On Monday, the Tax Court issued its long-awaited opinion in Otay Project LP v. Commissioner, TC Memo 2026-21, a case involving a “basis-shifting” transaction resulting in a claimed §743(b) basis adjustment north of $700 million. The Tax Court disallowed the §743(b) basis adjustment; however, the taxpayer avoided all the asserted penalties based on obtaining three opinions from nationally recognized firms with respect to which the court stated that “we are satisfied that each contains substantial authority for each and every conclusion reached therein.”
The structure of the transaction is way too complex to be described in this post, and, frankly, even reading the opinion is difficult to discern all the components of the transaction. Suffice it to say, there was a §708(b)(1)(B) termination (i.e., a sale of 50% or more of the partnership interests in capital and profits, a Code section repealed by TCJA), and the §743(b) basis adjustment resulted from an inside-outside basis differential primarily related to income that was deferred under the completed contract method of accounting (which provided cash that was distributed to the partners).
The opinion reaches two conclusions as to the propriety of the §743(b) basis adjustment. First, it indicates that the basis adjustment was computed improperly. In this regard, the court improperly conflates §704(b) concepts with §743(b) previously taxed capital computations. The court’s tortured explanation in this part of the opinion is amusing, as the court indicates that for an allocation to a partner to have substantial economic effect, the partner must have an “unconditional obligation to restore a negative tax capital account,” and this obligation must be taken into account as a liability when computing the partner’s §743(b) basis adjustment. If this were the sole basis of the court’s opinion, one would think there would be a substantial chance of reversal on appeal (which would be to the 9th Circuit). (In fact, two well-known partnership tax practitioners have been quoted as indicating that the Tax Court’s opinion in this regard is incorrect.)
However, the second basis for the Tax Court’s disallowance of the §743(b) basis adjustment is based on the “economic substance doctrine.” While many tax professionals may believe that the taxpayer had the better argument, reasonable minds certainly can differ as to whether an “engineered” transaction has economic substance. This aspect of the Tax Court’s opinion likely will be much more difficult to overturn on appeal, if there is one.
Is this case an outlier because of the magnitude of the claimed §743(b) basis adjustment? Probably not, given the Treasury/IRS 2024 refusal to withdraw Rev. Rul. 2024-14, 2024-28 IRB 18 (June 17, 2024), when it withdrew a lot of the basis-shifting guidance it had issued in response to the “simplification” requirements of the current administration. This revenue ruling provides that the IRS can apply the economic substance doctrine, the substance-over-form doctrine, the step-transaction doctrine and/or the partnership anti-abuse rule under Reg. §1.701-2, depending on the facts and circumstances of a specific “basis-shifting” transaction or series of transactions.
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