Newly Released Final Regulations on Partnership Basis-Shifting Transactions

I.  Introduction

On January 10, 2025, the United States Internal Revenue Service (the "IRS") released final regulations (the "Final Regulations") under section 6011 of the Internal Revenue Code of 1986, as amended (the "Code"), that identify certain partnership basis adjustment transactions as “transactions of interest.” Specifically, the Final Regulations identify four transactions of interest under Code sections 732, 734, and 743 between related persons or tax-indifferent persons that result in basis increases that for federal income tax purposes give rise to additional depreciation and amortization deductions or reduced gain on the sale of property. The IRS previously noted in Revenue Ruling 2024-14 that it intended to challenge many of these types of transactions as lacking economic substance under Code section 7701(o).  “Transactions of interest” are one of the categories of “reportable transactions” under Treasury Regulations Section 1.6011-4.  A taxpayer participating in a reportable transaction must disclose details about the transaction to the IRS in the taxpayer’s return, which disclosure is sent to the Office of Tax Shelter Analysis.  Accordingly, taxpayers participating in reportable transactions face a significant risk of audit.

II.  Background

Normally, the federal income tax basis of property is unaffected by distributions of property from the partnership to its partners.  The Code, however, contains several provisions that provide for adjusting the federal income tax basis of retained or distributed property following certain transactions.  The purpose of these provisions is to minimize the difference between the partners’ federal income tax bases in their partnership interests (outside basis) and the partnership’s federal income tax basis in its property (inside basis) or to preserve the unrecognized gain or loss when a partnership distributes property to a partner.

For example, Code section 732(a)(1) provides that a partner’s tax basis in property distributed from a partnership is the partnership’s inside basis immediately before the distribution.   However, there are two exceptions.  First, if the partner’s outside basis is less than the inside basis of the distributed property, then the partner’s tax basis in the distributed property is limited to the partner’s outside basis.  Second, a partner’s tax basis in partnership property distributed in complete liquidation of the partner’s partnership interest (or in complete liquidation of the entire partnership) equals the partner’s outside basis immediately before the distribution reduced by any money received in the same distribution.  Therefore, if the partnership’s inside basis in property distributed to a partner is less than the distributee partner’s outside basis, then the distributee partner increases the tax basis of the distributed property.  If more than one item of property is distributed in liquidation of a partnership interest, Code section 732(c) provides rules for allocating the basis increase among the distributed properties.

Under Code section 734(a), if a partnership distributes property to a partner, the partnership will not normally increase or decrease the inside basis of its remaining property.  However, a partnership that has an election in effect under Code section 754 (the "754 Election") will adjust the inside basis of its property if either (1) the distributee partner recognizes gain because the sum of the money and the adjusted tax basis of the property distributed to the partner exceeds the partner’s outside basis or (2) an adjustment to the basis of the distributed property occurs under Code section 732 upon a complete liquidation of a distributee partner’s partnership interest.  The amount of the increase in the partnership’s inside basis in its property equals either the amount of gain recognized by the distributee partner or the amount of any downward basis adjustment taken into account by the distributee partner under Code section 732.  Code section 755 provides rules for allocating the basis increase among the partnership’s remaining properties.

Code section 743(a) normally precludes an adjustment to the inside basis of partnership property following a transfer of a partnership interest.  If, however, the partnership as a 754 Election in effect, then Code section 743(b) directs the partnership to increase the inside basis of its property in an amount equal to the difference between the transferee partner’s outside basis and the transferee partner’s share of the inside basis of the partnership’s property.  A Code section 743(b) adjustment can occur, for example, if a partner sells a partnership interest for an amount greater than the partner’s share of the partnership’s inside basis or if a partner dies and the partner’s estate increases the outside basis of the partnership interest under Code section 1014.  Unlike basis increases under Code sections 732 and 734(b), the basis increase under Code section 743(b) is unique to the transferee partner only and does not impact the common inside basis of partnership property.

Additionally, Code section 732(d) provides a special rule for a partner who acquired his partnership interest in a transfer with respect to which a 754 Election was not in effect and who receives a distribution of property within two years of the transfer.  This special rule allows the partner to elect to treat the tax basis of the distributed property as being the same as it would have been had a 754 Election been in effect at the time of the distribution.  Accordingly, the partner can obtain a higher tax basis in the distributed property than would otherwise have been possible under the default rule of Code section 732(a)(1).

