Subchapter K Anti-Abuse Rule

Federal RegisterJan 3, 1995

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8588]

RIN 1545-AS70

Subchapter K Anti-Abuse Rule

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document contains a final 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. The final regulation affects partnerships and the partners

of those partnerships and is necessary to provide guidance needed to

comply with the applicable tax law.

[[Page 24]] EFFECTIVE DATES: This regulation is effective May 12, 1994,

except that Sec. 1.701-2 (e) and (f) are effective December 29, 1994.

FOR FURTHER INFORMATION CONTACT: Mary A. Berman or D. Lindsay Russell,

(202) 622-3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Introduction

This document adds Sec. 1.701-2 to the Income Tax Regulations (26

CFR part 1) under section 701 of the Code.

Background

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).

On May 12, 1994, the IRS and Treasury issued a notice of proposed

rulemaking (59 FR 25581) under section 701 of the Code. That document

proposed to add an anti-abuse rule under subchapter K. Comments

responding to the notice were received, and a public hearing was held

on July 25, 1994. After considering the comments that were received in

response to the notice of proposed rulemaking and the statements made

at the hearing, the IRS and Treasury adopt the proposed regulation as

revised by this Treasury decision. The anti-abuse rule in this final

regulation applies to the operation and interpretation of any provision

of the Code and the regulations thereunder that may be relevant to a

particular partnership transaction (including income, estate, gift,

generation-skipping, and excise tax). The anti-abuse rule in the final

regulation is expected primarily to affect a relatively small number of

partnership transactions that make inappropriate use of the rules of

subchapter K. The regulation is not intended to interfere with bona

fide joint business arrangements conducted through partnerships.

Explanation of Provisions

A. Overview of Provisions

As noted above, subchapter K is intended to permit taxpayers to

conduct joint business (including investment) activities through a

flexible economic arrangement without incurring an entity-level tax.

Implicit in the intent of subchapter K are three requirements. First,

the partnership must be bona fide and each partnership transaction (or

series of related transactions) must be entered into for a substantial

business purpose. Second, the form of each partnership transaction must

be respected under substance over form principles. Third, the tax

consequences under subchapter K to each partner of partnership

operations and of transactions between the partner and the partnership

must accurately reflect the partners' economic agreement and clearly

reflect the partner's income (referred to in the final regulation as

proper reflection of income), except to the extent that a provision of

subchapter K that is intended to promote administrative convenience or

other policy objectives causes tax results that deviate from that

requirement. In those cases, if the application of that provision of

subchapter K and the ultimate tax results to the partners and the

partnership, taking into account all the relevant facts and

circumstances, are clearly contemplated by that provision, the

transaction is treated as properly reflecting the partners' income. In

determining whether a transaction clearly reflects the partners'

income, the principles of sections 446(b) and 482 apply.

The provisions of subchapter K must be applied to partnership

transactions in a manner consistent with the intent of subchapter K.

The final regulation clarifies the authority of the Commissioner to

recast transactions that attempt to use partnerships in a manner

inconsistent with the intent of subchapter K as appropriate to achieve

tax results that are consistent with this intent, taking into account

all the facts and circumstances.

In addition, the final regulation provides that the Commissioner

can treat a partnership as an aggregate of its partners in whole or in

part as appropriate to carry out the purpose of any provision of the

Code or regulations, except to the extent that (1) a provision of the

Code or regulations prescribes the treatment of the partnership as an

entity, and (2) that treatment and the ultimate tax results, taking

into account all of the facts and circumstances, are clearly

contemplated by that provision.

B. Discussion of Comments Relating to Provisions in the Regulation

Comments that relate to the application of the proposed regulation

and the responses to them, including an explanation of the revisions

made to the final regulation, are summarized below.

1. Scope of the Regulation

Several comments stated that, as drafted, the language in the

proposed regulation was too broad and too vague to provide adequate

guidance to taxpayers as to which transactions are affected by the

regulation. Similarly, some comments suggested that the intent of

subchapter K as stated in the proposed regulation (upon which the

regulation operates) was overbroad and potentially conflicted with

explicit statutory or regulatory provisions. Several comments expressed

concern that the regulation, if finalized as proposed, would adversely

affect the legitimate use of partnerships. Other comments suggested

that additional examples should be added to clarify the scope of the

regulation, which would provide the necessary guidance. Some of the

comments requested that the regulation be withdrawn, or revised and

reproposed.

On the other hand, other comments supported the approach in the

proposed regulation, noting that it was well established that the

provisions of the Code must be interpreted consistent with their

purpose. Some of these comments noted that the regulation would in

large part simply be codifying aspects of existing judicial doctrines,

such as substance over form and business purpose, as they relate to

partnership transactions. Finally, some of these comments suggested

that the regulation be modified in various respects, including by

adding additional examples of its application.

In response to these comments, the IRS and Treasury have revised

the final regulation in three principal respects. First, the scope of

the regulation has been clarified substantially by revising the portion

captioned Intent of Subchapter K, in paragraph (a) of the proposed

regulation. Paragraph (a) of the final regulation now specifically

requires that (1) the partnership must be bona fide and each

partnership transaction or series of related transactions (individually

or collectively, the transaction) must be entered into for a

substantial business purpose, (2) the form of each partnership

transaction must be [[Page 25]] respected under substance over form

principles, and (3) the tax consequences under subchapter K to each

partner of partnership operations and of transactions between the

partner and the partnership must, subject to certain exceptions,

accurately reflect the partners' economic agreement and clearly reflect

the partner's income (proper reflection of income). However, certain

provisions of subchapter K that were adopted to promote administrative

convenience or other policy objectives may, under certain

circumstances, produce tax results that do not properly reflect income.

To reflect the conscious choice in these instances to favor

administrative convenience or such other objectives over the accurate

measurement of income, the final regulation provides that proper

reflection of income will be treated as satisfied with respect to the

tax consequences of a partnership transaction that satisfies paragraphs

(a) (1) and (2) of the final regulation to the extent the application

of such a provision to the transaction and the ultimate tax results,

taking into account all the relevant facts and circumstances, are

clearly contemplated by that provision. Examples of such provisions

include section 732, the elective feature of section 754, and the

value-equals-basis rule in Sec. 1.704-1(b)(2)(iii)(c), as well as

regulatory de minimis rules such as those reflected in Secs. 1.704-

3(e)(1) and 1.752-2(e)(4). A number of examples in the final regulation

demonstrate the proper application of these rules.

