The IRS has issued new guidance to prevent related parties from using partnerships to achieve tax benefits through basis-shifting among assets.
The IRS recently released a guidance package aimed at preventing "basis-shifting" transactions through partnerships owned by related parties. These transactions involve related taxpayers transferring basis among assets to achieve a tax benefit, without any meaningful business purpose. The tax benefit being sought is typically increased or accelerated depreciation deductions or increased loss or decreased gain on sale. This practice allows closely related parties to reduce their overall tax liabilities.
These transactions exploit a set of highly technical partnership rules that provide for basis adjustments to partnership property in an attempt to equalize the "outside" basis of partners in their partnership interests with the "inside" basis of partnership property. These adjustment rules are triggered upon the transfer of a partnership interest or the distribution of partnership property. Many of these basis adjustments are elective through having the partnership make a "754 election" pursuant to Section 754 of the Code. With unrelated parties, these adjustments typically have economic substance because unrelated taxpayers have adverse economic interests. However, the IRS believes that related taxpayers have been manipulating these rules through transactions that would not likely occur between partners acting at arm's-length.
A straightforward example of how related partners of a partnership may generate a tax benefit through basis-shifting is a partnership that makes a non-liquidating distribution of high-basis, non-depreciable property that the partnership has no intention of selling to a partner with low outside basis. Under the partnership rules, the distributee partner would take a basis in the distributed property that is limited to the partner's low basis in its partnership interest. If the partnership has made a 754 election, the partnership would increase its basis in its remaining assets by the amount of basis that was "lost" due to the limitation caused by the distributee partner's low outside basis. If the remaining assets of the partnership are depreciable, it would be able to claim depreciation deductions on the newly increased basis. If the partners are related, they will have achieved a tax benefit without any meaningful economic impact to them as a whole. To make matters worse from the IRS's perspective, prior to a transaction such as this, the partners may have engaged in transactions that deliberately created the inside/outside basis disparities.
The IRS guidance package to address this perceived abuse includes three parts:
- Notice 2024-54 announces two sets of future proposed regulations. The first set of regulations would require partnerships to treat basis adjustments arising from certain "covered transactions" in a way that would restrict them from deriving inappropriate tax benefits. The second set of regulations would prevent basis-shifting among members of a consolidated group.
- REG-124593-23 would make certain basis-shifting transactions "transactions of interest" that impose reporting obligations on taxpayers and advisors that participate in certain defined transactions.
- Revenue Ruling 2024-14 describes three basis-shifting transactions where the IRS would disregard the favorable basis adjustments under the economic substance doctrine.
Notably absent from the IRS guidance is an intent requirement, which means that non-tax motivated partnership transactions could be adversely affected. There is a particular concern among advisors to private equity funds that transactions undertaken for legitimate business reasons could be adversely impacted, given that many private equity investors and their affiliates are invested in multiple funds of the same manager. The IRS guidance also notes that these rules could apply retroactively, meaning that taxpayers and their advisors may have to analyze transactions done in previous years to determine if they involved related parties. Each of these points may cause significant challenges for taxpayers.
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