[Federal Register Volume 60, Number 1 (Tuesday, January 3, 1995)]
[Rules and Regulations]
[Pages 23-33]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-32331]



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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.
    (c) Facts and circumstances analysis; factors. Whether a 
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.
    (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. 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 the 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) A's basis in the assets distributed to it was determined 
under section 732 (b) and (c). The transaction does not properly 
reflect A's income due to the basis distortions caused by the 
distribution and the shifting of basis from a nondepreciable to a 
depreciable asset. However, the basis rules under section 732, which 
in some situations can produce tax results that are inconsistent 
with the proper reflection of income standard (see paragraph (a)(3) 
of this section), are intended to provide simplifying administrative 
rules for bona fide partnerships that are engaged in transactions 
with a substantial business purpose. Taking into account all the 
facts and circumstances of the transaction, the application of the 
basis rules under section 732 to the distribution from PRS to A, and 
the ultimate tax consequences of the application of that provision 
of subchapter K, are clearly contemplated. Thus, the application of 
section 732 to 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 13. Basis adjustments under section 732; plan or 
arrangement to distort basis allocations artificially; use of 
partnership not consistent with the intent of subchapter K. (i) 
Partnership PRS has for several years been engaged in the 
development and management of commercial real estate projects. X, an 
unrelated party, desires to acquire undeveloped land owned by PRS, 
which has a value of $95 and a basis of $5. X expects to hold the 
land indefinitely after its acquisition. Pursuant to a plan a 
principal purpose of which is to permit X to acquire and hold the 
land but nevertheless to recover for tax purposes a substantial 
portion of the purchase price for the land, X contributes $100 to 
PRS for an interest therein. Subsequently (at a time when the value 
of the partnership's assets have not materially changed), PRS 
distributes to X in liquidation of its interest in PRS the land and 
another asset with a value and basis to PRS of $5. The second asset 
is an insignificant part of the economic transaction but is 
important to achieve the desired tax results. Under section 732 (b) 
and (c), X's $100 basis in its partnership interest is allocated 
between the assets distributed to it in proportion to their bases to 
PRS, or $50 each. Thereafter, X plans to sell the second asset for 
its value of $5, recognizing a loss of $45. In this manner, X will, 
in effect, recover a substantial portion of the purchase price of 
the land almost immediately. In selecting the assets to be 
distributed to X, the partners had a principal purpose to take 
advantage of the fact that X's basis in the assets will be 
determined under section 732 (b) and (c), thus, in effect, shifting 
a portion of X's basis economically allocable to the land that X 
intends to retain to an inconsequential asset that X intends to 
dispose of quickly. This shift provides a federal tax timing 
advantage to X, with no offsetting detriment to any of PRS's other 
partners.
    (ii) Although section 732 recognizes that basis distortions can 
occur in certain situations, which may produce tax results that do 
not satisfy the proper reflection of income standard of paragraph 
(a)(3) of this section, the provision is intended only to provide 
ancillary, simplifying tax results for bona fide partnership 
transactions that are engaged in for substantial business purposes. 
Section 732 is not intended to serve as the basis for plans or 
arrangements in which inconsequential or immaterial assets are 
included in the distribution with a principal purpose of obtaining 
substantially favorable tax results by virtue of the statute's 
simplifying rules. The transaction does not properly reflect X's 
income due to the basis distortions caused by the distribution that 
result in shifting a significant portion of X's basis to this 
inconsequential asset. Moreover, the proper reflection of income 
standard contained in paragraph (a)(3) of this section is not 
treated as satisfied, because, taking into account all the facts and 
circumstances, the application of section 732 to this arrangement, 
and the ultimate tax consequences that would thereby result, were 
not clearly contemplated by that provision of subchapter K. In 
addition, by using a partnership (if respected), the partners' 
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 the taxpayers' 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 and statutory 
authorities, such as 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.

    (e) Abuse of entity treatment--(1) General rule. 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 
Internal Revenue Code or the regulations promulgated thereunder.
    (2) Clearly contemplated entity treatment. Paragraph (e)(1) of this 
section does not apply to the extent that--
    (i) A provision of the Internal Revenue Code or the regulations 
promulgated thereunder prescribes the treatment of a partnership as an 
entity, in whole or in part, and
    (ii) That treatment and the ultimate tax results, taking into 
account all the relevant facts and circumstances, are clearly 
contemplated by that provision.
    (f) Examples. The following examples illustrate the principles of 
paragraph (e) 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. See also paragraph (d) 
Example 5 (iii) of this section (also demonstrating the application of 
the principles of paragraph (e) of this section).

