IRS Targets 3 Types of Partnership Transactions

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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