Anti-abuse regulation calls for showing "substantial" business purpose.

The "substantial business purpose" requirement of Regs. Sec. 1.701-2 has generated controversy and confusion in terms of its application. While the controversy may not soon abate, at least some of the confusion can be alleviated by drawing inferences from the regulation as a whole and by references to analogous authority.

The requirement that each partnership transaction or series of related transactions must be entered into for a substantial business purpose is imposed under Regs. Sec. 1.701-2 by virtue of its being "implicit in the intent of subchapter K." Regs. Sec. 1.701-2(a) sets forth three other "implicit" requirements: (1) the partnership must be bona fide, (2) the form of each partnership transaction must comport with its substance and (3) the tax consequences under subchapter K to each partner of partnership operations and of transactions between the partner and the partnership must reflect accurately the partners' economic agreement and clearly reflect the partner's income (collectively, the "proper reflection of income" requirement), except when the governing subchapter K principles allow and clearly contemplate a possibly different result. Regs. Sec. 1.701-2(b) uses the term "intent of subchapter K" to refer to these four requirements.

In light of this intent, Regs. Sec. 1.701-2(b) prescribes the following test for generally determining that the tax treatment of a transaction under subchapter K is abusive: (1) the partnership must be formed or availed of (2) with a principal purpose to reduce substantially the present value of the partners' aggregate Federal tax liability (3) in a manner inconsistent with the intent of subchapter K. The test is applied in light of all of the facts and circumstances, including a comparison of the purported business purpose and the tax benefits claimed in connection with the transaction.

Accordingly, the tax treatment of any transaction that is entered into by a bona fide partnership for a substantial business purpose and that passes muster under the substance and proper-reflection-of-income requirements cannot be recast by the IRS under Regs. Sec. 1.701-2, whether or not tax avoidance was a principal purpose for the transaction, since such treatment would not be inconsistent with the intent of subchapter K.

Regs. Sec. 1.701-2 does not provide a special definition of "substantial" for purposes of the regulation. Ordinarily, "substantial" means "real" or "more than de minimis" (see, e.g., Regs. Sec. 25.2703-1(c)(1)). For purposes of the anti-abuse regulation, both meanings are consistent with reported statements to date of Treasury and IRS officials. Because business purpose is viewed relative to claimed tax benefits under the regulation, it seems logical to conclude that the meaning "more than de minimis" was contemplated. In any event, the "substantial" standard represents a lower threshold than a "primary," "principal" or "a principal" standard.

The substantial business purpose requirement is viewed as controversial for at least two reasons. First, the "substantial" standard conflicts with traditional notions of the business purpose doctrine, which requires only that transactions be entered into for any business purpose other than obtaining tax benefits. The higher "substantial" standard may lead the Service and courts to substitute their own business judgment for the taxpayer's with respect to a transaction, an approach the courts generally seek to avoid. In limited situations in which the taxpayer's business purpose is considered "infinitesimally nominal" in comparison to the expected tax benefits, the weight of the business purpose may be considered under existing case law in determining whether a transaction should be respected for tax purposes (see Sheldon, 94 TC 738 (1990)); however, even that standard has generated some controversy.

Second, the new requirement complicates the determination by taxpayers, their advisers, the IRS and the courts of the proper tax treatment of partnership transactions when there are no controlling authorities directly on point. Of course, the application of any standard based on intent can be difficult, particularly when the intent must be measured. The value of a business purpose, unlike the amount of tax benefits involved, generally is subjective and may vary among entities even under similar circumstances.

The difficulty in predicating tax treatment in part on a comparison of business purpose and claimed tax benefits can be illustrated by the following example. Two partners who own all the interests in a partnership become embroiled in a dispute over partnership management. Consequently, the partners agree to a "divorce" and purposefully structure a liquidation of the partnership that substantially reduces their aggregate Federal tax liability. Since the business purpose underlying the liquidation is real, any recasting of this transaction by the Service so as to increase the partners' taxes would be unjustifiable under existing judicial doctrines, regardless of the magnitude of the tax benefits. Nonetheless, merely because of the subjective nature of analyzing intent, it is possible that under Regs. Sec. 1.701-2 the IRS might not deem the business purpose "substantial" vis-a-vis the claimed tax benefits.

In light of the pivotal role of "substantial business purpose" in applying Regs. Sec. 1.701-2, taxpayers face greater uncertainty with respect to partnership taxation. In response, practitioners should urge taxpayers to document fully the business purposes of all transactions governed by subchapter K.