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Robert Bloink and William H. Byrnes

Regulation and Compliance > Federal Regulation

IRS Targets 3 Types of Partnership Transactions

By Robert Bloink By William H. Byrnes

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What You Need to Know

  • These types of transactions create no real economic value apart from tax reduction, the agency contends.
  • The IRS intends to use additional funding under the Inflation Reduction Act to significantly increase audits and challenge these techniques.
  • The regulations would deny depreciation deductions in future years even if the relevant transaction occurred before 2024.

The Internal Revenue Service has announced that it intends to propose regulations designed to close certain loopholes used by partnerships to minimize their tax liability through transactions that have no real economic substance.

The guidance focuses on complicated basis-shifting transactions through which taxpayers shift the basis of assets between closely related partners or entities to reduce taxable gain or increase depreciation deductions. 

According to the IRS, these types of transactions create no real economic value apart from tax reduction. The IRS announced its intent to provide rules regarding the impact of basis adjustments in certain types of transactions — and also identifies related-party transactions resulting in basis adjustments as reportable transactions of interest.

The IRS intends to use its additional funding under the Inflation Reduction Act to significantly increase audits and challenge these related-party transactions going forward. 

Although the new guidance is only in proposed form, the IRS was clear that the regulations would deny depreciation deductions, or reduction in gain on disposition, in future years even if the relevant transaction occurred before 2024. Taxpayers should consult their tax advisors to explore the tax ramifications of these transactions.

Three Types of Transactions

The IRS has identified three specific types of transactions used by partnerships to minimize taxation through basis adjustments: (1) transfer of partnership interests to related parties, (2) distribution of property to a related party, and (3) liquidation of related partnership or partner.

In the first type of transaction, a partner with a low share of the partnership’s “inside” tax basis and a high “outside” tax basis transfers the interest tax-free to a related party. The transfer is valuable to the partnership because it generates a tax-free basis increase to the transferee partner’s share of “inside” basis.

In the second type of transaction, a partnership with related partners distributes a high-basis asset to one of the related partners that has a low outside basis. The recipient then reduces the basis of the distributed asset, and the partnership receives a corresponding increase in the basis of its remaining assets to create tax savings.

Finally, the IRS identifies transactions where a partnership takes advantage of the cost recovery rules by liquidating and distributing (1) a low-basis asset that is subject to accelerated cost recovery (or that the parties intend to sell to a partner with a high outside basis) and (2) high-basis property subject to longer cost recovery (or no cost recovery). 

Using the partnership liquidation rules, the first related partner increases the basis of the property with a shorter life and the second related partner decreases the basis of the property that is subject to longer cost recovery periods or is non-depreciable property. This type of transaction allows the partnership to generate or accelerate tax benefits.

Essentially, these complicated transactions allow partners to decrease their tax liability by decreasing their taxable gain (or increasing their loss) or through benefiting from increased depreciation deductions.

Federal Guidance

The IRS released guidance designed to prevent partnerships from manipulating these basis-shifting transactions to minimize taxation. First, a notice of proposed rulemaking states that the IRS will provide mechanical rules on the effects of basis adjustments resulting from related-party transactions. 

The rules will be designed to eliminate inappropriate tax benefits and will provide rules for how (and whether) a basis adjustment arising from a covered transaction will be taken into account upon disposition of the property. According to the IRS, these rules will apply without regard to the taxpayer’s intent and without regard to whether the transaction is abusive or lacking in economic substance.

The second proposed rule addresses situations involving consolidated groups. The IRS will apply a single-entity approach to interests in partnerships held by members of these consolidated groups to ensure clear reflection of taxable income and liability. 

If the regulations are finalized, partnerships (and their material advisors) participating in related-party basis adjustment transactions and substantially similar transactions would be subject to the disclosure requirements that apply to reportable transactions. The reporting requirements would apply to transactions that generate $5 million or more in positive basis adjustments in the tax year if no tax was paid on the transaction.

The IRS also released Revenue Ruling 2024-14, which provides that the identified types of related-party basis shifting transactions lack economic substance. The ruling can then be used to challenge these basis adjustment transactions in future audits and litigation.

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Robert Bloink

William H. Byrnes

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