Partnerships and Tax Avoidance: the Irs Breaks Up the Party
| Publication year | 1995 |
| Pages | 821 |
1995, April, Pg. 821. Partnerships and Tax Avoidance: The IRS Breaks Up the Party
In May 1994, the Internal Revenue Service ("IRS") created a ruckus in the tax community by proposing a general "anti-abuse" rule for partnership transactions ("Proposed Regulation").(fn1) The Proposed Regulation permitted the IRS to recharacterize tax-motivated partnership transactions that literally complied with the mechanical partnership rules of Subchapter K of the Internal Revenue Code ("Code"), but, in the view of the IRS, produced tax results inconsistent with the economic arrangements of the parties or the substance of the transactions, or used partnerships to avoid the purposes of other provisions of the Code.
After seven months of nearly unrelenting attack from tax practitioners,(fn2) the IRS revised its anti-abuse rule and issued it in final form(fn3) ("Final Regulation"). Most tax practitioners concur that the Final Regulation represents a significant improvement over the Proposed Regulation. Notwithstanding these revisions, however, the Final Regulation still presents a potential concern for many partnership transactions, even those that are seemingly legitimate and nonabusive.
Subchapter K of the Code (§§ 701-761) is intended to provide taxpayers with the ability to conduct joint business activities (including investment activities) through flexible economic arrangements and without an entity-level tax.(fn4) Sub-chapter K provides this flexibility at the cost of complexity, prompting one judge to remark:
The distressingly complex and confusing nature of the provisions of the Subchapter K present a formidable obstacle to the comprehension of these provisions without the expenditure of a disproportionate amount of time and effort even by one who is sophisticated in tax matters with many years of experience in the tax field. . . . Surely, a statute has not achieved "simplicity" when its complex provisions may be confidently dealt with by at most only a comparatively small number of specialists who have been initiated into its mysteries.(fn5)
In recent years, sophisticated taxpayers have exploited this flexibility and complexity, together with Subchapter K's failure to keep pace with the incessant changes in other areas of the tax law, to structure transactions that produced tax results that were arguably inconsistent with the underlying economic realities.(fn6) In response, Congress has amended Subchapter K numerous times in recent years,(fn7) and the IRS has issued many regulations addressing specific abuses.(fn8) In addition, the IRS has litigated (and won) many "tax shelter" cases using general tax principles such as "sham transaction," "business purpose," and "substance over form."(fn9) Despite these efforts, the IRS still felt that it was fighting a losing battle, and that a more general regulatory response, such as the Final Regulation, was needed to combat abusive transactions.(fn10)
The Final Regulation restates the antiabuse rule as follows:
The provisions of subchapter K and the regulations thereunder must be applied in a manner that is consistent with the intent of subchapter K. . . . Accordingly, if a partnership is formed or availed of 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.(fn11)
The Final Regulation thus more tightly circumscribes the IRS's recharacterization power, in that the recasting must be consistent with the intent of Subchapter K. This power was seemingly unlimited under the Proposed Regulation.
The preamble to the Final Regulation, like the Proposed Regulation, states that the anti-abuse rule is expected primarily to affect a relatively small number of partnership transactions making inappropriate use of Subchapter K, and that
it is not intended to interfere with bona fide joint business arrangements conducted through partnerships. Although taxpayers and their advisors may draw little comfort from this IRS "expectation," the Final Regulation does reflect an attempt by the IRS to respond to taxpayer criticism of the Proposed Regulation.
In a significant improvement over the Proposed Regulation, the Final Regulation clarifies when a partnership transaction will be considered consistent with the "intent of Subchapter K," by listing three requirements that are deemed implicit in the intent of Subchapter K.(fn12) 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...
To continue reading
Request your trial