Fixing the Leak: IRS Targets Basis Shifting, a Multi-Billion Dollar Tax Loophole

The battle between tax fairness and tax optimization has come to a head. The U.S. Treasury Department and the Internal Revenue Service (IRS) just announced a new effort to go after a favorite tax strategy of the wealthy and complex partnerships: basis shifting. This is a big deal and could bring in billions of dollars and change the taxation policies for years to come.

What is the Basis Shifting:

Basis shifting is about manipulating the concept of “basis” in the tax code. Basis is the original cost of an asset, such as stocks, real estate or intellectual property. When an asset is sold for a gain, the capital gains tax is calculated on the difference between the sale price and the basis. The lower the basis the higher the capital gains tax liability.

This is where the “shifting” comes in. Complex partnerships, often involving hedge funds and private equity firms, can engage in fancy financial footwork to artificially lower the basis of their assets. Here’s how it might work:

●        Scenario 1: The Subsidiary Shuffle - A company owns a valuable asset with a low basis, say a building purchased years ago for $1 million. Through a series of transactions they create a subsidiary. This subsidiary then “buys” the asset from the original company at a much higher value, say $10 million. This inflated basis allows the subsidiary to pay a much lower capital gains tax when they sell the asset at an even higher price.

●        Scenario 2: The Debt Dance - Another strategy is to take on debt secured by the appreciated asset. This debt reduces the basis for tax purposes as the IRS allows taxpayers to subtract the debt from the original basis when calculating capital gains. As the asset value continues to go up the company can keep taking on more debt and lower the taxable gains.

These are just two of examples and basis shifting can get much more complicated with all sorts of financial instruments and legal structures. But the principle is the same: exploiting loopholes in the tax code to minimize tax on big capital gains.

The Price of Unfairness: Why the IRS is Acting

The Treasury Department estimates that closing the basis shifting loophole could be a big deal for government revenue. They project it will bring in over $50 billion over the next 10 years. That’s a lot of money to fund infrastructure, social safety nets, scientific research and national defense initiatives.

Beyond the dollars and cents, the IRS sees basis shifting as an unfairness. It’s an example of how the tax code can be manipulated, and everyone doesn’t pay their fair share. A 2021 Congressional Research Service report showed the top 1% of taxpayers get most of the capital gains. Now the obstacles.

While this is a good start, it won’t be easy. Here are the hurdles:

●        Lawsuits: Wealthy individuals and corporations who benefit from basis shifting will sue. That means long, costly legal fights that could slow or stop the IRS.

●        Lobbying: Financial industry lobbying groups will push hard to weaken or kill the rules. That’ll muddy the public debate and influence legislation.

The Tax Code is a moving target. Even if the IRS closes the basis-shifting loopholes, new ways to minimize taxes will pop up, and the tax authorities will have to stay on their toes.

Taxpayers: A Mixed Bag

For most Americans, the basis-shifting crackdown will be a non-event. Closing this loophole might even help them indirectly by creating a fairer tax system and a more stable tax code that will help everyone. But here are the bigger picture implications:

●        Market Turbulence: Some say basis shifting restrictions will cause market chaos as investors adjust and look for other tax havens.

Impact on Investment: TBD. Some say closing the basis-shifting loophole will scare off long term investors especially for riskier investments. The thinking is that with less tax advantage on potential gains investors will be less likely to hold onto assets for the long term. This will have a domino effect on the entire economy from startup funding to venture capital activity.

The Road to Fairness: A Long Way to Go

The IRS’s move on basis shifting is a step in the right direction towards a fairer tax system. But it’s just one piece of the puzzle. Here are some other things to consider:

●        Tax Code Overhaul: The current tax code is a mess of loopholes and special interest carve outs. Calls for a full tax code overhaul have been growing louder in recent years. While a full overhaul may be a long way off, the basis shifting initiative could be a trigger for broader tax reform conversations.

●        Global Tax Complexities: Tax havens and multinational corporations shifting profits to countries with lower tax rates makes the issue of tax fairness even more complicated. International cooperation and coordination is needed to address these loopholes and level the playing field globally.

●        Public Scrutiny and Transparency: Shining a light on the complex tax strategies of the wealthy and powerful is key to keeping the public trust in the tax system. More transparency and public discourse around tax fairness can build consensus for real reform.

In the end the basis shifting fight is a small part of the larger tax fairness battle. The outcome will have big implications for government funding, market stability and public perception of the tax system. One thing is for sure: tax loopholes and the pursuit of fairness will be a national conversation for a long time to come.