IRS targets partnership basis-shifting transactions

The IRS released a package of guidance on June 17 that targets basis shifting transactions involving partnerships and related parties that seek to take advantage of the mechanical Subchapter K rules that apply to distributions of partnership property and transfers of partnership interests.

The guidance package includes three parts:

• Notice 2024-54 announces two forthcoming sets of proposed regulations targeting the ability of partnerships and partners to effectively utilize favorable basis adjustments generated through certain basis-shifting transactions.
• New proposed regulations (REG-124593-23) would make certain basis shifting transactions and substantially similar transactions “transactions of interest,” a designation that requires certain disclosures from taxpayers as well as advisors participating in certain defined transactions.
• Revenue Ruling 2024-14 provides three factual situations involving partnership basis shifting transactions in which the IRS would disregard the favorable basis adjustments under the codified economic substance doctrine described in Section 7701(o).

Taken together, the guidance makes clear that IRS will closely scrutinize the potential benefits of any future or past transactions described in the guidance. In addition, the IRS and Treasury intend to issue specific guidance that would curtail the ability to claim benefits from these transactions, as well as drastically increase the level of scrutiny on taxpayers and advisors structuring and executing these transactions. Designating certain transactions as “transactions of interest” allows the IRS and Treasury to gather broad-based information that will be used to further develop examination techniques for the transactions perceived as abusive.

Categories of basis shifting transactions

The basis-shifting transactions (sometimes referred to as “covered transactions”) targeted in the June 17 guidance generally fall into several categories, including:

• High-basis property to low-basis partner: In this transaction, a partnership with related partners distributes high-basis property to a related partner with a low-tax basis in its partnership interest. This may allow the partnership to allocate a basis adjustment under Section 734(b) to its remaining properties equal to the excess of the partnership’s prior basis in the distributed property over the distributee partner’s basis in the property (which is limited to such partner’s basis in its partnership interest under Section 732). Such distributions could be structured to shift basis off nondepreciable or long-lived distributed properties and onto retained properties with more favorable cost recovery rules, or property anticipated to be sold in the near future.
• Transfers of partnership interests: These transactions involve transfers of partnership interests between related parties in which the transferor’s basis in its partnership interest exceeds its share of the partnership’s bases in its assets in a transaction that is effectively a non-recognition event to the transferor. These covered transactions seek to take advantage of the transferee’s ability to receive a step-up in the basis of the partnership’s assets through a Section 743(b) adjustment, without a corresponding tax cost to the transferor.
  
• Low-basis property distribution in liquidation: These transactions involve distributions of low basis property to a partner in liquidation of its partnership interest, where the distributee has a relatively high basis in its partnership interest. The distributee then relies on the Section 732 rules applicable to liquidating distributions of property to assert a stepped-up basis in the distributed property equal to its prior basis in its partnership interest. In this case, the distributed property may be subject to a favorable cost recovery method, or the distributee may anticipate selling the distributed property soon after receiving it.

Notice 2024-54

The notice outlines two sets of regulations the IRS intends to propose. The first would seek to neutralize the benefits sought from covered transactions by preventing partnerships and related partners from utilizing the basis adjustments generated through such transactions. For instance, a basis adjustment allocated to partnership property under Section 734(b) as a result of a covered transaction would remain subject to the cost recovery period and remaining recovery period, if any, applicable to the distributed property giving rise to the adjustment. Further, the partnership would not be permitted to take the Section 734(b) adjustment into account in determining gain from the sale of adjusted property until the distributee partner sells the distributed property to an unrelated taxpayer in a fully taxable, arm’s-length transaction. The proposed regulations would employ conceptually similar limitations on basis adjustments generated through other types of covered transactions.

The IRS said that it intends to propose that final regulations would apply to taxable years ending on or after June 17, 2024. The scope of the regulations would apply to cost recovery deductions and gain or loss calculations related to basis adjustments from covered transactions that occurred in a prior year, or even a tax year for which the period of limitations has expired.  

These proposed regulations will utilize a concept of “related persons” that expands beyond the generally applicable relationships under Sections 267(b) and 707(b) to apply the covered transaction rules to transactions involving tax indifferent partners. Potential examples of partners who could be treated the same as related parties, regardless of their relationship to the other partners, may include tax-exempt partners, foreign partners, or partners with tax attributes (such as losses from other sources) that could make them indifferent to tax gain resulting from a covered transaction. For example, a distribution of property to a tax-exempt partner that creates an increase to the basis of the remaining partnership property under Section 734(b) would be treated as a covered transaction.

The second set of forthcoming proposed regulations announced by the notice would be issued under Section 1502. This set of proposed regulations would provide single-entity treatment for members of a consolidated group of corporations that are partners in a partnership with an eye toward preventing covered transactions from shifting basis between group members. The notice mentions that the 2023 corporate tax return forms contain new questions for consolidated groups with gross income in excess of $1 billion to allow the IRS to potentially identify whether the consolidated group reports basis adjustments resulting from covered transactions. The proposed effective date for this second set of proposed regulations would be specified when such proposed regulations are actually issued.

Proposed regulations on reportable transactions

The second component of the June 17 guidance package is a set of proposed regulations (REG-124593-23) that would designate various partnership basis-shifting transactions as transactions of interest under Section 6011 and the regulations thereunder. The designated transactions generally correspond to the covered transactions described in Notice 2024-54. If finalized, these proposed regulations would require taxpayers and material advisors participating in partnership basis-shifting transactions (subject to certain dollar-amount thresholds) to file certain disclosures for reportable transactions under the Section 6011 regulations or be subject to penalties.

The proposed regulations would be effective from the date they appear in the Federal Register as final regulations. Nevertheless, it appears that disclosure could still be required where a partnership or related party takes a cost recovery deduction on a basis adjustment or takes the basis adjustment into account determining gain or loss on the disposition of an asset, where the basis adjustment arose from a transaction of interest in a prior tax year. If such a broad disclosure requirement is ultimately finalized, taxpayers may need to spend additional effort to confirm whether existing basis adjustments are within the scope of the regulations.

Revenue Ruling 2024-14

The final component of the June 17 guidance package is Rev. Rul. 2024-14, which provides some insight into how the IRS may challenge partnership basis-shifting transactions now under the current economic substance doctrine. The ruling describes three situations (corresponding to the three categories of covered transactions described in Notice 2024-54) involving a partnership owned by members of a corporate consolidated group. In each situation, the partners undertake various transactions to create inside-outside basis discrepancies to facilitate the use of partnership basis shifting transactions. The IRS considered whether the beneficial basis adjustments resulting from the basis-shifting transactions are disregarded under the economic substance doctrine, as codified in Section 7701(o).

Under Section 7701(o)(1) both prongs of a two-prong test must be satisfied in order for a transaction to have economic substance. First, the transaction must change in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position. Second, the taxpayer must have a substantial purpose (apart from federal income tax effects) for entering into the transaction.

For each of the situations considered, the IRS determined that neither prong was satisfied. The IRS determined that the transactions did not change the economic position of any members of the consolidated group in a meaningful way (given that the transactions principally moved assets between taxpayers under common control) and the only stated business purpose for the transactions was cost savings from cleaning up intercompany accounts, reducing administrative complexity, and achieving administrative efficiencies. These items were apparently insignificant compared to the tax savings from the transactions. Holding that the transactions described in all three situations lacked economic substance, the IRS held that the favorable basis adjustments arising from these transactions would be disregarded, with accuracy-related penalties (including for a nondisclosed noneconomic substance transaction) imposed on the relevant parties.