New Proposed Regulations to Classify Certain Basket Contract Transactions as Listed Transactions

A basket contract is a type of structured financial transaction in which a taxpayer attempts to defer income recognition and may attempt to convert short-term capital gain or loss and ordinary income to long-term capital gain or loss through a contract denominated as an option, notional principal contract, forward contract, or other derivative contract. On July 11, 2024, the Treasury Department and the Internal Revenue Service (IRS) issued proposed regulations that would classify certain basket contract transactions as listed transactions, making them a reportable transaction to the IRS, and subject to hefty penalties if the required disclosures are not filed.

Background on Basket Contract Transactions

The Treasury Department and the IRS determined this transaction has a potential for tax avoidance or evasion. As a result, the Treasury Department and the IRS released various notices in July and October 2015 addressing these types of transactions. It is important to note the October notices revoked an earlier July 2015 notice and provided additional details on the types of basket contracts that were identified as listed transactions and transactions of interest.

In the basket contracts referenced in the October 2015 notices (Notice 2015-73 and Notice 2015-74), the taxpayer claims that their short-term trading gains, as well as interest, dividend, and other ordinary periodic income from the performance of the reference basket, are deferred until the basket contract is terminated. Additionally, if the basket contract is held for more than one year, the taxpayer argues that the entire gain should be classified as a long-term capital gain. The Treasury Department and the IRS expressed concerns over the potential use of basket contracts to inappropriately defer income recognition or convert ordinary income or short-term capital gain into long-term capital gain, and that the taxpayers may be mischaracterizing the transactions as an option or certain other derivatives in an effort to avoid application of section 1260 (with respect to constructive ownership transactions), section 1291 (with respect to passive foreign investment companies), or both. The recent IRS and Treasury proposal includes some exceptions for reporting of transactions, including when the contract is traded on a national securities exchange with proper regulation or when the contract is treated as a contingent payment debt instrument.

Disclosure for Participants and Material Advisors and Penalties for Nondisclosure

If the proposed regulations are finalized as currently written, taxpayers involved in these basket contract transactions classified as “listed transactions,” as well as those who act as material advisors with respect to these transactions, would be required to disclose them under sections 6011 and 6111. Failure to disclose will result in penalties.

Participants must attach Form 8886, Reportable Transaction Disclosure Statement (or successor form) to the taxpayer’s tax return for each tax year for which a taxpayer participated in a reportable transaction, and a copy of the disclosure statement must be sent to IRS’s Office of Tax Shelter Analysis (OTSA). Those who fail to do so are subject to penalties under section 6707A, which are subject to specified minimum and maximum amounts depending on the type of transaction. Additional penalties may also apply (refer to Section 6662A). Participants required to disclose listed transactions who fail to do so are also subject to an extended period of limitations under section 6501(c)(10).

Material advisors are required to file Form 8918, Material Advisor Disclosure Statement (or successor form), with the OSTA by the last day of the month following the end of the calendar quarter in which they become a material advisor for a reportable transaction or when circumstances arise that require an amended disclosure statement. Material advisors would also have to list maintenance obligations under section 6112. Per Section 301.6111-3(b)(1), a material advisor is a person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and directly or indirectly derives gross income in excess of the threshold amount as defined in §301.6111-3(b)(3) for the material aid, assistance, or advice. Material advisors who fail to file a disclosure statement or file an incomplete or false disclosure statement are subject to penalties under section 6707(a) and may be subject to additional penalties under section 6708.

Next Steps

The proposed guidance will likely prompt feedback from taxpayers and tax professionals. Affected individuals should consider providing their comments to the Treasury Department and the IRS. It Any written or electronic comments must be submitted by September 10, 2024, and a public hearing is currently scheduled for September 26, 2024 at 10:00 a.m. ET.

Conclusion

The regulations were proposed to better monitor and control potential tax avoidance strategies by strengthening disclosure requirements and imposing penalties for non-compliance. Depending on investment/trading strategies, it is recommended that taxpayers reassess how these regulations could affect their compliance obligations as the Treasury Department and the IRS continue to refine their approach to classifying certain basket contract transactions as listed transactions.

For more information and assistance with assessing the implications the proposed guidance will have on future and completed basket contract transactions, please reach out to E. George Teixeira, Cynthia Lee, or your Anchin Relationship Partner.