On February 7, 2022, the Internal Revenue Service (IRS) announced a new Large Business and International (LB&I) compliance campaign targeting pass-through entities. The Partnership Losses in Excess of Partner’s Basis Campaign will address taxpayer noncompliance related to reporting flow-through losses from partnerships. According to the IRS announcement, partners that report flow-through losses from partnerships must have adequate outside basis, as determined by Internal Revenue Code (IRC) Section 705. If the losses exceed the partner’s basis in the partnership interest, the losses generated in that tax year are suspended, per IRC Section 704(d), to the extent they exceed the partner’s adjusted basis in the partnership interest.
The new compliance campaign is part of a broader campaign program by the LB&I division to address significant compliance and resource challenges within the IRS. The campaign program launched in January 2017 to redefine compliance work and build a supportive infrastructure within the agency. To date, LB&I has rolled out 74 campaigns, identified through data analysis, suggestions from IRS employees and feedback from the tax community. Within the LB&I division is a pilot campaign that was launched in late 2021 titled the Large Partnership Compliance (LPC) Pilot Program. This program aims to address the LB&I’s compliance approach to large partnerships and develop procedures, using data analytics and other factors, to identify partnership returns that may be selected for audit. Partnership returns with more than $10 million in assets fall under the jurisdiction of LB&I.
Understanding a Partner’s Outside Basis
When a business operates as a partnership, the second most common type of pass-through entity, each partner has a basis in the partnership that represents their distributive share of the partnership’s activity. The basis of such interest is increased or decreased based on multiple factors.
Factors That May Increase a Partner’s Outside Basis
- An increased share of liabilities
- Contributions
- Taxable and tax-exempt income
Factors That May Decrease a Partner’s Outside Basis
- A decreased share of liabilities
- Distributions
- Partnership losses
- Non-deductible and non-capitalized expenses
Tax Gap and Noncompliance in Partnership Income
The tax gap is the difference between the taxes owed and paid to the IRS. As of September 2021, the tax gap in the United States results in about $600 billion of lost tax revenue each year, according to the U.S. Department of the Treasury. The IRS believes that partnership income is a significant contributor to this tax gap due to its opaque nature and a lack of access to information. Noncompliance for partnership income tax liabilities can reach 55 percent, compared to 1 percent for ordinary wage and salary income tax liabilities. The IRS is hoping this new compliance campaign will change that.
Tax Consulting and Compliance for Partners
Calculating your outside basis and understanding how much of the partnership losses you can deduct versus how much you must suspend can be complicated. It is also important to understand the other rules that may impact the partnership loss you may take and the order in which these rules are determined. In addition to the limitation of loss based on your outside basis, the loss also may be limited based on (1) how much of your basis is considered “at-risk”, (2) passive activity loss limitations, (3) excess business deduction limitations, and (4) capital loss limitations.
If you have questions about remaining compliant when reporting flow-through losses from the partnership, the Moore Colson Tax Practice is here to help. Don’t hesitate to contact us for more information.
