IRS Guidance Aims to Stop Use of Partnership ‘Basis Shifting’ Transactions to Avoid Tax

The IRS and Treasury on June 17 launched a multiprong approach to curtail inappropriate use of partnership rules to inflate the basis of assets without causing meaningful changes to the economics of a taxpayer’s business. 

The guidance focuses on complex transactions involving related-party partnerships through which taxpayers “strip” basis from certain assets and shift that basis to other assets where the increased basis is intended to generate tax benefits – through increased cost recovery deductions or reduced gain (or increased loss) on asset sales – in transactions that have little or no economic substance. 

To address what it deems the inappropriate use of such transactions to generate tax benefits, the IRS has taken several steps:

• Notice 2024-54 describes two sets of upcoming proposed regulations:
  • The first set would require partnerships and partners to treat certain basis adjustments under Sections 732, 734, and 743 arising from covered transactions in a way that would restrict them from deriving inappropriate tax benefits from the basis adjustments. 
  • The second set would provide rules to ensure clear reflection of the taxable income and tax liability of a consolidated group of corporations when members of the group own interests in partnerships. The Notice indicates that these proposed regulations would adopt a single-entity approach with respect to interests in a partnership held by members of a consolidated group.
• Proposed regulations (REG-124593-23) identify certain partnership basis shifting transactions as reportable Transactions of Interest.
• Revenue Ruling 2024-14 notifies taxpayers that engage in three variations of these related-party partnership transactions that the IRS will apply the codified economic substance doctrine to challenge inappropriate basis adjustments and other aspects of these transactions.
  
  

In addition, the IRS announced it is launching a new group within the IRS Office of Chief Counsel focused on developing new partnership guidance, including guidance aimed at “closing loopholes.” The new group – another component of the IRS’s increased focus on partnership compliance leveraging funding from the Inflation Reduction Act – will work with the previously announced new passthrough work group that is being established in the IRS Large Business & International division. 

The IRS states that the types of related-party partnership basis shifting transactions described in the current guidance cut across a wide variety of industries and individuals. It states that Treasury estimates the transactions could potentially cost taxpayers more than $50 billion over a 10-year period. The IRS adds that it currently has “tens of billions of dollars of deductions claimed in these transactions under audit.” 

Basis Adjustments Under Subchapter K

Under subchapter K of the Internal Revenue Code, a distribution by a partnership of the partnership’s property or a transfer of an interest in a partnership may result in an adjustment to the basis of the distributed property, partnership property, or both. 

A distribution of partnership property may result in an adjustment to the basis of the distributed property under Section 732(a), (b), or (d). In some cases, the distribution may also result in an adjustment to the basis of the partnership’s remaining property under Section 734(b). In addition, a transfer in certain cases may result in an adjustment to the basis of partnership property under Section 743(b) with respect to the transferee partner.

Under Section 754, if a partnership makes an election in accordance applicable regulations, the basis of partnership property shall be adjusted: (1) in the case of a distribution of property, in the manner provided by Section 734; and (2) in the case of a transfer of a partnership interest, in the manner provided in Section 743.

A partner’s adjusted basis in its partnership interest is commonly referred to as the partner’s “outside basis” in its partnership interest. A partnership’s adjusted basis in its property is commonly referred to as the “inside basis” of the partnership’s property, and each partner has a share of inside basis.

Basis Shifting Transactions Under IRS Scrutiny

An IRS Fact Sheet released concurrently with the basis shifting guidance states that there are generally three categories of basis shifting transactions that are the focus of the new guidance. It describes these three categories of transactions as: 

1. Transfer of partnership interest to related party: A partner with a low share of the partnership’s inside tax basis and a high outside tax basis transfers the interest in a tax-free transaction to a related person or to a person who is related to other partners in the partnership. This related-party transfer generates a tax-free basis increase to the transferee partner’s share of inside basis.
2. Distribution of property to a related party: A partnership with related partners distributes a high-basis asset to one of the related partners that has a low outside basis. The distributee partner then reduces the basis of the distributed asset, and the partnership increases the basis of its remaining assets. The related partners arrange this transaction so that the reduced tax basis of the distributed asset will not adversely impact the related partners, while the basis increase to the partnership’s retained assets can produce tax savings for the related parties.
3. Liquidation of related partnership or partner: A partnership with related partners liquidates and distributes (1) a low-basis asset that is subject to accelerated cost recovery or for which the parties intend to sell to a partner with a high outside basis and (2) a high-basis property that is subject to longer cost recovery (or no cost recovery at all) or for which the parties intend to hold to a partner with a low outside basis. Under the partnership liquidation rules, the first related partner increases the basis of the property with a shorter life or which is held for sale, while the second related partner decreases the basis of the long-lived or non-depreciable property. The result is that the related parties generate or accelerate tax benefits.
   
   

Notice 2024-54: Forthcoming Proposed Rules Governing Covered Transactions

Notice 2024-54 describes two sets of proposed regulations that the IRS plans to issue addressing certain partnership basis-shifting transactions (covered transactions):

• Proposed Related-Party Basis Adjustment Regulations. Proposed regulations under Sections 732, 734, 743, and 755 would provide special rules for the cost recovery of positive basis adjustments or the ability to take positive basis adjustments into account in computing gain or loss on the disposition of basis adjusted property following certain transactions.
• Proposed Consolidated Return Regulations. Proposed regulations under Section 1502 would provide rules to clearly reflect the taxable income and tax liability of a consolidated group whose members own interests in a partnership.
  