In addition, the revised Intent of Subchapter K set forth in

paragraph (a) no longer provides that the provisions of subchapter K

are not intended to permit taxpayers ``to use the existence of the

partnerships to avoid the purposes of other provisions of the Internal

Revenue Code.'' Many comments expressed confusion regarding the scope

of this clause. Other comments suggested that this clause should be

limited to questions of the appropriate treatment of a partnership as

an entity or as an aggregate of its partners for purposes of applying

another provision of the Code. Some comments further suggested that the

correct application of the aggregate/entity concept does not depend on

the intent of the taxpayer in structuring the transaction.

This clause was principally intended to address aggregate/entity

issues that exist under current law. The final regulation clarifies

this aspect of the regulation by removing the clause from paragraph (a)

and adding a new paragraph (e) to address inappropriate treatment of a

partnership as an entity. Paragraph (e) confirms the Commissioner's

authority to treat a partnership as an aggregate of its partners in

whole or in part as appropriate to carry out the purpose of any

provision of the Code or the regulations thereunder. As stated in some

comments, as well as under current law, the Commissioner's authority to

treat a partnership as an aggregate of its partners is not dependent on

the taxpayer's intent in structuring the transaction. However, the

Commissioner may not treat the partnership as an aggregate of its

partners under paragraph (e) to the extent that a provision of the Code

or the regulations thereunder prescribes the treatment of a partnership

as an entity, in whole or in part, and that treatment and the ultimate

tax results, taking into account all the relevant facts and

circumstances, are clearly contemplated by that provision. Underlying

the promulgation of paragraph (e) is the belief that significant

potential for abuse exists in the inappropriate treatment of a

partnership as an entity in applying rules outside of subchapter K to

transactions involving partnerships. Examples in new paragraph (f)

illustrate the application of paragraph (e).

Paragraph (c) contains the second principal revision reflected in

this final regulation. The corresponding paragraph in the proposed

regulation provides that the purposes for structuring a transaction

involving a partnership will be determined based on all of the facts

and circumstances. In response to comments requesting guidance

concerning the factors that will indicate that the taxpayers had a

principal purpose to reduce substantially their aggregate federal tax

liability in a manner inconsistent with the intent of subchapter K,

paragraph (c) of the final regulation sets forth several of those

factors.

Finally, in response to comments that the examples in the proposed

regulation do not provide adequate guidance regarding the application

of the regulation, as well as to suggestions that additional examples

would help clarify the scope of the regulation, the final regulation

contains numerous examples that illustrate the application of the

regulation to specifically described transactions, including the weight

to be given to relevant factors listed in paragraph (c) in the

particular situations involved. The examples include transactions that

are consistent with the intent of subchapter K as well as transactions

that are inconsistent with the intent of subchapter K.

2. A Principal Purpose

The proposed regulation provides that if a partnership is formed or

availed of in connection with a transaction or series of related

transactions 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. Some comments stated that

all partnership transactions have a principal purpose of reducing

federal taxes, and therefore, the standard should be changed from a

principal purpose to the principal purpose. Other comments supported an

``a principal purpose'' standard, because the Commissioner can recast

the transaction only if the tax results are also found to be

inconsistent with the intent of subchapter K. Other comments stated

that the taxpayer's intent should be irrelevant in all cases; rather,

the inquiry should only be whether the results are inconsistent with

the intent of subchapter K. Still other comments suggested that the

taxpayer's intent should be irrelevant only in the case of aggregate/

entity determinations.

The IRS and Treasury continue to believe that an inquiry into the

taxpayer's intent generally is appropriate for an anti-abuse rule of

this nature. As noted above, the regulation applies only if both (1)

the taxpayer has a principal purpose to achieve substantial federal tax

reduction, and (2) that tax reduction is inconsistent with the intent

of subchapter K. Having a principal purpose to use a bona fide

partnership to conduct business activities in a manner that is more tax

efficient than any alternative means available does not establish that

the resulting tax reduction is inconsistent with the intent of

subchapter K. In those cases, the Commissioner cannot recast the

transaction under this regulation. A number of examples in the final

regulation demonstrate this point. Thus, the additional requirement in

the regulation that the tax results be inconsistent with the intent of

subchapter K sufficiently restricts the potential application of the

regulation, so that the requirement of a principal purpose of federal

tax reduction is appropriate.

By contrast, as noted above, the entity/aggregate determination

under paragraph (e) of the final regulation does not require the

taxpayer to have a principal purpose of substantially reducing taxes

through misapplication of that principle. In this context, the IRS and

Treasury agree with those [[Page 26]] comments that suggested that the

entity/aggregate principle is properly applied, as under current law,

solely on the basis of carrying out the purpose of the particular

provision to be applied.

3. Scope of Commissioner's Ability To Recast Transactions

The proposed regulation provides that if a transaction is

determined to be inconsistent with the intent of subchapter K and the

taxpayer acted with the requisite principal purpose of federal tax

reduction, the Commissioner can disregard the form of the transaction.

The proposed regulation describes several ways in which a transaction

could appropriately be recast. Some comments interpreted this language

as attempting to provide the Commissioner with unlimited discretionary

recharacterization powers, without guidance as to which

recharacterization applies to a particular transaction. To address

these concerns, paragraph (b) of the final regulation has been revised

to clarify that the Commissioner may recast transactions only as

appropriate to ensure that the tax treatment of each transaction is

consistent with the intent of subchapter K.

4. Effective Date of the Regulation

The regulation was proposed to be effective for all transactions

relating to a partnership occurring on or after May 12, 1994, the date

the proposed regulation was issued. Some comments requested that, in

order to address the regulation's effect on bona fide partnership

transactions, it apply prospectively only from the date the final

regulation is issued. In light of the significant revisions made in the

final regulation that clarify and narrow its potential scope and

application, the final regulation generally continues to be effective

as of May 12, 1994. However, to preclude the possibility that the

regulation could be interpreted to apply, for example, when a partner

who received an asset from a partnership before the effective date

disposes of the asset after the effective date, the final regulation

has been revised to clarify that it applies only to transactions

involving a partnership after the effective date. Also, in light of the

elimination of the proposed requirement that the taxpayer must have a

principal purpose to achieve substantial tax reduction in the case of

aggregate/entity determinations under paragraph (e), paragraphs (e) and

(f) are effective for all transactions involving a partnership on or

after December 29, 1994. No inference is intended as to the treatment

of partnership transactions prior to the applicable effective date of

the regulation.

