Proposed regulations to treat "basket transactions" as listed transactions

ARTICLE | October 24, 2024

Authored by RSM US LLP

Executive summary

The IRS has identified certain financial arrangements known as basket contract transactions as having a high potential for tax evasion, leading to their classification as a “listed transaction” pursuant to proposed regulation 6011-16. Typically, a basket contract transaction involves the use of derivative contracts or options to defer income or convert short-term capital gains into long-term capital gains, thus reducing tax liabilities. If finalized, proposed regulation 6011-16 would require taxpayers and their material tax adviser to report any basket contract transaction executed to the IRS. Generally, participation in a listed transaction results in increased scrutiny from the IRS and may result in recharacterization of the transaction. Furthermore, failure to disclose participation in such transactions could result in significant penalties.

Since 2015, the IRS has viewed some basket transactions as tax avoidance listed transactions subject to special reporting requirements. Recent court decisions have called the IRS’s procedures into question in the absence of regulations regarding basket option and other listed transactions. The IRS now has released proposed regulations that would provide reportable listed transaction status for a more broadly defined class of basket contract transactions.

Taxpayers are required to disclose participation in listed transactions to the IRS, and certain tax penalties may apply at a higher rate to understatements of tax resulting from participation in listed transactions or failure to disclose participation in listed transactions.

Proposed regulations address basket transactions

What is a “basket transaction”

Basket contract transactions or substantially similar transaction (collectively “basket transactions”) involve use of options (or other derivative contracts) structured to defer income and convert short-term capital gains (“STCG”) into long-term capital gains (“LTCG”).

In a basket transaction, a taxpayer enters into a contract with a third party to earn returns based on a mix, or basket, of different assets. Those assets may be stocks, commodities, digital currencies or other personal property. The taxpayer typically pays a certain amount upfront, usually between 10% and 40% of the basket's value and often retains control over the assets in the basket and can change the assets held in the basket.

Here is an example of a basket contract transaction:

• The taxpayer, T, enters an option contract with a counterparty, C. Pursuant to the contract, T will receive a return based on the performance of a notional basket of referenced actively-traded assets. T, or someone designated by T, will determine what assets are in the basket and/or select a trading algorithm which determines which assets are in the basket. T retains the right to change or request that C change the assets in the basket or change the trading algorithm. The basket contract has a term of over one year but can be terminated by either party with proper notice.
• The amount paid to T on expiration or termination of the contract is based on the performance of the assets in the basket, based on a formula that commonly would return to T their initial payment plus or minus any net gains or losses. T may opt to take the appreciated property from the basket in lieu of a payout. If losses reach the upfront payment amount, the contract is terminated with no payout. The contract also includes safeguards to protect C, who holds the legal title to the assets in the basket.

As noted above, the goal of these transactions is usually to delay when income is recognized and/or to turn STCG, which is taxed at a higher rate, into LTCG that is taxed at a lower rate. The IRS has raised concerns regarding the use of basket contract transactions for tax avoidance.

What is a listed transaction?

The IRS has designated certain transactions as listed transactions that the IRS has concluded are abusive and having potential for tax evasion. Taxpayer must disclose their participation in listed transactions on Form 8886. Material advisors who assist taxpayers with structuring, advising, and marketing with respect to Listed Transactions also are subject to IRS disclosure requirements.

Generally, participation in a listed transaction results in increased scrutiny from the IRS. Additionally, significant penalties may apply for failing to properly disclose participation in a listed transaction (section 6707A) or for understatement of tax attributable to participation in a listed transaction (section 6662A).

Prior IRS Notices addressing Basket Transactions

In 2015, the IRS issued Notices labelling some basket transactions as listed transactions subject to disclosure requirements. Notice 2015-73 designated some basket transactions as listed transactions (tax avoidance transactions), and Notice 2015-74 designated others as “transactions of interest” (transactions with the potential for tax avoidance or evasion).¹

In 2022 the Tax Court upheld a challenge to another listed transaction designation the IRS made via a Notice rather than following the Administrative Procedures Act and issuing a notice of proposed regulations. See Green Valley Investors, LLC v. Commissioner.²In the wake of Green Valley the Treasury Department and the IRS have recently issued proposed regulations that identify basket contracts and similar transactions as listed transactions.

Proposed Regulation 6011-16

The proposed regulations describe a basket contract transaction as one in which:

• The taxpayer enters into a contract with a counterparty denominated as an option or notional principal contract, for returns based on a reference basket of assets;
• The contract has a term of more than one year or spans multiple tax years;
• The taxpayer or their designee has discretion to change the assets in the reference basket;
• The transaction results in a tax benefit for the taxpayer, such as deferral of income or conversion of the character of the gain;
• The transaction is not covered by any of the exceptions outlined in the regulations.

Exceptions include:

• Contracts traded on regulated national or foreign exchanges;
• Contracts treated as contingent payment debt instruments or variable rate debt instruments under federal tax regulations;
• Situations where the counterparty has obtained certain certifications from the taxpayer, indicating that no specified tax benefit will be claimed.

Once the proposed regulations are finalized, basket contract transactions generally will fall into the listed transaction category without regard to whether the IRS previously viewed them as listed transactions or transactions of interest.

Effective date

If finalized as proposed, these regulations generally would require taxpayers who have participated in a basket contract transaction to disclose their participation on Form 8886 filed with the IRS within 90 days of the date the regulation is issued in final format. However, taxpayers that previously disclosed their participation in basket contract transactions by filing Form 8886 would not need to file Form 8886 again to disclose the same participation.

Conclusion

For taxpayers, the proposed basket contract transaction regulations means continued IRS scrutiny of basket transactions. Taxpayers and their tax advisers should review transactions to determine if disclosure will be required under these regulations once they are finalized.

[1] Notice 2015-73 and Notice 2015-74 superseded prior Notices issued earlier in 2015 making similar designations – Notices 2015-47 and 2015-48 respectively – in response to commentators noting the potential overbreadth of earlier Notices.

[2] Green Valley Investors, LLC, et al. v. Comm’r, 159 T.C. No. 5 (2022). Green Valley did not address basket transactions specifically. In Green Valley, the court found that the IRS’ use of Notice 2017-10 to designate certain syndicated conservation easements as listed transactions was not effective.