What is now considered as the “abusive use of partnerships,” and why would this matter to the IRS? The agency recently released IR-2024-166, which is intended to provide “new guidance to stop partnerships from using sophisticated tax-free transactions that lack economic substance” to avoid paying taxes. .
The IRS continues to focus on and analyze the actions, behaviors, and strategies of high-income U.S. taxpayers to avoid paying the taxes they should owe each year. The IRS was the beneficiary of $80 billion in new funding from the Inflation Reduction Act (2022). Some of those new funds have been used to establish a new internal IRS team that will focus specifically on closing apparent “tax loopholes” while establishing new guidelines for high-income U.S. taxpayers.
IRS audit teams have been focused on a multi-billion dollar scheme and the use of deductions generated through sophisticated partnership transactions. The agency’s publication referred to a new focus on “Basis shifting” and the issuance of three new “pieces of guidance” focused on associated U.S. entities and taxpayers.
What is “Basis Shifting”?
Basis shifting is a strategy involving the transfer of an asset or assets from one entity to another affiliated entity to restructure the asset’s value in a manner that lowers associated effective tax rates, secure tax deductions that are not available under present ownership entities, or both. The IRS referred to the practice as a “shell game” that moves assets from one owner to another closely affiliated owner to “hide from a tax bill” or generate deductions that would otherwise not have existed..
Compliance Enforcement Targeting “Complex Partnerships”
These “complex partnerships” (as the IRS refers to them) are associated with pass-through entities such as S-corporations and legal partnerships that are not subject to taxation at the corporate level. Instead, income is passed “through” the corporate entity to the individual U.S. taxpayer(s) who own them, to be taxed at the individual’s associated tax rate.
Recent IRS audits have uncovered a similar application of these strategies across numerous separate audits and entities. The agency noted the abusive use of partnerships has substantially increased in recent years. IR-2024-166 provides a few insightful statistics:
Fewer than 100,000 tax filings were associated with pass-through entities with more than $10 million in assets in 2010. By 2019, the number of tax filings for these entities increased to almost 300,000. Meanwhile, the IRS notes that 3.8% of those entities faced an audit in 2010 versus 0.1% in 2019. The IRS points to past budget cuts that made it harder to enforce compliance. The recent agency publication makes it clear compliance enforcement is rapidly improving and increasing.
The IRS Large Business and International Division (LBI) presently serves pass-through entities and partnerships with assets exceeding $10 million.
New IRS Initiatives to Increase Compliance and Enforcement
Recent increases in funding and substantial advances in computer technology and Artificial Intelligence (AI) have provided the agency with new, efficient weapons to target and enforce compliance with the U.S. tax code and issues in areas of focus such as Large Partnership Compliance (LPC) and other abusive transactions such as basis shifting. The IRS noted it was presently auditing “tens of billions of dollars of deductions” claimed in the abusive use of partnerships.
“We are building teams and adding expertise inside the agency so we can reverse long-term compliance declines that have allowed high-income taxpayers and corporations to hide behind complexity to avoid paying taxes. Billions are at stake here,” noted IRS Commissioner Danny Werfel.
IRS guidance is intended to educate internal personnel and auditors in an effort to generate increased awareness of elements to look for in what the agency considers to be tax returns that are otherwise designed to confuse auditors and reviewers while evading U.S. taxation.
The IRS announced the creation of a new “Associate Office” that will “focus exclusively on partnerships, S-corporations, trusts and estates.” The new office will come out of the existing “Passthroughs and Special Industries (PSI) Office.”
The IRS LBI has previously disclosed the development of a special work group focused on pass-throughs and partnerships and intends to complete that process by early fall.
Commissioner Werfel emphasized the need to bring in “outside experts with private-sector experience regarding pass-throughs” to support the new teams and IRS efforts to increase compliance and enforcement. “We need to hone in on areas where we believe non-compliance has proliferated during the last decade of IRS budget cuts, and partnerships represent an area where complex business structures have allowed millionaires and high-income earners to avoid paying what they legally owe while average taxpayers play by the rules.”
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