[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