5. Relationship of the Regulation to Established Legal Doctrines

Several comments questioned the relationship between the regulation

and established legal doctrines, such as the business purpose and

substance over form doctrines (including the step transaction and sham

transaction doctrines), which are designed to assure that the tax

consequences of transactions under the Code are governed by their

substance and that statutes and regulations are interpreted consistent

with their purposes.

Partnerships, like other business arrangements, are subject to

those doctrines. The application of those doctrines to partnership

transactions is particularly important in light of (i) the flexibility

of partnership arrangements, which can take myriad forms that are often

of substantial complexity, and (ii) the tax rules for partnerships,

which are also often complex and, in many cases, appear purely

mechanical. A literal application of these partnership tax rules in

contexts not contemplated by Congress has, in certain circumstances,

resulted in taxpayers claiming tax results that are contrary to those

doctrines.

The final regulation confirms certain fundamental principles that

must, in all cases, be satisfied in applying the provisions of

subchapter K to partnership transactions, to assure that those

provisions are not used to achieve inappropriate tax results. While the

fundamental principles reflected in the regulation are consistent with

the established legal doctrines, those doctrines will also continue to

apply.

So viewed, the uncertainty regarding the application of the

regulation reflects the uncertainty that already exists in properly

evaluating transactions under current law, including the proper

application of existing legal doctrines. As a result, the regulation

should not impose any undue administrative burdens on either taxpayers

or the IRS.

C. Other Comments

1. Suggested Alternatives to the Regulation

While some comments stated that it is appropriate to include a

general anti-abuse rule in the regulations to limit the misuse of the

provisions of subchapter K, others claimed that was not necessary.

These comments stated that the IRS and Treasury already have sufficient

means to challenge abusive partnership transactions and that existing

authority should be used to address specific transactions as they are

discovered. These comments suggested using the established legal

doctrines, amending the section 704(b) regulations, and increasing

partnership audits. These comments are discussed below.

In the past, the IRS and Treasury have attempted to address

partnership transactions on a case-by-case basis. However, as

recognized in those comments supporting a regulatory anti-abuse rule,

experience has demonstrated that the case-by-case approach has been

inadequate. A case-by-case approach arguably encourages non-economic,

tax-motivated behavior by inappropriately putting a premium on being

the first to engage in a transaction that would violate the principles

of this regulation. The IRS and Treasury believe that the final

regulation is a reasonable and effective way to reduce the number and

magnitude of these abusive transactions. Moreover, the IRS and Treasury

believe that proper application of the principles embodied in the

regulation will forestall additional complexity in the Code and the

regulations, by reducing the pressure for case-by-case legislative or

regulatory revisions to prevent inappropriate use of the provisions of

subchapter K.

Although the section 704(b) regulations are one example of the

provisions of subchapter K that may be used inappropriately to reach

results that are inconsistent with the intent of subchapter K, there

are many other provisions of subchapter K that are being

inappropriately applied to partnership transactions in a manner

inconsistent with the intent of subchapter K. Therefore, an amendment

to the section 704(b) regulations, by itself, is not sufficient.

Significant efforts are already underway to reduce the

inappropriate use of subchapter K through increased resource allocation

to partnership audits. This regulation is part of that focus on

partnership transactions, and should not be viewed as an alternative to

increased audits of partnerships. As part of this overall focus, a new

team under the Industry Specialization Program has been established

that will coordinate partnership audits and (together with the IRS

National Office) the application of this regulation to partnership

transactions. Thus, the IRS and Treasury believe that the regulation

complements the increased enforcement of partnership transactions

through enhanced audit activity.

2. Application by Revenue Agents

Many comments expressed concern that the regulation, if finalized

as proposed, will not be applied [[Page 27]] appropriately by Revenue

Agents. As stated in Announcement 94-87, 1994-27 I.R.B. 124, when an

issue that may be affected by the regulation is considered on

examination, any application of the regulation must be coordinated with

both the Issue Specialist on the Partnership Industry Specialization

Program team and the IRS National Office. The IRS and Treasury believe

that this coordination, together with the many clarifying changes made

in the final regulation, will result in fair and consistent treatment

of taxpayers in the application of the final regulation to partnership

transactions.

3. Special Analyses and the Secretary's Authority

Some comments questioned the determination that the notice of

proposed rulemaking was not a significant regulatory action as defined

in EO 12866, as well as the determination 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. Some comments also

questioned the Secretary's authority to issue the regulation as

proposed. The IRS and Treasury believe that the regulation complies

with all statutory and regulatory requirements relating to the issuance

of the notice of proposed rulemaking, and that it is clearly within the

Secretary's authority to issue the final regulation. The final

regulation clarifies that the authority for the regulation includes

sections 701 through 761.

4. De Minimis Rule

In the preamble accompanying the proposed regulation, the IRS and

Treasury solicited comments on the appropriateness of a safe harbor or

de minimis rule. Some comments responded that a de minimis rule would

be appropriate, and suggested delineating the rule on the basis of the

number of partners, the value of the partnership assets, or the amount

of the reduction in the present value of the partners' aggregate

federal tax liability resulting from the transaction.

The requirement in the regulation that the present value of the

partners' aggregate federal tax reduction must be substantial assures

that the regulation will not be applied where the amounts involved are

not significant. In addition, the IRS and Treasury believe that the

clarifications made in the final regulation provide sufficient

safeguards for bona fide joint business arrangements involving

partnerships. For example, the exception from the proper reflection of

income standard set forth in paragraph (a)(3) for transactions that are

clearly contemplated by a particular provision of subchapter K provides

appropriate safeguards for these business arrangements. Finally, the

final regulation explicitly recognizes the application of specific

statutory and regulatory de minimis rules in subchapter K. In light of

these safeguards, the IRS and Treasury believe no additional specific

safe harbor rules are needed.

Special Analyses

It has been determined that this Treasury decision 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,

the notice of proposed rulemaking was submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on its

impact on small business. Comments were submitted and are addressed in

the Supplementary Information section of this document.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.701-2 also issued under 26 U.S.C. 701 through 761 * *

Par. 2. Section 1.701-2 is added under the heading ``Determination

of Tax Liability'' to read as follows:

Sec. 1.701-2 Anti-abuse rule.

