June 17, 2024
This alert describes the IRS’s recent focus on partnerships, provides background on basis adjustments under subchapter K, and discusses the Related-Party Basis Adjustment Guidance issued earlier today.
Earlier today, the IRS and Treasury issued a notice of proposed rulemaking, a notice of intent to publish future regulations, and a revenue ruling (collectively, the “Related-Party Basis Adjustment Guidance”) aimed at preventing taxpayers from benefiting from partnership basis adjustments in situations that the government views as inappropriate.[1]
As described in more detail below, the rules included in the Related-Party Basis Adjustment Guidance have three main elements.
If finalized, these rules will be relevant to any person who owns—or has at any time in living memory owned—an interest in a partnership in which a related person was also a partner. In addition, taxpayers should consider whether any of the proposed rules would apply to planned transactions.
This alert describes the IRS’s recent focus on partnerships, provides background on basis adjustments under subchapter K, and discusses the Related-Party Basis Adjustment Guidance.
In 2021, the IRS launched a “large partnership compliance” program focusing on partnership audit issues. In July 2023, the U.S. Government Accountability Office (the “GAO”) published a report on partnership audits, highlighting what it viewed as some shortcomings in the IRS’s approach to partnership audits.[3] In particular, the GAO pointed to the relatively low audit rate for large partnerships and the relatively high “no change” rate (that is, the rate at which partnership audits do not result in a change to tax liability).[4]
In response to the GAO report, on September 8, 2023, the IRS announced that it was expanding partnership audits.[5] Senior government officials have repeatedly expressed the IRS’s intent to issue guidance regarding the application of the basis adjustment rules (discussed in part II, below) to certain related-party transactions.[6]
Subchapter K (which houses the Code’s rules applicable to partnership taxation) includes several provisions that govern the interaction of a partner’s basis in its partnership interest with the partnership’s basis in its assets. In particular:
These basis adjustments arise in both taxable and tax-deferred transactions.[7]
In recent years, the IRS has expressed discomfort with basis adjustments that arise in nonrecognition transactions between related persons.[8] The IRS has, however, been unable to point to any law or regulation that prohibits taxpayers from undertaking such transactions (except in certain limited cases, such as transactions among members of a consolidated group that fall within the scope of Treas. Reg. § 1.1502-13 or transactions with respect to which Treas. Reg. § 1.701-2 may be applicable).[9]
In the proposed regulations, the IRS and Treasury identify four types of transactions involving related parties that would be designated “transactions of interest.” (The proposed regulations would also apply in the absence of related parties if there are unrelated parties that are “tax-indifferent.”) This designation would make the transactions reportable transactions under the section 6011(b) regime. As a result, taxpayers that have engaged, or that later engage, in these transactions would be required to file disclosures with the IRS. (Material advisors on the transaction also would be required to make filings.)
Importantly, the proposed regulations would require reporting with respect to past transactions. Specifically, if, during any taxable year for which the assessment limitations period has not expired, a taxpayer either (i) engaged in a covered transaction or (ii) filed a tax return that reflected the results of a covered transaction (e.g., depreciation or amortization), the taxpayer would have only 90 days from the finalization of the proposed regulations to report the transaction to the IRS.
Complying with these rules would require taxpayers to review decades of transactions to determine whether any transaction is, or is substantially similar to, one of the transactions described in the proposed regulations and if so, determine whether the “results” of that transaction are reflected on an open-year return. Thus, for example, if a taxpayer entered into a transaction in 1979 that gave rise to a basis adjustment that attached to 39-year property, the final year in which that adjustment would have been depreciated would have been 2018 (or possibly 2019). If the 2018 return is still open, the transaction that occurred in 1979 would be reportable. (If the use of a net operating losses attributable to a basis adjustment is included, it is possible that transactions occurring during the Eisenhower administration would be picked up.)
The proposed regulations would also apply to transactions in which partners are not related but one partner is a “tax-indifferent party” that facilitates the transaction (for example, a partner that is tax-exempt or non-U.S.). As a result, there will be a considerable compliance burden for many taxpayers.
