Guidance addresses related-party basis shifting transactions

In detail

Background

The partnership tax rules generally operate to minimize or eliminate disparities between a partner’s outside basis in its partnership interest and that partner’s share of the partnership’s inside basis in partnership assets. The Related Party Basis Adjustment Guidance addresses certain “transactions involving related parties in which basis adjustments were created to artificially generate or regenerate Federal income tax benefits that resulted in significant tax savings without a corresponding economic outlay.” As described in the guidance, the IRS believes that taxpayers designed these transactions to manipulate mechanical basis-adjustment provisions in a manner that would allow additional cost-recovery deductions, decreased taxable gain, or increased taxable loss without corresponding economic impact. The guidance concludes that parties negotiating at arm’s length would be unlikely to agree to the terms of the described transactions.

Reportable Transaction Proposed Regulations

Proposed regulations (the Reportable Transaction Proposed Regulations) would, if finalized, treat certain partnership related-party basis adjustment transactions (Covered Transactions or Related-Party Basis Adjustment Transactions) as transactions of interest required to be disclosed to the IRS by participants and material advisors. Covered Transactions include:

• A current or liquidating distribution of property by a partnership to a related partner that results in the partnership increasing the basis of one or more of its remaining properties.
• A liquidating distribution of property by a partnership to a related partner that results in an increase in the basis of one or more of the distributed properties.
• A distribution of property to a related partner that results in an increase in the basis of one or more of the distributed properties if the distributee partner’s acquisition of the interest would have resulted in a basis adjustment had the partnership had a Section 754 election in effect for the year of acquisition.
• The transfer of an interest in a partnership to a related partner that results in a basis increase to one or more partnership properties.

If finalized as proposed, taxpayers and material advisors would be required to disclose the described transactions as well as substantially similar transactions. Transactions involving “tax-indifferent parties” rather than related parties would also fall under the rules. Both current and past transactions would be required to be disclosed to the extent that the results of a Covered Transaction (including depreciation or amortization) are reflected on a tax return for any year that is open under the period of limitations within 90 days of the date finalized regulations are published. Transactions must be reported if the sum of all basis increases (without reduction for any transactions that reduce basis) exceeds the gain recognized from the transactions by more than $5 million. For this purpose, recognized gain may be ignored if no federal income tax is imposed due to other tax attributes.

Failing to disclose the transaction could result in penalties for both participants and material advisors.

Comments on the Reportable Transaction Proposed Regulations are due August 19, 2024, and a public hearing is scheduled for September 17, 2024. 

Proposed Consolidated Return Regulations

The Notice states that the Proposed Consolidated Return Regulations are intended to prevent the alteration of consolidated taxable income or consolidated tax liability that results from basis adjustments that arise from the transfer of partnership interests between group members or the distribution of property from a partnership to one or more member partners. The Proposed Consolidated Return Regulations would address this by taking a “single-entity” approach to partnership interests held by members of a consolidated group. This approach is not defined but is intended to prevent basis shifts that arise from Covered Transactions. 

The Proposed Consolidated Return Regulations are expected to be prospective only, with a proposed effective date to be identified when the proposed regulations are issued. One of the Related-Party Basis Adjustment Transactions, however, is similar in nature to a transaction described in previous taxpayer specific advice issued by the IRS in which the IRS disallowed the amortization of a basis adjustment as contrary to the purpose of the intercompany transaction regulations.

Observation: The broad approach described in the Notice could impact the movement of partnership interests within a consolidated group even if the original basis adjustment at issue arose from a third-party transaction and the movement is imbued with business purpose. 

Comments on the Notice are due July 17, 2024.

Rev. Rul. 2024-14: Clarification of Economic Substance Doctrine

Rev. Rul. 2024-14 holds that the economic substance doctrine applies to disallow tax benefits in three scenarios involving a related-party partnership that engaged in transactions with a view to creating a disparity between inside and outside basis that resulted in a basis adjustment to property that either generated increased cost recovery deductions with respect to the property or reduced gain or increased loss upon the sale of the property. The facts describing each scenario stipulate that the transaction was undertaken to achieve cost savings by “cleaning up intercompany accounts, reducing administrative complexity, and achieving other administrative efficiencies.”

The revenue ruling notes that Congress intended to preserve parity between inside and outside basis to prevent unintended tax benefits and detriments, but that it did not intend to allow “that taxpayers be able to avoid or indefinitely defer taxation altogether by creating basis disparities through contributions or distributions of property or through allocations of tax items….” The revenue ruling then analyzes economic substance doctrine case law and concludes that the changes in economic position described in the three scenarios were not meaningful apart from the Federal income tax effects. Finally, the revenue ruling holds that the transactions lacked substantial purpose and that the cost savings were insubstantial in relation to the reduction in the aggregate Federal income tax liability of the related parties.  

Although the distributions or transfers described in each of the three scenarios appear to have been respected, the basis adjustments resulting from the transactions were disregarded as lacking economic substance. The ruling also notes that the transactions could be subject to other anti-abuse doctrines, including the partnership anti-abuse rule, the section 704(c) anti-abuse rule, the substance-over-form doctrine, or the step-transaction doctrine.

Observation: The revenue ruling applies the profit potential rule, described in the codified economic substance doctrine as a “special rule,” without considering whether the rule as described in the statute applies only to transactions that have no profit potential whatsoever.