(a) Intent of subchapter K. Subchapter K is intended to permit

taxpayers to conduct joint business (including investment) activities

through a flexible economic arrangement without incurring an entity-

level tax. Implicit in the intent of subchapter K are the following

requirements--

(1) The partnership must be bona fide and each partnership

transaction or series of related transactions (individually or

collectively, the transaction) must be entered into for a substantial

business purpose.

(2) The form of each partnership transaction must be respected

under substance over form principles.

(3) Except as otherwise provided in this paragraph (a)(3), the tax

consequences under subchapter K to each partner of partnership

operations and of transactions between the partner and the partnership

must accurately reflect the partners' economic agreement and clearly

reflect the partner's income (collectively, proper reflection of

income). However, certain provisions of subchapter K and the

regulations thereunder were adopted to promote administrative

convenience and other policy objectives, with the recognition that the

application of those provisions to a transaction could, in some

circumstances, produce tax results that do not properly reflect income.

Thus, the proper reflection of income requirement of this paragraph

(a)(3) is treated as satisfied with respect to a transaction that

satisfies paragraphs (a)(1) and (2) of this section to the extent that

the application of such a provision to the transaction and the ultimate

tax results, taking into account all the relevant facts and

circumstances, are clearly contemplated by that provision. See, for

example, paragraph (d) Example 8 of this section (relating to the

value-equals-basis rule in Sec. 1.704-1(b)(2)(iii)(c)), paragraph (d)

Example 11 of this section (relating to the election under section 754

to adjust basis in partnership property), and paragraph (d) Examples 12

and 13 of this section (relating to the basis in property distributed

by a partnership under section 732). See also, for example,

Secs. 1.704-3(e)(1) and 1.752-2(e)(4) (providing certain de minimis

exceptions).

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

K and the regulations thereunder must be applied in a manner that is

consistent with the intent of subchapter K as set forth in paragraph

(a) of this section (intent of subchapter K). Accordingly, if a

partnership is formed or availed of in connection with a transaction a

principal purpose of which is to reduce substantially 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

recast the transaction for federal tax purposes, as appropriate to

achieve tax results that are consistent with the intent of subchapter

K, in light of the applicable statutory and regulatory provisions and

the pertinent facts and circumstances. Thus, even [[Page 28]] though

the transaction may fall within the literal words of a particular

statutory or regulatory provision, the Commissioner can determine,

based on the particular facts and circumstances, that to achieve tax

results that are consistent with the intent of subchapter K--

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

part, and the partnership's assets and activities should be considered,

in whole or in part, to be owned and conducted, respectively, by one or

more of its purported partners;

(2) One or more of the purported partners of the partnership should

not be treated as a partner;

(3) 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;

(4) The partnership's items of income, gain, loss, deduction, or

credit should be reallocated; or

(5) The claimed tax treatment should otherwise be adjusted or

modified.

partnership was formed or availed of with a principal purpose to reduce

substantially the present value of the partners' aggregate federal tax

liability in a manner inconsistent with the intent of subchapter K is

determined based on all of the facts and circumstances, including a

comparison of the purported business purpose for a transaction and the

claimed tax benefits resulting from the transaction. The factors set

forth below may be indicative, but do not necessarily establish, that a

partnership was used in such a manner. These factors are illustrative

only, and therefore may not be the only factors taken into account in

making the determination under this section. Moreover, the weight given

to any factor (whether specified in this paragraph or otherwise)

depends on all the facts and circumstances. The presence or absence of

any factor described in this paragraph does not create a presumption

that a partnership was (or was not) used in such a manner. Factors

include:

(1) The present value of the partners' aggregate federal tax

liability is substantially less than had the partners owned the

partnership's assets and conducted the partnership's activities

directly;

(2) The present value of the partners' aggregate federal tax

liability is substantially less than would be the case if purportedly

separate transactions that are designed to achieve a particular end

result are integrated and treated as steps in a single transaction. For

example, this analysis may indicate that it was contemplated that a

partner who was necessary to achieve the intended tax results and whose

interest in the partnership was liquidated or disposed of (in whole or

in part) would be a partner only temporarily in order to provide the

claimed tax benefits to the remaining partners;

(3) One or more partners who are necessary to achieve the claimed

tax results either have a nominal interest in the partnership, are

substantially protected from any risk of loss from the partnership's

activities (through distribution preferences, indemnity or loss

guaranty agreements, or other arrangements), or have little or no

participation in the profits from the partnership's activities other

than a preferred return that is in the nature of a payment for the use

of capital;

(4) Substantially all of the partners (measured by number or

interests in the partnership) are related (directly or indirectly) to

one another;

(5) Partnership items are allocated in compliance with the literal

language of Secs. 1.704-1 and 1.704-2 but with results that are

inconsistent with the purpose of section 704(b) and those regulations.

In this regard, particular scrutiny will be paid to partnerships in

which income or gain is specially allocated to one or more partners

that may be legally or effectively exempt from federal taxation (for

example, a foreign person, an exempt organization, an insolvent

taxpayer, or a taxpayer with unused federal tax attributes such as net

operating losses, capital losses, or foreign tax credits);

(6) The benefits and burdens of ownership of property nominally

contributed to the partnership are in substantial part retained

(directly or indirectly) by the contributing partner (or a related

party); or

(7) The benefits and burdens of ownership of partnership property

are in substantial part shifted (directly or indirectly) to the

distributee partner before or after the property is actually

distributed to the distributee partner (or a related party).

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

paragraphs (a), (b), and (c) of this section. The examples set forth

below do not delineate the boundaries of either permissible or

impermissible types of transactions. Further, the addition of any facts

or circumstances that are not specifically set forth in an example (or

the deletion of any facts or circumstances) may alter the outcome of

the transaction described in the example. Unless otherwise indicated,

parties to the transactions are not related to one another.

Example 1. Choice of entity; avoidance of entity-level tax; use

of partnership consistent with the intent of subchapter K. (i) A and

B form limited partnership PRS to conduct a bona fide business. A,

the corporate general partner, has a 1% partnership interest. B, the

individual limited partner, has a 99% interest. PRS is properly

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

and B chose limited partnership form as a means to provide B with

limited liability without subjecting the income from the business

operations to an entity-level tax.