    Example 1. Aggregate treatment of partnership appropriate to 
carry out purpose of section 163(e)(5). (i) Corporations X and Y are 
partners in partnership PRS, which for several years has engaged in 
substantial bona fide business activities. As part of these business 
activities, PRS issues certain high yield discount obligations to an 
unrelated third party. Section 163(e)(5) defers (and in certain 
circumstances disallows) the interest deductions on this type of 
obligation if issued by a corporation. PRS, X, and Y take the 
position that, because PRS is a partnership and not a corporation, 
section 163(e)(5) is not applicable.
    (ii) Section 163(e)(5) does not prescribe the treatment of a 
partnership as an entity for purposes of that section. The purpose 
of section 163(e)(5) is to limit corporate-level interest deductions 
on certain obligations. The treatment of PRS as an entity could 
result in a partnership with corporate partners issuing those 
obligations and thereby circumventing the purpose of section 
[[Page 33]] 163(e)(5), because the corporate partner would deduct 
its distributive share of the interest on obligations that would 
have been deferred until paid or disallowed had the corporation 
issued its share of the obligation directly. Thus, under paragraph 
(e)(1) of this section, PRS is properly treated as an aggregate of 
its partners for purposes of applying section 163(e)(5) (regardless 
of whether any party had a tax avoidance purpose in having PRS issue 
the obligation). Each partner of PRS will therefore be treated as 
issuing its share of the obligations for purposes of determining the 
deductibility of its distributive share of any interest on the 
obligations. See also section 163(i)(5)(B).
    Example 2. Aggregate treatment of partnership appropriate to 
carry out purpose of section 1059. (i) Corporations X and Y are 
partners in partnership PRS, which for several years has engaged in 
substantial bona fide business activities. As part of these business 
activities, PRS purchases 50 shares of Corporation Z common stock. 
Six months later, Corporation Z announces an extraordinary dividend 
(within the meaning of section 1059). Section 1059(a) generally 
provides that if any corporation receives an extraordinary dividend 
with respect to any share of stock and the corporation has not held 
the stock for more than two years before the dividend announcement 
date, the basis in the stock held by the corporation is reduced by 
the nontaxed portion of the dividend. PRS, X, and Y take the 
position that section 1059(a) is not applicable because PRS is a 
partnership and not a corporation.
    (ii) Section 1059(a) does not prescribe the treatment of a 
partnership as an entity for purposes of that section. The purpose 
of section 1059(a) is to limit the benefits of the dividends 
received deduction with respect to extraordinary dividends. The 
treatment of PRS as an entity could result in corporate partners in 
the partnership receiving dividends through partnerships in 
circumvention of the intent of section 1059. Thus, under paragraph 
(e)(1) of this section, PRS is properly treated as an aggregate of 
its partners for purposes of applying section 1059 (regardless of 
whether any party had a tax avoidance purpose in acquiring the Z 
stock through PRS). Each partner of PRS will therefore be treated as 
owning its share of the stock. Accordingly, PRS must make 
appropriate adjustments to the basis of the corporation Z stock, and 
the partners must also make adjustments to the basis in their 
respective interests in PRS under section 705(a)(2)(B). See also 
section 1059(g)(1).
    Example 3. Prescribed entity treatment of partnership; 
determination of CFC status clearly contemplated. (i) X, a domestic 
corporation, and Y, a foreign corporation, intend to conduct a joint 
venture in foreign Country A. They form PRS, a bona fide domestic 
general partnership in which X owns a 40% interest and Y owns a 60% 
interest. PRS is properly classified as a partnership under 
Secs. 301.7701-2 and 301.7701-3. PRS holds 100% of the voting stock 
of Z, a Country A entity that is classified as an association 
taxable as a corporation for federal tax purposes under 
Sec. 301.7701-2. Z conducts its business operations in Country A. By 
investing in Z through a domestic partnership, X seeks to obtain the 
benefit of the look-through rules of section 904(d)(3) and, as a 
result, maximize its ability to claim credits for its proper share 
of Country A taxes expected to be incurred by Z.
    (ii) Pursuant to sections 957(c) and 7701(a)(30), PRS is a 
United States person. Therefore, because it owns 10% or more of the 
voting stock of Z, PRS satisfies the definition of a U.S. 
shareholder under section 951(b). Under section 957(a), Z is a 
controlled foreign corporation (CFC) because more than 50% of the 
voting power or value of its stock is owned by PRS. Consequently, 
under section 904(d)(3), X qualifies for look-through treatment in 
computing its credit for foreign taxes paid or accrued by Z. In 
contrast, if X and Y owned their interests in Z directly, Z would 
not be a CFC because only 40% of its stock would be owned by U.S. 
shareholders. X's credit for foreign taxes paid or accrued by Z in 
that case would be subject to a separate foreign tax credit 
limitation for dividends from Z, a noncontrolled section 902 
corporation. See section 904(d)(1)(E) and Sec. 1.904-4(g).
    (iii) Sections 957(c) and 7701(a)(30) prescribe the treatment of 
a domestic partnership as an entity for purposes of defining a U.S. 
shareholder, and thus, for purposes of determining whether a foreign 
corporation is a CFC. The CFC rules prevent the deferral by U.S. 
shareholders of U.S. taxation of certain earnings of the CFC and 
reduce disparities that otherwise might occur between the amount of 
income subject to a particular foreign tax credit limitation when a 
taxpayer earns income abroad directly rather than indirectly through 
a CFC. The application of the look-through rules for foreign tax 
credit purposes is appropriately tied to CFC status. See sections 
904(d)(2)(E) and 904(d)(3). This analysis confirms that Congress 
clearly contemplated that taxpayers could use a bona fide domestic 
partnership to subject themselves to the CFC regime, and the 
resulting application of the look-through rules of section 
904(d)(3). Accordingly, under paragraph (e) of this section, the 
Commissioner cannot treat PRS as an aggregate of its partners for 
purposes of determining X's foreign tax credit limitation.

    (g) Effective date. Paragraphs (a), (b), (c), and (d) of this 
section are effective for all transactions involving a partnership that 
occur on or after May 12, 1994. Paragraphs (e) and (f) of this section 
are effective for all transactions involving a partnership that occur 
on or after December 29, 1994.
    (h) Application of nonstatutory principles and other statutory 
authorities. The Commissioner can continue to assert and to rely upon 
applicable nonstatutory principles and other statutory and regulatory 
authorities to challenge transactions. This section does not limit the 
applicability of those principles and authorities.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: December 20, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-32331 Filed 12-29-94; 8:45 am]
BILLING CODE 4830-01-U