In 2024, the IRS ramped up its focus on partnerships, including several actions before President Trump took office. However, with a new Treasury Secretary confirmed (i.e. Scott Bessent), a new IRS Commissioner nominated but not yet confirmed (i.e. Billy Long), federal funding cuts, a federal hiring freeze, and employee reductions at both IRS and the Department of Justice Tax Division those initiatives may have just run out of gas.
The Double-Edged Sword Of Partnership Taxation
The government has an interest in increasing economic activity and that can be accomplished by removing potential roadblocks like burdensome regulation and undesirable tax consequences. Another way to encourage economic activity is to make business activity more flexible and tax friendly. Partnerships allow business ventures incredible flexibility in structuring the economics of a wide variety of commercial deals. However, that flexibility also allows for a lot of misuse of rules to obtain results that do not reflect the true economics of the deal. Many of the transactions challenged by the IRS or the Department of Justice involve partnerships because they are, by design, the easiest entity to manipulate. During my own tenure at the Department of Justice I was involved in nationwide enforcement efforts against multiple transactions, considered by the government to be abusive, involving partnerships. As a private attorney, partnerships are often the appropriate solution to complicated transactions requiring a flexibility not available with the use of other entities. Whether a transaction is abusive or legitimate is often in the details.
The usual mechanism for testing the details of transactions and the potential tax benefits of those transactions is during the IRS audit process. Historically, however, the IRS has been terrible at auditing partnerships. When the IRS released its Strategic Operating Plan in May of 2024 it indicated increasing audits for wealthy taxpayers, large corporations, and partnerships. That announcement indicated a “ten-fold” increase for large complex partnerships but that increase would be from 0.1% in 2019 to 1% by 2026. According to a U.S. General Accountability Office (GAO) study indicated that large partnerships increased 600% between 2002 and 2019 but the audit rate continued to decline. The IRS blamed the declining audit rate to resource constraints. Further, the no-change results for the few partnerships audited are double those for large corporate taxpayers and the GAO study attributes the poor selection to statistical models used. This poor selection process isn’t only bad for the public fisc, but costs an unnecessary number of compliant partnerships the time and money required for an audit to merely confirm that everything is in order.
Fixing Old Problems With New Partnership Audit Rules
The Bipartisan Budget Act (BBA) created new rules for auditing partnerships that were applicable for tax years starting in 2018, unless you could meet the narrow circumstances allowing election out of the new rules. The goal of the new audit rules was to provide a more favorable framework for the audit of partnerships and improve the historically poor rate and performance experienced in IRS audits of partnerships. Tax advisors have been helping partnership amend their agreements, implement new internal controls, and otherwise adjust their businesses to account for a potential IRS audit. However, as Mike Tyson indicated before his fight with Evander Holyfield, “everybody has a plan until they get punched in the mouth.”
Some taxpayers are discovering that the IRS rule that only one “partnership representative” participates and is authorized to bind the entire partnership during the audit can cause unfavorable results. Minority partners and the partnerships they are involved in are struggling to navigate the longer and more complicated audit process, properly account for adjustments, use push-out elections, and otherwise navigate the complexities of the new audit rules. It appears clear that there are still a lot of growing pains for this new system of audit rules and many questions are going to be resolved through litigation. That litigation is already just beginning and will now occur in an environment of reduced general and enforcement funding for the IRS and Department of Justice. The government, with limited resources and funding, will likely need to choose its battles wisely and some disputes may just not be worth the cost of full litigation in Tax Court or the Federal District Courts. While this might be welcome news for individual taxpayers, it leaves other taxpayers without guidance needed to navigate transactional issues that arise in the partnership context.
Pre-Trump Administration Focus On Basis Shifting
Before the new Trump administration took over the IRS issued guidance indicating a focus on certain basis shifting transactions used by partnerships it believed were abusive. On June 17, 2024, The IRS issued guidance indicating that the IRS examination teams were seeing “sophisticated maneuvers by related-party partnerships” they believed were generating inappropriate tax benefits. These alleged “maneuvers” involved related party transfers of partnership interests, distributions of property, and liquidations of partnerships or partners. The proposed regulations, issued around the same time, would classify these “basis shifting” transactions as transactions of interest with disclosure obligations for those transactions backed up by penalties for failure to make the required disclosures. The partnership basis focus also included a Revenue Ruling indicating that the IRS would challenge certain transactions it labeled as “basis stripping” transactions. Also issued around that time was IRS Notice 2024-54, which announced two sets of upcoming regulations that were also intended to curb certain transactions the IRS believed were resulting in inappropriate tax benefits and treatment.
The proposed regulations for disclosure of certain allegedly abusive transactions may never get finalized under the more hostile regulatory environment. The current administration has made it a priority to not only reduce the overall size of government but also decrease the amount of regulation. For example, on January 31, 2025 President Trump signed the executive order “Unleashing Prosperity Through Deregulation” requiring the repeal of 10 regulations for every new regulation proposed. The “upcoming regulations” may never be released given that they would now require the removal of another 20 regulations already on the books according to the recent Trump Executive Order on deregulation. All that is left of the previous partnership initiatives are outlines of alleged abusive activity and threats of action with a much smaller or potentially non-existent stick to enforce those threats.
Conclusion
Enforcement resources at the IRS and DOJ in 2025 appear to be set to get worse, not better, and so the planned increase in audit rates for large partnerships and enforcement of abusive basis structures seems unlikely. Trump’s Executive Order creating the Department of Government Efficiency (DOGE) specifically requires “large-scale reductions in force” and other provisions that will certainly result in more scaling back of the personnel and resources originally planned for partnership enforcement efforts. Whether this will lead to more abusive behavior by partnerships or not remains to be seen. Although threats were made in 2024, the ability to make good on those threats has certainly diminished in 2025 and appear to decrease with every passing day.
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