The U.S. Department of the Treasury and IRS recently issued guidance aimed at curtailing purportedly abusive basis-shifting transactions utilized by businesses taxed as partnerships. This guidance represents additional enforcement efforts that are part of a broader IRS campaign to specifically target partnerships and other high-income taxpayers. (See Holland & Knight's previous alert, "IRS Announces Sweeping Enforcement Effort Targeting Partnerships," Oct. 2, 2023.)

Basis Shifting Guidance

The recently issued guidance addresses basis-shifting transactions between partnerships and related parties. Basis-shifting transactions rely on the application of specific rules in Subchapter K of the Internal Revenue Code (Code) – the subchapter applicable to entities taxed as partnerships – as to when a partnership may receive a basis "step-up" in its assets. A basis "step-up" in the partnership assets can allow for additional depreciation or decreased taxable gain or increased taxable loss upon disposition.

Though many basis-shifting transactions comply with the literal requirements of Subchapter K, the IRS believes that such transactions have been inappropriately utilized to provide additional cost-recovery deductions or increased or decreased taxable gain/loss without corresponding economic impact.

To combat these perceived abuses, the Treasury Department and IRS released three guidance items:

Proposed Regulations Modifying Partnership and Consolidated Return Code Provisions

Notice 2024-54 announces two sets of future proposed regulations that would address basis-shifting transactions involving partnerships and related parties. The first set of regulations would provide mechanical rules that limit cost recovery deductions (or reductions in disposition gains) in future periods from certain covered transactions.

The second set of regulations would provide rules to prevent partnership basis shifting among members of a consolidated corporate group whose members own interests in a partnership. Though the description of the proposed future regulations is more general in nature, the proposed regulations would affect a large number of ordinary-course transactions entered into by partnerships. These proposed regulations will likely be subject to significant comments and challenges because they will change the tax treatment provided by the Code. By means of regulation, it appears that the IRS is seeking to rewrite various statutory partnership provisions. In light of Garland v. Cargill, -- U.S. – (2024), whether such regulations will ultimately be successful is an open item.

Transactions of Interest

Proposed regulations REG-124593-23 identify certain partnership related-party basis adjustment transactions that would be treated as "transactions of interest" – a form of reportable transaction. Taxpayers and material advisers participating in transactions of interest would be required to comply with heightened reporting and recordkeeping requirements with respect to such transactions that result in at least a $5 million increase in asset basis.

Once the proposed regulations are finalized, taxpayers and material advisors would have 90 days to disclose any existing covered transactions. Importantly, taxpayers would also be required to report in each year their cost recovery allowances and taxable gain or loss attributable to any basis increase from related-party basis adjustment transactions undertaken in prior years, apparently even if the initial transactions took place before the proposed regulations are finalized.

The proposed reporting requirements are extremely broad in scope and would impose compliance burdens on taxpayers that could result in significant penalties or potential tolling of the statute of limitations on assessment.

Application of Economic Substance Doctrine to Basis-Shifting Transactions

Rev. Rul. 2024-14 provides that the IRS will apply the codified economic substance doctrine in audits, appeals and litigation to deny the tax benefits from three specific basis-shifting transactions involving a related-party partnership. The ruling appears to incorporate other judicial doctrines, including substance-over-form and step transaction doctrines, into the economic substance doctrine and references other anti-abuse provisions, including the partnership anti-abuse regulation.

The ruling fails to address whether the codified economic substance doctrine, as an initial matter, is relevant to the facts at issue, as required under the statute. This issue is currently on appeal to the U.S. Court of Appeals for the Tenth Circuit in Liberty Global. Instead, the IRS wants to chill these transactions and will assert a strict liability penalty because a transaction lacks economic substance. The penalty is 20 percent of an underpayment and increases to 40 percent if the transaction is not disclosed.

Conclusions and Takeaways

The guidance will almost certainly be subject to a challenge that the Treasury Department and IRS lack the authority to change the tax consequences of transactions expressly dictated by the relevant statutes. Those challenges will be particularly interesting if, as many expect, the U.S. Supreme Court overturns or limits Chevron deference this term. See Loper Bright Enterprises v. Raimondo (No. 22-451).

Further, the proposed guidance is expected to generate significant comments from taxpayers and tax practitioners. Affected taxpayers should consider submitting comments to the Treasury Department and IRS on areas of particular concern.