IRS Partnership Crackdown Move Likely Moot Due to Supreme Court

The IRS and Treasury Department face an uphill battle taking on related-party basis-shifting transactions, which is when a business shifts its tax basis among its assets to lower the overall amount of taxes it must pay.

The proposed regulations the IRS is expected to issue would change the requirements spelled out in the federal tax code for common partnership transactions, such as distributions or sale of a partnership interest. It’s the latest example of a growing enforcement effort that targets partnerships and wealthy taxpayers.

A potential change in administration after the presidential election may delay the proposal’s release. But when it comes, there will be widespread comments noting that there is no clear grant of authority for the IRS to issue these regulations in any of the tax code’s provisions cited in the notice.

If the regulations are finalized, expect to see lawsuits if the IRS attempts to rely on them to disallow the tax benefits provided by the tax code. Now that the US Supreme Court has overruled Chevron deference in Loper Bright Enterprises v. Raimondo, the landscape for a such a challenge will be dramatically different.

No longer will a court apply the two-step analysis that defers to agency regulations if the statute at issue is ambiguous, and the agency’s interpretation is reasonable. There is no longer deference to the agency’s interpretation. Courts will have to exercise their independent judgment.

Chief Justice John Roberts, writing for the 6-3 majority, indicated that an agency’s interpretation may be informative if it was issued concurrently with the statute itself and remained consistent over time. But the tax code provisions at issue in the basis-shifting guidance were enacted decades ago, and the IRS and Treasury are just now attempting to change their application to related parties.

As a result, a court could easily disregard the regulations as inconsistent with the statute and conclude—as many commentators have already suggested—that a change such as this must come from Congress, not the IRS and Treasury Department.

The tax treatment of these transactions likely will come down to the codified economic substance doctrine. The government outlined its view of applying the economic substance doctrine to these transactions in the revenue ruling it issued as part of the guidance package.

This may be a warning shot to taxpayers to expect an economic substance challenge and the strict liability penalty, but it certainly isn’t the last word.

Revenue rulings aren’t binding on courts, and the facts in the revenue ruling likely are easily distinguishable from any real-world transaction. The stated business purpose in the revenue ruling is cleaning up intercompany accounts. Many partners likely have more compelling business reasons for different parties wanting different assets.

The revenue ruling also fails to consider whether the codified economic substance doctrine even applies to these transactions. The ruling implicates several of the basic business transactions that legislative history has exempted from the codified economic substance doctrine, including the choice to use related parties and the tax classification of an entity.

Presumably, if taxpayers are allowed to choose entity classification based solely on tax considerations, they also should be able to choose what property is contributed to or distributed from that entity based solely on tax considerations.

These related-party basis-shifting transactions are already being challenged, and many more will be identified for auditing because of the proposed regulations regarding disclosure. Given the disparate views on the correct tax treatment and the application of the economic substance doctrine, the government and taxpayers are unlikely to resolve these cases administratively.

Instead, we can expect a wave of litigation, and these transactions will be addressed by the courts under each one’s specific facts.

The cases are Loper Bright Enters. v. Raimondo, 2024 BL 221307, U.S., 22-451, 6/28/24 and Relentless v. Department of Commerce, U.S., 22-1219, 6/28/24.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Lee Meyercord and Mary McNulty are tax partners at Holland & Knight in Dallas. Meyercord has significant expertise in partnership tax issues relating to energy, real estate, and private equity, and McNulty represents large business taxpayers in IRS audits, appeals, and tax litigation.

Write for Us: Author Guidelines