Proposed partnership anti-abuse regulations.

On May 12, 1994, the Internal Revenue Service issued proposed regulations under section 701 of the Internal Revenue Code to prevent taxpayers from using the rules governing partnership entities to produce tax results that are either inconsistent with the intent of subchapter K or that differ from the underlying economic arrangements of the parties or to circumvent the intent of other Code provisions through transactions conducted through partnerships.

The proposed regulations (PS-27-94) were published in the Federal Register on May 17, 1994 (59 Fed. Reg. 25581), and in the Internal Revenue Bulletin (1994-23 I.R.B. 29).(1) A public hearing on the proposed regulations is scheduled for July 25, 1994. Tax Executives Institute is pleased to submit its comments on the proposed regulations. In summary, we believe that--

* The proposed regulations do not properly balance taxpayers' need for meaningful guidance with the tax administrator's desire to prevent abuses by over-formalistic transactions. Existing judicial anti-abuse doctrines already permit the tax administrator to combat abusive transactions.

* The proposed regulations should be withdrawn because (i) their principal effect may well be to inhibit legitimate rather than abusive transactions and (ii) they represent an ill-advised and unworkable attempt to exercise legislative power.

* In the event that a new subchapter K anti-abuse rule is to be promulgated, the effective date should be entirely and purely prospective in effect. The currently proposed rule, broadly construed, would produce inequitable results for taxpayers relying on pre-May 12, 1994 authority.

Background

Tax Executives Institute is the principal association of business tax executives in North America. The Institute's approximately 5,000 members represent nearly 3,000 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises, including partnerships. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to the subchapter K anti-abuse rule.

Overview

"[A]nyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes."

* Judge Learned Hand, Helvering v. Gregory

"[The partnership] provisions are not intended ... to permit taxpayers either to structure transactions using partnerships to achieve tax results that are inconsistent with the underlying economic arrangements of the parties or the substance of the transactions, or to use the existence of the partnerships to avoid the purposes of other provisions of the Code."

* Prop. Reg. [sections] 1.701-2(a)

Do the Right Thing.

* Spike Lee 

Aphorisms and proverbs are wonderful devices for imparting the wisdom of the ages. The moral of each is concise, generally universal, yet flexible enough to adapt to many situations. More important for purposes of authority figures, aphorisms are inarguable. When evaluating human behavior or providing rules of thumb to guide judgment, however, an aphorism that encapsulates what should or should not be done is clear, if at all, only in hindsight.

And so it is with the Treasury and IRS's proposed prophylactic subchapter K anti-abuse rule.(2) concerned about the use of the partnership rules to "game" the tax system, the government has promulgated Prop. Reg. [sections] 1.701-2 to forestall abuse either of the partnership provisions themselves or of other Code sections through transactions conducted by or through partnerships. Although the goal of ending abuses of the tax system is laudable, promulgating amorphous maxims is, in our view, no way to run an administrable tax system. One person's "abuse" may well be another's "creative tax planning." Judge Hand's unassailable statement in Helvering v. Gregory concerning the proper role of tax planning must, in specific cases, be weighed against the tax collector's interest in preventing circumvention of prescribed tax rules. In their current form, the proposed regulations inadequately balance these interests.

Prop. Reg. [sections] 1.701-2(b) states--

The provisions of subchapter K and the regulations thereunder must be applied in a manner consistent with their intent.... Accordingly, if a partnership is formed or availed of in connection with a transaction or series of related transactions (individually or collectively, the transaction) with a principal purpose of substantially reducting 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 disregard the form of the transaction.

Thus, rather than describing the nature of the offending transactions the Treasury and IRS have promulgated a general anti-abuse rule. Indeed, the Treasury and IRS appear to be attempting to limit debate on the proper scope of tax planning--or precisely defining what is or is not an "abuse"--by invoking the shibboleth of "anti-abuse" rules. By providing little or no useful information on the "bad" transactions to be avoided, however, the Treasury and IRS prevent taxpayers from knowing, before the fact, what the proper tax planning standard is to be. As a result, the proposed subchapter K anti-abuse regulations seemingly can be reduced to a simple statement: Do the Right Thing.

Unfortunately, the Treasury and IRS's anti-abuse net has been cast so wide that it cannot help but catch scores of ordinary business transactions--transactions that are not abusive under any standard. Truly nefarious transactions, on the other hand, may well continue unabated because the proposed anti-abuse rule is so vague that it will be ineffective in deterring taxpayers with both the propensity and appetite to engage in transactions that the government deems objectionable.

