Subchapter K Anti-Abuse Rule

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[PS-27-94]

RIN 1545-AS70

Subchapter K Anti-Abuse Rule

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains a proposed regulation providing an

anti-abuse rule under subchapter K of the Internal Revenue Code of 1986

(Code). The rule authorizes the Commissioner of Internal Revenue, in

certain circumstances, to recast a transaction involving the use of a

partnership to reflect the underlying economic arrangement under

subchapter K or to prevent the use of a partnership to circumvent the

intended purpose of a provision of the Code. The proposed regulation

affects partnerships and their partners and is necessary to provide

guidance needed to comply with the applicable tax law.

DATES: Written comments must be received by July 1, 1994. Outlines of

topics to be discussed at the public hearing scheduled for Monday, July

25, 1994, at 10 a.m. must be received by Tuesday, July 5, 1994.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (PS-27-94), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (PS-27-94),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue,

NW., Washington, DC. The public hearing will be held in the Auditorium,

Internal Revenue Building, 1111 Constitution Avenue, NW., Washington,

DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Mary A.

Berman or D. Lindsay Russell, (202) 622-3050; concerning submissions

and the hearing, Michael Slaughter, (202) 622-7190 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

This document proposes to add Sec. 1.701-2 to the Income Tax

Regulations (26 CFR part 1) to provide for an anti-abuse rule under

subchapter K of the Code. This rule is proposed to apply for all

purposes of the Code (e.g., income, estate, gift, generation-skipping,

and excise tax).

Subchapter K was enacted to permit businesses organized for joint

profit to be conducted with ``simplicity, flexibility, and equity as

between the partners.'' S. Rep. No. 1622, 83d Cong., 2d Sess. 89

(1954); H.R. Rep. No. 1337, 83d Cong., 2d Sess. 65 (1954). It was not

intended, however, that the provisions of subchapter K be used for tax

avoidance purposes. For example, in enacting subchapter K, Congress

indicated that aggregate, rather than entity, concepts should be

applied if such concepts are more appropriate in applying other

provisions of the Code. H.R. Conf. Rep. No. 2543, 83d Cong., 2d Sess.

59 (1954). Similarly, in later amending the rules relating to special

allocations, Congress sought to ``prevent the use of special

allocations for tax avoidance purposes, while allowing their use for

bona fide business purposes.'' S. Rep. No. 938, 94th Cong., 2d Sess.

100 (1976). Thus, the intent of the partnership provisions in

subchapter K is to permit taxpayers to conduct business for joint

economic profit through a flexible arrangement that accurately reflects

the partners' economic agreement without incurring an entity-level tax.

These provisions are not intended, however, to permit taxpayers either

to structure transactions using partnerships to achieve tax results

that are inconsistent with the underlying economic arrangements of the

parties or the substance of the transactions, or to use the existence

of the partnerships to avoid the purposes of other provisions of the

Code.

The provisions of subchapter K should be applied in a manner

consistent with their intent. Treasury and the IRS are aware, however,

of an increasing number of transactions that attempt to use the

partnership form in a manner inconsistent with that intent. For

example, some transactions attempt to use a partnership to circumvent

other provisions of the Code or purport to create tax advantages

inconsistent with the substance of the transaction. See, e.g., Notice

94-48, 1994-19 I.R.B. 10. Other transactions appear to rely on the

literal language of rules in the subchapter K regulations (or

elsewhere) to produce tax results that are inconsistent with the

intended purpose of those rules.

The proposed regulation clarifies the authority of the Commissioner

of Internal Revenue to recast those transactions that exploit and

misuse the provisions of subchapter K in an attempt to avoid tax. In

promulgating this regulation, it is intended that all taxpayers,

including partners and partnerships, will remain subject to other

statutory and regulatory rules and judicial doctrines. See, e.g.,

Merryman v. Commissioner, 873 F.2d 879 (5th Cir. 1989) (sham

transaction).

The proposed regulation is not intended to interfere with bona fide

joint business arrangements involving partnerships. For example, a

partnership's use of nonrecourse financing and special allocations

generally is not inconsistent with the intent of subchapter K.

The proposed regulation also is not intended to override specific

regulatory de minimis rules, such as those contained in Sec. 1.704-

3(e)(1), Sec. 1.514(c)-2(k) (2) and (3), and regulations proposed under

sections 337(d) and 1374 (excepting certain small partnership interests

or holdings from the scope of those provisions). The regulation also is

not intended to override rules provided elsewhere that prescribe

special treatment for partnerships and their partners. See, e.g.,

Sec. 1.904-5(h), Sec. 1.1362-2(c)(4)(ii)(B)(4)(i), and proposed

regulations under section 1374 pertaining to recognized built-in gain

and loss limitations.

The proposed regulation primarily will affect a relatively small

number of abusive large partnership transactions and reflects

Treasury's and the IRS's commitment to preventing those abuses from

undermining the intent of subchapter K. Nevertheless, Treasury and the

IRS initially have determined that a specific safe harbor or de minimis

rule is unnecessary and may in fact be inappropriate in light of the

purpose of this regulation. Treasury and the IRS invite comments on

this issue.

