27 June 2024 Treasury and IRS issue guidance on certain partnership related-party basis adjustment transactions On June 17, 2024, the Treasury Department and the IRS issued three items of guidance on partnership related-party basis adjustment transactions:
Under the partnership tax rules, various transactions may result in basis adjustments to either the property of a partnership or property distributed by a partnership to its partners. The rules generally attempt to ensure that each partner's adjusted basis in its partnership interest (outside basis) equals its corresponding share of the partnership's adjusted basis in its property (inside basis). The guidance addresses the following three types of transactions giving rise to basis adjustments (so-called related party basis adjustments):
In the Notice, Treasury and the IRS stated they intend to publish two sets of proposed regulations in the future addressing basis-shifting transactions involving partnerships and related parties (covered transactions). The first set of proposed regulations under IRC Sections 732, 734(b), 743(b) and 7555 (proposed related-party basis adjustment regulations) would (i) provide methods for recovering basis adjustments resulting from a covered transaction, (ii) provide rules for determining gain or loss on the disposition of basis-adjusted property, and (iii) treat as covered transactions similar non-related party transactions involving taxable parties or tax-indifferent parties, such as certain foreign persons, a tax-exempt organization, or a party with tax attributes that make it tax-indifferent. The second set of proposed regulations under IRC Section 1502 (consolidated return regulations) would treat consolidated group members that are partners in a partnership as a "single entity," so that a covered transaction cannot shift basis among group members and, according to Treasury and the IRS, thereby distort group income. The proposed regulations would apply special rules to the cost recovery of basis adjustments arising from a covered transaction, generally called a related party basis adjustment (RPBA). The proposed guidance, if finalized, would govern whether and how to account for an RPBA. According to the Notice, the proposed regulations are intended to be mechanical in nature and apply to all covered transactions, regardless of taxpayer intent and without regard to potential abuse or a lack of economic substance. The proposed regulations would define "related persons" as having a relation described by IRC Section 267(b) (determined without regard to IRC Sections 267(c)(3)) or 707(b)(1) immediately before or immediately after a covered transaction. The term "cost recovery" would mean an allowance for depreciation, amortization, or depletion under subtitle A of the Internal Revenue Code (Subtitle A). An IRC Section 734(b) RPBA would arise when a partnership has a valid IRC Section 754 election in effect, the relatedness thresholds exist among two or more partners, and the partnership makes a current or liquidating distribution of property to one of the related partners that results in a positive basis adjustment to one or more of the partnership's remaining assets under IRC Section 734(b) For such a basis adjustment to arise, the distributed property must have a relatively high inside basis in the hands of the partnership when compared to the distributee partner's outside basis in its partnership interest. Under the proposed rules, the partnership would recover deductions attributable to the IRC Section 734(b) RPBA using the cost recovery method and period of the distributed property giving rise to the adjustment (referenced in the Notice as the "corresponding distributed property"). However, the special cost recovery method does not apply to an unrelated partner's share of the IRC Section 734(b) adjustment. The determination of each partner's share of the IRC Section 734(b) adjustment would follow the principles in the regulations for determining the partners' shares of IRC Section 734(b) basis adjustments for purposes of the IRC Section 197 "anti-churning" rules. Furthermore, the partnership generally would be prohibited from taking the IRC Section 734(b) RPBA into account upon the sale or disposition of partnership property. Upon a "qualifying disposition" of the corresponding distributed property, any remaining basis attributable to the IRC Section 734(b) RPBA would be treated as giving rise to newly placed-in-service property, subject to the cost recovery period and method applicable to property to which it is allocated. Also, following a qualifying disposition, an IRC Section 734(b) RPBA could be taken into account in computing gain or loss upon that property's disposition. A qualifying disposition is one in which the distributed property is disposed of in a fully taxable transaction to an unrelated person. If a partnership distributes property to a partner for which an IRC Section 734(b) RPBA exists, the partner would take the RPBA into account in calculating the basis of the property in the partner's hands under IRC Section 732 and the partner's remaining outside basis. The basis adjustment in the distributed property would, however, remain an IRC Section 734(b) RPBA until a qualifying disposition occurs. If a partnership disposes of property (other than by distribution) that is subject to an IRC Section 734(b) RPBA, the IRC Section 734(b) RPBA would be reallocated to the partnership's other property under rules similar to Treas. Reg. Section 1.755-1(c) and would remain an IRC Section 734(b) RPBA. If the IRC Section 734(b) RPBA cannot be reallocated to