Guidance to Taxpayers

At the heart of the anti-abuse rule is the notion that the IRS may intervene to preclude tax results that are "inconsistent with the intent of subchapter K."(3) Prop. Reg. [sections] 1.701-2(a) does not, however, adequately define that intent in a fashion that can be applied to actual transactions; indeed, the proposed regulation expands rather than diminishes the ambiguity of the phrase "intent of subchapter K," since it simply splinters that concept into other obscure notions. The only other guidance in the text of the proposal is in Prop. Reg. [sections] 1.701-2(c), which states that a reduction in the partners' aggregate tax liability is not, in and of itself, sufficient to invoke the anti-abuse rule. Although such a limitation is welcome, it scarcely informs taxpayers--or revenue agents--of the true contours of the rule.

Nor do the examples in the proposed regulations provide a practical framework for meaningful analysis. Indeed, even though three of the four examples (Examples 1, 2, and 4) illustrate transactions that are consistent with the subchapter K rules and are not recast by the Commissioner, the holdings are qualified by the foreboding phrase "[a]bsent other facts"--leaving one to wonder what facts may tip the scale toward recasting the transactions. The fourth example (Example 3), arguably, is not even illustrative of an abuse of "the intent of subchapter K" generally, but rather is illustrative of the need for adjustments to the rules governing section 704(b) allocations.

The fundamental problem with the "intent of subchapter K" rule is that, without more meaningful guidance, the taxpayer, the revenue agent, the appeals officer, the IRS National Office, and Treasury each may have a good faith--but different--position on what that intent is in the context of a particular transaction. In other words, the proposed regulations are not much more helpful than the precatory Do the Right Thing. There is no guidance on what the "right thing" is.

Under the circumstances, TEI believes the Treasury and IRS must put some conceptual meat on the "intent of subchapter K" rule. Prop. Reg. [sections] 1.701-2(a) in its present form simply is not helpful and does not reflect sound principles of tax administration. Guidance in the form of additional examples addressing specific transactions may help but it will not cure the problem. Individual fact patterns will differ materially from any list of examples the IRS could assemble; the very fact that a broad anti-abuse rule has been proposed is implicit recognition of this fact.

Accordingly, we recommend that the proposed regulations be withdrawn and that Treasury and IRS undertake to work with taxpayers and practitioners to define the key elements embodied in the concept of the "intent of subchapter K." The goal of the endeavor should be to provide taxpayers and agents alike with the practical guidance needed for analyzing actual transactions. Although such an undertaking will be extraordinarily difficult, it is better for the IRS and Treasury to act now to make the anti-abuse rule administrable than to put off the task. The challenge will not go away. Put another way, if the IRS National Office and the Treasury Department cannot articulate a useful and practical rule on "the intent of subchapter K," how can a revenue agent be expected to do so? Just as important, how are taxpayers to evaluate and report the effects of their transactions?

Principal Purpose Standard

Prop. Reg. [sections] 1.701-2(b) states in part 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," the Commissioner may recast the partnership or its transactions. The "a principal purpose" standard of tax reduction was recently interpreted by the Seventh Circuit in Santa Fe Pacific Corp. v. Central States, Southeast Southwest Areas Pension Fund,(4) with the court observing that "a principal purpose" need not be the only purpose. It need only be one factor that weighed heavily in a taxpayer's thinking. Experience teaches that some revenue agents may view the "a principal purpose" standard met whenever a corporate tax department (or a company's outside adviser) is requested to evaluate the effects of a proposed transaction. In other words, a taxpayer's exercise of due diligence in assessing the potential tax consequences of a transaction may, almost automatically, cause a taxpayer to trip the "a principal purpose" wire.

