The IRS Takes Aim at Partnership "Basis-Shifting": What the Economic Substance Doctrine Means for Your Tax Strategy

The Internal Revenue Service has fired a warning shot across the bow of sophisticated tax planning: basis-shifting transactions in partnerships are squarely in their crosshairs. With tens of billions of dollars in questionable deductions already under audit, the IRS is wielding the Economic Substance Doctrine as its weapon of choice against what it views as abusive partnership transactions. Economic Substance Coming for Partnerships

Understanding the Economic Substance Doctrine

At its core, the Economic Substance Doctrine is elegantly simple: if a transaction exists solely to avoid taxes and lacks any real business purpose, the IRS can disallow it. Think of it as the IRS's way of saying, "Nice try, but we're looking at what you actually did, not just how you papered it."

This doctrine allows the IRS to look beyond the form of a transaction to its substance. If the only meaningful change from a series of complex transactions is a lower tax bill, you might have a problem.

The Partnership Shell Game: How Basis-Shifting Works

The IRS describes basis-shifting as "a shell game where sophisticated tax maneuvers take place by shifting the basis of assets between closely related entities." Here's what's happening in plain English:

Imagine you have two pockets. In one pocket, you have an asset with high basis (your tax investment in the asset) that isn't generating any current tax benefits. In the other pocket, you have an asset where additional basis would create immediate tax deductions. Basis-shifting is essentially moving money from the first pocket to the second—except you're using complex partnership structures to make it look legitimate.

Three Red Flags the IRS is Watching

The IRS has identified three specific transactions that are raising red flags:

1. Transfer of Partnership Interests to Related Parties

This involves moving your ownership stake in a partnership to a related entity or person. While transfers between related parties aren't inherently problematic, when done solely to shift tax basis around, they become suspect.

2. Distribution of Property to Related Parties

Here, a partnership distributes property to certain partners (who happen to be related to each other), allowing basis to be moved in ways that create tax benefits without any real economic change.

3. Liquidation of Related Partnership or Partner Interests

This involves shutting down partnership interests or entire partnerships among related parties, again with the primary goal of redistributing basis for tax advantages.

Why This Matters Now

The IRS estimates these transactions "could potentially cost taxpayers more than $50 billion over a 10-year period." That's billion with a 'B'—enough to catch anyone's attention.

But it's not just about the money. Partnership tax filings from businesses with more than $10 million in assets jumped 70% between 2010 and 2019, while audit rates plummeted from 3.8% to just 0.1%. The IRS is essentially admitting they took their eye off the ball during a decade of budget cuts, and sophisticated taxpayers took advantage.

What's Changing

The IRS isn't just talking tough—they're taking concrete action:

• New Specialized Teams: The IRS is creating dedicated groups in both the Office of Chief Counsel and the Large Business and International division specifically focused on partnership compliance

• Increased Audits: The agency has already launched audits on 76 of the largest partnerships with average assets over $10 billion

• New Guidance: Three pieces of guidance have been issued to close these loopholes

• Outside Expertise: The IRS plans to bring in private-sector experts who understand these complex structures

What This Means for Taxpayers and Advisors

If you're involved in partnership transactions, especially those involving related parties, it's time for a careful review. Ask yourself:

1. Does this transaction have a legitimate business purpose beyond tax savings?

2. Are we creating real economic changes, or just shuffling paper?

3. Would this transaction make sense if there were no tax benefits?

The IRS has made clear that complexity won't hide these transactions anymore. As Commissioner Danny Werfel stated, they're "reversing long-term compliance declines that have allowed high-income taxpayers and corporations to hide behind complexity to avoid paying taxes."

The Bottom Line

The era of flying under the radar with sophisticated partnership transactions is ending. The Economic Substance Doctrine gives the IRS a powerful tool to challenge transactions that lack genuine business purpose, and they're showing every sign of using it aggressively.

For tax preparers and their clients, the message is clear: if you can't explain the business reason for a transaction without mentioning taxes, it's time to reconsider. The IRS has put everyone on notice that basis-stripping transactions will be "heavily scrutinized and challenged."

In the world of tax planning, sometimes the most sophisticated strategy is simply paying what you owe. With the IRS's renewed focus on partnership compliance and the Economic Substance Doctrine as their enforcement tool, that might be the smartest move of all.