property of a like character, the reallocation would occur when the partnership acquires property of a like character in the future. Similar rules would apply if a partner that receives property with an IRC Section 734(b) RPBA in a distribution subsequently disposes of that property. An IRC Section 743(b) RPBA would arise when (i) a partner transfers an interest in a partnership that has an IRC Section 754 election in effect or a substantial built-in loss within the meaning of IRC Section 743(d) immediately after such transfer (ii) to a related transferee or a transferee that is related to one or more of the partners (iii) in a nonrecognition transaction in which the gain recognized, if any, and for which tax imposed by Subtitle A of the Code (subtitle A) 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 IRC Sections 743(b) and 755. In addition, a transferee partner would have to have outside basis that does not equal the transferee partner's share of inside basis (ignoring any existing IRC Section 743(b) adjustment) of partnership assets. The term "nonrecognition transaction" would have the same meaning as in IRC Section 7701(a)(45), i.e., any disposition of property in a transaction in which gain or loss is not recognized in whole or in part for purposes of Subtitle A. Under the proposed rules, the IRC Section 743(b) RPBA would be ineligible for cost recovery and could not be taken into account on the sale or other disposition of partnership property until the transferee partner ceases to be related to both the transferor and all persons that were partners immediately before or immediately after the covered transaction. If a basis adjustment ceases to be an IRC Section 743(b) RPBA as a result of the transferee partner's ceasing to be related to the transferor and all others who were partners immediately before and after the covered transaction, the basis adjustment in question would be treated as giving rise to newly placed-in-service property that is subject to the cost recovery method and period of the property to which it was allocated and the basis adjustment may be taken into account on the disposition of that property. If a partnership distributes property subject to an IRC Section 743(b) RPBA to the transferee partner, the transferee partner would take into account the basis adjustment in determining the partner's basis in the distributed property under IRC Section 732 and the partner's remaining outside basis in its partnership interest. The IRC Section 743(b) RPBA attached to property distributed to the transferee partner would be ineligible for cost recovery or for use in computing gain or loss on the disposition of the distributed property while it remains an IRC Section 743(b) RPBA (i.e., as long as the partners remain related). If a partnership disposes of property to which an IRC Section 743(b) RPBA applies (other than in a distribution to the transferee partner) or a transferee partner disposes of distributed property to which the RPBA applies, the IRC Section 743(b) RPBA would be reallocated to other property of the partnership or partner under rules similar to Treas. Reg. Section 1.755-1(c) and remain an IRC Section 743(b) RPBA. If the IRC Section 743(b) RPBA could not be reallocated to property of a like character, the reallocation would occur when property of a like character is acquired in the future. If tax must be paid on any gain recognized in an IRC Section 743(b) covered transaction, the portion of each basis increase attributed to that gain would not be treated as an IRC Section 743(b) RPBA (e.g., such increased basis amount would be eligible for cost recovery). An IRC Section 732 RPBA would arise when a partnership makes a liquidating distribution of property to a partner that results in a basis increase to the distributed property under IRC Section 732(b) and (c), and either:
Under the proposed rules described in the Notice, the IRC Section 732 RPBA from a covered transaction resulting in a basis increase under IRC Section 732(b) and (c) to a distributee partner's property would be recovered using the cost recovery method and period of the corresponding partnership property whose basis was reduced (in the case of a complete liquidation, the basis reduction under IRC Section 732; or in the case of a continuing partnership, the basis reduction that either was made under IRC Section 734(b), or that would have been made under IRC Section 734(b) if the partnership had had a IRC Section 754 election in effect) with respect to a related partner. The distributee partner would not take the 732 RPBA into account in calculating gain or loss upon the disposition of the property to which it applies. The preceding rules would not apply to any portion of a basis increase corresponding to a basis decrease to property distributed to an unrelated partner. The determination of an unrelated partner's share of the basis decrease would follow the principles in the regulations under IRC Section 197 for determining the partners' shares of IRC Section 734(b) basis adjustments for purposes of the IRC Section 197 "anti-churning" rules. For multiple distributed properties, each distributed property would be treated as having a separate IRC Section 732 RPBA for each basis decrease to corresponding property. The IRC Section 732 RPBA would be proportional to the share of the basis decrease to that IRC Section 732 RPBA's property out of the aggregate of the basis decrease for all corresponding property. A distributee partner would not be eligible to take the IRC Section 732 RPBA into account when disposing the property to which it applies unless