The IRS has released an array of guidance targeting certain basis-shifting transactions utilized by partnerships owned by related parties. The IRS asserts that these transactions inflate the basis of assets and, in turn, increase cost recovery deductions or reduce gains on the sale of assets, without the presence of any material economic substance other than avoiding federal income tax.
In an IRS news release issued in conjunction with the guidance, the effort by the IRS is estimated to save taxpayers more than $50 billion over 10 years and continues its campaign to combat “transactions that allow wealthy taxpayers to avoid paying what they owe,” and is made possible by additional funding provided by the Inflation Reduction Act of 2022. The IRS Office of Chief Counsel is creating a new associate office to focus exclusively on partnerships, S corporations, trusts, and estates. In addition, the IRS announced it will be using outside experts with private sector experience to work with IRS employees. These experts are anticipated to provide IRS employees with “an inside look at the maneuvers taking place with partnerships.”
The guidance includes Notice 2024-54, Notice of Proposed Rulemaking (Proposed Regulations 1.6011-18), and Revenue Ruling 2024-14.
Notice 2024-54
This notice announces the IRS’s intent to release two sets of proposed regulations addressing certain basis-shifting transactions involving partnerships and related parties. Special rules would apply to tax-indifferent parties, such as tax-exempt organizations, even if they are not related. The IRS is seeking to curb artificially generated basis adjustments among related partnerships and partners that would not normally occur between partners negotiating at arm’s length. The Notice designates such a basis adjustment as a “related-party basis adjustment” or RPBA. The covered transactions result in significant tax savings without a corresponding economic outlay. The Notice provides that the proposed regulations would be “mechanical rules” applicable to all covered transactions without regard to intent or lack of economic substance and would only apply to the extent that property has been allocated a basis increase. The proposed rules would not apply to the extent that property has been allocated a basis decrease.
The first intended proposed regulation will address related-party basis adjustments under Internal Revenue Code (IRC) Sections 732, 734(b), 743(b), and 755. The IRS intends that these regulations would apply to taxable years ending on or after June 17, 2024. The second will address consolidated return regulations under §1502 to determine taxable income and liability of a consolidated group whose members own partnership interests. The applicability date for these regulations will be provided in the forthcoming proposed regulations.
IRC §732
This code section governs the basis of property distributed by a partnership to a partner. For non-liquidating distributions, the basis of the property to the distributee partner is generally the adjusted basis of the property to the partnership immediately before the distribution, but it cannot exceed the distributee partner’s adjusted basis in its partnership interest, minus any money distributed in the same transaction. In liquidating distributions, the basis of the property equals the distributee partner’s adjusted basis in its partnership interest, reduced by any money distributed in the same transaction. In the case of multiple assets distributed to a distributee partner, basis allocation prioritizes unrealized receivables and inventory items, with remaining basis allocated to the other distributed properties.
A covered transaction under this section could involve a related partner with high outside basis receiving a liquidating distribution of a low-basis asset that is eligible for accelerated depreciation. Another related partner with low outside basis receives a liquidating distribution of an asset subject to a longer cost recovery term (or no cost recovery). The basis-shifting arrangement results in a decrease in basis of an asset with a longer cost recovery. Meanwhile, the basis of an asset eligible for accelerated depreciation receives a basis increase, thereby accelerating cost recovery deductions.
A basis adjustment under this section would generally be considered an RPBA to the extent that an increase in basis corresponds to a basis decrease of a related partner. The RPBA would be recovered using the cost recovery method and remaining recovery period, if any, of the corresponding property the basis of which the partnership reduced under §734(b) or would have reduced under this section if the partnership had a §754 election in effect. Therefore, if a related distributee partner receives a high-basis asset with a long or no recovery period while the partnership retains assets subject to accelerated cost recovery deductions, the assets retained by the partnership would be depreciated according to the distributed asset’s cost recovery method and period, if any, rather than the accelerated method and period as would normally occur in a noncovered §734(b) transaction. In addition, the distributee partner would not take the RPBA into account upon the sale or disposition of the property. Upon the qualifying disposition of a corresponding property, any related RPBA would cease to be so. A qualified disposition is defined as being a disposition of the distributed property “to an unrelated person in an arm’s length transaction in which taxable gain or loss is fully recognized.” The remaining basis of the former RPBA would be treated as a newly placed in service property that is subject to the cost recovery period and method, if any, of the distributed property. This new basis adjustment would be taken into account in determining gain or loss upon the sale or disposition of the property.
IRC §734(b)
This code section addresses adjustments to the basis of partnership property following a cash or property distribution to a partner, contingent on the partnership making or previously made a §754 election or there is a substantial basis reduction. The partnership must increase the basis of its remaining property by any gain recognized by the partner receiving the distribution or the excess of the property’s adjusted basis to the partnership before the distribution over its basis to the partner receiving the distribution. Conversely, the basis must be decreased by any loss recognized by the partner receiving the distribution or the excess of the property’s basis to the partner receiving the distribution over its adjusted basis before distribution. Allocation of basis adjustments among the properties follows rules under §755.
A covered transaction under this section could involve a partnership with a §754 election in effect. A related partner with low outside basis receives a distribution of a high-basis asset, generally a non-depreciable asset. The related partner receiving the distribution reduces the basis of the distributed asset while the partnership must increase the basis of its remaining assets, generally assets subject to cost recovery deductions, generating additional cost recovery deductions for the partnership.
