IRS Crackdown on Partnership Basis Shifting Strategies

June 28, 2024

The Inflation Reduction Act of 2022, included a number of provisions that promoted Energy Incentives and Investments in American‘s Infrastructure. Included in the law was the increase in funding of the Internal Revenue Service. This additional funding was designed to allow the IRS to hire more auditors and allow them to focus on areas of potential abuse.

Over the last couple of months the IRS has indicated what area they were going to target as areas of potential abuse. One of the first areas was the deductions related to ownership of private jets. This directive though interesting had little effect on most individuals and businesses.

However, in recent weeks, the IRS has turned their attention to partnerships and the issue of basis shifting which may have a large impact on many businesses that use partnerships and LLC’s to conduct business. On June 18, 2024, the IRS issued three pieces of guidance addressing certain “basis-shifting” transactions in the context of related party partnerships.

The use of partnerships and LLC’s has long been a favored vehicle for doing business in certain industries including real estate. One reason for the popularity is the flexibility partnership taxation allows that can translate into tax efficiency. One area in which that tax efficiency is evidenced is the area of tax basis and managing that basis to maximize tax deductions.

In order for partner in a partnership to take advantage of deductions and losses allocated to them is that the partner must have basis in the partnership to allow for the use of those losses. A common tax strategy is to insure that prior to year end a partner has sufficient tax basis in the partnership to allow the partner the benefit of using those allocated losses. When there are related parties and multiple partners involved, a strategy would include making a distribution from one partnership to its partners who contribute those funds to another partnership that needs basis to benefit from its losses and deductions.

Under the existing Internal Revenue Code Sections that govern partnerships, the shifting of basis between entities can be accomplished without adverse tax consequences if structured properly.

This new mandate by the IRS would potentially reverse these otherwise allowable transactions by asserting that the transactions as a whole lack “Economic Substance”.

One Revenue Ruling, Rev. Rul. 2024-14 highlights three specific transaction dealing with related party entities. These transactions that on the surface would provide the parties with significant tax benefits are disallowed on the basis that the transaction lacked economic substance.

The IRS not only applied the Economic Substance doctrine in that revenue ruling but has indicated that they will be issuing several new regulations on the issue and the formation of a new group to focus on this issue. Included in these rules will be a requirement to highlight through additional disclosures transactions that involve basis shifting between related parties.

These developments will make it important for partnerships that have transactions with related parties to analyze the economic substance of certain transactions.

We at Stephano Slack have extensive experience with Partnerships and will be closely monitoring the IRS actions on this issue. Please contact us if you would like more information on this development or any other questions regarding Partnership taxation issues.