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

• Author: Dell, F. Michael

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...