a qualifying disposition of corresponding property occurs. A "qualifying disposition" is a disposition of property to an unrelated person in a fully taxable arm's length transaction. Upon a qualifying disposition, the remaining basis previously attributed to the IRC Section 732 RPBA would be treated as giving rise to newly placed-in-service property subject to the cost recovery period and method of the distributed property. In addition, a qualifying disposition would allow the distributee partner to take into account the IRC Section 732 RPBA when disposing of the property. The forthcoming proposed related-party basis adjustment regulations would apply to covered transactions that involve other provisions, such as IRC Section 732(d) and (f), as well as tiered-partnership structures. According to the Notice, the proposed regulations would also treat as covered transactions certain partnership arrangements involving taxable and tax-indifferent parties and would otherwise be covered transactions if the relatedness requirements described in Section 3.02, 3.03, or 3.04 of the Notice (relating to the definition of covered transactions) were satisfied. For purposes of these forthcoming provisions, a tax-indifferent party would be defined as a person that is not liable for US federal income tax (due to tax-exempt or foreign status) or for which gain from a transaction would not result in tax liability for the tax year in which the gain is recognized. To prevent distortions of consolidated group income, the forthcoming proposed consolidated return regulations would apply a "single-entity" approach to interests in a partnership held by consolidated group members. The regulations would be intended to prevent direct or indirect basis shifts among members of a consolidated group through covered transactions. The final regulations, if adopted, would apply to some transactions occurring before June 17, 2024. More specifically, once adopted, the final regulations would apply to the availability and amount of cost recovery deductions and gain or loss calculations for tax years ending on or after June 17, 2024, even if the related transaction that originally gave rise to the basis adjustment occurred in a prior year. The proposed applicability date for the consolidated return regulations will be contained in forthcoming proposed regulations. The Notice defines covered transactions broadly and mechanically, without regard to a taxpayer's intent or the economic substance associated with a transaction. Given this broad application, it is likely that many ordinary-course business transactions would be covered transactions. For example, the proposed IRC Section 732 RBPA rules could apply to an actual or deemed liquidation of a partnership (including as part of a merger, division, or incorporation) with related partners in which the basis of distributed property is increased for one related partner and decreased for another related partner under IRC Section 732. As another example, if a taxpayer purchases a partnership interest from an unrelated party in a taxable transaction, giving rise to a positive basis adjustment under IRC Section 743(b), and the taxpayer then transfers the partnership interest to a related party in a nonrecognition transaction, such as a contribution under Section 351, giving rise to a new basis adjustment under Section 743(b) for the benefit of the transferee, it appears that the proposed rules governing IRC Section 743(b) RBPAs could apply to the final transferee's IRC Section 743(b) adjustment. This is the case even though the original acquisition of the partnership interest was an arm's length transaction with an unrelated party and the related transferee's IRC Section 743(b) basis adjustment will likely not exceed the IRC Section 743(b) basis adjustment of the related transferor. The proposed regulations described by the Notice have a seemingly broad tax-indifferent party rule that expands covered transactions well beyond related-party transactions. The tax-indifferent party rule relates to partnerships with partners that are tax-exempt, foreign, and perhaps even partners with net operating loss attributes. It seems possible that many partnerships with unrelated owners participating in ordinary-course business transactions could become subject to this particular provision. In addition, the same language in the Notice also provides that the proposed regulations would apply to certain transactions with taxable persons where the transactions would otherwise be covered by the Notice if the relatedness requirements had been met. It is not clear exactly what type of transactions this language is intended to cover. However, because this language signals an intention to apply the rules in the Notice to transactions with taxable parties, even where the relatedness requirements are not satisfied, it potentially represents a broad extension of the principles set forth in the Notice. The proposed regulations, as described in the Notice, would lead to significant administrative complexity. Tax preparers for both partnerships and their partners would need to track RPBAs and monitor relevant distributions and disposals of property, both past and present. For example, where multiple properties with different recovery periods are distributed giving rise to IRC Section 734 RPBAs to the partnership's remaining assets, those RPBAs apparently would have split recovery periods based on the profile of the various distributed assets. Moreover, if individual distributed assets are then sold separately in qualifying dispositions, the IRC Section 734 RPBAs to the