(ii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. Although B has retained, indirectly, substantially all of

the benefits and burdens of ownership of the money or property B

contributed to PRS (see paragraph (c)(6) of this section), the

decision to organize and conduct business through PRS under these

circumstances is consistent with this intent. In addition, on these

facts, the requirements of paragraphs (a)(1), (2), and (3) of this

section have been satisfied. The Commissioner therefore cannot

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

Example 2. Choice of entity; avoidance of subchapter S

shareholder requirements; use of partnership consistent with the

intent of subchapter K. (i) A and B form partnership PRS to conduct

a bona fide business. A is a corporation that has elected to be

treated as an S corporation under subchapter S. B is a nonresident

alien. PRS is properly classified as a partnership under

Secs. 301.7701-2 and 301.7701-3. Because section 1361(b) prohibits B

from being a shareholder in A, A and B chose partnership form,

rather than admit B as a shareholder in A, as a means to retain the

benefits of subchapter S treatment for A and its shareholders.

(ii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. The decision to organize and conduct business through PRS

is consistent with this intent. In addition, on these facts, the

requirements of paragraphs (a)(1), (2), and (3) of this section have

been satisfied. Although it may be argued that the form of the

partnership transaction should not be respected because it does not

reflect its substance (inasmuch as application of the substance over

form doctrine arguably could result in B being treated as a

shareholder of A, thereby invalidating A's subchapter S election),

the facts indicate otherwise. The shareholders of A are subject to

tax on their pro rata shares of A's income (see section 1361 et

seq.), and B is subject to tax on B's distributive share of

partnership income (see sections 871 and 875). Thus, the form in

which this arrangement is cast accurately reflects its substance as

a separate partnership and S corporation. The Commissioner therefore

cannot invoke paragraph (b) of this section to recast the

transaction.

Example 3. Choice of entity; avoidance of more restrictive

foreign tax credit limitation; [[Page 29]] use of partnership

consistent with the intent of subchapter K. (i) X, a domestic

corporation, and Y, a foreign corporation, form partnership PRS

under the laws of foreign Country A to conduct a bona fide joint

business. X and Y each owns a 50% interest in PRS. PRS is properly

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

PRS pays income taxes to Country A. X and Y chose partnership form

to enable X to qualify for a direct foreign tax credit under section

901, with look-through treatment under Sec. 1.904-5(h)(1).

Conversely, if PRS were a foreign corporation for U.S. tax purposes,

X would be entitled only to indirect foreign tax credits under

section 902 with respect to dividend distributions from PRS. The

look-through rules, however, would not apply, and pursuant to

section 904(d)(1)(E) and Sec. 1.904-4(g), the dividends and

associated taxes would be subject to a separate foreign tax credit

limitation for dividends from PRS, a noncontrolled section 902

corporation.

(ii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. The decision to organize and conduct business through PRS

in order to take advantage of the look-through rules for foreign tax

credit purposes, thereby maximizing X's use of its proper share of

foreign taxes paid by PRS, is consistent with this intent. In

addition, on these facts, the requirements of paragraphs (a)(1),

(2), and (3) of this section have been satisfied. The Commissioner

therefore cannot invoke paragraph (b) of this section to recast the

transaction.

Example 4. Choice of entity; avoidance of gain recognition under

sections 351(e) and 357(c); use of partnership consistent with the

intent of subchapter K. (i) X, ABC, and DEF form limited partnership

PRS to conduct a bona fide real estate management business. PRS is

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

301.7701-3. X, the general partner, is a newly formed corporation

that elects to be treated as a real estate investment trust as

defined in section 856. X offers its stock to the public and

contributes substantially all of the proceeds from the public

offering to PRS. ABC and DEF, the limited partners, are existing

partnerships with substantial real estate holdings. ABC and DEF

contribute all of their real property assets to PRS, subject to

liabilities that exceed their respective aggregate bases in the real

property contributed, and terminate under section 708(b)(1)(A). In

addition, some of the former partners of ABC and DEF each have the

right, beginning two years after the formation of PRS, to require

the redemption of their limited partnership interests in PRS in

exchange for cash or X stock (at X's option) equal to the fair

market value of their respective interests in PRS at the time of the

redemption. These partners are not compelled, as a legal or

practical matter, to exercise their exchange rights at any time. X,

ABC, and DEF chose to form a partnership rather than have ABC and

DEF invest directly in X to allow ABC and DEF to avoid recognition

of gain under sections 351(e) and 357(c). Because PRS would not be

treated as an investment company within the meaning of section

351(e) if PRS were incorporated (so long as it did not elect under

section 856), section 721(a) applies to the contribution of the real

property to PRS. See section 721(b).

(ii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. The decision to organize and conduct business through PRS,

thereby avoiding the tax consequences that would have resulted from

contributing the existing partnerships' real estate assets to X (by

applying the rules of sections 721, 731, and 752 in lieu of the

rules of sections 351(e) and 357(c)), is consistent with this

intent. In addition, on these facts, the requirements of paragraphs

(a)(1), (2), and (3) of this section have been satisfied. Although

it may be argued that the form of the transaction should not be

respected because it does not reflect its substance (inasmuch as the

present value of the partners' aggregate federal tax liability is

substantially less than would be the case if the transaction were

integrated and treated as a contribution of the encumbered assets by

ABC and DEF directly to X, see paragraph (c)(2) of this section),

the facts indicate otherwise. For example, the right of some of the

former ABC and DEF partners after two years to exchange their PRS

interests for cash or X stock (at X's option) equal to the fair

market value of their PRS interest at that time would not require

that right to be considered as exercised prior to its actual

exercise. Moreover, X may make other real estate investments and

other business decisions, including the decision to raise additional

capital for those purposes. Thus, although it may be likely that

some or all of the partners with the right to do so will, at some

point, exercise their exchange rights, and thereby receive either

cash or X stock, the form of the transaction as a separate

partnership and real estate investment trust is respected under

substance over form principles (see paragraph (a)(2) of this

section). The Commissioner therefore cannot invoke paragraph (b) of

this section to recast the transaction.

Example 5. Family partnership to conduct joint business

activities; valuation discount; use of partnership consistent with

the intent of subchapter K. (i) H and W, husband and wife, form

limited partnership PRS by contributing their interests in actively

managed, income-producing real property that PRS will own and

operate. H holds a general partnership interest, and W holds a

limited partnership interest. At a later date, W makes a gift of a

portion of her limited partnership interest to each of H and W's two

children, S and D. Appropriate discounts, consistent with the

taxpayers' treatment of the arrangement as a partnership, were

applied in determining the value of W's gifts to the children.

