IRS Guidance Targets Partnership Basis Shifting Transactions Involving Related Parties

(Parker Tax Publishing June 2024)

On June 17, the IRS issued guidance on the inappropriate use of partnership rules to inflate the basis of the underlying assets without causing any meaningful change to the economics of their business (i.e., covered transactions). The guidance includes a notice announcing two sets of forthcoming proposed regulations addressing covered transactions, proposed regulations that identify certain covered transactions as reportable transactions of interest, and a ruling notifying taxpayers that the IRS will use the codified economic substance doctrine under Code Sec. 7701(o) to challenge inappropriate basis adjustments and other aspects of these transactions. Notice 2024-54; REG-124593-23; Rev. Rul. 2024-14; FS-2024-21.

Background

Under Subchapter K of the Code, a distribution by a partnership of the partnership's property (partnership property) or a transfer of an interest in a partnership (partnership interest) 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 Code Sec. 732(a), (b), or (d). In the case of a distribution of partnership property to a partner by a partnership with an election under Code Sec. 754 (Section 754 election) in effect, or with respect to which there is a substantial basis reduction as described in Code Sec. 734(d), the distribution may also result in an adjustment to the basis of the partnership's remaining partnership property under Code Sec. 734(b).

If a partnership interest is transferred by sale or exchange or on the death of a partner, and the partnership either has a Section 754 election in effect or has a substantial built-in loss with respect to the transfer of the partnership interest, the transfer may result in an adjustment to the basis of partnership property under Code Sec. 743(b) with respect to the transferee partner. Code Sec. 754 provides that if a partnership makes an election in accordance with regulations, the basis of partnership property shall be adjusted, in the case of a distribution of property, in the manner provided in Code Sec. 734, and in the case of a transfer of a partnership interest, in the manner provided in Code Sec. 743. Unless the election is revoked in accordance with the regulations under Code Sec. 754, the Section 754 election applies with respect to all distributions of property by the partnership and to all transfers of interests in the partnership during the tax year with respect to which the election was filed and all subsequent tax years.

A partner's adjusted basis in its partnership interest commonly is referred to as the partner's "outside basis" in its partnership interest. A partnership's adjusted basis in its property commonly is referred to as the "inside basis" of the partnership's property. Each partner has a share of inside basis.

Covered Transactions

The IRS is aware of related persons using partnerships to engage in transactions (i.e., covered transactions) that inappropriately exploit the basis-adjustment provisions applicable to distributions of partnership property or transfers of partnership interests.

Generally, in a covered transaction, partnership property is distributed to a partner who is related to one or more other partners, and that distribution results in a person related to the distributee partner, the distributee partner, or both, receiving all or a share of a basis increase in the distributed property or remaining partnership property under Code Sec. 732 or Code Sec. 734(b) (as applicable); alternatively, a partnership interest is transferred between related persons or to a transferee partner who is related to an existing partner in the partnership, and that transfer results in an increase to the inside basis in partnership property with respect to the transferee partner under Code Sec. 743(b).

Covered Transactions Under Code Sec. 734(b)

In a covered transaction under Code Sec. 734(b), a partnership with a Section 754 election in effect and two or more related partners makes a current or liquidating distribution of property to one or more of the related partners. Immediately before the distribution, the partnership's basis in the distributed partnership property exceeds the distributee partner's basis in its partnership interest (that is, the partnership distributes property with a relatively high inside basis to a distributee partner with a relatively low outside basis). Under Code Sec. 732(a)(2) or (b), the low-outside basis partner takes a basis in the distributed property that is lower than the inside basis of the property immediately before the distribution.

As a result of the basis decrease to the distributed property in the hands of the distributee partner, the partnership increases the basis of its remaining properties under Code Sec. 734(b) by an amount equal to the excess of the partnership's basis in the distributed property immediately before the distribution over the basis of the distributed property in the hands of the distributee partner immediately after the distribution. Under Code Secs. 734(c) and 755, the partnership allocates this basis increase among remaining partnership properties.

Covered Transactions Under Code Sec. 743(b)

In a covered transaction under Code Sec. 743(b), (1) a partner transfers an interest in a partnership that has a Section 754 election in effect or a substantial built-in loss immediately after such transfer (2) to a related transferee or a transferee that is related to one or more of the partners (3) in a nonrecognition transaction within the meaning of Code Sec. 7701(a)(45) in which the gain recognized, if any, and for which income tax imposed is required to be paid, is less than the aggregate amount of the increase(s) in the basis of partnership property with respect to the transferee partner under Code Secs. 743(b) and 755.

