic known as basis-shifting transactions. In these setups, a single business, operating through multiple legal entities, engages in a series of transactions that leverage partnership tax rules to reduce taxable income. This often minimizes the overall tax liability.

This tax-reduction strategy benefits from rules governing when a partnership can receive a basis step-up in assets, allowing for:

• Additional depreciation, or

• Reduced taxable gain or increased taxable loss when disposing of assets.

For instance, a partnership may shift tax basis from property like land or stocks, which don't generate deductions, to equipment or machinery that does. Some taxpayers even use this tactic to depreciate the same asset more than once.

According to the IRS, these schemes grew while the agency was underfunded. Between 2010 and 2019, filings from pass-through businesses with over $10 million in assets surged 70%, but audit rates for these entities dropped to just 0.1%. With the funding provided under the Inflation Reduction Act, the IRS aims to raise over $50 billion in revenue over the next decade by cracking down on basis shifting.

Multipronged Attack

The IRS plans to issue three sets of proposed regulations and released a revenue ruling to alert taxpayers about challenges to these transactions.

1. Proposed Rules to Block Basis Shifting: The IRS aims to eliminate inappropriate tax benefits from these transactions by changing partnership tax provisions.

2. Proposed Rules for Reporting: Certain partnerships and their advisors will be required to report basis-shifting transactions over $5 million that generate significant tax benefits.

3. Revenue Ruling: IRS Revenue Ruling 2024-14 outlines that three specific types of related-party basis-shifting transactions lack economic substance, making the associated tax benefits unallowable.

Partnerships should work closely with their tax advisors to ensure they are compliant while managing their taxable income.

For expert advice on navigating these complex changes, contact Verity CPAs at info@verity.cpa or 808.546.5026.