Closing asset loophole could add billions to tax collections, IRS says

“These transactions don’t create any economic activity for the U.S.,” Deputy Treasury Secretary Wally Adeyemo said. “Their sole purpose is to reduce tax bills.”

Shutting down inappropriate basis shifting can increase tax collections from partnerships by at least $5 billion a year over the next decade, Adeyemo said.

A partnership is a “pass-through” business structure of linked entities that passes income and losses directly to investors, rather than being taxed at a corporate level. When a partnership sells assets such as land or equipment, the taxes are determined only after subtracting the asset’s original cost — the “basis” — from the proceeds.

Certain rules in the tax code allow partnerships to recalculate that basis when other assets move in or out of the business. The IRS asserts that partnerships are regularly manipulating the basis of assets to avoid taxes.

In some cases, the business might repeatedly depreciate the same asset.

“What you do is things like, you’ve depreciated the asset in one entity, so now the basis is zero,” said Mark Luscombe, a Wolters Kluwer tax lawyer who serves on the American Bar Association’s committee on partnerships. “If you sold it, you’d have a big gain and you don’t have any more depreciation. You instead sell it to a related party so you can start the depreciation all over again.”

An existing rule requires that transactions have “economic substance” rather than merely reducing tax bills. A top IRS official mentioned the economic substance rule as the root of the agency’s belief that most of these closely related partnership transactions are illegal.

“It is possible that taxpayers believe their transactions meet the literal regulation,” the official said, speaking on the condition of anonymity to discuss the new rule before specific regulations are announced. “However, they do not have economic substance. We believe they are illegal under current law.”

The tax agency will publish guidance for accountants and lawyers meant to make clear that the federal government believes basis shifting purely to avoid taxes is illegal and will be subject to audits. It will propose regulations to require large partnerships to provide more detail to the IRS about certain transactions when they occur. And it will create teams within the IRS’s legal arm and its large-business auditing unit to focus on such partnerships, staffed by some of the hundreds of auditors the IRS has hired this year.

Those new employees have already turned up many basis-shifting transactions that they believe to be illegal, IRS Commissioner Danny Werfel said in a call with reporters. “In the audits we’re doing today, we are seeing this systemic use of basis shifting where there is no economic basis to the transaction,” Werfel said. “That is not allowed.”

If Adeyemo’s projection of $50 billion in additional tax collections over 10 years comes to pass, it would go a long way toward recouping the billions in additional funding that Congress allotted to the IRS at President Biden’s urging. The Biden administration and others have argued that the investment would more than pay for itself as new auditors hired with the money crack down on wealthy tax evaders.

The Biden administration said in a statement Monday that the basis-shifting maneuvers, promoted by high-end lawyers and accountants who get paid millions of dollars to structure these businesses’ complicated tax returns, have probably soared in popularity in recent years but gone unnoticed by the IRS until recently. The 2010s saw a 70 percent increase in filings by pass-through businesses with more than $10 million in assets, rising to nearly 300,000 in 2019.

“They’re the form of business of choice for most new businesses, including businesses that get quite large and very successful,” said Michael Sardar, a partner at Kostelanetz LLP who represents firms under IRS audit. “It’s an area that has seen so much growth in terms of the value that’s sitting inside partnerships. People think of the big bad corporation; that’s maybe not the right character today. Because a lot of the money is in partnerships.”

Meanwhile, the cash-strapped IRS went from auditing 3.8 percent of those large partnerships in 2010 to auditing just 1 in 1,000 in 2019.

Auditors hired by the tax agency this year noted tens of billions in assets hidden from taxation by partnerships that are currently under audit, leading to the agency’s decision to focus specifically on basis shifting, Werfel said.

Robert Kovacev, a lawyer at Miller & Chevalier who represents partnerships under audit, argued that the businesses might not be doing anything wrong, since the tax code allows changes in basis. The agency’s proposed new rules probably will be challenged in court, he said.

“I don’t think it’s tax evasion at all,” Kovacev said. “That has a fraudulent tinge to it that I don’t think exists here. It’s a tax planning tool that follows what Congress said you can do.”

The IRS on its own can’t stop basis shifting, Kovacev argued. “If Congress wanted to change the rules to prohibit basis shifting between related parties, they can do that, but it’s Congress’s job to do that,” he said.

But Luscombe said the IRS doesn’t need additional congressional authorization to crack down on many attempts at basis shifting because “these transactions are probably abusive” under the current system.