The four transactions described in Prop. Treas. Reg. § 1.6011-18 are:
(1) A partnership distributes property to a person who is a related partner in a current or liquidating distribution and the partnership increases the basis of one or more of its remaining properties under section 734(b).
(2) A partnership distributes property to a person who is a related partner in liquidation of the person’s partnership interest (or in complete liquidation of the partnership) and the basis of one or more distributed properties is increased under section 732(b).
(3) A partnership distributes property to a person who is a related partner, the basis of one or more distributed properties is increased under section 732(d), and the related partner acquired all or a part of its interest in the partnership in a transaction that would have been a transaction described in paragraph (4), below, if the partnership had a section 754 election in effect for the year of transfer.
(4) A partner transfers an interest in a partnership to a related partner in a recognition or nonrecognition transaction and the basis of one or more partnership properties is increased under section 743(b).
In each case, a transaction is reportable only if the sum of all basis increases resulting from all such transactions of a partnership or partner during the taxable year (without reduction for any basis adjustment in the same transaction or another transaction that reduces basis) exceeds by at least $5 million the gain recognized from such transactions, if any, on which U.S. federal income tax imposed is required to be paid by any of the related partners.
B. Forthcoming Proposed Regulations under Sections 732, 734, 743, and
1502
In addition to subjecting past and future transactions to the reporting requirements in section 6011, the IRS and Treasury announced an intention to issue two sets of proposed regulations that would reduce or eliminate the benefit of transactions involving partnerships and related parties (or tax-indifferent parties).
As with the reporting regime described above, these rules effectively would be retroactive because they would apply to taxable years ending on or after June 17, 2024 but would apply to basis adjustments that arise before the finalization of the regulations.
Proposed Related-Party Basis Adjustment Regulations
The first set of proposed regulations, which would be issued under sections 732, 734(b), 743(b), and 755, would apply to a wide range of ordinary course transactions and would (very generally) include rules intended to match the timing of the depreciation and amortization of the basis adjustment with the timing of the inclusion of the associated income or gain. The exact manner in which the rules accomplish this would depend on the type of basis adjustment.
In each case, the proposed regulations would prohibit the use of any “suspended” basis adjustment to increase loss or decrease gain until the occurrence of applicable triggering events.
Proposed Consolidated Return Regulations
The second set of proposed regulations, which would be issued under section 1502, “would apply a single-entity approach with respect to interests in a partnership held by members of a consolidated group.”[10] Although the exact meaning of “single-entity approach” in this context is unclear, the intent is to “prevent distortions of a consolidated group’s income” and “avoid many of the anomalous results that arise” from transactions between members of a consolidated group.
The description of both sets of regulations in Notice 2024-54 is general and quite high level; there are many nuances and unanswered questions that the IRS and Treasury will need to consider and address in drafting the proposed regulations. One thing that is clear is that the proposed regulations will affect a large number of ordinary course transactions and impose considerable additional burdens on taxpayers.
C. Revenue Ruling on Economic Substance Doctrine
Rev. Rul. 2024-14 sets out the IRS’s position that certain related-party basis adjustment transactions may be covered by the economic substance doctrine as codified in section 7701(o). The ruling is unsurprising and, given that any revenue ruling effectively reflects the IRS’s litigating position and is not binding on taxpayers or the courts, is unlikely to be given much weight.
There are, however, a handful of interesting points worth noting.
__________
[1] Notice 2024-54; Notice of Proposed Rulemaking and Public Hearing, Certain Partnership Related-Party Basis Adjustment Transactions as Transactions of Interests Fed. Reg. 2024-12,282 (Jun. 18, 2024); Rev. Rul. 2024-14. As the preamble to the proposed regulations explains, the IRS and Treasury believe that related-party basis adjustment transactions are “carefully structured to exploit the mechanical basis adjustment provisions of subchapter K to produce significant tax benefits with little or no economic impact on the related parties, and in a manner that would not be a likely arrangement between partners negotiating at arm’s-length.”
