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Financial Planning > Tax Planning > Tax Loss Harvesting

Partnership Crackdown

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The Internal Revenue Service has been engaged in a major compliance effort. Increased resources have been earmarked for a handful of priority areas that the IRS says reflect a broader, agency-wide plan to both pursue promoters of abusive tax schemes, shelters, and trusts, and identify tax-evading participants in those endeavors. In an effort to reach out to the taxpaying public, the IRS launched earlier this year a 120-day disclosure initiative, which ended April 23. The initiative gave ordinary taxpayers an opportunity to disclose to the IRS their “questionable” transactions of various types. In exchange, the IRS said it would waive any penalties normally assessed for any underpayment of tax on those questionable transactions as long as the taxpayers provided all relevant information concerning the transactions.

A September report released by the IRS Office of Tax Shelter Analysis notes that the initiative netted 1,664 voluntary disclosures from 1,206 taxpayers. Here’s where it gets interesting. At the time of disclosure, these taxpayers submitted to the IRS names of the tax-shelter promoters who sold them the transactions. Since promoters are by law required to keep lists of investors to whom they sold tax shelters, the IRS will be able to identity taxpayers who participated in abusive tax shelters and failed to disclose that they had done so.

Compliance and enforcement efforts are being conducted by various IRS divisions, such as the Large and Mid-Sized Business (LMSB) Division. We caught up recently with an LMSB tax attorney in Washington, D.C., who did not wish to be identified, to find out more about abusive shelters, and one in particular, the partnership tax straddle. Before June this particular shelter affected businesses only. Now, however, the regulation applies to individuals as well, via partnerships, S corporations, and trusts. The IRS is currently accepting disclosure statements on this straddle abuse. (For more information you can call the IRS, even anonymously, at 866-775-7474.)

What’s the general mechanism behind most of these abusive shelters? Frequently you will try to get a timing benefit. In other words, get a tax loss in an earlier year, and then a corresponding tax gain would be deferred or pushed off into a future year. Another transaction attempt is to get a permanent tax loss. A fair number of listed transactions claim to do that. The most recent would be this partnership tax straddle [IRS Notice 2002-50].

How does it work? It’s an investment where the idea is to generate a permanent loss that doesn’t affect the economic loss, if there is any. Usually a tiered partnership is employed to create a loss that, in fact, may never have occurred. What happens is that you have the partnership invest in two offsetting positions–basically a straddle–so that one position goes up in value while the other goes down in value by a corresponding amount. The gain flows out to a promoter, someone that’s tax indifferent, and then the loss will be triggered and be recognized by the tax of the individual through the partnership.

What was the genesis for IRS actions in regard to partnership tax straddles, and why are individuals now potentially at risk for tax abuse? In February 2000, the IRS came out with the first set of tax shelter regulations. One of the things those regulations did was to require corporations to disclose reportable transactions. We’ve been modifying those rules over time in response to the disclosure statements we were receiving, and also in response to comments from practitioners and taxpayers. One of the things we found is that this problem of shelters or tax avoidance transactions is not limited to corporations, but involves individuals, partnerships, and S corporations as well. So in June of this year we expanded that disclosure requirement to individuals and other non-corporate entities. Now partnerships, S corporations, trusts, and individuals have an obligation to disclose a list of transactions that they invested in. They are required to attach a statement to their return, and also send a statement to the IRS’s Office of Tax Shelter Analysis. This office will review the disclosure statements, and, if there’s a problem, send them out to agents to follow up.

There’s a balance between imposing a burden on individuals to disclose–you don’t want to make that burden too great–but on the other hand, you don’t want to miss finding non-corporations that have invested in tax shelters.

Are many individuals at risk? Potentially, it could have a big impact on individuals. Because, for example, the 165 loss is fairly broad. [Section 165(a) of the Internal Revenue Code provides for the allowance of a deduction for any losses sustained during the taxable year which are not compensated for by insurance or otherwise. In the case of an individual, section 165(c) of the Code limits the deduction provided for in section 165(a) of the Code to losses incurred in a trade or business; losses incurred in any transaction entered into for profit, though not connected with a trade or business; and losses of property not connected with a trade or business.] If someone had a lot of depreciated property and sold it and triggered a loss, he might have to disclose, even though all he’s disclosing is a real loss. The problem is distinguishing between a true loss someone’s entitled to take and these artificial losses created by complex transactions that we consider tax shelters.

Senior Editor Cort Smith can be reached at [email protected].


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