In Otay Project LP v. Commissioner, TC Memo 2026-21, the Tax Court denied the taxpayers a $714 million deduction. The court determined that the partnership’s claim for a §743(b) basis adjustment, which was created through a structure the court found to lack economic substance, was invalid.

Facts of the Case

Albert and James Baldwin operated a successful real estate business in Southern California, acquiring large tracts of land for development, including a 22,000-acre master-planned community known as Otay Ranch. Following a bankruptcy reorganization, the brothers formed Otay Project, LP (OPLP), a TEFRA partnership, to act as the master developer overseeing land entitlements and infrastructure construction. OPLP sold "blue-top" lots to separate homebuilding entities owned by Albert and James. Because OPLP retained substantial long-term contractual obligations to complete infrastructure, the partnership elected to defer its profits under the completed contract method of accounting (CCM).

A bitter dispute arose between the brothers regarding unequal cash withdrawals, eventually leading to arbitration. The arbitrator issued an order mandating that all joint entities holding title to mutually owned properties be dissolved and their assets separated. Rather than simply dissolving OPLP, however, the brothers sought advice from Ernst & Young, LLP (EY) and Loeb & Loeb, LLP (Loeb). At the suggestion of their advisors, the brothers engaged in a highly complex restructuring. They formed new finance companies (the Finco entities). OPLP contributed intercompany promissory notes to the Fincos and subsequently distributed its interests in the Fincos to its 99.9% limited partner, OPLLC, which then passed the interests out to the brothers’ separate entities. Throughout this asset division, OPLP deliberately retained its ongoing construction obligations and continued deferring hundreds of millions of dollars of income under CCM.

In 2007, the brothers engaged in comprehensive estate planning, transferring massive interests in upper-tier partnerships to trusts for their children and grandchildren. These transfers resulted in a 50% or greater change in ownership, triggering a technical termination of OPLP under I.R.C. § 708(b)(1)(B). Five years later, on October 3, 2012, OPLP formally liquidated. At the time of its liquidation, OPLP held over $710 million in deferred profits under its CCM schedule.

The Taxpayers’ Request for Relief

The crux of the taxpayer’s position relies on basis adjustments arising from the 2007 technical termination. Because OPLP had an I.R.C. § 754 election in effect, the taxpayer argued that the technical termination mandated an I.R.C. § 743(b) step-up in basis with respect to OPLLC.

Following the mechanics of Treas. Reg. § 1.743-1(d), the taxpayer calculated OPLLC’s share of inside basis based on a hypothetical liquidation scenario where OPLP disposed of its CCM contracts. The taxpayer determined OPLLC’s share of inside basis was a negative $866,981,686, resulting in a positive § 743(b) basis adjustment of over $867 million.

When OPLP formally liquidated in 2012, it finally recognized approximately $716 million in deferred CCM income. To offset this massive income recognition, OPLP reported $743,977,826 in "other deductions" directly attributable to its prior § 743(b) basis adjustment (the "Basis Deduction"). The Commissioner issued a Notice of Final Partnership Administrative Adjustment (FPAA) disallowing $713,759,615 of the Basis Deduction and assessing severe penalties. The taxpayer petitioned the Tax Court to respect the mechanical calculation of the basis adjustment under the Treasury Regulations and reverse the FPAA.

The Court’s Analysis of the Law

The Tax Court first examined the mechanics of I.R.C. § 743(b). The Court explicitly noted that the Code is intended to adjust the transferee partner’s outside basis upon the transfer of a partnership interest. Key to the Court’s analysis was the statutory text of § 743(b), which mandates that "[a] partner’s proportionate share of the adjusted basis of partnership property shall be determined in accordance with his interest in partnership capital".

The Court further analyzed Treas. Reg. § 1.743-1(d), which stipulates that a transferee’s share of adjusted basis equals the sum of their interest in the partnership’s "previously taxed capital" plus their share of partnership liabilities. Furthermore, the Court highlighted that under the substantial economic effect test of Treas. Reg. § 1.704-1(b)(2), "any tax items allocated to a partner for tax purposes should have an equivalent impact on the amount of cash that the partner would be entitled to receive upon liquidation of the partnership". If a partner maintains a deficit capital account, the allocation rules dictate that "that partner is unconditionally obligated to restore the amount of that deficit balance to the partnership".

