In the summer of 2023, the IRS announced a significant enforcement initiative targeting so-called "basis shifting" transactions involving related-party partnerships. These arrangements—which the IRS has characterized as abusive tax shelters—exploit the mechanical rules governing partnerships to generate artificial tax basis in assets, enabling taxpayers to claim deductions or offset gains that bear no relationship to any economic investment. The initiative represents one of the most significant partnership tax enforcement actions in recent years, and it puts taxpayers and their advisors on notice that the IRS is devoting substantial resources to this area.^[1]

How Basis Shifting Works

The fundamental premise of basis shifting is the exploitation of the partnership tax rules governing contributions, distributions, and liability allocations. Under Subchapter K of the Internal Revenue Code, a partner's basis in a partnership interest is adjusted to reflect contributions, distributions, allocated income and loss, and the partner's share of partnership liabilities. These rules are designed to ensure that economic gains and losses are properly tracked and taxed—but they can be manipulated in arrangements where related parties control all sides of the transaction.

A simplified example illustrates the concept. Suppose related persons A and B form a partnership. A contributes a high-basis, low-value asset (such as a debt instrument purchased at par that has declined in value), while B contributes cash or other low-basis, high-value property. Through a series of transactions—which may include distributions, redemptions, or liability shifts within the partnership—the high basis from A's contributed asset is effectively transferred to B's property, or to new property acquired by the partnership and distributed to B. The result is that B obtains a tax basis in property that far exceeds B's economic investment, enabling B to claim depreciation deductions or to offset gain on a subsequent sale.^[2]

The transactions at issue typically involve multiple steps and may span several years. They are often structured by sophisticated tax advisors and involve entities controlled by a single family, a corporate group, or a private equity fund. The IRS has indicated that the transactions under scrutiny involve billions of dollars in artificial basis.

The Legal Framework

The IRS has several tools at its disposal to challenge basis shifting transactions. The most straightforward is the economic substance doctrine, codified at IRC § 7701(o), which provides that a transaction will be respected for tax purposes only if it changes the taxpayer's economic position in a meaningful way (apart from the tax benefits) and the taxpayer has a substantial purpose for entering into the transaction (apart from the tax benefits). Transactions that lack economic substance can be disregarded entirely, and the taxpayer may be subject to a strict liability penalty of 20 percent (or 40 percent if the transaction was not adequately disclosed).^[3]

The IRS may also invoke the partnership anti-abuse rule under Treasury Regulation § 1.701-2, which provides that a partnership transaction may be recast if it is inconsistent with the intent of Subchapter K. Additionally, specific provisions such as IRC § 704(c) (requiring that built-in gain or loss on contributed property be allocated to the contributing partner) and IRC § 737 (triggering gain recognition on certain distributions of contributed property) are designed to prevent exactly the type of basis arbitrage that these transactions exploit.

Who Is at Risk

The IRS enforcement initiative is primarily focused on large, sophisticated taxpayers: private equity funds, family offices, corporate groups, and high-net-worth individuals who have entered into complex partnership arrangements with related parties. However, the principles at stake extend more broadly. Any taxpayer who has used a partnership structure to generate basis that does not correspond to an actual economic investment should evaluate whether the arrangement is defensible.

The IRS has indicated that it is using data analytics and advanced technology to identify potential basis shifting transactions from partnership returns. The agency has also been hiring and training additional personnel to examine these returns. Taxpayers who have claimed deductions or offset gains based on artificially inflated basis should be aware that the IRS's ability to identify and challenge these transactions is increasing.

Practical Considerations

For taxpayers and their advisors, the IRS's basis shifting initiative reinforces several fundamental principles. First, partnership transactions between related parties will be scrutinized more carefully than arm's-length transactions. The IRS and the courts are less likely to respect the form of a transaction when the parties on all sides are controlled by the same person or group. Second, the economic substance doctrine is a real and enforceable limitation. Transactions that have no business purpose apart from generating tax benefits are at significant risk of being disallowed, with penalties on top of the additional tax.

Third, adequate disclosure can reduce penalty exposure even if the underlying position is ultimately unsuccessful. Taxpayers who disclose their positions on the appropriate forms (such as Form 8275 or Form 8886 for reportable transactions) are typically subject to the 20 percent accuracy-related penalty rather than the 40 percent non-disclosure penalty—a meaningful difference when the amounts at stake are substantial.^[4]

For businesses that use partnership structures for legitimate operational reasons, the basis shifting initiative should not cause alarm. The IRS has been clear that its enforcement efforts are directed at abusive transactions, not at the routine use of partnerships for business operations. However, any taxpayer who has entered into a partnership transaction with related parties that generated significant tax benefits should consult with experienced tax counsel to evaluate the transaction's defensibility and to ensure that adequate disclosure has been made.^[5]