Explanation of Provisions

Under the proposed regulation, if a partnership is formed or

availed of in connection with a transaction or series of related

transactions (individually or collectively, the transaction) with a

principal purpose of substantially reducing the present value of the

partners' aggregate federal tax liability in a manner inconsistent with

the intent of subchapter K, the Commissioner can disregard the form of

the transaction. In such a case, even if the partnership and the

partners comply with the literal language of one or more provisions of

the Code or the regulations thereunder, the Commissioner can recast the

transaction for federal tax purposes, as appropriate. For example, the

Commissioner can determine that (1) the purported partnership should be

disregarded in whole or in part in determining the tax effects of the

transaction, (2) one or more of the purported partners of the

partnership should not be treated as a partner, (3) the partnership and

its partners should be respected but the partners should be treated as

owning their respective shares of partnership assets directly (applying

the aggregate concept of partnership taxation), (4) the methods of

accounting used by the partnership or a partner should be revised to

reflect clearly the partnership's or the partner's income, (5) the

allocations of the partnership's items of income, gain, loss,

deduction, or credit should be disregarded and reallocated, or (6) the

intended tax treatment should otherwise be precluded.

The proposed regulation provides that the purposes for structuring

a transaction will be determined based on all of the facts and

circumstances. A reduction in the present value of the partners'

aggregate federal tax liability through the use of a partnership does

not, by itself, establish inconsistency with the intent of subchapter

K.

The regulation is proposed to be effective for all transactions

relating to a partnership occurring on and after May 12, 1994. The

Commissioner can continue to rely upon applicable principles and

authorities to challenge abusive transactions occurring before and

after the effective date of the regulation. This regulation does not

limit the applicability of those principles and authorities.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It has also been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to this regulation, and, therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to section 7805(f) of the Internal

Revenue Code, this notice of proposed rulemaking will be submitted to

the Chief Counsel for Advocacy of the Small Business Administration for

comment on its impact on small business.

Comments and Public Hearing

Before this proposed regulation is adopted as a final regulation,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for July 25, 1994, at 10 a.m.

in the Internal Revenue Auditorium, Seventh Floor, 7400 Corridor,

Internal Revenue Building, 1111 Constitution Avenue, NW., Washington,

DC. Because of access restrictions, visitors will not be admitted

beyond the building lobby until 15 minutes prior to the hearing.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must

submit written comments by July 1, 1994, and submit an outline of the

topics to be discussed and the time to be devoted to each topic by July

5, 1994.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.701-2 also issued

under 26 U.S.C. 701 * * *

Par. 2. Section 1.701-2 is added to read as follows:

Sec. 1.701-2 Anti-Abuse rule.

(a) Intent of subchapter K. The intent of the partnership

provisions in subchapter K is to permit taxpayers to conduct business

for joint economic profit through a flexible arrangement that

accurately reflects the partners' economic agreement without incurring

an entity-level tax. These provisions are not intended, however, to

permit taxpayers either to structure transactions using partnerships to

achieve tax results that are inconsistent with the underlying economic

arrangements of the parties or the substance of the transactions, or to

use the existence of the partnerships to avoid the purposes of other

provisions of the Internal Revenue Code.

(b) Application of subchapter K rules. The provisions of subchapter

K and the regulations thereunder must be applied in a manner consistent

with their intent as set forth in paragraph (a) of this section.

Accordingly, if a partnership is formed or availed of in connection

with a transaction or series of related transactions (individually or

collectively, the transaction) with a principal purpose of

substantially reducing the present value of the partners' aggregate

federal tax liability in a manner that is inconsistent with the intent

of subchapter K, the Commissioner can disregard the form of the

transaction. In such a case, even if the taxpayer complies with the

literal language of one or more of the provisions of the Internal

Revenue Code or the regulations thereunder, the Commissioner can recast

the transaction for federal tax purposes as appropriate. For example,

the Commissioner can determine that--

(1) The purported partnership should be disregarded in whole or in

part in determining the tax effects of the transaction;

(2) One or more of the purported partners should not be treated as

a partner;

(3) The partnership and its partners should be respected but the

partners should be treated as owning their respective shares of

partnership assets directly (applying the aggregate concept of

partnership taxation);

(4) The methods of accounting used by the partnership or a partner

should be adjusted to reflect clearly the partnership's or the

partner's income;

(5) The allocations of the partnership's items of income, gain,

loss, deduction, or credit should be disregarded and reallocated; or

(6) The intended tax treatment should otherwise be precluded.

(c) Facts and circumstances test. The purposes for structuring a

transaction involving a partnership will be determined based on all of

the facts and circumstances. A reduction in the present value of the

partners' aggregate federal tax liability through the use of a

partnership does not, by itself, establish inconsistency with the

intent of subchapter K.

(d) Application of judicial principles and authorities. The

Commissioner can continue to assert and to rely upon applicable

judicial principles and authorities (for example, the substance over

form, step transaction, and sham transaction doctrines) to challenge

abusive transactions. This regulation does not limit the applicability

of those principles and authorities.

