The IRS has announced a new campaign to crack down on partners who deduct losses that may exceed the basis in their partnership interest. The Partnership Losses in Excess of Partner’s Basis Campaign is part of a larger effort by the IRS Large Business and International (LB&I) division, beginning in 2017, to move toward issue-based examinations where the IRS decides which issues present the greatest risk of noncompliance. The campaigns are identified through data analysis and suggestions from IRS compliance employees. With the new campaign, the IRS is making it a priority to scrutinize partnership loss deductions, an important benefit of operating in the partnership firm.
Rules on Basis and Loss Deductions
Partners that report flow-through losses from partnerships must have an adequate outside basis to deduct the losses or the losses must be suspended until the partner’s basis increases. A partner’s outside basis is the basis the partner has in his or her ownership interest. Here is a simplified version of what causes a partner’s basis to change.
Basis is increased by:
- Income, taxable or tax-exempt
- Partnership debt acquisition
Basis is decreased by:
- Losses and non-deductible expenses
- Partnership debt reduction
Basis adjustments also are subject to ordering and timing rules that can get quite complex. For example, cash contributions and income allocations are applied first to increase basis before distributions are applied to reduce basis. Also, cash distributions are applied to reduce basis before loss deductions can be determined.
A has a basis of $50 in her partnership interest at the beginning of the taxable year. During the year, A receives a cash distribution of $30 and is allocated a $60 distributive share of partnership loss. To what extent may A deduct her $60 loss? A’s basis must first be reduced by the $30 cash distribution, leaving $20 as the loss limitation. Thus, A may deduct $20 of the $60 loss, leaving $40 of the loss suspended and unusable until her basis increases in a later taxable year or until she disposes of her interest.
Tax Gap Figures in Partnership Loss Campaign
One of the Treasury Department’s stated goals is to address the tax gap, and it believes that passthrough entities and their owners represent a significant amount of lost tax revenue. In a 2021 release, the Department estimated that for “opaque income sources that accrue disproportionately to higher earners—like partnership income, proprietorship income and rental income–noncompliance can reach 55 percent.” Treasury observed that it needs funding to hire and train revenue agents who can decipher thousands of pages of sophisticated tax filings. The LB&I division’s compliance campaigns provide the infrastructure to vet complicated partnership structures and examine common noncompliance issues like overstated basis and excessive loss deductions.
LB&I’s goal is to improve return selection, identify issues representing a risk of non-compliance and make the greatest use of limited resources. The IRS’s data analysis and employee feedback point to partnership loss deductions as an area with a high likelihood of tax non-compliance, so it is more important than ever that partnerships and their owners prepare for stricter scrutiny of basis computations and loss deductions going forward.