Taxpayers have manipulated these basis adjustment provisions by utilizing sophisticated basis-shifting transactions involving related parties. Typically, before undergoing one of these transactions, the partnership and its related partners artificially create differences between outside basis and inside basis. Then the partnership and the related partners manipulate Code sections 732, 734, and 743 to reduce the bases of non-depreciable assets and shift that basis to depreciable assets. Increases in the tax basis of depreciable or amortizable property can trigger new or increased amounts of depreciation, amortization, or other cost recovery deductions that benefit either the partnership or one or more of its partners. The partnership and the related partners may also shift basis to assets that a related partner intends to sell, reducing the amount of tax gain realized by the related partner in the sale. These transactions generate tax benefits without causing any meaningful changes to the economics of the taxpayer’s business because they involve related parties.  The Final Regulations require taxpayers that participate in one or more of these basis-shifting techniques, along with any substantially similar transactions, to disclose the transactions on their income tax returns as transactions of interest.

III.  Basis-Shifting Transactions of Interest

The Final Regulations identify four basis adjustment transactions involving a partnership that has at least two related partners as transactions of interest, provided that a $10 million applicable threshold amount is met:

1. The partnership distributes property to one of the related partners in a current or liquidating distribution and the partnership increases the basis of one or more of its remaining properties under Code section 734(b).  For example, a basis-shifting transaction utilizing Code section 734(b) might involve a partnership with a 754 Election in effect distributing non-depreciable property to one of the related partners.  Immediately before the distribution, the partnership’s inside basis in the distributed property exceeds the distributee partner’s outside basis. Under section 732, the distributee partner with a low outside basis takes a lower tax basis in the distributed property than the inside basis of the property immediately before the distribution.  Because of the basis decrease to the distributed property, the partnership increases the basis of its remaining properties under section 734(b) by an amount equal to the downward basis adjustment taken into account by the distributee partner under Code section 732.  The partnership is able under Code section 755 to allocate the basis increase to remaining partnership properties are eligible for cost recovery deductions, thereby increasing the tax deductions allowable to the partnership’s other partners.
2. The partnership distributes property to one of the related partners in complete liquidation of that partner’s interest in the partnership (or in complete liquidation of the partnership) and the basis of the distributed property is increased under Code section 732(b).  In a typical basis-shifting transaction utilizing Code section 732(b), the partnership makes a liquidating distribution of depreciable or amortizable property to one of the related partners. Immediately before the distribution, the partnership’s inside basis in the distributed property is much lower than the distributee partner’s outside basis.  The distribution increases the partner’s tax basis in the distributed property to equal the partner’s outside basis, generating greater cost recovery deductions for the distributee partner.
3. A partner transfers all or a part of its partnership interest to a related partner in a nonrecognition transaction and the basis of partnership property is increased under Code section 743(b).  For example, assume a partner in a partnership with a 754 Election in effect has an outside basis substantially exceeding the partner’s share of the inside basis of the partnership’s property.  The partner then transfers the partnership interest to a related party in a transaction in which gain or loss is not recognized for federal income tax purposes (such as a transfer under Code section 351(a) or 721(a)).  Because the transfer does not result in the recognition of gain or loss, the transferee will typically succeed to the transferor’s outside basis in the partnership interest.  Because a 754 Election is in effect, the transferee partner, who is related to the transferor, will obtain a special inside basis adjustment under Code section 743(b).  To the extent the basis increase is attributable to depreciable or amortizable property, the transferee partner will be able to claim additional cost recovery deductions that would not otherwise have been available.
4. The partnership distributes property to one of the related partners, the basis of the distributed property is increased under Code section 732(d), and the distributee partner received all or a part of its partnership interest within the last two years from a related partner in a nonrecognition transaction that would have resulted in an adjustment to the basis of partnership property if the partnership had a 743 Election in effect. Because the distributee partner received its partnership interest within the past two years, the partner could elect to (or potentially must) adjust the basis of the distributed property under Code section 732(d).  If the distributee partner receives the distributed property with a tax basis higher than its inside basis to the partnership, the distributee partner can claim depreciation, amortization, or other cost recovery deductions greater than would otherwise have been available.

