Partnership Basis-Shifting Loopholes: IRS Final Regs

by Prof. Robert Bloink and Prof. William H. Byrnes

The IRS and Treasury have now finalized regulations that require partnerships to disclose information about certain transactions involving distributions and transfers of partnership interests and assets when those transactions could be abusive.  The regulations apply to 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 without any real cost or economic value to the partnership.  While the regulations largely track guidance issued in 2024, they also contain notable changes.  Importantly, the final regulations may apply retroactively, so it’s critical for small business partners to evaluate both current and past transactions to avoid running afoul of the new reporting rules.

Background

The law allows partnerships to increase basis in their assets when participating in certain types of transactions to avoid recognizing gain twice.  That said, some partnerships attempt to manipulate the rules to achieve a stepped-up basis and improperly avoid taxation.  The new regulations attempt to put a stop to these transactions that lack real economic substance by imposing reporting obligations.

For example, when a partnership has an IRC Section 754 election in place and distributes property to a partner, the partnership can increase its basis in its remaining assets if the adjusted basis in the property distributed exceeds the partner’s adjusted basis in its partnership interest immediately prior to the distribution.  Under IRC Section 743, if partnership interests are transferred, the partnership can adjust the basis in its assets so that it equals the transferee’s basis in the partnership interests.

If the partnership does not have a Section 754 election in place, basis adjustment is also permitted if a partner receives a distribution of the partnership property within two years after the partner acquired its partnership interest.  The partner can then elect to adjust their basis to what it would have been if the Section 754 election had been in place.

Transactions of Interest Covered by the Final Regs

The IRS has identified four different types of complex transactions that are specifically considered reportable “transactions of interest”.

First, transactions involving Section 734(b) are covered.  In these transactions, as a general matter, (1) the partnership distributes property to a "related partner" in a current or liquidating distribution, (2) the partnership increases the basis of one or more of its assets under Section 734(b) and (3) the value of the transaction exceeds the relevant threshold (discussed below).

Pursuant to the second scenario (involving Section 732(b)), (1) the partnership distributes property to a related partner in liquidation of the partner’s partnership interest or in liquidation of the partnership, (2) the basis of one or more distributed properties in increased under Section 732(b) and (3) and the relevant threshold is met.

The third scenario involves IRC Section 732(d), where (1) a partnership distributes property to a related partner, (2) the basis of one or more of the properties distributed is increased under Section 732(d), (3) the related partner acquired all or a portion of its partnership interest in a transaction that would have been considered a nonrecognition transaction (described below in scenario 4) had the partnership had a Section 754 election in the year of transfer and (4) the relevant threshold is met.

The fourth scenario involves Section 743, where (1) the partner transfers a partnership interest to a related partner in a nonrecognition transaction, (2) the basis of one or more partnership properties is increased under Section 743(b)(1) or (c) and (3) the relevant threshold is met.

These transactions are specifically identified as reportable transactions.  However, the regulations also apply to transactions that are deemed to be “substantially similar”.  That means the transaction would have the same, or a similar, tax result when compared to the listed transactions.  Note that the IRS has specifically stated that it’s possible for the regulations to apply even if the parties aren’t “related” under the definitions contained in the IRC if the parties include “tax-indifferent parties” that achieve a stepped-up basis by participation in the transaction.

Applicability and Possible Penalties

Partnerships (and their material advisors) participating in identified related-party basis adjustment transactions and substantially similar transactions are now subject to the disclosure requirements that apply to reportable transactions.  Generally speaking, the participating taxpayer must attach a Form 8886 disclosure statement to each tax return reflecting participation in the reportable transaction and send a copy to the Office of Tax Shelter Analysis.

The regulations will apply to transactions where the total stepped-up basis increases (reduced by taxable gain that was recognized) for all transactions by the same partner or partnership exceed $10 million for the year.  Note also that a six-year lookback period applies, so the regulations can apply to transactions that occurred as early as January 1, 2019.  During the six-year lookback period, the relevant threshold is $25 million.

The penalties for violations are steep.  Penalties may equal up to $50,000 per transaction and/or participant.  Small business clients may wish to report transactions to avoid inadvertently running afoul of the rules with respect to transactions that occurred during the six-year lookback period.

Conclusion

The new partnership anti-abuse regulations are complex and potentially apply to a number of common transactions that occur in the ordinary course of a partnership’s business.  Small business clients who have engaged in transactions similar to those identified by the IRS should be advised to review the terms and determine whether disclosure is advisable to avoid penalties.