It's time for clients who benefit from pass-through tax breaks to make sure they can withstand IRS scrutiny, advisors say.
A flow-through or pass-through business funnels income straight to its owners, shareholders or investors so only these individuals and not the entity are taxed on the revenues.
Though pass-throughs are often used legitimately to avoid double taxation, clients involved in these entities need to know that the IRS finally has a new investigative division to take an even harder look at these business structures, advisors say.
“This includes a new office focusing exclusively on partnerships, S corporations, trusts and estates, as well as a specialized work group within [the IRS] Large Business and International Division,” said Dave Alison, founder and CEO of Alison Wealth Management in Charleston, S.C. “Previously, audits of pass-throughs were divided between different IRS divisions based on the entity's size. The new unit will handle pass-through exams regardless of size, centralizing expertise and aiming to increase audit rates.”
Richard Pianoforte, managing director of tax at Fiduciary Trust International in New York, said that “the IRS has said that with the help of artificial intelligence they’ll be able to better detect compliance issues and tax evasion.”
The IRS has also hired the first associate chief counsel for the agency’s new Pass Throughs, Trusts and Estates Office, said Bill Smith, national director of tax technical services at CBIZ’s national tax office in Washington, D.C. The counsel, he said, “is very sophisticated in partnership tax and is likely to create the type of training and issue focus that will bring his team up to speed on how to audit large partnerships fairly efficiently.”
Who will be targeted first?
“In June, the IRS did announce its plan to crack down on a partnership tax loophole called ‘basis shifting transactions,’ where high-income taxpayers and corporations strip basis from assets that are not generating tax benefits to assets where the basis will generate tax benefits,” said Jeffrey T. Getty, managing director for business and transaction advisory with Callan Family Office in Radnor, Pa. “Clients engaged in this strategy are likely candidates for an audit.”
Additional audit targets, Getty said, likely include partnership returns with tiered structures where it’s difficult to determine if income is properly reported at different levels; returns with partnership and trust investment vehicles that do not withhold taxes on U.S. income earned through investment structures owned through foreign investors; and estate and gift tax returns that reflect low-tax or no-tax transfers of assets to younger generations.
“Any other pass-through strategies that appear overly complex, contain unusual or complex financial products or reduce or eliminate federal transfer tax strategies are likely going to increase the chance of audit,” Getty said. Clients should ensure they’re comfortable that their returns are prepared properly, all required information is included in the return and they and their tax advisor have a plan for an audit if one occurs.”
Alison said that clients and their advisors can assume the IRS will step up the rate of audits on these tax breaks. “So clients and their professionals need to be prepared for the workload that comes with an IRS audit,” Alison said, noting that the Inflation Reduction Act allocated billions to the IRS to increase compliance, particularly among businesses.
Wealthy clients should realize by now that they're gaining renewed attention from the IRS, but many of them are not acting to strengthen their financials, advisors say.
“Not only do they receive communications from their accounting and law firms, but [the IRS initiative] has been in the news,” Smith said. “It tends to get swallowed up by the bickering over IRS funding, however, and I think they don’t feel any immediate need to address it.”