Basis-shifting transactions involving partnerships and related parties

Editor: Mark G. Cook, CPA, CGMA

Rev. Rul. 2024-14 clarified that the IRS will disallow tax benefits and challenge inappropriate basis-shifting transactions involving partnerships and related parties by applying the codified economic substance doctrine under Sec. 7701(o). The revenue ruling is part of an enforcement initiative targeting abusive partnership transactions (see IRS News Release IR-2024-166 and Waggoner, “IRS Moves to End ‘Shell Game’ of Basis-Shifting Transactions,” The Tax Adviser (June 17, 2024)).

Along with its release of the revenue ruling on June 17, 2024, the Service issued proposed regulations that would identify certain partnership related-party basis adjustment transactions as transactions of interest, making them reportable transactions under Sec. 6011(a) (REG-124593-23, 89 Fed. Reg. 51476).

In a third piece of guidance released the same day, Notice 2024-54, the Service also said it would be issuing two additional sets of related proposed regulations. One set will provide the required method of recovering adjustments to the basis of property arising from covered transactions and provide rules for determining gain or loss on such property’s disposition. The other set of proposed regulations, under the Sec. 1502 consolidated-return rules, will provide for single-entity treatment of consolidated group members that are partners in a partnership, to prevent basis shifting among group members.

Economic substance doctrine

The economic substance doctrine is defined in Sec. 7701(o)(5)(A) as “the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” Under Sec. 7701(o)(1), in the case of any transaction to which the economic substance doctrine is relevant, the transaction will be considered as having economic substance only if a two-part test is met: (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.

Moreover, to determine that a transaction has economic substance, the present value of the reasonably expected pretax profit of that transaction must be substantial compared to the present value of the expected net tax benefits of the transaction, according to Sec. 7701(o)(2)(A). Additionally, Sec. 7701(o)(5)(D) states that “transaction” includes a series of transactions.

The revenue ruling states that certain basis-shifting transactions between partnerships and related parties do not have meaningful economic substance or purpose. Thus, the IRS will use Sec. 7701(o), described above, to disregard any tax benefit generated from such transactions. To illustrate, the revenue ruling outlines the application of the economic substance doctrine in three situations.

In each situation, the parties first create disparities between inside and outside basis through various methods, such as the contribution or distribution of property with specific federal income tax attributes or the allocation of federal income tax items in accordance with Secs. 704(b) and (c) . Then, they capitalize on 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. Finally, they claim a basis adjustment under Sec. 732(b), 734(b), or 743(b) resulting from the nonrecognition transaction or distribution.

The transactions described in the three examples shift ownership of property among commonly controlled entities and may reduce administrative complexity and achieve administrative efficiencies by cleaning up intercompany accounts. However, in all these example transactions, the cost savings achieved are insubstantial compared to federal income tax benefits created and thus produce little or no meaningful change to the economic positions and demonstrate a lack of substantial purpose for these related parties. Essentially, the resulting inflated basis adjustments, if allowed, will not change the economic position of the related parties but only increase depreciation deductions or reduce gain upon future sale of the property involved.

According to the revenue ruling, the IRS will disregard the transactions’ tax benefits and will disallow the basis step-ups to property by applying Sec. 7701(o). Under Sec. 7701(o)(4), in the three scenarios, the financial accounting benefit achieved is not taken into account as a purpose for entering into the transactions because the origin of such a financial accounting benefit is a reduction of federal income tax.

Additionally, under Sec. 6662(b) (6) , the series of transactions described in the three scenarios are subject to the 20% penalty applicable to an underpayment attributable to a transaction lacking economic substance under Sec. 7701(o). The penalty could be increased to 40% on any underpayment portion attributable to one or more nondisclosed, noneconomic-substance transactions. Other than that, the partnership anti-abuse rule under Regs. Sec. 1.701-2 or the Sec. 704(c) antiabuse rule under Regs. Sec. 1.704-3(a) (10) can be applied to the illustrated transactions, and other anti-abuse doctrines, such as the substance-over-form doctrine and step-transaction doctrine, may also be relevant.

In a nutshell, the IRS is targeting partnership basis-shifting transactions, and this ruling and further planned guidance specifically focus on related-party transactions. Taxpayers and their advisers should consider how this newly issued guidance impacts both potential transactions and completed basis adjustment transactions.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.