[Federal Register Volume 59, Number 94 (Tuesday, May 17, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11909]


[[Page Unknown]]

[Federal Register: May 17, 1994]


=======================================================================
-----------------------------------------------------------------------

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.

-----------------------------------------------------------------------

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