Practitioner’s Tax Action Bulletin® Advisory
In June 2024, the IRS released a guidance package on related party basis adjustments (RPBAs) that includes Prop. Reg. 1.6011-18, Notice 2024-54, and Revenue Ruling 2024-14. These pronouncements aim to prevent related parties from benefitting from certain basis-shifting transactions using partnerships where their overall economic situation is unchanged. Typically, in these so-called covered transactions, tax basis is shifted to assets subject to cost recovery (i.e., depreciation, amortization, or depletion) under the rules for adjusting the basis in partnership assets under IRC Sec. 734 (when partnership distributions are made) and IRC Sec. 743 (when partnership interests are sold or exchanged) or the rules for adjusting the basis of distributed property in the receiving partner’s hands under IRC Sec. 732.
This guidance package targets transactions by related parties that the IRS views as abusive. But, many practitioners have expressed concerns that if the guidance is finalized as it’s currently written, it will exceed its intended scope by including real, substantive transactions, potentially causing undue hardship to taxpayers. Also, with the recent Loper Bright Supreme Court decision to overturn the longstanding “Chevron deference” doctrine, more IRS regulations will be challenged in court. The Otay case is potentially testing the new related party basis shifting rules as this article is being written. On the taxpayer side, this case is apparently well-funded and has very good counsel. Tax practitioners should keep their eye on this one.
Notice 2024-54
Notice 2024-54 says that the IRS is planning on releasing proposed regulations addressing covered transactions. The first set of proposed regulations will require partnerships to treat RPBAs from four covered transactions in a way that would prevent them from benefitting from the basis adjustments. The covered transactions are:
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- Section 734(b) Covered Transactions. A partnership with a Section 754 election in effect and two or more related partners distributes property to one or more of the related partners.
- Section 743(b) Covered Transactions. A partner transfers a partnership interest to a related transferee (or a transferee that is related to one or more of the partners) when the partnership has a Section 754 election in effect or a substantial built-in loss immediately after the transfer. The transfer must be a nonrecognition transaction where any gain recognized and any income tax required to be paid is less than the aggregate amount of the Section 743(b) basis increase(s) made to partnership property with respect to the transferee partner.
- Section 732 Covered Transaction (Partnership Liquidates). A partner receives a liquidating distribution of property, increasing their basis in the property under IRC Sec. 732(b). This occurs when a related party has an outside basis less than their share of the partnership’s inside basis, resulting in a basis increase.
- Section 732 Covered Transaction (Partnership Continues). A partner receives a liquidating property distribution increasing their basis in the distributed property under IRC Sec. 732(b). A related continuing partner in the partnership then shares a negative basis adjustment under IRC Sec. 734(b) due to a Section 754 election or substantial basis reduction, resulting from the distribution.
Note that none of these transactions would be considered covered transactions if none of the partners in the partnership are related to each other, either immediately before or after the transaction.
The proposed regulations will provide special cost recovery rules for basis adjustments arising from covered transactions and for how those basis adjustments are taken into account when property for which a basis adjustment was made is disposed of.
The second set of proposed regulations will provide rules under IRC Sec. 1502 to clearly reflect a consolidated group of corporation’s taxable income and tax liability when members of the group own interests in partnerships. A single-entity approach to partnership interests will apply so that covered transactions cannot shift basis among group members and (in the IRS’s eyes) distort group income.
Some Covered Transactions Lack Economic Substance
Rev. Rul. 2024-14 targets transactions lacking economic substance and presents three situations that fall into the definition of a covered transaction. In all three situations, a C corporation owns over 50% of subsidiaries that are partners in a partnership. The parties engage in transactions to create disparities between tax basis and partnership asset basis, followed by covered transactions under Sections 734(b), 743(b), or 732(b) to achieve administrative efficiencies. The IRS disregards the basis adjustments, deeming the transactions lacking economic substance as they merely shift ownership without changing economic benefits or profit opportunities. This may result in a 20% penalty under IRC Sec. 6662(b)(6) or 40% for nondisclosed transactions.
