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Highlights
- The U.S. Tax Court issued its decision in Otay Project LP v. Commissioner, sustaining the IRS' disallowance of more than $713 million in deductions attributable to a Section 743(b) basis adjustment, finding that the basis increase was technically flawed and the restructuring lacked economic substance.
- Despite the disallowance, the court declined to impose penalties, finding that taxpayers reasonably relied in good faith on detailed tax opinions from three separate firms.
The U.S. Tax Court on February 23, 2026, issued a decision in Otay Project LP v. Commissioner sustaining the IRS' disallowance of more than $713 million in deductions attributable to a Section 743(b) basis adjustment. The court found the basis increase was technically flawed and the restructuring lacked economic substance.
Case Background
Otay Project LP (Otay) was a developer of the Otay Ranch master-planned community in Chula Vista, California, that used the completed contract method to defer approximately $921 million of income from land sales. A business dispute between the taxpayers led Otay – on professional advice – to pursue restructuring and estate-planning transactions the partners claimed resulted in a basis adjustment of approximately $867 million that was used to offset deferred income from land sales. The IRS disallowed $713 million of the deduction and asserted penalties.
Decision
The Tax Court sustained the disallowance on two independent grounds. First, it held that Otay's basis step-up was fundamentally flawed because it ignored a partner's $912 million negative capital account and corresponding restoration obligation. Second, the underlying restructuring transactions must be disregarded because there was no meaningful economic effect apart from tax benefits and no nontax business purpose.
Despite sustaining the disallowance, the court declined to impose penalties. The court found that the taxpayers reasonably relied on professional advice of three separate firms, each of which provided detailed written opinions reaching a "substantial authority" confidence level, and the substantial detail of the opinions and the taxpayers' efforts to obtain multiple independent analyses negated any finding of negligence.
Implications for Partnerships and Tax Planning
The Otay Project decision carries several important takeaways for partnerships and taxpayers considering complex restructuring or estate-planning transactions:
- Basis-Shifting Transactions Subject to Economic Substance Doctrine. The decision is a win for the IRS to apply the economic substance doctrine to related-party basis-shifting transactions. Although the IRS and U.S. Department of the Treasury recently issued proposed regulations (REG-108921-25) that would remove the final regulations imposing extensive reporting requirements on related-party basis-shifting transactions, the IRS has not withdrawn Rev. Rul. 2024-14, which clarifies that the IRS intends to apply the economic substance doctrine to these transactions.
- Circular Cash Flows Attract Scrutiny. Courts will scrutinize transactions with circular cash flows among related parties with minimal risk shifting.
- Tax Opinions Continue to Provide Penalty Protection. Despite the adverse outcome on the merits, the taxpayers' tax opinions from multiple firms defeated penalties. However, taxpayers should be aware that relying on tax opinions for penalty protection risks that the opinions may need to be disclosed, potentially resulting in a waiver of attorney‑client privilege and work product protections.
Looking Ahead
Otay Project is the first basis-shifting transaction decided by the Tax Court and likely to be closely watched on appeal. Although the application of the economic substance doctrine to the Otay Project transaction is a win for the IRS, other transactions may be structured with different business purposes and economic consequences to avoid an economic substance challenge.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