[2] Any reference to “section” is a reference to section of the Internal Revenue Code of 1986, as amended (the “Code”), and any reference to Treasury regulations or “Treas. Reg. §” is a reference to sections of the United States Treasury regulations promulgated under the Code.
[3] U.S. Gov. Accountability Office, GAO-23-106020, Tax Enforcement: IRS Audit Processes Can Be Strengthened to Address a Growing Number of Large, Complex Partnerships (2023).
[4] The GAO report concluded that more than 80 percent of large partnership audits resulted in no change, more than double the rate of similarly sized corporate audits. In the GAO’s view, this reflects a shortcoming in the IRS’s audit strategy or conduct. The GAO does not seem to have considered, however, the possibility that large partnerships are less complex from a tax perspective when compared with similarly sized corporations. For example, a corporation with $1 billion of revenue may have manufacturing activities, international operations, R&D expenses and credits, and significant fixed assets. A partnership with $1 billion of revenue, however, may be a law firm or accounting firm with a comparatively simple business model with only domestic operations.
[5] News Release IR-2023-166 (Sept. 8, 2023).
[6] See, e.g., Kristen A. Parillo, IRS Cracking Down on Related-Party Basis Shifting, 175 TAX NOTES FEDERAL 1747 (June 13, 2022)
[7] For purposes of section 743(b), a “sale or exchange” generally includes nonrecognition transactions. See, e.g., section 761(e)(2) (distribution of a partnership interest), Treas. Reg. § 1.755-1(b)(5) (contribution of a partnership interest to a partnership), and CCA 201726012 (a reorganization to which section 368(a)(1)(A) or (D) applies).
[8] CCA 201726012 (discussing related-party basis adjustment transactions in a consolidated group). Congress has twice made changes to the basis adjustment rules to limit what were, at the time, perceived abuses. In 1984, as part of the Deficit Reduction Act of 1984 (P.L. 98-369), Congress added the flush language at the end of section 734(b) to prevent taxpayers from obtaining a benefit from a positive section 734(b) adjustment attributable to a lower-tier partnership interest where the lower-tier partnership did not have a section 754 election in effect. Then, in 1999, as part of the Tax Relief Extension Act of 1999 (P.L. 106-170), Congress enacted section 732(f) in an attempt to achieve the same result with respect to the stock of a corporation.
[9] See, e.g., CCA 201726012; CCA 202240017. It is not clear whether the regulations under Treas. Reg. § 1.701-2 are valid.
[10] Notice 2024-54 (Section 5).
[11] For a discussion of this issue, see https://www.taxnotes.com/tax-notes-today-federal/litigation-and-appeals/nam-urges-remand-economic-substance-case-consider-relevance/2024/05/08/7jhkp.
Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Tax and Global Tax Controversy and Litigation practice groups:
Tax:
Dora Arash – Los Angeles (+1 213.229.7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 20 7071 4266, [email protected])
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Anne Devereaux* – Los Angeles (+1 213.229.7616, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])
Pamela Lawrence Endreny – New York (+1 212.351.2474, [email protected])
Benjamin Fryer – London (+44 20 7071 4232, [email protected])
Evan M. Gusler – New York (+1 212.351.2445, [email protected])
Kathryn A. Kelly – New York (+1 212.351.3876, [email protected])
Brian W. Kniesly – New York (+1 212.351.2379, [email protected])
Loren Lembo – New York (+1 212.351.3986, [email protected])
Jennifer Sabin – New York (+1 212.351.5208, [email protected])
Eric B. Sloan – Co-Chair, New York/Washington, D.C. (+1 212.351.2340, [email protected])
Edward S. Wei – New York (+1 212.351.3925, [email protected])
Lorna Wilson – Los Angeles (+1 213.229.7547, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202.887.3768, [email protected])
Global Tax Controversy and Litigation:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202.955.8693, [email protected])
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202.887.3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202.887.3612, [email protected])
*Anne Devereaux, of counsel in the firm’s Los Angeles office, is admitted to practice in Washington, D.C.
© 2024 Gibson, Dunn & Crutcher LLP. All rights reserved. For contact and other information, please visit us at www.gibsondunn.com.
Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials. The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel. Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.