  

Generally, for purpose of the notice and planned proposed rules, covered transactions:

1. Involve partners in a partnership and their related parties,
2. Result in increases to the basis of property under Section 732, Section 734(b), or Section 743(b), and
3. Generate increased cost recovery allowances or reduced gain (or increased loss) upon the sale or other disposition of the basis-adjusted property.
   
   

The Proposed Related-Party Basis Adjustment Regulations would set forth a required method of recovering adjustments to the bases of property held by a partnership, property distributed by a partnership, or both, arising from the covered transactions described in the notice. These rules would also govern the determination of gain or loss on the disposition of such basis-adjusted property. The regulations would also address similar transactions involving tax-indifferent parties (e.g., certain foreign persons, a tax-exempt organization, or a party with tax attributes that make it tax-indifferent) rather than related parties. 

The IRS describes the Proposed Related-Party Basis Adjustment Regulations as “mechanical rules applicable to all covered transactions without regard to the taxpayer’s intent and without regard to whether the transactions could be abusive or lacking in economic substance.” The rules would apply only if, and to the extent that, property has been allocated a basis increase. 

The IRS intends to propose that the Proposed Related-Party Basis Adjustment Regulations, when adopted as final regulations, would apply to tax years ending on or after June 17, 2024. The IRS adds that, once final, the regulations would govern the availability and amount of cost recovery deductions and gain or loss calculations for tax years ending on or after June 17, 2024, even if the relevant covered transaction was completed in a prior tax year.

The Proposed Consolidated Return Regulations would, the IRS plans, provide for single-entity treatment of members that are partners in a partnership, so that covered transactions cannot shift basis among group members and distort group income. The IRS intends these rules to prevent direct or indirect basis shifts among the members of a consolidated group resulting from covered transactions. 

The IRS states that the proposed applicability date for the Proposed Consolidated Return Regulations “will not relate to the issuance” of Notice 2024-54 but will be set forth in the proposed regulations once issued. 

The IRS requests comments by July 17, 2024, on both the Proposed Related-Party Basis Adjustment Regulations and Proposed Consolidated Return Regulations.

Proposed Rules Identifying Basis Shifting as Transaction of Interest

The proposed regulations issued concurrently with Notice 2024-54 identify related-partnership basis adjustment transactions and substantially similar transactions as reportable Transactions of Interest. 

Under the proposed rules, disclosure requirements for these transactions would apply to taxpayers and material advisers with respect to partnerships participating in the identified transactions, including by receiving a distribution of partnership property, transferring a partnership interest, or receiving a partnership interest.

Generally, the identified Transactions of Interest would involve positive basis adjustments of $5 million or more under subchapter K of the Internal Revenue Code in excess of the gain recognized from such transactions, if any, on which tax imposed under subtitle A is required to be paid by any of the related partners (or tax-indifferent party) to such transactions – specifically, Section 732(b) or (d), Section 734(b), or Section 743(b) – for which no corresponding tax is paid. 

The transactions would include either: 

1. A distribution of partnership property to a partner that is related to one or more other partners in the partnership, or
2. A transfer of a partnership interest where the transferor is related to the transferee or the transferee is related to one or more of the partners.
   
   

The proposed regulations identify that a transaction would be substantially similar to the related-partnership basis adjustment transactions above if the transaction does not involve related partners and one or more partners of the partnership is a tax-indifferent party.

The IRS proposes these rules to apply to identify certain partnership related-party basis adjustment transactions and substantially similar transactions as transactions of interest effective as of the date of publication of final regulations in the Federal Register.

Notification that IRS Will Challenge Basis Stripping

In Revenue Ruling 2024-14, the IRS notifies taxpayers and advisors that the IRS will apply the codified economic substance doctrine to challenge basis adjustments and other aspects of certain transactions between related-party partnerships. The IRS will raise the economic substance doctrine with respect to transactions in which related parties:

1. Create inside/outside basis disparities through various methods, including the use of partnership contributions and distributions and allocation of items under Section 704(b) and (c),
2. Capitalize on the disparity by either transferring a partnership interest in a nonrecognition transaction or making a current or liquidating distribution of partnership property to a partner, and
3. Claim a basis adjustment under Sections 732(b), 734(b), or 743(b) resulting from the nonrecognition transaction or distribution.
   
   

The revenue ruling describes three situations in which related parties coordinate to create disparities between inside and outside basis through various methods, such as the contribution or distribution of property with specific tax attributes or the allocation of tax items in accordance with Section 704(b) and (c). The parties then attempt to exploit these disparities by engaging in transfers resulting in basis adjustments under the rules of Section 732(b), 734(b), or 743(b) to reduce taxable income through increased deductions, reduced gain, or increased loss.

In the revenue ruling, the IRS rules that the transactions in the three described situations lack economic substance under Section 7701(o) and that taxpayers involved are not entitled to the associated basis adjustments. 

New Partnership Group in Office of Chief Counsel

Continuing the agency’s expansion of compliance efforts focused on partnerships and other high-income taxpayers following the enhanced funding provided by the Inflation Reduction Act, the IRS is creating a new group in its Office of Chief Counsel dedicated to developing guidance on partnerships and related compliance issues. The announcement follows an announcement of a similar effort by the IRS to dedicate a group within the IRS Large Business & International division to partnerships and other passthrough entities. 

The new Associate Office that will focus exclusively on partnerships, S-corporations, trusts, and estates. The office will be drawn from the current Passthroughs and Special Industries Office. In addition, the IRS plans to bring into the office outside experts with private-sector experience with passthroughs to work alongside the current IRS employees.