Earlier this week, Treasury and the IRS issued guidance to halt the use of partnership rules in the Internal Revenue Code to engage in abusive basis-shifting transactions whereby tax basis is stripped from certain assets and allocated to other assets to increase a taxpayer's depreciation deductions or reduce taxable gain. According to the IRS Commissioner, this announcement signals the IRS is accelerating its work in the partnership arena, an area that was historically overlooked due to the lack of IRS funding. With increased funding secured, the IRS is closely scrutinizing transactions employed by partnerships, LLCs, and other pass-through entities to ensure wealthy taxpayers are not engaging in transactions that lack economic substance solely to avoid taxes. In fact, a new associate office has been created within the IRS chief counsel's office to focus exclusively on partnerships and S corporations, as well as trusts and estates.

However, prior experiences with rules promulgated by Treasury to address abusive tax strategies, such as those issued to halt abusive deferred compensation arrangements and those proposed to address carried interest arrangements demonstrate that Treasury sometimes attempts to squash a perceived bug with a sledge hammer. Consequently, there is no guaranty that investors and business partners engaged in legitimate transactions will not get caught in the web of IRS audits targeting pass-through transactions.

The centralized partnership audit regime, enacted almost a decade ago, requires partnerships (and LLCs taxed as partnerships) to designate a partnership representative who has absolute authority to act on behalf of a partnership undergoing a tax audit. Because partnership audits have been few and far between, many partners and LLC members do not fully appreciate the enormous power granted to these individuals. Those that do may have tried to contractually limit this power through provisions in partnership and operating agreements, but these provisions have rarely been put to the test.

Investors and business parties who utilize pass-through structures need to take heed of this recent announcement by the IRS and Treasury and understand that the likelihood of the IRS auditing your entity has significantly increased. Now is the time to ensure you have the proper person representing your entity and that proper checks and balances are in place.

Due to previous years of underfunding, the IRS had cut back on the auditing of wealthy individuals and the shifting of assets among partnerships and companies became common.

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