The U.S. Department of the Treasury and IRS on July 11, 2024, issued proposed regulations that would classify certain basket contract transactions as listed transactions. Taxpayers and material advisers participating in listed transactions must comply with disclosure and recordkeeping requirements and are subject to penalties for failure to comply.
Basket Contracts
A basket contract transaction is a structured financial transaction, generally involving an option, notional principal contract, forward contract or other derivative contract, through which taxpayers invest in assets normally generating ordinary income and short-term capital gain if held directly by the taxpayer. In the basket contract transactions identified by the proposed regulations, the taxpayer's position is that if they hold their basket contract for more than one year, ordinary income generated by the investments is deferred, and what would otherwise be short-term capital gain is converted to long-term capital gain.
A listed transaction is the same or substantially similar to a transaction that the IRS has identified in other guidance as a tax avoidance transaction. In 2015, the IRS issued two notices identifying certain basket contract transactions as listed transactions and others as transactions of interest. See Notice 2015-73, 2015-46 I.R.B. 660 and Notice 2015-74, 2015-46 I.R.B. 663.
After conducting audits and reviewing taxpayer and material advisor disclosures under the 2015 notices, the IRS believes that its concerns that basket contracts "have been used to inappropriately defer income recognition or inappropriately convert ordinary income or short-term capital gain into long-term capital gain" have proven to be true. In addition, the Treasury Department and IRS continue to be concerned that taxpayers are mischaracterizing basket contract transactions as options or other derivatives to avoid constructive ownership and passive foreign investment rules. Thus, the proposed regulations would classify all of the basket contract transactions addressed in the 2015 notices as listed transactions, including those previously identified only as transactions of interest.
IRS Continues to Target Wealthy Taxpayers and Partnerships
Basket contract transactions commonly involve hedge funds and high-wealth individuals. Thus, the proposed regulations were issued as part of continued compliance efforts by the IRS under the Inflation Reduction Act, which targets high-wealth individuals and large partnerships who may be participating in these transactions.
Conclusions and Takeaways
The proposed basket contract guidance is expected to generate comments from taxpayers and tax practitioners. Affected taxpayers should consider submitting comments to the Treasury Department and IRS on areas of concern.
If you have questions about the implications of the proposed guidance on future and completed basket contract transactions, please contact the authors or another member of Holland & Knight's Tax Practice or the Tax Controversy and Litigation Practice.