The IRS is cracking down on abusive transactions, but planners should review the ruling carefully to determine if a transaction has economic substance. The IRS focuses on planned transactions creating basis disparities, but if disparities arise otherwise, a covered transaction may have substantial economic effect.
Proposed Reg. 1.6011-18 Makes Some RPBA Transactions Reportable
Prop. Reg. 1.6011-18 defines certain transactions as “transactions of interest” (TOI), requiring disclosure by material advisors and participants. RPBAs that result in a $5 million or more positive tax basis adjustment, without corresponding tax gain, are considered TOIs. This includes distributions of partnership property to related partners or transfers of partnership interests between related parties. Taxpayers and advisors will have 90 days to disclose existing TOIs once the regulations are finalized and will be required to annually report cost recovery allowances and taxable gains or losses from RPBA transactions.
Loper Bright Decision
The Supreme Court’s Loper Bright decision issued in late June 2024 has made various regulations vulnerable to a challenge, including the latest partnership RPBA rules. The case overturned the 40-year-old Chevron doctrine that directed courts to defer to regulatory interpretations of ambiguous statutes as long as the regulators’ interpretations were reasonable. Under the Administrative Procedure Act (APA), it is the courts (not agencies) that must decide all relevant questions of law. Thus, the Supreme Court ruled that the courts may not defer to agency interpretations simply because a statute is ambiguous and must independently determine a statute’s single best meaning using traditional tools of statutory construction. Now that the IRS can no longer rely on automatic deference to its regulations, taxpayers have a better chance at successfully challenging interpretive tax regulations. A seemingly unbeatable 40-year cycle of IRS control has come to an end.
The latest partnership related-party basis shifting guidance was issued just weeks before the Loper Bright decision. Mentioned in Notice 2024-54, one set of proposed regulations would be issued under various subchapter K provisions, and the other set would be issued under the Section 1502 consolidated loss rules. Since the subchapter K proposed regulations are expected to turn off the application of existing subchapter K rules under IRC Secs. 732, 734, and 743 in the transactions the IRS is targeting, there’s a good chance that taxpayers will challenge the new regulations based on the Loper Bright decision.
Otay Project LP
The Otay case began in October 2024. Here, the taxpayer entered into a series of transactions that resulted in a large basis adjustment to partnership assets under Section 743 because the partnership had a Section 754 election in effect. The IRS is arguing that Otay “used sham negative inside basis to eliminate gain altogether by way of an adjustment under Section 743(b), a statute that was intended to prevent the duplication of gain.” In its pretrial memo, Otay counters that the IRS can’t use the economic substance doctrine or other anti-abuse rules to disallow the tax consequences of a transaction when those consequences are “mandated by the application of the plain text of a Code provision that admits of no other interpretation [IRC Sec. 743(b)] and, indeed, is triggered by an election Congress expressly permits taxpayers to make solely for tax purposes (IRC Sec. 754).”
Although Otay deals with transactions that occurred before the IRS issued its guidance on RPBAs, it is a good case to keep an eye on. If the IRS loses, taxpayers will have a good chance of bringing a lawsuit that could overturn the RPBA rules.
Conclusion
Even though the IRS released the behemoth guidance package on related-party basis shifting, they may not be able to benefit too much from it. It will be interesting to see if the IRS releases the promised proposed regulations described in Notice 2024-54. Right now, the Otay court case decision might be the most interesting thing to watch out for, as it could open the door for a lawsuit that blows up the partnership related-party basis shifting guidance package entirely. This is definitely an amusing time to be in the tax profession.
Editor’s note: The full article presented above is available in the Practitioner’s Tax Action Bulletin, as National Tax Advisory (NTA -1289), Issue 23, first published December 10, 2024, along with other valuable tax practitioner articles. Contact our sales team to receive Checkpoint’s bi-monthly Practitioner’s Tax Action Bulletin — available in print and online — or to add Thomson Reuters Planner CS to your advisory toolkit.
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