An RPBA under this section would be recovered using the cost recovery method and remaining recovery period, if any, of the corresponding distributed property that gave rise to the RPBA. In addition, the RPBA would not be taken into account upon the sale or disposition of the partnership’s property. Upon the qualified disposition (defined previously) of the distributed property, the basis adjustment ceases to be an RPBA. The remaining basis formerly attributable to the RPBA would then be treated as a newly placed in service property subject to the cost recovery method and period, if any, to which it was allocated. This new basis adjustment would be taken into account in determining gain or loss upon the sale or disposition of the property.
IRC §743(b)
This code section addresses adjustments to the basis of partnership property when a partnership interest is transferred by sale, exchange, or upon a partner’s death, provided a §754 election is in effect or there is a substantial built-in loss. The adjustment ensures the transferee partner’s basis in the partnership interest aligns with their proportionate share of the partnership property. This adjustment can either increase or decrease the basis of the partnership property and applies solely to the transferee partner. Allocation of basis adjustments among the properties follow rules under §755.
The covered transaction under this section involves a transfer of partnership interest with a §754 election in effect. A partner with a share of low inside basis and a high outside basis transfers their interest to a related person in a tax-free transaction. As a result, the partnership allocates basis increases to partnership property with respect to the transferee partner, creating additional cost recovery deductions for the transferee partner.
An RPBA under this section would be ineligible for cost recovery until the transferee partner becomes unrelated to both the transferor partner and to all partners existing immediately before or immediately after the covered transaction. Additionally, the transferee partner could not take the RPBA into account upon the sale or disposition of partnership property to which the RPBA applies. If the transferee partner ceases to be related to the transferor and all other partners, as explained above, then the basis adjustment ceases to be an RPBA. The remaining basis attributable to the former RPBA is treated as a newly placed in service property subject to the cost recovery method and period, if any, of the property to which it was allocated. This new basis adjustment would be taken into account in determining gain or loss upon the sale or disposition of the partnership's property.
IRC §1502
This code section prescribes regulations necessary to ensure that the tax liability of any affiliated group of corporations filing a consolidated return, as well as each corporation within the group, is accurately calculated and reported.
According to the Notice, the IRS is concerned that consolidated groups may attempt to reshape taxable income through basis-shifting arrangements to the property owned by partnerships in which the consolidated group’s members have ownership. To prevent these potential taxable income alterations within a consolidated group, the proposed regulations would apply a single-entity approach with respect to the partnership interests held by members of the consolidated group.
Proposed Regulations 1.6011-18
The proposed regulations aim to identify certain related-party basis adjustment transactions and substantially similar transactions as transactions of interest (TOI), a type of reportable transaction under §6011. TOIs are defined as having the potential for tax avoidance or evasion but lack sufficient information to determine whether the transaction should be identified specifically as a tax avoidance transaction. The TOI would generally include a relatedness requirement, positive basis adjustments, and a minimum basis increase threshold of $5 million. The threshold is calculated as the sum of all basis increases resulting from all such transactions by the same partner or partnership during the taxable year, unreduced by basis adjustment decreases, and after reducing for any taxable gain recognized.
Form 8886, Reportable Transaction Disclosure Statement
Affected taxpayers and material advisors are subject to the disclosure requirements for reportable transactions and must file Form 8886 with the taxpayer’s tax return for each taxable year in which a taxpayer participates in a reportable transaction. It is important to note that if a transaction, such as the subject basis adjustment transaction, becomes a TOI after the filing of a taxpayer’s tax return in which such transactions occurred and during the period of limitations, then a disclosure statement must be filed with the IRS’s Office of Tax Shelter Analysis 90 days after the date the transaction becomes a TOI. Material advisors would be required to disclose only if they have made a tax statement on or after six years before the date of the adoption of these regulations as final regulations.
Revenue Ruling 2024-14
This revenue ruling contemplates the economic substance doctrine under §7701(o) and if it would disallow tax benefits derived from certain transactions between related-party partnerships. Such partnerships first generate disparity between inside and outside basis and then trigger basis adjustments under §732(b), 734(b), and 743(b). The triggering event generates increased cost recovery deductions or reduced gain (or increased loss) upon the sale of the property.
The ruling applies the two prongs of the conjunctive test under §7701(o)(1) to determine economic substance among a series of facts and circumstances similar to those outlined in the aforementioned Notice and in the proposed regulations. The two prongs require that a transaction must change in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position and the taxpayer must have had a substantial purpose (apart from federal income tax effects) for entering into the transaction. The ruling holds that such transactions fail the tests and, therefore, lack economic substance.
The IRS plans to apply the economic substance doctrine to challenge basis adjustments in instances where related parties create disparities between inside and outside basis through various methods, exploit the disparities by either transferring a partnership interest in a nonrecognition transaction or making a current or liquidating distribution of partnership property to a partner, and claim a basis adjustment under §732(b), 734(b), or 743(b) resulting from the nonrecognition transaction or distribution.
Transactions under these code sections have significant tax benefits and compliance consequences. The release of this IRS guidance only amplifies the importance of properly structuring and reporting these transactions. If you are planning or have already executed a transaction as described, especially within a related party ownership structure, and would like further information or assistance, please reach out to one of our professionals at Forvis Mazars.