(ii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. Although PRS is owned entirely by related parties (see

paragraph (c)(4) of this section), the decision to organize and

conduct business through PRS under these circumstances is consistent

with this intent. In addition, on these facts, the requirements of

paragraphs (a)(1), (2), and (3) of this section have been satisfied.

Therefore, absent other facts (such as the creation of the

partnership immediately before the gifts by W), the Commissioner

cannot invoke paragraph (b) of this section to recast the

transaction. But see sections 2701 through 2704 for special

valuation rules applicable to family arrangements for estate and

gift tax purposes. See also sections 2036 through 2039.

(iii) The special valuation rules provided under chapter 14 of

the Code, in particular section 2701, prescribe certain special

rules in valuing gifts of family controlled partnership interests.

These special rules clearly contemplate that a bona fide partnership

like PRS be treated as an entity and not as an aggregate of its

partners for that purpose. Accordingly, under paragraph (e) of this

section, the Commissioner cannot treat PRS as an aggregate of its

partners for purposes of valuing the gifts from W to S and D.

Example 6. Family partnership not engaged in bona fide joint

business activities; valuation discount; use of partnership not

consistent with the intent of subchapter K. (i) H and W, husband and

wife, form limited partnership PRS and contribute to it their

respective interests in their vacation home. H holds a general

partnership interest, and W holds a limited partnership interest. At

a later date, W makes a gift of a portion of her limited partnership

interest to each of H and W's two children, S and D. Discounts,

consistent with the taxpayers' treatment of the arrangement as a

partnership, were applied in determining the value of W's gifts to

the children.

(ii) PRS is not bona fide and there is no substantial business

purpose for the purported activities of PRS. In addition, by using a

partnership (if respected), H and W's aggregate federal tax

liability would be substantially less than had they owned the

partnership's assets directly (see paragraph (c)(1) of this

section). On these facts, PRS has been formed and availed of with a

principal purpose to reduce H's and W's aggregate federal tax

liability in a manner that is inconsistent with the intent of

subchapter K. Therefore (in addition to possibly challenging the

transaction under applicable judicial principles, such as the

substance over form doctrine, see paragraph (h) of this section),

the Commissioner can recast the transaction as appropriate under

paragraph (b) of this section.

Example 7. Special allocations; dividends received deductions;

use of partnership consistent with the intent of subchapter K. (i)

Corporations X and Y contribute equal amounts to PRS, a bona fide

partnership formed to make joint investments. PRS pays $100 for a

share of common stock of Z, an unrelated corporation, which has

historically paid an annual dividend of $6. PRS specially allocates

the dividend income on the Z stock to X to the extent of the London

Inter-Bank Offered Rate (LIBOR) on the record date, applied to X's

contribution of $50, and allocates the remainder of the dividend

[[Page 30]] income to Y. All other items of partnership income and

loss are allocated equally between X and Y. The allocations under

the partnership agreement have substantial economic effect within

the meaning of Sec. 1.704-1(b)(2). In addition to avoiding an

entity-level tax, a principal purpose for the formation of the

partnership was to invest in the Z common stock and to allocate the

dividend income from the stock to provide X with a floating-rate

return based on LIBOR, while permitting X and Y to claim the

dividends received deduction under section 243 on the dividends

allocated to each of them.

(ii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. The decision to organize and conduct business through PRS

is consistent with this intent. In addition, on these facts, the

requirements of paragraphs (a)(1), (2), and (3) of this section have

been satisfied. Section 704(b) and Sec. 1.704-1(b)(2) permit income

realized by the partnership to be allocated validly to the partners

separate from the partners' respective ownership of the capital to

which the allocations relate, provided that the allocations satisfy

both the literal requirements of the statute and regulations and the

purpose of those provisions (see paragraph (c)(5) of this section).

Section 704(e)(2) is not applicable to the facts of this example

(otherwise, the allocations would be required to be proportionate to

the partners' ownership of contributed capital). The Commissioner

therefore cannot invoke paragraph (b) of this section to recast the

transaction.

Example 8. Special allocations; nonrecourse financing; low-

income housing credit; use of partnership consistent with the intent

of subchapter K. (i) A and B, high-bracket taxpayers, and X, a

corporation with net operating loss carryforwards, form general

partnership PRS to own and operate a building that qualifies for the

low-income housing credit provided by section 42. The project is

financed with both cash contributions from the partners and

nonrecourse indebtedness. The partnership agreement provides for

special allocations of income and deductions, including the

allocation of all depreciation deductions attributable to the

building to A and B equally in a manner that is reasonably

consistent with allocations that have substantial economic effect of

some other significant partnership item attributable to the

building. The section 42 credits are allocated to A and B in

accordance with the allocation of depreciation deductions. PRS's

allocations comply with all applicable regulations, including the

requirements of Secs. 1.704-1(b)(2)(ii) (pertaining to economic

effect) and 1.704-2(e) (requirements for allocations of nonrecourse

deductions). The nonrecourse indebtedness is validly allocated to

the partners under the rules of Sec. 1.752-3, thereby increasing the

basis of the partners' respective partnership interests. The basis

increase created by the nonrecourse indebtedness enables A and B 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 and to apply the

credits against their tax liability.

(ii) At a time when the depreciation deductions attributable to

the building are not treated as nonrecourse deductions under

Sec. 1.704-2(c) (because there is no net increase in partnership

minimum gain during the year), the special allocation of

depreciation deductions to A and B has substantial economic effect

because of the value-equals-basis safe harbor contained in

Sec. 1.704-1(b)(2)(iii)(c) and the fact that A and B would bear the

economic burden of any decline in the value of the building (to the

extent of the partnership's investment in the building),

notwithstanding that A and B believe it is unlikely that the

building will decline in value (and, accordingly, they anticipate

significant timing benefits through the special allocation).

Moreover, in later years, when the depreciation deductions

attributable to the building are treated as nonrecourse deductions

under Sec. 1.704-2(c), the special allocation of depreciation

deductions to A and B is considered to be consistent with the

partners' interests in the partnership under Sec. 1.704-2(e).