More important, the proposed "a principal purpose" anti-abuse standard for subchapter K transactions can be instructively contrasted with the statutory anti-abuse standard for corporate acquisitions, which is set forth in section 269 of the Code. In that provision, Congress crafted an anti-abuse standard based on whether a transaction was motivated by "the principal purpose" of tax avoidance. The broader anti-abuse standard incorporated in Prop. Reg. [sections] 1.701-2 is unsupported by a statutory mandate and, furthermore, places partnerships at a disadvantage relative to the corporate form in terms of the degree of certainty of tax result achieved for transactions that comply with the literal terms of the law. Transactions not subject to a specific statutory anti-abuse rule generally have been respected under the case law as long as they are motivated by any legitimate, non-tax purpose.(5) In the absence of a direct expression of congressional concern or a broad delegation of authority to promulgate legislative rules, we submit that Treasury should exercise its authority to prevent abuses either by crafting highly specific anti-abuse guidance or, alternatively, limiting the application of a general anti-abuse rule to instances where tax avoidance is, at a minimum, "the" principal purpose.

Compliance and Administration

The preamble states that "Treasury and IRS are aware ... of an increasing number of transactions that attempt to use the partnership form in a manner inconsistent with [their] intent,"(6) citing Notice 94-48(7) as setting forth examples of abusive transactions. The preamble later avers that "[t]he proposed regulation primarily will affect a relatively small number of abusive large partnership transactions...."(8)

Notwithstanding the "it's an ugly world out there" tone of the preamble, the anti-abuse rule will be applied in the field by revenue agents who may not be aware of the particular facts and circumstances involved in the "increasing number of transactions" about which the Treasury and IRS National Office are concerned. As a result, agents are likely to expend substantial resources examining, and taxpayers will be compelled to expend a substantial amount of their limited resources defending, bona fide partnership arrangements and transactions entered into without any abusive purpose. Again, the amorphous nature of the rule renders it unadministrable.

TEI believes that if there are specific, abusive transactions of which "Treasury and IRS are aware," the anti-abuse rule should be revised to target the perceived abuse that Treasury and IRS seek to prevent. For example, in Notice 94-48 the IRS sets forth specific transactions that it believes abuse the subchapter K regime. Regardless of whether one agrees or disagrees with Notice 94-48, it does provide guidance. With its promulgation, all taxpayers and, equally important, revenue agents are placed on the same footing regarding the particulars of a proscribed transaction.(9) Similar guidance should be issued on other transactions through a notice, revenue ruling, or particularized anti-abuse regulation (where Congress has granted commensurate authority) addressing the transaction.(10)

In public statements, government representatives have complained of playing "catch-up" in their attempts to curb abusive transactions. Thus, they argue, a broad, amorphous anti-abuse rule is necessary to choke off abusive transactions in the planning stage. We do not share those representatives' collective belief that "abusive" transactions will be eliminated by such a broad rule. Indeed, the Institute believes that general anti-abuse rules are generally ineffective. We believe that only rigorous training of IRS agents and vigorous enforcement of the laws, including litigation, will curb abusive transactions. Unfortunately, absent particularized guidance, taxpayers will bear the burden of educating themselves and revenue agents on the application of the proposed partnership anti-abuse rule to specific transactions.

In part to allay criticism regarding the broad scope of the subchapter K anti-abuse rule and in part to "provide expertise to field examiners on all issues under proposed regulation [sections] 1.701-2,"(11) the IRS in Announcement 94-87 established an Industry Specialization Program (ISP) to enhance its effort to examine partnership transactions. That announcement, paradoxically, is both an ominous and welcome development. It is ominous because it portends an aggressive assault by revenue agents against all manner of legitimate partnership transactions in an attempt to root out the "abusive" transactions.(12) Nonetheless, the announcement is welcome in that a National Office representative will be charged with interdicting controversy before an examination or appeal bogs down in a protracted dispute over legitimate partnership transactions.(13)

Remedies for Abusive Subchapter K Transactions

Prop. Reg. [sections] 1.701-2(b) sets forth a list of administrative actions that the Commissioner may employ to recast transactions where the tax results under the form of a transaction are deemed to subvert the subchapter K rules, to contravene the economic arrangements of the parties or economic substance of a transaction, or otherwise to circumvent other provisions of the Code. The listed actions include: ignoring the existence of the purported partnership or the status of one or more of the participants as partners; treating the partners as owning the respective shares of partnership assets directly; adjusting the accounting methods of the partnership; reallocating items of income, gain, loss, deduction, or credit; and precluding the intended tax treatment. In effect, the list sweeps in nearly all the remedial actions courts have developed to enforce various anti-abuse doctrines in many different contexts, plus a new wrinkle or two. Curiously, Prop. Reg. [sections] 1.701-2(d) elaborates on the comprehensive list of anti-abuse weapons by averring that "the Commissioner can continue to assert and to rely upon applicable judicial principles and authorities (for example, substance-over-form, step-transaction, and sham-transaction doctrines) to challenge abusive transactions."

