On Your Mark Get Set - Go for it! The Anti-Abuse Regs.

This past week Tax Notes Today ran a story entitled: “IRS gives Agents Blanket Authority to Apply Partnership Anti-abuse Reg.” Stratton, 2007 TNT 51-5. It was a great article.

The article reported that there seven areas were the revenue agents have blanket authority to raise the anti-abuse provisions. These seven areas are:

    1. Use of a partnership to facilitate the sale of state tax credits. 
    2. Son-of-Boss Transaction. 
    3. Transaction described in Notice 2002-50. 
    4. Transaction described in Notice 2002-65. 
    5. Compensatory options sold that have Notice 2003-47 as a basis. 
    6. Transaction described in Notice 2004-31, i.e. deals involving foreign corporations dealing in the U.S. that create deductions where interest payments are limited under section 163(j). 
    7. Redemption Bogus Optional Basis shelters which are dependent on the partnership making a section 754 election.  

It is a nice short but informative article which is worth a read. However, it did raise a question. Why now? To answer that question it is worthwhile taking a quick review of the anti-abuse regulations.

Section 704(b) provides that a partner's distributive share of income, gain, loss, deduction, or credit is determined in accordance with the partner's interest in the partnership, if the allocation to a partner under the agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect. (Emphasis Added). See Treas. Reg. §1.704-1(b)(1); McKee, Nelson & Whitmire at ¶ 10.02[2]. Thus, the general underlying theme of the anti-abuse regulations is that the tax consequences under Sub-Chapter K to each partner of partnership operations and of the transactions between the partner and the partnership must accurately reflect the partners’ economic agreement, clearly reflect the partner’s income, or is clearly contemplated by the provision at issue. Implicit in the intent of Sub-Chapter 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. The tax consequences under Sub-Chapter 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). Treas. Reg. §1.701-2(a)(1)-(3).

To determine what constitutes an abusive situation, Treas. Reg. § 1.701-2(b) provides that 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 Sub-Chapter K, the Service can recast the transaction for federal tax purposes, as appropriate to achieve tax results that are consistent with the intent of Sub-Chapter K, in light of the applicable statutory and regulatory provisions and the pertinent facts and circumstances, even though a particular transaction may fall within the literal words of a particular statutory or regulatory provision under Sub-Chapter K. See McKee, Nelson & Whitmire at ¶ 10.02[2][b].

Treas. Reg. §1.701-2(c) provides that 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 Sub-Chapter K is determined and based upon 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 used to determine the use/role of the partnership 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 §§ 1.704-1 and 1.704-2 but, with results that are inconsistent with the purpose of § 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 (i.e., 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 related party).
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 related party).

See Example 7 of the regulations. Example 7 focuses on transactions that are “Tax Planned.” As stated in McKee, Nelson:

Transactions that are “tax planned” from the outset are vulnerable to attack, especially if the tax plan minimizes the economic risks and rewards to one or more partners. In contrast, transactions involving historic partnerships, partners, and partnership assets will generally be respected even if the transaction in question is highly tax charged. Although large tax benefits are not fatal per se, they weigh against a transaction and can be determinative in close cases.

Example 7 deals with a “rent strip” transaction. Example 7 concludes that the partnership is not bona fide, the transaction is not respected under applicable substance over form principles, and the transaction does not properly reflect the income of Y. The analysis in the example notes that four of the negative factors listed in Paragraph (c) are present: (Factor 1) a reduction in tax liability as compared to direct ownership of assets; (Factor 2) a reduction in tax liability as compared to integration into a single transaction; (Factor 3) a necessary partner has a nominal interest, is substantially protected from risk of loss, or has little or no participation in profits other than a preferred return that is in the nature of a payment for the use of capital; and (Factor 4) items are allocated in compliance with the literal language of the § 704 Regulations but with results that are inconsistent with the purposes thereof (Factor5). The example concludes that “any purported business purpose of 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).” Reading into the facts of the example, a very short period during which X participates in the partnership and the partnership owns the equipment, it may well be that “on these facts” there is no substantial business purpose for X's participation or for the partnership's ownership of the equipment. Read literally, however, the statements in the example suggest that even if there is a business purpose for the transaction, no matter how substantial, it is to be disregarded because the tax benefits from the transaction are so great. See McKee, Nelson & Whitmire at ¶ 10.02[2][b].


Note: Interestingly the IRS did not give its agents the blanket authority to raise the anti-abuse regs on these transactions. How does that song go – Things that make you go hmm.

Thus, the IRS could determine, based upon the particular facts and circumstances, that to achieve tax results that are consistent with the intent of Sub-Chapter 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 partners 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.

Under the anti-abuse regulations, the IRS will disregard the partnership and then disallow the losses generated by the partnerships. The only challenge that could be made is that the Anti-Abuse Regulations are invalid. Being that the IRS possesses a litany of a strong economic substance tests it is unlikely that the Court would even have to reach this issue.

However, it is the tests that have caused the IRS to trot out the anti-abuse regulations. That is the IRS does not have a test rather it wishes that the standard set forth in Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006) was the uniform standard in all of the circuits but it is not. Coltec allows the IRS to attack the transaction at issue even though the entire transaction may have “economic substance” Isn’t that what the anti-abuse regulations were trying to seek? Call it bringing back the night crawler or better yet call it Jurassic park. Bottom line is the IRS believes it can finally find a Court to approve the anti-abuse regs. I call it interesting.

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