partnership's retained assets would apparently be treated in part as newly placed-in-service property. For partnerships with many different distributed assets of different characteristics and/or many retained assets of different characteristics, these calculations would be quite complex.Adding to the complexity is the fact that, if the partnership has some partners who are related to the distributee partner and some partners who are not, only a portion of the IRC Section 734 basis adjustments would be subject to the rules on IRC Section 734 RPBAs. The balance of the IRC Section 734 basis adjustments would be subject to the existing rules under IRC Sections 734 and 755. Interestingly, the Ruling (discussed later) makes clear an intent to subject partnerships to consequences from other provisions of Subchapter K (such as the basis reduction rules under IRC Section 732(f), relating to distributions of stock in controlled corporations), while the Notice simultaneously creates limitations around cost recovery of an RPBA. The interaction of these various provisions will hopefully be evaluated further by the IRS as part of its notice and comment procedures. Finally, taxpayers should carefully consider the scope of transactions subject to the Notice in light of the proposed effective date provision. The regulations described in the Notice are proposed to apply to tax years ending on or after June 17, 2024. Therefore, as stated explicitly by the Notice, the regulations would govern the availability and amount of cost recovery deductions and gain or loss calculations for tax years ending on or after June 17, 2024, even if the relevant covered transaction was completed in a prior tax year. Thus, transactions completed before 2024 would be subject to the rules described in the Notice, to the extent that basis adjustments arising from such transactions continue to give rise to cost recovery deductions or to impact the taxpayer's gain or loss on the disposition of property in tax years ending on or after June 17, 2024. The Proposed TOI Regulations would identify certain partnership related-party basis adjustment transactions as "transactions of interest," subjecting them to reporting under the reportable transaction rules6 and the material advisor rules.7 The Proposed TOI Regulations will become effective on the date Treasury and the IRS publish final regulations in the Federal Register. Generally, every taxpayer that has participated in a reportable transaction and who is required to file a tax return must file a disclosure statement with the IRS. Reportable transactions include listed transactions, confidential transactions, transactions with contractual protection, loss transactions, and transactions of interest (TOIs). A TOI is a transaction that is the same as or substantially similar to one of the types of transaction the IRS has identified by notice, regulation, or other form of published guidance as a TOI. A brief overview of the taxpayer rules for reportable transactions is provided below. The Proposed TOI Regulations are then described in detail. A taxpayer that participates in a reportable transaction must attach a disclosure statement,8 Form 8886, Reportable Transaction Disclosure Statement (or successor form), to its tax return for each tax year in which it participates in a reportable transaction. The taxpayer must also send the disclosure statement to the IRS's Office of Tax Shelter Analysis (OTSA) at the same time that it first files a disclosure statement for a particular reportable transaction. If a transaction becomes a TOI between the time a taxpayer files a tax return (including an amended return) reflecting its participation in the TOI and the end of the period of limitations for assessment for that tax year, the taxpayer must file the disclosure statement with the OTSA within 90 calendar days after the date on which the transaction becomes a TOI. This requirement exists regardless of whether the taxpayer participated in the transaction in the year the transaction became a TOI. Taxpayers that participate in a reportable transaction and fail to disclose may be subject to penalties under IRC Section 6707A. Those taxpayers may also be subject to additional understatement penalties under IRC Sections 6662A. The Proposed TOI Regulations identify two types of basis adjustment transactions as TOIs: (i) certain transactions involving transfers of partnership interests between partners (Transfer TOIs) and (ii) certain transactions involving partnership distributions (Distribution TOIs and, collectively with the Transfer TOIs, Basis Adjustment TOIs). Transfer TOIs. A Transfer TOI is defined as a transaction in which a partner transfers an interest in a partnership to a "related partner" (as defined later) in a nonrecognition transaction, the basis of one or more partnership properties is increased under IRC Section 743(b)(1) and (c), and the $5m threshold (as defined later) is met. For purposes of the rules on Transfer TOIs, the term "related partner" means that the transferor of a partnership interest is related to the transferee, or the transferee is related to one or more of the partners in the partnership, immediately before or immediately after the transaction giving rise to the IRC Section 743(b) adjustment. "Related" means that the relevant partners have a relationship described in IRC Section 267(b) (without regard to IRC Section 267(c)(3)) or IRC Section 707(b)(1). "Nonrecognition transaction" means for this purpose a nonrecognition transaction within the meaning of IRC Section 7701(a)(45) (other than a transfer on the death of a partner).
