Now holding 30 trillion dollars in assets, partnerships require increased scrutiny and broad reforms

By John Rooney and Grace Henley

The IRS has recently announced several welcome initiatives designed to increase the rate and quality of audits of large and complex partnerships but, as many commentators have noted, broader reforms are needed.

The need for reform is increasingly important given the growth in the size and scope of partnerships. Partnerships now control more than $30 trillion in assets and vastly outnumber public firms. Research has found that over 60 percent of pass-through income earned by individuals flows to the top 1 percent of filers. Passthroughs are also a key source of tax non-compliance, thought to account for $130 billion of unpaid owed taxes annually in the most recent tax gap estimates, a full 26 percent of the tax gap, and more than three times as large as unpaid owed taxes annually from corporate tax noncompliance. Recent research has also suggested that passthrough tax evasion may be especially underestimated for high-income filers because of the difficulty the IRS currently has tracing partnership income to its true owners.

We believe there are three important objectives for reform of partnership taxation.

The first objective would be to fix many of the deliberate and accidental holes in the tax base specifically involving pass-throughs. In general, this reform should seek to move tax results closer to economic reality and reduce known inconsistencies and optionality in ways that would make the pass-through regime more administrable. For example, section 199A could be repealed and the various workarounds to the SALT cap could be addressed. The President’s FY2024 budget proposes to close the holes in the Medicare payroll taxes and Net Investment Income Tax (“NIIT”), raising $306 billion over ten years. Another proposal in the President’s budget would increase the rate on Medicare payroll, self-employment, and NIIT taxes for filers with incomes over $400,000 from 3.8 to 5 percent, raising $344 billion over ten years.

The second objective would be to ensure that the IRS continues to have the resources needed to increase the number and quality of partnership audits. These additional resources are especially needed because, as some experts have noted, the “complexity of partnership structures makes them an apt vehicle for business tax planning.” For example, some partnerships are owned through circular structures of partnerships owning partnerships owning other partnerships, or partnerships that “resemble ‘spiderwebs’ with groups of related entities and clusters of overlapping partners.” In addition, given the low level of audit activity in this area, it is difficult to get an accurate estimate of the current level of underreporting by partnerships. An increase in the number and quality of audits would provide the IRS with much-needed insight to begin addressing tax under-reporting by partnerships.

The third objective would be to improve tools for understanding and addressing pass-through non-compliance, including closing holes in information reporting. As we mention above, pass-through regimes are often complex and much of the income that flows through these entities is not subject to information reporting. Lawmakers can provide the IRS with information reporting tools that encourage voluntary compliance and allow the IRS to identify the most egregious forms of tax evasion using pass-throughs. One option is to strengthen the bipartisan Corporate Transparency by including partnership beneficial ownership.

A first step on guidance

Any meaningful reform of partnership taxation will require both statutory and regulatory changes. We look forward to contributing to this process and, as an initial proposal, would suggest two relatively simple steps that the IRS could take now to begin this needed reform. First, consistent with the 2023–2024 Priority Guidance Plan, the IRS could finalize a number of the currently proposed Subchapter K regulations. Second, the IRS could issue an “omnibus” regulation package consisting of important technical corrections and updates to a number of the existing regulations. The recently issued proposed regulation that would amend the outdated partnership loss regulations in Treas. Reg. § 1.267(b)-1(b) and Temp Reg. § 1.267(a)-2T(c) (Answers 2 & 3) is an excellent example of this type of corrective regulation. This welcome technical fix is especially commendable given the current burden on the IRS to issue regulations in such complex areas as the IRA energy credits, CAMT, and crypto broker reporting.

Outlined below is a list of six potential regulations we recommend the IRS include in such an omnibus package. For a more in-depth explanation of our recommendations, read our full letter to Treasury and the IRS here.

1. Update Treas. Reg. § 1.1245–1(e)(3) to remove any uncertainty as to the allocation of section 1245 recapture gain after the transfer of a partnership interest in a nonrecognition transaction.
2. Finalize Prop. Treas. Reg. § 1.751–1(a)(2) on a stand-alone basis — with the same November 2014 retroactive effective date in the proposed regulations — to eliminate any ambiguity regarding the amount of ordinary income recognized on the sale of a partnership interest under section 751(a).
3. Finalize Prop. Treas. Reg. § 1.755–1(b)(5) — with the same January 2014 retroactive effective date in the proposed regulations — to address the unintended consequences that can occur in certain substituted basis transactions and also finalize Prop. Treas. Reg. § 1.755–1(e)(1)(A), which provides that the section 755(c) allocation rules apply to related persons within the meaning of section 267(c) or section 707(b)(1), to clarify that amended section 755(c) apples in a broader set of circumstances.
4. Issue a simple proposed regulation and example to confirm that section 707(a)(2)(B) currently applies to the disguised sale of a partnership interest.
5. Eliminate or significantly restrict the disguised sales exception for the reimbursement of capital expenditures in Treas. Reg. § 1.707–4(d).
6. Issue a proposed regulation modeled after the 707 Temporary Regulation to treat all partnership liabilities as nonrecourse liabilities for purposes of the disguised sale debt-financed distribution exception in Treas. Reg. §1.707–5(b)(1).

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