Even without a general anti-abuse provision, TEI believes that the Commissioner's power to combat abusive transactions is sufficiently robust to challenge any transaction targeted regardless of whether the transaction was undertaken by, through, or with a partnership.(14) Yet, by promulgating an open-ended subchapter K anti-abuse rule, the government admits that some transactions escape the gauntlet of judicial doctrines and statutory anti-abuse provisions aimed at taxpayers that go beyond the pale in minimizing their tax liabilities. Assuming that a transaction (i) complies with the literal requirements of the Internal Revenue Code and (ii) survives the various judicial tests for determining the bona fides of transactions, may the Secretary and Commissioner arrogate to themselves--especially through interpretative regulations that seemingly disregard the taxpayer's compliance with the literal terms of statutes, case law, and other regulations--the power to recast such a transaction? We do not believe that power exists without a more specific congressional delegation of authority. Consequently, TEI submits that the proposed regulations represent either a restatement of existing law--in which case they are largely irrelevant in attacking abusive transactions and function as an impediment to legitimate transactions--or an ill-advised and unworkable attempt to exercise legislative power. TEI urges that the proposed regulations be withdrawn because they either are meaningless or are beyond the authority of the Treasury and IRS to prescribe.

Effective Date

The subchapter K anti-abuse regulations are proposed to be "effective for all transactions relating to a partnership occurring on and after May 12, 1994."(15) In fact, however, the proposed anti-abuse rule may apply with respect to pre-May 12, 1994, transactions where the government is able to assert some connection between such transactions and a transaction occurring after May 12. Since the proposed regulations purport to provide new authority for recasting partnership transactions, the retrospective effect of the proposed regulations improperly penalizes taxpayers that have already established partnership entities in reasonable reliance on the rules in effect prior to May 12, 1994.

TEI submits that, in the event a new subchapter K anti-abuse rule is to be promulgated, it should be wholly prospective. The government should not apply new rules in a manner that recasts tax attributes resulting from transactions consummated before the effective date. In this regard, the effective date of the deemed sale rule in section 704(c)(1)(B) is instructive; that provision was made applicable to property contributed to a partnership after the date of congressional committee action, not to property that had already been contributed to a partnership. An effective date revised in accordance with our suggestion would preclude a post-May 11, 1994, transactional planning "window," without penalizing taxpayers that engaged in transactions before such date.

At a minimum, the effective date of a subsequently promulgated anti-abuse regulation should incorporate the following limitations:

* The proposed anti-abuse rule should not apply to any post-May 11, 1994, transaction effected pursuant to a binding contract in effect prior to May 12, 1994.

* In addition, the utilization of tax attributes attributable to transactions consummated before May 12, 1994, should not be restricted by the application of the post-May 11 rule.

Conclusion

TEI is pleased to have the opportunity to present its views on the subject of the proposed regulations relating to the subchapter K anti-abuse rule. These comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is Michael A. DeLuca. If you have any questions concerning these comments, please call either Mr. DeLuca of Household International, Inc. at [phone], or Jeffery P. Rasmussen of the Institute's professional tax staff at [phone].

CPE/CLE Credits

Boards of Accountancy. TEI is currently registered with the following Boards of Accountancy: Illinois (#158-000651), Indiana (#CE92000119, Exp. 12/96), New Jersey (#160, Exp. 6/30/95), New York (E93-253 (9/1/93-8/31/96)), Ohio (P0087), Pennsylvania (PX613L), and Texas (#3512). TEI is also registered with the National Association of State Boards of Accountancy (Sponsor No. 91-00116-95).

Continuing Legal Education. The Institute is registered in the following states as a sponsor of continuing legal education programs: California (Exp. 8/95), lowa, Kentucky (1993 48th Annual Conference -- 27 credit hours; 1994 44th Midyear Conference -- 27.5 credit hours), Minnesota (1993 48th Annual Conference -- 17.25 credit hours; 1994 44th Midyear Conference -- 18.25 credit hours), Missouri, Ohio (1993 48th Annual Conference -- 23.75 credit hours; 1994 44th Midyear Conference -- 23.0 credit hours; International Tax Course -- 25.25 credit hours), Oklahoma (1993 48th Annual Conference -- 26.5 credit hours; 1994 44th Midyear Conference -- 27.5 credit hours), and Wisconsin (1993 48th Annual Conference -- 28.0 credit hours; 1994 44th Midyear Conference -- 25.5 credit hours).