For purposes of the rules on Distribution TOIs, the Proposed TOI Regulations define a "related partner" as a partnership with two or more direct or indirect partners that have a relationship described in IRC Section 267(b) (without regard to IRC Section 267(c)(3)) or IRC Section 707(b)(1) immediately before or immediately after the Distribution TOI. The Proposed TOI Regulations would also apply to transactions that are "substantially similar" to Basis Adjustment TOIs. The proposed regulations state that "substantially similar" transactions include, but are not limited to:
The Proposed TOI Regulations define a tax-indifferent party as any person that is not liable for US federal income tax because of tax-exempt or, in certain cases, foreign status. A tax-indifferent party also includes a person that would not recognize US federal income tax because of other attributes (e.g., the taxpayer has a net operating loss carryforward or capital loss carryforward). For the purpose of determining whether a transaction is a Basis Adjustment TOI or a substantially similar transaction, the $5m threshold is met for a tax year if the sum of all basis increases resulting from all such transactions of a partnership or partner during the tax year (without netting for any basis adjustment in the same transaction or another transaction that reduces basis) exceeds by at least $5m the gain recognized from such transactions, if any, on which tax imposed under subtitle A is required to be paid by any of the related partners (or tax-indifferent party, in the case of a substantially similar transaction). As discussed previously, only participants in, or material advisors to, TOIs have disclosure obligations under the reportable transaction rules. Under the Proposed TOI Regulations, participants in Basis Adjustment TOIs include participating partners (Participating Partners), participating partnerships (Participating Partnerships), and related subsequent transferees (Related Subsequent Transferees) as described next (collectively, participants).
A Participating Partner, Participating Partnership, or Related Subsequent Transferee would have to attach a Form 8886 (or successor form) to the taxpayer's tax return and at the same time file the form with the OTSA for the first year it participates in a Basis Adjustment TOI. The participant must also attach a Form 8886 (or successor form) to its return for each subsequent year that it participates in a Basis Adjustment TOI, as participation is defined under the rules. In addition, a participant that disposes of the basis-adjusted property in a transaction in which gain or loss is recognized, in whole or in part, in a subsequent tax year must attach a Form 8886 (or successor form) to its tax return for that year and simultaneously file the form with the OTSA (even if the taxpayer previously filed the form with the OTSA in the first year of participation).
