IRS, Treasury Crack Down on Abusive Partnership Transactions in New Initiative

The IRS and Treasury Department issued a suite of guidance as part of a new regulatory initiative aimed at closing tax loopholes related to abusive partnership basis-shifting transactions. (IR 2024-166; Fact Sheet 2024-21; Notice 2024-54 and Rev Rul 2024-14, 2024-28 IRB; NPRM REG-124593-23, 6/17/2024)

“This is part of a larger effort at the IRS taking place in the compliance arena,” IRS Commissioner Danny Werfel told reporters June 14. “Using Inflation Reduction Act [PL 117-169] funding, we’re working to reverse more than a decade of declining audits among the highest income taxpayers as well as complex partnerships and corporations.”

According to Werfel, the IRS is concerned that tax abuse is “growing in this space.” He explained that these tax loopholes involve related party partnerships that “strip basis from the assets they borrowed” and “move the basis that’s not generating tax benefits into assets they earn elsewhere.” By doing so, partnerships “generate tax benefits without causing any meaningful change to the economics of their businesses,” the commissioner continued.

Announced Monday in a Treasury release, an IRS News Release (IR 2024-166), and an IRS Fact Sheet 2024-21, the initiative is comprised of multiple components that address transactions that generally fit within the following categories: 1) transfers of partnership interests to a related party; 2) distributions of property to a related party; and 3) liquidations of assets which are then distributed to a related party. These types of transactions would be “covered transactions” under the proposed regs.

Notice 2024-54 outlined two sets of forthcoming proposed regs. The first applies to Code Sec. 732, Code Sec. 734(b), and Code Sec. 755. In the covered transactions described above and in further detail within the notice, tax benefits are received directly or indirectly from basis increases that result in related partners lowering their “overall taxable income,” such as via accelerated cost recovery allowances, the IRS said. To combat this, the forthcoming regs will modify how basis adjustments from covered transactions are treated to prevent inappropriate tax benefits.

The second set of proposed regs that IRS and Treasury intend to release are under Code Sec. 1502. These regs will set rules to “clearly reflect” a consolidated group’s taxable income and tax liability when members own partnership interests. Specifically, the regs will “provide for single-entity treatment of members that are partners in a partnership, so that covered transactions cannot shift basis among group members and distort group income,” read the notice.

Importantly, these rules will incorporate the basis adjustments detailed in the first set of regs for relevant covered transactions. Further guidance (Rev Rul 2024-14) provides that the IRS will challenge abusive partnership nonrecognition transactions or distributions using the economic substance doctrine to disallow basis adjustments under Code Sec. 732(b), Code Sec. 734(b), or Code Sec. 743(b).

Taxpayers may face the 20% accuracy penalty under Code Sec. 6662(b)(6) for claiming tax benefits from transactions deemed to be lacking economic substance or the 40% penalty under Code Sec. 6662(i) for nondisclosed noneconomic substance transactions.

Deputy Treasury Secretary Wally Adeyemo said the initiative is estimated to bring in $50 billion in revenue over 10 years “and more than $5 billion per year on average.” The initiative compliments recently announced new audits on 76 partnerships with assets averaging over $10 billion, including hedge funds, real estate investment partnerships, and large law firms.

According to Monday’s IRS release, there has been an inverse relationship between the number of large partnerships and corporations and how frequently they face IRS scrutiny. “Tax filings from pass-through businesses with more than $10 million in assets jumped to nearly 300,000 filings in 2019, 70% more than 2010,” it said. “At the same time, audit rates fell from 3.8% in 2010 to 0.1% in 2019.”

In addition, IRS Chief Counsel Margie Rollinson announced that a new Associate Office will be added to the Office of Chief Counsel specifically geared toward partnerships, as well as S corporations, trusts, and estates. The new office will coordinate with a pass-through work group that will be established in the IRS Large Business and International Division this fall.

“Creating these new work groups is important,” said Commissioner Werfel. “We plan to bring in outside experts with private sector experience regarding pass-throughs to work alongside current IRS employees familiar with these efforts.”