IRS targets partnership Related Party Basis Adjustments

The IRS and Treasury are targeting so-called Related Party Basis Adjustments (RPBA). On June 17, 2024, the IRS issued comprehensive guidance (Notice 2024-54, Revenue Ruling 2024-14 and Prop. Reg. section 1.6011-18) which provides that certain partnership basis adjustments arising from transactions between related partners lack economic substance and should be disregarded for federal income tax purposes (see our previous Tax Alert). Further, the IRS argues that they can challenge these transactions today via the economic substance doctrine.

In general, when a partner purchases an interest in a partnership, dies, recognizes gain from distributions in excess of outside basis or receives a distribution of property with a basis that differs from the tax basis that asset had inside the partnership, the partnership will be entitled to make a section 754 election and adjust the “inside basis” of its assets. A related party basis adjustment arises when related partners exploit differences between partners’ shares of the “inside basis” of partnership property and their “outside basis” in their partnership interests to shift basis between partners and/or assets. In Notice 2024-54, the IRS has defined three “transactions of interest” that broadly involve basis adjustments:

Section 734(b) RPBA

• The partnership distributes property with a relatively high inside basis to a partner with a relatively low outside basis.
• This creates a basis adjustment to partnership property under section 734(b).

Section 743(b) RPBA

• A partner transfers their partnership interest in a nonrecognition transaction to a related party.
• This creates an adjustment to partnership property under section 743(b), which is specially allocated to the transferee.

Section 732 RPBA

• The partnership makes a liquidating distribution of property to a related partner resulting in a basis increase to the property distributed in the hands of the distributee partner, and
• Either the partnership liquidates, and the remaining property’s basis is decreased, or the partnership continues and there is a negative adjustment to partnership property.

In Revenue Ruling 2024-14, the IRS asserts that RPBAs lack economic substance under section 7701(o), which defines a two-prong economic substance test:

• The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
• The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

The IRS argues that RPBA fails both prongs, and that any economic benefits attributable to restructuring are insubstantial in relation to the tax benefits. Similarly, they argue that “the stated business purpose of achieving cost savings from cleaning up intercompany accounts between subsidiaries, reducing administrative complexity, and achieving administrative efficiencies may be a legitimate nontax economic purpose. However, any such business purpose is not substantial compared to the Federal income tax purposes the transactions were designed to carry out.”

The IRS believes RPBAs lack economic substance and should be disregarded for federal tax purposes. This includes both past and future adjustments.

Prop. Reg. section 1.6011-18 outlines the aforementioned reporting requirements. Taxpayers do not currently have to report RPBAs to the IRS; however, this will change if these proposed regulations become final. Critically, these disclosure requirements would apply to RPBAs reported on returns that have been filed, but the statute of limitations for which has not expired, at the time (if and when) the regulations become final. Additionally, the proposed regulations include a $5 million threshold for required disclosure. Note, this threshold does not protect transactions from IRS challenge, it is just the threshold for reporting. Furthermore, even if partners are not related but one or more partners is a tax-indifferent party (i.e. certain foreign persons and tax-exempt organizations), the RPBA reporting requirement applies.

The IRS has stated their intention is to issue more regulations regarding these transactions. Regulations targeting the use of consolidated entities to create RPBAs would be included in this.

In light of the Supreme Court’s overturning of the Chevron doctrine, it is unclear how the IRS and Treasury’s pursuit of these and other guidance projects will unfold. We further note that the tax practitioner community at large believes this guidance exceeds the IRS and Treasury’s authority given these RPBAs do not violate the plan language of the related code sections. It is also possible the guidance could be withdrawn should there be a change in the administration resulting from the November 2024 election. We continue to monitor these and other partnership-related developments and will issue additional communications as warranted.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.