IRS, Treasury Look to Challenge So-Called Basis-Shifting Transactions, But It Won’t Be Easy

Key takeaways from the guidance are as follows:

• Proposed Regulations: The Treasury and IRS will issue proposed regulations under subchapter K and the consolidated return regulations on so-called basis-shifting transactions involving partnerships and related parties. Once effective, the regulations will apply to taxable years ending on or after June 17, 2024 and could affect cost recovery deductions and gain or loss calculations for transactions entered into before that date.
• Economic Substance Doctrine: IRS’s position on audit and in litigation will be that the tax benefits from certain basis-shifting transactions should be disallowed under the economic substance doctrine.
• Transaction of Interest: Under a notice of proposed rulemaking, basis-shifting transactions will be treated as transactions of interest – a form of reportable transaction, subject to enhanced reporting requirements.

The guidance came in three parts: (1) Notice 2024-54 (the “Notice”), which describes the proposed regulations and requests comments on the approach described; (2) Revenue Ruling 2024-14, which sets out the IRS’s audit and litigation position that the economic substance doctrine under IRC § 7701(o) applies to basis-shifting transactions; and (3) a notice of proposed rulemaking that, if finalized, would treat basis-shifting transactions as transactions of interest, a form of reportable transaction.

The Notice describes the perceived need for regulations:

The Treasury Department and the IRS are aware of related persons using partnerships to engage in transactions that inappropriately exploit the basis-adjustment provisions of subchapter K applicable to distributions of partnership property or transfers of partnership interests…. This awareness results from the IRS’s review of various partnership transactions involving related parties in which basis adjustments were created to artificially generate or regenerate Federal income tax benefits that resulted in significant tax savings without a corresponding economic outlay. These transactions were carefully structured to exploit the mechanical basis adjustment provisions of subchapter K to produce significant tax benefits with little or no economic impact on the related parties, and in a manner that would not be a likely arrangement between partners negotiating at arm’s-length.

Notice 2024-54: The Notice describes two sets of anticipated regulations. The first set, purported to be promulgated under various sections of subchapter K and IRC § 482, will include three elements: (1) provide the required method of recovering adjustments to the basis of property held by a partnership, property distributed by a partnership, or both, in transactions that “inappropriately exploit the basis-adjustment provisions of subchapter K”; (2) provide rules governing the determination of gain or loss on the disposition of such basis-adjusted property; and (3) include similar transactions involving tax-indifferent parties, rather than related parties. Treasury and IRS seek comments on the proposed approach described in the Notice by July 17, 2024. It is unclear when the proposed regulations will be published.

The second set of anticipated proposed regulations will be issued as part of the consolidated return regulations under IRC § 1502. According to the Notice, the proposed regulations are intended to “clearly reflect the taxable income and tax liability of a consolidated group … whose members own interests in a partnership.” Treasury and IRS anticipate that the proposed regulations will “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 income.”

Revenue Ruling 2024-14: The revenue ruling asks whether “the economic substance doctrine disallows tax benefits associated with a series of transactions involving a related-party partnership, through which the parties first generate a disparity between inside basis and outside basis and then trigger a basis adjustment to property under § 732(b), § 734(b), or § 743(b), which generates increased cost recovery deductions with respect to the property or reduced gain (or increased loss) upon a sale of the property?” Given the loaded question, it is not surprising that IRS concludes that the economic substance doctrine applies. It analyzes three situations and concludes that the economic substance doctrine applies in each of them. The ruling does not directly address whether the economic substance doctrine is relevant to the interpretation of the Internal Revenue Code, a key issue on appeal to the U.S. Court of Appeals for the Tenth Circuit in Liberty Global v. United States. The ruling notes that a 20 or 40 percent penalty may apply, and that the IRS may assert other anti-abuse doctrines or provisions.

Notice of Proposed Rule Making: In a notice of proposed rulemaking published on June 18, 2024, Treasury and IRS propose regulations that would identify certain partnership related-party basis adjustment transactions and substantially similar transactions as transactions of interest, a type of reportable transaction. While the proposed regulation provides an example of a transaction that is “substantially similar” to the basis-shifting transaction targeted by the rule (it has a “tax indifferent party,” rather than a related party), it also provides that “substantially similar” is not limited to the transaction described in the example. The proposed rules would apply to transactions with basis adjustments of $5 million or more. If finalized, the rule would require taxpayers and material advisors to file certain disclosures with IRS and the Office of Tax Shelter Analysis. Failure to comply with the reportable transaction rules can result in significant penalties and toll the statute of limitations on assessment. Comments are requested by August 19, 2024.

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For today, not much has changed. The IRS’s audit and litigating position on economic substance is already well known to practitioners and the identification of related party basis-shifting transactions as “transactions of interest” doesn’t amount to anything except more paperwork for most taxpayers. The real battle will begin once Treasury and IRS issue proposed regulations, as described in Notice 2024-54, and more economic substance cases make their way to litigation. We anticipate significant challenges to these regulations, which are likely to be shaped by the Supreme Court’s anticipated ruling in Loper Bright Enterprises v. Raimondo (No. 22-451) this term.