(iii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. The decision to organize and conduct business through PRS

is consistent with this intent. In addition, on these facts, the

requirements of paragraphs (a) (1), (2), and (3) of this section

have been satisfied. Section 704(b), Sec. 1.704-1(b)(2), and

Sec. 1.704-2(e) allow partnership items of income, gain, loss,

deduction, and credit to be allocated validly to the partners

separate from the partners' respective ownership of the capital to

which the allocations relate, provided that the allocations satisfy

both the literal requirements of the statute and regulations and the

purpose of those provisions (see paragraph (c)(5) of this section).

Moreover, the application of the value-equals-basis safe harbor and

the provisions of Sec. 1.704-2(e) with respect to the allocations to

A and B, and the tax results of the application of those provisions,

taking into account all the facts and circumstances, are clearly

contemplated. Accordingly, even if the allocations would not

otherwise be considered to satisfy the proper reflection of income

standard in paragraph (a)(3) of this section, that requirement will

be treated as satisfied under these facts. Thus, even though the

partners' aggregate federal tax liability may be substantially less

than had the partners owned the partnership's assets directly (due

to X's inability to use its allocable share of the partnership's

losses and credits) (see paragraph (c)(1) of this section), the

transaction is not inconsistent with the intent of subchapter K. The

Commissioner therefore cannot invoke paragraph (b) of this section

to recast the transaction.

Example 9. Partner with nominal interest; temporary partner; use

of partnership not consistent with the intent of subchapter K. (i)

Pursuant to a plan a principal purpose of which is to generate

artificial losses and thereby shelter from federal taxation a

substantial amount of income, X (a foreign corporation), Y (a

domestic corporation), and Z (a promoter) form partnership PRS by

contributing $9,000, $990, and $10, respectively, for proportionate

interests (90.0%, 9.9%, and 0.1%, respectively) in the capital and

profits of PRS. PRS purchases offshore equipment for $10,000 and

validly leases the equipment offshore for a term representing most

of its projected useful life. Shortly thereafter, PRS sells its

rights to receive income under the lease to a third party for

$9,000, and allocates the resulting $9,000 of income $8,100 to X,

$891 to Y, and $9 to Z. PRS thereafter makes a distribution of

$9,000 to X in complete liquidation of its interest. Under

Sec. 1.704-1(b)(2)(iv)(f), PRS restates the partners' capital

accounts immediately before making the liquidating distribution to X

to reflect its assets consisting of the offshore equipment worth

$1,000 and $9,000 in cash. Thus, because the capital accounts

immediately before the distribution reflect assets of $19,000 (that

is, the initial capital contributions of $10,000 plus the $9,000 of

income realized from the sale of the lease), PRS allocates a $9,000

book loss among the partners (for capital account purposes only),

resulting in restated capital accounts for X, Y, and Z of $9,000,

$990, and $10, respectively. Thereafter, PRS purchases real property

by borrowing the $8,000 purchase price on a recourse basis, which

increases Y's and Z's bases in their respective partnership

interests from $1,881 and $19, to $9,801 and $99, respectively

(reflecting Y's and Z's adjusted interests in the partnership of 99%

and 1%, respectively). PRS subsequently sells the offshore

equipment, subject to the lease, for $1,000 and allocates the $9,000

tax loss $8,910 to Y and $90 to Z. Y's and Z's bases in their

partnership interests are therefore reduced to $891 and $9,

respectively.

(ii) On these facts, any purported business purpose for the

transaction is insignificant in comparison to the tax benefits that

would result if the transaction were respected for federal tax

purposes (see paragraph (c) of this section). Accordingly, the

transaction lacks a substantial business purpose (see paragraph

(a)(1) of this section). In addition, factors (1), (2), (3), and (5)

of paragraph (c) of this section indicate that PRS was used with a

principal purpose to reduce substantially the partners' tax

liability in a manner inconsistent with the intent of subchapter K.

On these facts, PRS is not bona fide (see paragraph (a)(1) of this

section), and the transaction is not respected under applicable

substance over form principles (see paragraph (a)(2) of this

section) and does not properly reflect the income of Y (see

paragraph (a)(3) of this section). Thus, PRS has been formed and

availed of with a principal purpose of reducing substantially the

present value of the partners' aggregate federal tax liability in a

manner inconsistent with the intent of subchapter K. Therefore (in

addition to possibly challenging the transaction under judicial

principles or the validity of the allocations under Sec. 1.704-

1(b)(2) (see paragraph (h) of this section)), the Commissioner can

recast the transaction as appropriate under paragraph (b) of this

section.

[[Page 31]]

Example 10. Plan to duplicate losses through absence of section

754 election; use of partnership not consistent with the intent of

subchapter K. (i) A owns land with a basis of $100 and a fair market

value of $60. A would like to sell the land to B. A and B devise a

plan a principal purpose of which is to permit the duplication, for

a substantial period of time, of the tax benefit of A's built-in

loss in the land. To effect this plan, A, C (A's brother), and W

(C's wife) form partnership PRS, to which A contributes the land,

and C and W each contribute $30. All partnership items are shared in

proportion to the partners' respective contributions to PRS. PRS

invests the cash in an investment asset (that is not a marketable

security within the meaning of section 731(c)). PRS also leases the

land to B under a three-year lease pursuant to which B has the

option to purchase the land from PRS upon the expiration of the

lease for an amount equal to its fair market value at that time. All

lease proceeds received are immediately distributed to the partners.

In year 3, at a time when the values of the partnership's assets

have not materially changed, PRS agrees with A to liquidate A's

interest in exchange for the investment asset held by PRS. Under

section 732(b), A's basis in the asset distributed equals $100, A's

basis in A's partnership interest immediately before the

distribution. Shortly thereafter, A sells the investment asset to X,

an unrelated party, recognizing a $40 loss.

(ii) PRS does not make an election under section 754.

Accordingly, PRS's basis in the land contributed by A remains $100.

At the end of year 3, pursuant to the lease option, PRS sells the

land to B for $60 (its fair market value). Thus, PRS recognizes a

$40 loss on the sale, which is allocated equally between C and W.

C's and W's bases in their partnership interests are reduced to $10

each pursuant to section 705. Their respective interests are worth

$30 each. Thus, upon liquidation of PRS (or their interests

therein), each of C and W will recognize $20 of gain. However, PRS's

continued existence defers recognition of that gain indefinitely.

Thus, if this arrangement is respected, C and W duplicate for their

benefit A's built-in loss in the land prior to its contribution to

PRS.

