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On Feb. 23, 2026, the Tax Court issued a memorandum opinion in Otay Project LP v. Commissioner (T.C. Memo 2026-21), which disallowed the majority of a deduction related to the recovery of a partner’s Section 743(b) basis adjustment arising from transactions among related parties. As part of its analysis, the court held that the basis adjustment was incorrectly computed and that the transactions that gave rise to the adjustment lacked economic substance.
With basis adjustments arising from transfers of partnership interests and distributions among related parties — also referred to as “basis-shifting transactions” — being a recent area of focus for the IRS, Otay is a prime example that the IRS can broadly apply the economic substance doctrine to override the mechanical nature of certain code sections (e.g., Sections 732(b), 732(d), 734(b) and 743(b)) if the transaction does not have a non-tax impact to the taxpayer.
Background
The case concerned the dissolution of Otay Project LP (OPLP), a partnership formed in 1999 that brothers Al and Jim Baldwin, both real estate developers, formed to jointly develop a master-planned community in San Diego County, Calif., known as Otay Ranch.
Prior to the completion of the development, the brothers’ working relationship deteriorated, eventually leading to an arbitration ruling that required them to separate their joint business interest. The Baldwins engaged a large national accounting firm and a law firm to help them unwind OPLP, a process that began in 2005 and ended with the partnership’s liquidation in October 2012.
The first step in the complex series of transactions intended to separate the joint ownership of OPLP was for OPLP to contribute the rights to receive payments on land sales into newly created entities for each brother, separating the rights to receive payments from the obligation to perform related construction work.
In 2007, the Baldwin brothers restructured the ownership in upper-tier partnerships so that each held an interest in Otay Project LLC (OPLLC), the majority partner in OPLP. This was done through a series of Section 721 transfers of affiliated partnership interests to new partnerships owned by the brothers and their family members.
The transactions caused a technical termination of OPLP under section 708(b)(1)(B), a provision since repealed by the Tax Cuts and Jobs Act, and the creation of a large Section 743(b) basis adjustment for OPLLC. At the time of the transaction, OPLP had deferred profits outstanding under the completed-contract method of accounting under Section 460. The regulations under Section 460 provided that the constructive completion rules did not apply to a technical termination of a partnership, allowing OPLP to continue to defer income from its outstanding development obligations.
When OPLP liquidated in 2012, it recognized the deferred income but also recognized offsetting deductions attributable to OPLLC’s basis adjustment. The IRS disallowed the deduction, arguing that the transactions ran afoul of the partnership anti-abuse rule under Treas. Reg. Section 1.701-2.
Economic substance doctrine
In its ruling, the court held that OPLP incorrectly computed OPLLC’s Section 743(b) adjustment amount. More importantly, the court also held that the transaction should be disallowed under the common-law economic substance doctrine, regardless of calculation errors.
The transactions in Otay occurred prior to the codification of the economic substance doctrine under Section 7701(o) in 2010. As such, the court applied a two-pronged objective and subjective analysis that is generally used by the Ninth Circuit Court of Appeals — the circuit to which this case would be appealed — to determine whether the transactions had economic substance.
From an objective analysis, the court found the transactions lacked objective economic substance. The business purpose of the transactions was to separate the brothers' interests as ordered by the arbitration, but the court found that the restructuring did not materially impact the brothers’ economic position or business risk.
From a subjective analysis, the court also concluded there was no compelling non-tax business purpose for the transactions and that the series of transactions was engineered to create a basis adjustment at OPLP to achieve “indefinite tax deferral.”
Although the court determined the transactions did not have economic substance, it ultimately ruled the taxpayer was not subject to accuracy-related penalties under Section 6662(a). These penalties are equal to 20% for an underpayment due to a reason listed in Section 6662(b) and can increase to 40% in the case of a gross valuation misstatement as determined under Section 6662(h).
Ultimately, the court found that the taxpayer had reasonably relied on the advice of its tax professionals — an accounting firm and two law firms — which provided a confidence level of substantial authority on each material issue relating to the transactions at issue.
Grant Thornton insight:
Basis-shifting transactions have been a recent area of focus for the IRS with the issuance of Rev. Rul. 2024-14 (PDF - 147.05KB) and transaction of interest guidance. While Treasury is currently in the process of removing some regulations by Notice 2025-23 (PDF - 96.54KB) and recently followed up with proposed regulations (REG-108921-25 (PDF - 284.06KB)), taxpayers should still be mindful of the importance of accurately tracking basis and having nontax purposes to transactions. For further discussion on the withdrawal of the regulations, see our recent article.
The ruling in Otay reinforces that the economic substance doctrine is a tool that may be used to disallow basis adjustments. This is true where parties structure transactions to generate disparities between inside basis and outside basis and then trigger a basis adjustment to property under Section 732(b), 734(b) or 743(b) using the mechanical nature of those provisions to create increased cost recovery deductions from the property or reduce gain upon a future disposition of the property.
Although application of the codified economic substance doctrine under Section 7701(o) is still a developing area of the law (see, e.g., Patel v. Commissioner, 165 T.C. No. 10), common-law economic substance doctrine precedent informs the current application. Thus, transactions similar to those in Otay would likely be challenged via application of the codified economic substance doctrine.
The codified economic substance doctrine first has a threshold test of whether the doctrine is relevant to a transaction. Next, it applies a two-pronged analysis that looks at whether 1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and 2) the taxpayer has a substantial purpose, apart from federal income tax effects, for entering into the transaction.
Taxpayers should ensure transactions that could give rise to basis adjustments — particularly among related and/or affiliated parties — possess a valid business purpose or non-tax purpose beyond tax reduction. Taxpayers should review and maintain contemporaneous documentation of the purpose for their records.
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