[Federal Register Volume 59, Number 94 (Tuesday, May 17, 1994)]
[Unknown Section]
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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]
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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