On June 17, 2024, the IRS published Revenue Ruling 2024-14 as part of a package it says will raise an additional $50 billion dollars of income taxes over the next decade from "basis-shifting transactions." In addition to the Revenue Ruling, the package includes three proposed regulations affecting basis adjustments. The Revenue Ruling seeks to curtail basis-shifting transactions between related entities by applying the economic substance doctrine to situations where the non-tax justifications for transactions are insubstantial when compared to the tax benefits associated with the transactions.
The Revenue Ruling illustrates three separate scenarios involving basis adjustments that the IRS ultimately considers to be improper basis-shifting transactions. Each of the three scenarios involves a series of transactions where taxpayers create disparities between inside and outside basis, "with and eye towards" taking advantage of the basis reallocation rules. The taxpayers in the three scenarios then enter into a transaction necessitating a basis reallocation supported by a legitimate business purpose such as reducing administrative complexity or cleaning up intercompany accounts. The IRS determined that in each scenario, the non-tax benefits were insubstantial compared to the tax benefits received. Section 7701(o) of the Code, commonly referred to as the economic substance doctrine, applies a 20% penalty if disclosed on the tax return and a 40% penalty if not disclosed.
The economic substance doctrine has two prongs, which the Revenue Ruling analyzes. The first prong requires that a transaction have a meaningful impact on the taxpayer's economic situation without regard to tax benefits. Because the Ruling found that the non-tax benefits were insubstantial in comparison to the tax benefits, the transactions did not change the taxpayer's economic situation "in a meaningful way." The second prong requires the taxpayer to have a "substantial purpose" for the transaction other than the tax benefits. The Ruling found that "any such business purpose is not substantial compared to the Federal income tax purposes the transactions were designed to carry out." Importantly, both prongs were measured against the tax benefits created by the transactions.
Because all three scenarios lacked economic substance, in the view of the IRS, the transactions were disregarded for income tax purposes. The basis reallocations under Sections 732(b), 734(b), and 743(b) were ignored and the taxpayers did not enjoy the increased basis as a result. Finally, the IRS applied the 20% or 40% lack of economic substance penalties to any addition to tax owed as a result of the adjustment. The IRS also mentioned that the anti-abuse rules under Sections 1.701-2 and 1.704-3(a)(10) may also apply to the three scenarios described. But other than an anti-abuse theory, there are no statutes or regulations which directly support the application of the economic substance doctrine to the fact patterns presented. This Revenue Ruling continues a trend by the IRS of applying the economic substance doctrine to different kinds of transactions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.