Economic substance doctrine and related-party partnership transactions

Editors: Brian Hagene, CPA, CGMA, and Mark G. Cook, CPA, CGMA

In Rev. Rul. 2024-14, the IRS ruled on the application of the economic substance doctrine to a series of transactions involving a related-party partnership that were undertaken by a controlled group.

Facts

Rev. Rul. 2024-14 presents the following situation: C is a domestic corporation engaged in operating a trade or business, including through several subsidiary entities commonly managed by C or in which C directly or indirectly holds controlling financial interests (C subsidiaries), such that C is a related party to each of the C subsidiaries under Sec. 267(b) or Sec. 707(b)(1). The C subsidiaries include domestic corporations Sub 1, Sub 2, and Sub 3 (each owned 50% by C) and partnerships A (owned 50% each by Sub 1 and Sub 2) and B (owned 50% each by Sub 1 and Sub 3). The C subsidiaries own various depreciable or amortizable assets used in, and have incurred various liabilities as part of, the conduct of C’s trade or business.

Through a series of transactions undertaken by Sub 1 and Partnership A involving contributions, distributions, and allocations of passthrough income with the intent of creating a disparity between inside and outside basis, a significant disparity of basis has been created between Sub 1’s outside basis in Partnership A and Sub 1’s share of the inside basis of Partnership A’s property.

Partnership A has a valid Sec. 754 election in place. Sub 1 contributes its ownership of Partnership A to Partnership B, triggering a Sec. 754 step-up in basis of Partnership A’s property. The stated business purpose of the transaction is to simplify administrative needs for the parent corporation and achieve cost savings as a result. However, these cost savings are insubstantial in relation to the reduction in the aggregate federal income tax liability of C’s three subsidiaries resulting from the increase in Partnership A’s basis in its property, which results in Partnership B’s being allocated increased amounts of deductions for depreciation or amortization or reduced amounts of gain (or increased amounts of loss) upon the sale of Partnership A’s basis-adjusted property.

Economic substance doctrine

The economic substance doctrine requires that two prongs be satisfied. First, the transaction must change in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and, second, the taxpayer must have had a substantial purpose (apart from federal income tax effects) for entering into the transaction (Sec. 7701(o)(1)).

Rev. Rul. 2024-14 explains that the basis adjustment rules under Secs. 732(b), 734(b), and 743(b) are intended to reduce disparities between inside and outside basis that would otherwise result from a distribution of property or transfer of a partnership interest. In the situation from the revenue ruling described above, however, the parties engaged in a concerted effort to create disparities between inside and outside basis through various methods. They then exploited the disparities created by engaging in transfers resulting in basis adjustments under the mechanical rules of Sec. 732(b), 734(b), or 743(b) to inappropriately reduce taxable income through increased deductions or reduced gain (or increased loss).

Thus, the IRS ruled in Rev. Rul. 2024-14 that the economic substance doctrine was not met, as the series of transactions did not change the taxpayer’s economic position in a meaningful way and a substantial business purpose was not established. For federal income tax purposes, the step-up in basis and resultant increases in deductions for depreciation and amortization or reduction of gain (or increase in loss) on the sale of the Partnership A property must be disregarded.

The economic substance doctrine in Sec. 7701(o) complements other operative sections of the Code by removing loopholes that taxpayers might otherwise be able to exploit by following the Code’s literal words in order to manipulate federal tax liabilities. As Rev. Rul. 2024-14 states:

Unless a “meaning plainly appears” that Congress intended a provision to grant a tax benefit to transactions without economic substance or business purpose, such an intent “will not [be] attribute[d] to Congress” (Knetsch v. United States, 364 U.S. 361, 367–69 (1960)). The economic substance doctrine is intended to apply “despite literal compliance with the statute” (Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1354 (Fed Cir. 2006); see Gregory v. Helvering, 293 U.S. 465, 470 (1935)).

Potential penalties

Penalties related to attempts to circumvent the economic substance doctrine are significant. As noted in Rev. Rul. 2024-14:

Section 6662(b)(6) provides that a 20 percent penalty applies to an underpayment attributable to a transaction lacking economic substance under §7701(o) or failing to meet the requirements of any similar rule of law. Under §6662(i), the penalty is increased to 40 percent on any portion of an underpayment that is attributable to one or more nondisclosed noneconomic substance transactions. Under §6664(c)(2), there is no reasonable cause exception to the penalties described in §6662(b)(6) or (i).

Taxpayers must remain vigilant regarding the application of the economic substance doctrine with respect to transactions in a controlled group setting between relatedparty entities that involve basis shifting. There should be a clear, meaningful economic change as a result of such transactions apart from the federal tax benefits of the transactions. In addition, there must be a substantial purpose for entering into such transactions other than federal income tax liability avoidance. The courts have clearly held that literal compliance with Code sections is not sufficient alone to justify such transactions, and the penalties related to circumventing the economic substance doctrine are steep, with limited options for relief.

Editor Notes

Brian Hagene, CPA, CGMA, is partner/owner at Mathieson, Moyski, Austin & Co. LLP in Lisle, Ill., with CPAmerica. Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with CPAmerica or SingerLewak LLP.