What are the proposed IRS regulations on basis shifting in partnerships?

The IRS proposed regulations under IRC Sections 732 and 734 targeting basis-shifting transactions among related parties using partnerships. The rules would change how related-party partners are treated when partnership distributions shift tax basis from one asset to another without economic substance.

Who is affected by the IRS basis-shifting partnership regulations?

The proposed regulations primarily affect closely held businesses operating through multi-entity partnership structures where related parties use distributions and basis adjustments to shift tax basis between assets or partners. Real estate investment groups and family partnerships with complex structures are particularly at risk.

IRS Proposes New Regulations on Basis Shifting in Related-Party Partnerships | Lynch Law

In June 2024, the IRS and Treasury Department proposed sweeping new regulations targeting basis-shifting transactions among related parties using partnerships. The proposed rules, published under IRC §§ 732 and 734, would fundamentally change how related-party partners are treated when partnership distributions shift tax basis from one asset to another — or from one partner to another — without economic substance. For closely held businesses that operate through multi-entity partnership structures, these regulations demand immediate attention.^[1]

The Problem Being Addressed

Partnership tax law allows basis adjustments in certain situations — when a partner receives a distribution of property, or when a partnership makes a § 754 election. These rules exist for sound policy reasons: they ensure that partners are not taxed twice on the same economic income and that basis accurately reflects the partners' economic investment. But the IRS has identified transactions in which related parties exploit these rules to shift basis from low-value or fully depreciated assets to high-value assets that can then be depreciated or sold with a reduced gain — generating tax benefits without any change in economic ownership.

The classic example involves related partners who contribute assets with different bases to a partnership, then engineer distributions or liquidations that shift the basis among the assets. Partner A contributes a high-basis, low-value asset; Partner B (a related party) contributes a low-basis, high-value asset. Through a carefully structured distribution, Partner B receives the high-basis asset, effectively importing basis from Partner A's contribution without any economic cost. The result is a tax-free step-up in basis that reduces Partner B's future tax liability.^[2]

What the Proposed Regulations Do

The proposed regulations address related-party basis shifting through two primary mechanisms. First, for distributions of property under § 732, the regulations would modify the basis allocation rules when the distributee partner and the contributing partner are related parties. Under current law, when a partner receives a distribution of contributed property, the basis of the distributed property is determined under § 732(a) or (b), potentially shifting basis from other partnership assets. The proposed rules would limit the basis that can be allocated to distributed property in related-party contexts, preventing the artificial inflation of basis through related-party distributions.

Second, for § 734(b) adjustments (which adjust the basis of remaining partnership assets when a distribution occurs and a § 754 election is in effect), the regulations would impose new limitations when the distribution involves related parties. These limitations would prevent related parties from using distributions to increase the basis of partnership assets held for the benefit of the related group without any corresponding economic outlay.^[3]

The regulations also propose new reporting requirements. Partnerships that engage in transactions covered by the proposed rules would be required to disclose the transactions on their returns, providing the IRS with the information needed to identify and examine potential basis-shifting arrangements.

Who Is Affected

The proposed regulations primarily affect partnerships with related partners — which, in the closely held business context, means virtually every family-owned partnership, LLC taxed as a partnership, or multi-entity structure owned by the same individuals or family group. The related-party rules under § 267(b) and § 707(b) cast a wide net: family members (spouses, ancestors, descendants, and siblings), controlled entities (entities in which the same persons own more than 50%), and other related persons as defined in the Code are all within scope.

For Mississippi business owners who operate through multi-entity structures — which is common for tax planning, asset protection, and operational reasons — the proposed regulations require a careful review of existing arrangements. Any transaction that involves contributions and distributions of property with disparate bases among related partners should be evaluated for potential basis-shifting implications. Existing structures that rely on basis adjustments to reduce future tax liability may need to be restructured.

Practical Takeaways

The proposed regulations are not yet final, and the IRS has invited public comments. But the direction of the regulations is clear: the IRS intends to curtail related-party basis shifting in partnerships, and the final regulations — whenever they are issued — will likely be broadly similar to the proposed rules. Taxpayers should not wait for final regulations to begin evaluating their exposure.

For business owners with partnership structures, the immediate steps are: (1) identify any transactions or structures that involve basis shifting among related partners; (2) assess the potential tax impact if the proposed regulations are finalized as proposed; (3) evaluate whether any restructuring is appropriate to mitigate the impact; and (4) monitor the regulatory process for changes between the proposed and final rules. Working with experienced tax counsel is essential, both to evaluate the impact of the proposed rules and to participate in the public comment process if the rules would have a significant effect on a particular client's structure.^[4]

References

^[1] REG-124593-23, 89 Fed. Reg. 47,446 (June 2024) (proposed regulations under IRC §§ 732 and 734 targeting related-party basis shifting in partnership transactions).
^[2] IRC § 732 (basis of distributed property to partner); § 734 (adjustment to basis of undistributed partnership property). The proposed regulations target transactions where these provisions are used to shift basis among related parties without economic substance.
^[3] IRC § 754 (election to adjust basis of partnership property); § 734(b) (adjustment to basis of remaining partnership property following a distribution when § 754 election is in effect).
^[4] IRC §§ 267(b), 707(b) (related-party definitions for partnership transactions). See also our earlier coverage: The IRS Strikes Back on Basis Shifting.