In order for the transfer to give rise to a basis adjustment under Code Sec. 743(b), the transferee partner must have an inside-outside basis disparity with respect to its partnership interest so that the transferee partner's outside basis does not equal the transferee partner's share of inside basis. Because a Section 754 election is in effect for the tax year of the transfer or the partnership or a substantial built-in loss immediately after such transfer, a basis adjustment is made under Code Sec. 743(b) or (d) to partnership property with respect to the transferee partner to eliminate the inside-outside basis disparity of the transferee partner. As a result of the transfer, the partnership allocates one or more basis increases to partnership property with respect to the transferee partner under Code Secs. 743(c) and 755.

Covered Transactions Under Code Sec. 732

In a covered transaction under Code Sec. 732, a partner (distributee partner) receives a liquidating distribution of property resulting in a basis increase in the distributed property under Code Sec. 732(b) and (c), and either:

(1) the partnership liquidates and distributes the partnership's remaining partnership property to one or more parties related to the distributee partner (related distributee partner) resulting in a basis adjustment that reduces the basis (basis decrease) of such property to the related distributee partners under Code Sec. 732(b) and (c), or

(2) the partnership continues, and a related party to the distributee partner is a continuing partner (related continuing partner) that has a share of the partnership's basis decrease under Code Sec. 734(b) or (d) resulting from the liquidating distribution or would have had a share of the partnership's basis decrease under Code Sec. 734(b) if the partnership had a Section 754 election in effect.

Guidance Regarding Covered Transactions

On June 17, the IRS issued guidance regarding covered transactions in Notice 2024-54, REG-124593-23, Rev. Rul. 2024-14. The IRS also issued a Fact Sheet (FS-2024-21) that summarizes this guidance.

In Notice 2024-54, the IRS announced that it intends to publish two sets of forthcoming proposed regulations on covered transactions. First, the IRS intends to issue proposed regulations under Code Secs. 732, 734(b), 743(b) and Code Sec. 755 that would:

(1) provide the required method of recovering adjustments to the bases of property held by a partnership, property distributed by a partnership, or both, arising from covered transactions,

(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 (for example, certain foreign persons, a tax-exempt organization, or a party with tax attributes that make it tax-indifferent) rather than related parties.

Second, the IRS intends to issue proposed regulations under Code Sec. 1502 to clearly reflect the taxable income and tax liability of a consolidated group (as defined in Reg. Sec. 1.1502-1(h)) whose members own interests in a partnership. More specifically, the IRS anticipates that these forthcoming proposed regulations would 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.

In REG-124593-23, the IRS issued proposed regulations under Prop. Reg. Sec. 1.6011-18 that identify partnership related-party basis adjustment transactions and substantially similar transactions as transactions of interest, a type of reportable transaction. Prop. Reg. Sec. 1.6011-18(a) identifies transactions that are the same as or substantially similar to transactions described in Prop. Reg. Sec. 1.6011-18(c) as transactions of interest for the purposes of Reg. Sec. 1.6011-4(b)(6). Prop. Reg. Sec. 1.6011-18(c) includes a relatedness requirement and a $5 million minimum threshold requirement. Under Prop. Reg. Sec. 1.6011-18(b)(8), "related" is defined as having a relationship described in Code Sec. 267(b) (without regard to Code Sec. 267(c)(3) or Code Sec. 707(b)(1)). Further, Prop. Reg. Sec. 1.6011-18(a) identifies transactions that are substantially similar to the transactions described in Prop. Reg. Sec. 1.6011-18(c) as including the transactions described in Prop. Reg. Sec. 1.6011-18(d).

In Rev. Rul. 2024-14, the IRS notified taxpayers and advisors using partnerships that engage in three variations of covered transactions that the IRS will apply the codified economic substance doctrine under Code Sec. 7701(o) to challenge inappropriate basis adjustments and other aspects of these transactions. Under the ruling, the economic substance doctrine will be raised in cases where related parties:

(1) create inside/outside basis disparities through various methods, including the use of certain partnership allocations and distributions,

(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 Code Secs. 732(b), 734(b), or Code Sec. 743(b) resulting from the nonrecognition transaction or distribution.

For a discussion of determining basis in a partnership interest, see Parker Tax ¶24,610. For a discussion of the basis of partnership property, see Parker Tax ¶24,650. For a discussion of penalties relating to transactions lacking economic substance, see Parker Tax ¶99,740. For a discussion of transactions of interest, see Parker Tax ¶253,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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