(e) Examples. The following examples illustrate the principles of

this section:

Example 1. Use of partnership form consistent with the intent of

subchapter K. A and B form limited partnership PRS. A is a corporate

general partner with a 1% partnership interest. B, the limited

partner, has a 99% interest. A and B choose partnership form in

order to conduct a business, achieve flow-through tax treatment, and

provide B with limited liability. Assume that PRS is properly

classified as a partnership under Secs. 301.7701-2 and 301.7701-3.

Even though A and B chose to conduct their pooled business in

partnership form in order to avoid an entity-level tax on any income

generated by the business, because section 701 contemplates one

level of tax, PRS has not been formed or availed of with a purpose

inconsistent with the intent of subchapter K. Absent other facts,

the Commissioner will not invoke paragraph (b) of this section to

recast the transaction.

Example 2. Use of partnership form consistent with the intent of

subchapter K. C, D, and E form partnership PRS for the purpose of

owning and operating a qualified low-income building that qualifies

for the low-income housing credit provided by section 42. The

partnership agreement provides for special allocations of income and

deductions, except as otherwise required by its qualified income

offset and minimum gain chargeback provisions. The project is

financed with nonrecourse indebtedness and the indebtedness is

allocated to the partners under the rules of Secs. 1.704-2 and

1.752-3, thereby (among other things) increasing the basis of their

respective partnership interests. The basis increase created by, and

resulting deductions attributable to, the nonrecourse indebtedness

enables the investors to deduct their distributive share of losses

from the partnership (subject to all other applicable limitations

under the Internal Revenue Code) against their nonpartnership

income. The low-income housing credit is a statutory benefit not

derived from the use of the partnership. Similarly, basis

attributable to nonrecourse indebtedness can be obtained without the

use of a partnership. The purpose of using the partnership is to

facilitate the ownership and the operation of the property, to

enable multiple investors to realize the benefits of the credit, and

to finance the venture using nonrecourse indebtedness. Under these

facts, PRS has not been formed or availed of with a purpose

inconsistent with the intent of subchapter K even though the use of

the partnership form enabled the partners to obtain basis in their

respective partnership interests for borrowing at the partnership

level for which neither the partnership nor any of the partners had

personal liability and enabled multiple investors to obtain the

credit. Absent other facts, the Commissioner will not invoke

paragraph (b) of this section to recast the transaction.

Example 3. Partnership allocation inconsistent with the intent

of subchapter K. F, G, and H form partnership PRS by contributing

cash to conduct a business. PRS's allocations generally comply with

all applicable regulations, including the alternate economic effect

test under Sec. 1.704-1(b)(2)(ii)(d). In year 2, PRS recognizes

taxable income with no corresponding increase in PRS's net worth

(phantom income). F, G, and H attempt to achieve significant tax

reduction by combining, over a period of time, partnership

allocations of the income with a restatement of their capital

accounts to fair market value pursuant to Sec. 1.704-1(b)(2)(iv)(f).

The intended result is that the partner who receives the income

allocation does not receive the economic benefits associated with

that allocation. The parties, in order to implement this plan, amend

the partnership agreement to reflect the special allocation of the

phantom income and, some time later, restate their respective book

capital accounts to fair market value. F, G, and H rely on a

regulatory provision whose literal language appears to permit the

intended tax result. If the intended allocation were upheld, F, G,

and H would, as a group, substantially reduce the present value of

their aggregate federal tax liability. Under these facts, the

special allocation of the phantom income and the restatement of

capital accounts are inconsistent with the intent of subchapter K.

The Commissioner, in addition to challenging the transaction under

Sec. 1.704-1(b), can recast the transaction as appropriate under

paragraph (b) of this section, even if it is determined that PRS

complied with the literal language of the regulations under

Sec. 1.704-1(b).

Example 4. Absence of Sec. 754 election consistent with the

intent of subchapter K. I, J, and K are equal partners in general

partnership PRS that operates a business. The partnership has not

made an election under section 754, relating to the optional

adjustment to the basis of partnership property. At a time when

PRS's assets have declined in value, K sells K's partnership

interest to L, an unrelated third party, and recognizes a loss. PRS

subsequently sells one of its assets at a loss. L has sufficient

basis in its partnership interest to deduct L's distributive share

of the loss. Because PRS has no section 754 election in effect, K

and L have each effectively recognized the same loss (although L

will ultimately recognize corresponding gain (or reduced loss) when

L disposes of L's partnership interest), thereby reducing the

present value of the partners' aggregate federal tax liability. The

failure to make the election under section 754 in some situations

allows temporary duplication of gain or loss. That duplication is

generally not, by itself, inconsistent with the intent of subchapter

K. Absent other facts, the Commissioner will not invoke paragraph

(b) of this section to recast the transaction.

(f) Effective date. Paragraphs (a), (b), (c), and (e) of this

section are effective for all transactions relating to a partnership

occurring on and after May 12, 1994.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 94-11909 Filed 5-12-94; 10:25 am]

BILLING CODE 4830-01-U