Note. Several states, such as Wisconsin and Georgia, require the individual to submit conference materials directly to the CLE Board. TEI provides a continuing professional education form for each registrant at its conferences, courses, and seminars, which should be completed at the conclusion of the program and returned to the TEI Registration Desk for verification and signature. A copy of the form is retained and filed at TEI Headquarters.

(1)For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

(2)A representative from Treasury's Office of Legislative Counsel characterized the anti-abuse regulation as "almost a truism." See "New IRS Partnership Anti-Abuse Rules Draw Criticism at ABA Meeting," BNA Daily Tax Report, No. 92, at G-6 (May 16, 1994).

(3)Prop. Reg. [sections] 1.701-2(b).

(4)Nos. 93-2736, 93-2899 (7th Cir., April 22, 1994).

(5)See, e.g., Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978) (holding that "the Government should honor the allocation of rights and duties effectuated by the parties" in the context of "a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached").

(6)1994-23 I.R.B. at 29.

(7)1994-19 I.R.B. at 10.

(8)1994-23 I.R.B. at 30.

(9)To a certain extent, the debate over the propriety and scope of the proposed regulations has laid bare a seeming arrogance over both the transactions to which the proposed rules apply and the persons for whom the regulations are written. Hence, the defenders of Prop. Reg. [sections] 1.701-2 have adopted an almost accusatory "you know who you are" stance; furthermore, certain commentators who have generally embraced the proposed regulations seemingly are imploring the Treasury and IRS to "stop us before we plan again." Rhetorically, the commentators may score points, but in the end taxpayers who seek to know the scope of the tax law are left frustrated--armed only with the beguiling but ultimately unhelpful anti-abuse rule.

(10)Published articles have appeared recently discussing the propriety of various partnership transactions in the context of Prop. Reg. [sections] 1.701-2. Should the transactions described in those articles be considered the abusive transactions of which the "Treasury and IRS are aware," the Treasury and IRS should issue guidance expressly to that effect rather than allow the vacuum to be filled by the conjecture of commentators.

(11)Announcement 94-87, reprinted in BNA Daily Tax Report, No. 112, at L-1 (June 14, 1994).

(12)To our mind's eye, the flawed nature of Prop. Reg. [sections] 1.701-2 is underscored by government's first promulgating a broad anti-abuse rule and then establishing a specific industry specialist to interpret and administer it. Are the "Treasury and IRS aware" of transactions that they wish to prevent, as they aver in the preamble to the proposed regulations, or are they concerned that there "might" be transactions that they wish to discover and evaluate? If Treasury and IRS are "aware" of transactions they desire to prevent, should they not propose specific rules to permit taxpayers to conform their behavior and plan transactions according to the law? Simultaneously telling taxpayers they may not engage in "abusive" transactions without giving meaningful guidance regarding the types of transactions that are to be deemed "abusive" is tantamount to a shell game. On the other hand, if specific rules are not to be issued, what constraints exist to prevent the ISP coordinator from issuing arbitrary or inconsistent interpretations of a general "intent of subchapter K" standard?

(13)There is already substantial controversy regarding the scope of the proposed anti-abuse rule. The tax-trade press has reported divergent opinions concerning, for example, the application of the anti-abuse rule to family limited partnerships and to UPREITs. See also Remarks of Treasury Associate International Tax Counsel Carol Doran Klein reported in "Anti-Abuse Subchapter K Rules Could Apply, in Foreign Context, to Tax Treaties," BNA Daily Tax Report, No. 92, at G-12 (May 16, 1994), suggesting that the proposed regulations have a very broad reach, extending to support the IRS's view regarding the application of the aggregate approach to Subpart F determinations--a view rejected by the Tax Court decision in Brown Group v. Commissioner, 102 T.C. No. 24 (April 12, 1994).

(14)In addition to the three judicially developed remedies listed in the parenthetical clause of Prop. Reg. [sections] 1.701-2(d), the assignment-of-income doctrine, the clear-reflection-of-income principle, and the statutory authority of section 482 provide ample means for the Commissioner to attack and recast transactions.

(15)Prop. Reg. [sections] 1.701-2(f).