The Final Regulations require disclosure only of basis-shifting transactions involving partnerships distributing property or partnership interests to related partners. The Final Regulations define relatedness as having one of the relationships described by Code sections 267(b) and 707(b)(1).  The constructive ownership rules of Code section 267(c), other than paragraph (3) thereof, are taken into consideration in determining relatedness.

For any of the transactions mentioned above to constitute a disclosable transaction of interest for any given taxable year, the $10 million applicable threshold must be met.  Whether the applicable threshold for a taxable year is met is determined by calculating the excess of: (1) the sum of all basis increases (without reduction for any basis decreases) resulting from all transactions of a partnership or partner during the taxable year, over (2) the gain recognized from those transactions on which income tax is actually paid.  Because the Final Regulations use the phrase “actually paid,” the applicable threshold is computed without reduction for any gain realized on which income tax is not paid, for instance, because a partner is exempt from federal income tax or the gain is offset by a net operating loss deduction, charitable deduction, or suspended losses under the Code section 465 at-risk rules.  In the case of a basis shifting transaction under Code section 734(b), the applicable threshold is computed only with regard to the basis increases of related partners.  In the case of a basis shifting transaction under Code section 732(b), the applicable threshold is met only if there is a basis increase in property distributed to related partners, excluding any basis increases or decreases to property distributed to other partners (aside from tax-indifferent partners) or to the partnership’s undistributed properties.

IV.  Disclosure Requirements

A taxpayer who “participates” in a transaction of interest or a substantially similar transaction under the Final Regulations must disclose to the IRS all the information required by IRS Form 8886 along with the following information:

1. the names and identifying numbers of all participants in the transaction, including the participating partnership, participating partners, and any related subsequent transferees of property involved in the transaction;
2. all basis adjustments resulting from the transaction, including:
   • the participating partnership’s adjusted basis in the distributed property immediately before the distribution,
   • any basis adjustments under Code sections 732, 734(b), or 743(b),
   • any participating partner’s adjusted basis in its partnership interest and share of the partnership’s adjusted tax basis in its property immediately before the transfer; and
3. any federal income tax consequences realized during the taxable year because of the transaction, including any cost recovery deductions attributable to any basis increase and any gain or loss attributable to the disposition of property that was subject to a basis increase.

The disclosure requirements apply to any taxpayer that “participates” during a taxable year in a transaction of interest or a substantially similar transaction satisfying the applicable threshold.   A partnership “participates” in a transaction of interest if the partnership makes a distribution of property to a partner in one of the enumerated basis-shifting transactions of interest or a substantially similar transaction.  A partner in a partnership “participates” in a transaction of interest if the partner receives a distribution of property from, or receives an interest in, a partnership that during the taxable year engages in one of the enumerated basis-shifting transactions of interest or a substantially similar transaction.  A taxpayer also “participates” in a transaction of interest if the taxpayer receives property from a related person in a nonrecognition transaction and the property previously had its tax basis increased in one of the enumerated basis-shifting transactions of interest or a substantially similar transaction.  Furthermore, a taxpayer also “participates” in a transaction of interest during a taxable year if the taxpayer realizes the income tax benefits of a transaction completed in an earlier taxable year; for example, by selling property that previously received a basis increase in a transaction of interest.

V.  Disclosure For Previous Taxable Years

The Final Regulations require taxpayers to disclose certain transactions of interest that occurred in previous taxable years.  Taxpayers have 180 days from the publication date of the Final Regulations to disclose transactions of interest that occurred during taxable years for which the statute of limitations on assessment is open and for which the taxpayer has already filed a return.  However, the applicable threshold for transactions of interest occurring during the six-year period before the publication date of the Final Regulations is $25 million rather than $10 million.

VI.  Questions

Williams Mullen will continue to monitor developments related to the newly issued final regulations. Should you have any questions regarding compliance with the new final regulations, please do not hesitate to reach out to any member of the firm’s Tax Section.