Taxpayers should be mindful that the reporting requirements under the Proposed TOI Regulations may apply to transactions entered in prior tax years. First, if a transaction becomes a TOI after the filing of Participating Partner's, Participating Partnership's, or Related Subsequent Transferee's tax return (including an amended return) reflecting its participation in the TOI and before the end of the period of limitations for assessment for any tax year in which it participated in the TOI, the Participating Partner, Participating Partnership, or Related Subsequent Transferee must file a Form 8886 with the OTSA within 90 calendar days after the date on which the transaction becomes a TOI. Second, as described above, the Proposed TOI Regulations also provide that a Participating Partner, Participating Partnership, or Related Subsequent Transferee participates in a transaction in any year in which the participant's tax return reflects the U.S. federal income tax consequences of the basis increase (e.g., claiming amortization or depreciation deductions). Therefore, even if the transaction that resulted in the positive adjustment occurred in the early 2010s, it is possible that the participant would have to attach a Form 8886 to its tax return once the Proposed TOI Regulations become final in the 2020s. Given their broad scope, the Proposed TOI Regulations could apply to many ordinary-course business transactions where the parties entered into the arrangement for commercial reasons wholly unrelated to basis adjustments under Subchapter K. For example, the types of transactions previously described as potentially subject to the Notice would potentially also be subject to reporting under the Proposed TOI Regulations. It is likely that the "substantially similar" transactions that the IRS identified in the Proposed TOI Regulations will have surprising consequences. Some examples of this are listed below.
In the Ruling, the IRS applied the economic substance doctrine to disallow basis adjustments generated through partnership transactions where all the partners of the partnership were related under IRC Section 267(b) or IRC Section 707(b)(1). The ruling outlines three situations in which a corporation and its subsidiaries (each Sub 1, Sub 2, and Sub 3) generated inside-outside basis disparities in a partnership that, in conjunction with later transactions undertaken with a view to exploit those earlier basis disparities, resulted in basis adjustments to either partnership property or distributed property in the hands of a partner. Depreciable or amortizable assets received additional basis through application of the mechanical partnership tax rules in each of the three situations described. For each situation, the stated business purpose was "cleaning up intercompany accounts, reducing administrative complexity, and achieving other administrative efficiencies." The actual cost savings were relatively small compared to the tax effect of the basis adjustment. Additionally, inside-outside basis disparities arose due to partnership contributions, distributions, and allocations that were undertaken by the parties with a view to creating such disparities. In all cases, the relevant partnership had a valid IRC Section 754 election in effect.
The Ruling states that the economic substance doctrine was developed to address transactions such as those at issue in the Ruling, which follow the literal words of the Code but lie outside of Congress's plain intent. In the Ruling, the IRS applied the two-prong conjunctive test for economic substance under IRC Section 7701(o)(1) to each of the situations. For each of the three situations, the IRS determined that the contribution or distribution lacked economic substance because the transactions (1) did not change the economic position of the parties and (2) the parties did not have a substantial purpose to enter the transactions outside of the US federal income tax benefits. The IRS determined that each situation failed the first prong of the economic substance doctrine because the contribution or distribution, as the case may be, shifted ownership of property among related entities without effecting any real change in the flow of economic benefits or providing any real opportunity to make a profit. Each situation also failed the second prong because the stated business purpose was not substantial when compared to the associated US federal income tax benefits of the transactions. The IRS noted that the basis increase generated by the contribution or distribution in each situation was relatively large compared to any cost savings for the corporation or its subsidiaries. The basis adjustments were disregarded because the transactions lacked economic substance. The corporation and/or its subsidiaries, as applicable, were also subject to the 20% penalty under IRC Section 6662(b)(6) for a transaction lacking economic substance, or the 40% penalty under IRC Section 6662(i) for a nondisclosed transaction lacking economic substance, as applicable. The Ruling makes clear that Treasury and the IRS believe that the economic substance doctrine is relevant and applies to various basis-shifting transactions. Though not a change in law or particularly surprising, the Ruling's conclusions make clear that the IRS will analyze the extent to which a transaction changes the economic position of its participants and will weigh potential tax benefits of a related-party basis-shifting transaction against a taxpayer's articulated business purposes. When applying the economic substance doctrine to the three situations, the IRS looked at a series of "connected" transactions that may occur over the course of several tax years. It is unclear from the Ruling what makes a transaction "connected" to other transactions. It is also unclear how the IRS will determine if the related partners and the partnership made contributions, distributions or allocations "with a view to creating" a basis disparity or whether a later transaction was made "with a view to exploiting" an existing basis disparity. While focusing on the economic substance doctrine in its analysis, the IRS noted that the partnership anti-abuse rules under Treas. Reg. Section 1.701-2 could also apply to the three situations, as well as the substance-over-form and step-transaction doctrines.
Document ID: 2024-1273 | ||||||
