IRS Attacks Basis Shifting Among Related Parties With Flurry of Guidance and Forthcoming Regulations

With a flurry of IRS announcements regarding wealthy individuals and large partnerships, recent guidance on related-party basis transactions may have been easily overlooked. For many, this oversight may be a non-issue. But some unsuspecting taxpayers may find themselves ill-prepared to address new reporting requirements for themselves and their material advisors if the IRS’s proposed regulations take effect. It’s worth taking a second look at what the Agency has to say on these related-party basis, or “covered transactions.”

A Three-Pronged Regulatory Approach

Last month, the IRS announced a three-pronged approach to combat what it views as the “inappropriate use” of the Tax Code to allocate the basis of partnership assets among related parties in a manner that increases the basis of assets subject to cost recovery and decreases the basis of non-depreciable assets. The Agency’s actions include issuance of Notice 2024-54, Revenue Ruling 2024-14, and a Notice of Proposed Rulemaking.

Inside vs. Outside Basis: The Issue at Hand

The transactions at issue occur when a discrepancy exists between a partner’s “outside basis” in a partnership and that partner’s share of the partnership’s basis in its assets, or “inside basis.” In certain circumstances, such as when the partnership has made a Section 754 election, the partner or partnership may benefit from the basis adjustment provisions found in Sections 732, 734 or 743 to increase the basis of depreciable assets subject to such adjustments or to shift basis from assets with long depreciable lives to those with relatively shorter recovery periods. While the notice focuses on three particular transactions, the proposed changes nonetheless may impact many taxpayers engaged in routine transactions.

Notice 2024-54: Two Sets of Proposed Regulations

With this is mind, let’s turn to the IRS’s new guidance. Notice 2024-54 announces two sets of forthcoming proposed regulations relating to the treatment of covered transactions:

1. Substantive Regulations – These would change how partnerships treat cost recovery allowances and gain or loss from the distribution of partnership property where basis adjustments under Sections 732, 734(b), or 743(b) arise from covered transactions. As explained in Section 4 of the Notice, “[t]hese proposed regulations would be mechanical rules applicable to all covered transactions without regard to the taxpayer’s intent and without regard to whether the transactions could be abusive or lacking in economic substance.”

2. Procedural Regulations – These would apply to consolidated group returns and “…would apply a single-entity approach with respect to interests in a partnership held by members of a consolidated group.”

Commentators Push Back on IRS Authority and Scope

Trade groups, law firms and other groups took full advantage of the IRS’s request for comments with respect to Notice 2024-14. As expected in the wake of Loper Bright Enterprises v. Raimondo, commentators critiqued the IRS’s reliance on Sections 482, 732, 734(b), 743(b), 755, and 7805 as the basis for its regulatory authority to issue forthcoming regulations under Subchapter K.

Others questioned whether Revenue Ruling 2024-14, discussed below, applies mechanically to related party transactions without regard to the taxpayer’s intent and the transaction(s) economic substance, such that legitimate transactions between related parties could be negatively impacted by the IRS’s new guidance.

Perhaps the most ubiquitous concern, though, is the potentially retroactive nature of the proposed rules. As written, the proposed rules would limit cost-recovery deductions for tax years ending on or after June 17, 2024, even if the related-party basis transaction which gave rise to that deduction occurred in a prior year. Taxpayers are justifiably concerned with the potential administrative burden of having to substantiate transactions which, given some cost-recovery schedules, may have taken place decades in the past.

Revenue Ruling 2024-14: Economic Substance Doctrine Enforcement

Revenue Ruling 2024-14, in turn, advises taxpayers of the government’s use of the economic substance doctrine to challenge three variations of basis adjustments resulting from covered transactions. Under Revenue Ruling 2024-14, the government will apply the economic substance doctrine in instances where:

• A partnership uses allocations and distributions to create a disparity between inside and outside basis,

• The partnership uses this disparity to transfer partnership property in a nonrecognition transaction or a “current or liquidating distribution of partnership property to a partner,” and

• The taxpayer claims an adjustment to basis as a result of the foregoing under Sections 732(b), 734(b), or 743(b).

Transactions of Interest and Disclosure Requirements

Finally, under the Agency’s Notice of Proposed Rulemaking, the related-party basis transactions at issue would be classified as Transactions of Interest. As a result, both taxpayers and their material advisors would be subject to additional disclosure requirements and resulting penalties for failure to disclose.

It is important to note that such disclosure requirements would apply to basis adjustment transactions which occurred in prior years so long as the statute of limitations has not run on the years in which those transactions took place.

We will continue to monitor the IRS’s forthcoming proposed regulations and will be interested to see how the IRS addresses several meaningful comments.

Authored by Anson H. Asbury and David Hoy