(iii) On these facts, any purported business purpose for the

transaction is insignificant in comparison to the tax benefits that

would result if the transaction were respected for federal tax

purposes (see paragraph (c) of this section). Accordingly, the

transaction lacks a substantial business purpose (see paragraph

(a)(1) of this section). In addition, factors (1), (2), and (4) of

paragraph (c) of this section indicate that PRS was used with a

principal purpose to reduce substantially the partners' tax

liability in a manner inconsistent with the intent of subchapter K.

On these facts, PRS is not bona fide (see paragraph (a)(1) of this

section), and the transaction is not respected under applicable

substance over form principles (see paragraph (a)(2) of this

section). Further, the tax consequences to the partners do not

properly reflect the partners' income; and Congress did not

contemplate application of section 754 to partnerships such as PRS,

which was formed for a principal purpose of producing a double tax

benefit from a single economic loss (see paragraph (a)(3) of this

section). Thus, PRS has been formed and availed of with a principal

purpose of reducing substantially the present value of the partners'

aggregate federal tax liability in a manner inconsistent with the

intent of subchapter K. Therefore (in addition to possibly

challenging the transaction under judicial principles or other

statutory authorities, such as the substance over form doctrine or

the disguised sale rules under section 707 (see paragraph (h) of

this section)), the Commissioner can recast the transaction as

appropriate under paragraph (b) of this section.

Example 11. Absence of section 754 election; use of partnership

consistent with the intent of subchapter K. (i) PRS is a bona fide

partnership formed to engage in investment activities with

contributions of cash from each partner. Several years after joining

PRS, A, a partner with a capital account balance and basis in its

partnership interest of $100, wishes to withdraw from PRS. The

partnership agreement entitles A to receive the balance of A's

capital account in cash or securities owned by PRS at the time of

withdrawal, as mutually agreed to by A and the managing general

partner, P. P and A agree to distribute to A $100 worth of non-

marketable securities (see section 731(c)) in which PRS has an

aggregate basis of $20. Upon distribution, A's aggregate basis in

the securities is $100 under section 732(b). PRS does not make an

election to adjust the basis in its remaining assets under section

754. Thus, PRS's basis in its remaining assets is unaffected by the

distribution. In contrast, if a section 754 election had been in

effect for the year of the distribution, under these facts section

734(b) would have required PRS to adjust the basis in its remaining

assets downward by the amount of the untaxed appreciation in the

distributed property, thus reflecting that gain in PRS's retained

assets. In selecting the assets to be distributed, A and P had a

principal purpose to take advantage of the facts that (i) A's basis

in the securities will be determined by reference to A's basis in

its partnership interest under section 732(b), and (ii) because PRS

will not make an election under section 754, the remaining partners

of PRS will likely enjoy a federal tax timing advantage (i.e., from

the $80 of additional basis in its assets that would have been

eliminated if the section 754 election had been made) that is

inconsistent with proper reflection of income under paragraph (a)(3)

of this section.

(ii) Subchapter K is intended to permit taxpayers to conduct

joint business activity through a flexible economic arrangement

without incurring an entity-level tax. See paragraph (a) of this

section. The decision to organize and conduct business through PRS

is consistent with this intent. In addition, on these facts, the

requirements of paragraphs (a)(1) and (2) of this section have been

satisfied. The validity of the tax treatment of this transaction is

therefore dependent upon whether the transaction satisfies (or is

treated as satisfying) the proper reflection of income standard

under paragraph (a)(3) of this section. A's basis in the distributed

securities is properly determined under section 732(b). The benefit

to the remaining partners is a result of PRS not having made an

election under section 754. Subchapter K is generally intended to

produce tax consequences that achieve proper reflection of income.

However, paragraph (a)(3) of this section provides that if the

application of a provision of subchapter K produces tax results that

do not properly reflect income, but application of that provision to

the transaction and the ultimate tax results, taking into account

all the relevant facts and circumstances, are clearly contemplated

by that provision (and the transaction satisfies the requirements of

paragraphs (a)(1) and (2) of this section), then the application of

that provision to the transaction will be treated as satisfying the

proper reflection of income standard.

(iii) In general, the adjustments that would be made if an

election under section 754 were in effect are necessary to minimize

distortions between the partners' bases in their partnership

interests and the partnership's basis in its assets following, for

example, a distribution to a partner. The electivity of section 754

is intended to provide administrative convenience for bona fide

partnerships that are engaged in transactions for a substantial

business purpose, by providing those partnerships the option of not

adjusting their bases in their remaining assets following a

distribution to a partner. Congress clearly recognized that if the

section 754 election were not made, basis distortions may result.

Taking into account all the facts and circumstances of the

transaction, the electivity of section 754 in the context of the

distribution from PRS to A, and the ultimate tax consequences that

follow from the failure to make the election with respect to the

transaction, are clearly contemplated by section 754. Thus, the tax

consequences of this transaction will be treated as satisfying the

proper reflection of income standard under paragraph (a)(3) of this

section. The Commissioner therefore cannot invoke paragraph (b) of

this section to recast the transaction.

Example 12. Basis adjustments under section 732; use of

partnership consistent with the intent of subchapter K. (i) A, B,

and C are partners in partnership PRS, which has for several years

been engaged in substantial bona fide business activities. For valid

business reasons, the partners agree that A's interest in PRS, which

has a value and basis of $100, will be liquidated with the following

assets of PRS: a nondepreciable asset with a value of $60 and a

basis to PRS of $40, and related equipment with two years of cost

recovery remaining and a value and basis to PRS of $40. Neither

asset is described in section 751 and the transaction is not

described in section 732(d). Under section 732 (b) and (c), A's $100

basis in A's partnership interest will be allocated between the

nondepreciable asset and the equipment received in the liquidating

distribution in proportion to PRS's bases in those assets, or $50 to

the nondepreciable asset and $50 to the equipment. Thus, A will have

a $10 built-in gain in the nondepreciable asset ($60 value less $50

basis) and a $10 built-in loss in the equipment ($50 basis less $40

value), which it expects to recover rapidly through cost recovery

deductions. In selecting the assets to [[Page 32]] be distributed to

A, the partners had a principal purpose to take advantage of the

fact that A's basis in the assets will be determined by reference to

A's basis in A's partnership interest, thus, in effect, shifting a

portion of A's basis from the nondepreciable asset to the equipment,

which in turn would allow A to recover that portion of its basis

more rapidly. This shift provides a federal tax timing advantage to

A, with no offsetting detriment to B or C.