In addition to statutory basis provisions, the Court analyzed the Commissioner’s invocation of the economic substance doctrine. The Court soundly rejected the taxpayer’s argument that mechanical compliance with § 743(b) insulated the transaction from judicial review, relying on long-standing Supreme Court precedent in Gregory v. Helvering, 293 U.S. 465 (1935), and Frank Lyon Co. v. United States, 435 U.S. 561 (1978). Because the case would be appealable to the Ninth Circuit, the Court applied the Ninth Circuit’s framework from Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988), and Reddam v. Commissioner, 755 F.3d 1051 (9th Cir. 2014), which focuses holistically on whether "the transaction had any practical economic effects other than the creation of income tax losses".

Application of the Law to the Facts

The Tax Court unequivocally ruled against the taxpayer’s highly engineered § 743(b) calculation. The Court observed that OPLLC reported a negative capital account balance of $912 million, stemming from prior tax-deferred distributions of the Finco entity interests. The taxpayer conveniently ignored this massive negative capital balance when computing the hypothetical liquidation value.

The Court pointed out that "OPLLC’s negative capital flies in the face of reality and proper tax accounting" and found it impossible for a partner to withdraw a billion dollars in excess of contributed capital without acknowledging the economic reality of the deferred CCM gains. To claim that the distributions had substantial economic effect, OPLLC was required to maintain an unconditional deficit restoration obligation under the I.R.C. § 704(b) regulations. Therefore, "[a] correct section 743(b) adjustment must account for OPLLC’s negative capital of $912 million and its unconditional obligation to restore this negative balance". Because the taxpayer’s calculation failed to account for this liability, the Court found the basis adjustment to be incomplete and sustained the IRS’s disallowance.

Alternatively, the Court examined the transactions under the economic substance doctrine and found them utterly lacking in nontax business purpose. Although the brothers had a legitimate goal to separate their joint business operations pursuant to the arbitrator’s order, the creation of the Finco entities and the separation of promissory notes from OPLP’s construction obligations served no purpose other than tax avoidance. The Court agreed with the Commissioner that the restructuring was "an artifice to facilitate indefinite tax deferral, as ultimately, the Baldwin Brothers and their families, indirectly, continued to receive all payments and have all construction obligations". The Court concluded that "the transactions at issue were a tax-driven sham since these transactions primarily resulted in mere tax benefits".

However, the taxpayer did achieve a victory regarding the imposition of the 40% gross valuation misstatement penalty and the 20% negligence penalty under I.R.C. § 6662. The Court examined the taxpayer’s "reasonable cause" defense under I.R.C. § 6664(c)(1). Quoting Oakhill Woods, LLC v. Commissioner, T.C. Memo. 2020-24, the Court noted that "if a taxpayer alleges reliance on the advice of a tax professional, that ‘advice must generally be from a competent and independent advisor unburdened with a conflict of interest’". The Court found that the brothers had engaged multiple independent, highly sophisticated advisors—EY, Loeb, and McKee Nelson—and had provided them with full and accurate details of the business. Because the transactions involved incredibly complex subchapter K rules and the taxpayers obtained three separate opinions concluding there was substantial authority for the positions, the Court ruled that the taxpayers acted with ordinary and reasonable care.

Conclusion

The Tax Court firmly sustained the IRS’s disallowance of the $713,759,615 Basis Deduction. The ruling demonstrates that taxpayers cannot utilize hyper-technical mechanical applications of I.R.C. § 743(b) to permanently eliminate hundreds of millions of dollars in deferred income while simultaneously ignoring substantial deficit capital accounts. The Court additionally found the entirety of the restructuring to be a sham lacking economic substance. Nevertheless, because the taxpayers sought and relied upon extensive, well-documented guidance from highly competent tax advisors, the Court successfully shielded the taxpayers from severe accuracy-related and valuation misstatement penalties.

Prepared with assistance from NotebookLM.