Final partnership anti-abuse regulations.

The IRS has released final partnership anti-abuse regulations under Sec. 701 in an attempt to clarify Prop. Regs. Sec. 1.701-2. The final regulations are generally effective as of May 12, 1994 (when the proposed regulations were originally issued), although one provision is effective as of Dec. 29, 1994.

The wording of the final regulation will continue to create uncertainty for many partnership transactions. The anti-abuse rule in Regs. Sec. 1.701-2(b) states:

[I]f 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.

The IRS has further defined "the intent of subchapter K." Regs. Sec. 1.701-2(a) states that implicit in the intent of subchapter K are the following: (1) the partnership is bona fide and entered into for a substantial business purpose; (2) the form of each partnership transaction must be 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 accurately reflect the partners' economic agreement and clearly reflect the partner's income (with certain limited exceptions for p o visions adopted with administrative convenience or other policy objectives).

In describing the intent of subchapter K, the proposed regulation had provided that the provisions of subchapter K were not intended to permit taxpayers "to use the existence of the partnerships to avoid the purposes of other provisions of the Internal Revenue Code."

Although apparently intended to address aggregate entity issues, because of the confusion created by this clause, it was removed from the general anti-abuse rule; in its place, Regs. See. 1.701-2(e) was added to address inappropriate treatment of a partnership as an entity. Generally, Regs. Sec. 1.701-2(e) provides that in applying particular sections of the Code, the Service may look through a partnership and consider the partners to be directly engaged in a particular transaction. Regs. Sec. 1.701-2(e) provides examples treating a partnership as an aggregate of its partners for purposes of Secs. 163(e)(5) and 1059, and has a separate effective date of Dec. 29, 1994.

Regs. Sec. 1.701-2(c) provides that any determination of whether a partnership was formed or availed of with a principal purpose of substantially reducing the present value of the partners' aggregate tax liability in a manner inconsistent with subchapter K must be made on a facts and circumstances basis. Regs. Sec. 1.701-2(b) includes a list of several factors to be used in making that analysis.

If the IRS finds that a particular transaction or partnership violates the anti-abuse rule, it has considerable flexibility in recasting the transaction, including the ability to disregard the partnership and treat the partners as owning the assets directly, disregard a purported partner as a partner, adjust the methods of accounting to clearly reflect the partners' income and reallocate partnership items.

Regs. Sec. 1.701-2 originally included 16 examples, most describing fact patterns that will not run afoul of the partnership anti-abuse regulation. Ann. 95-8, in an attempt to clarify that the scope of the anti-abuse regulations is limited to income taxes, deleted Examples 5 and 6, which focused on transfer taxes. Examples that do illustrate situations in which the anti-abuse rule would be applied include the following: * Inclusion of a temporary partner and a nominal partner in a partnership, as part of a scheme to generate artificial losses (Example 9). * A plan to duplicate losses by contributing property to a partnership and failing to make a Sec. 754 election (Example 10). * A plan to distort basis allocations artificially by use of Sec. 732 basis adjustments (Example 13).