What's in a name: can the partnership anti-abuse rule really stop partnership tax abuse?

• Author: Monroe, Andrea

INTRODUCTION I. HISTORY OF THE PARTNERSHIP ANTI-ABUSE RULE A. The Problem B. The Proposed Partnership Anti-Abuse Rule 1. The Proposed Regulation 2. The Reaction--The Fury of the Tax Practitioners C. The Final Partnership Anti-Abuse Rule D. The Post-Issuance World: 1995 to Present 1. Administrative Guidance 2. Judicial Decisions 3. Practitioner Advice E. The Failure of the Partnership Anti-Abuse Rule II. WHY THE PARTNERSHIP ANTI-ABUSE RULE FAILED A. The Practitioners' Role B. The Service's Role C. The Treasury's Role III. BUILDING A BETTER PARTNERSHIP ANTI-ABUSE RULE A. Back to Basics: The Partnership Anti-Abuse Rule Version 2.0 B. Addition by Subtraction: The Benefits of the Revised Partnership Anti-Abuse Rule 1. Saying What it Means 2. Meaning What it Says C. Objections to the Better-Built Partnership Anti-Abuse Rule 1. We Don't Want Uncertain Anti-Abuse Rules 2. We Don't Need Redundant Anti-Abuse Rules CONCLUSION INTRODUCTION

Partnership taxation is a disaster. Subchapter K, which contains the rules governing the taxation of partners and partnerships, (1) suffers from flaws that have wrought havoc on the government's ability to tax one of our most rapidly increasing categories of business and investment entities. (2) Subchapter K's most longstanding affliction is its commitment to flexibility. Since subchapter K's enactment in 1954, (3) Congress has been steadfast in its desire that partnership tax be flexible, enabling partners to structure their ventures in whatever manner seems most sensible. (4)

But this grant of latitude in structuring partnerships is not without cost. Congress has struggled to reconcile this flexibility with subchapter K's other goals, such as equity. Subchapter K's flexibility has also led to abuse. (5) Taken together, these problems have triggered another of subchapter K's afflictions--complexity. Over the years, Congress and the Treasury have added myriad technical provisions to subchapter K in an attempt to prevent abuse or promote equity. As a consequence, subchapter K requires taxpayers who wish to do business in the partnership form to navigate a grueling array of technical provisions. (6) And as the years pass, the level of complexity continues to worsen.

Subchapter K nonetheless remains appealing to many taxpayers because the enforcement resources dedicated to partnership taxation have been woefully insufficient. (7) Audit rates in subchapter K remain low, and the temptation to play the audit lottery remains high. (8) Thus, for taxpayers with enough sophistication or financial resources to exploit subchapter K's complexity, partnerships offer plentiful opportunities to engage in strategic behavior. Indeed, many taxpayers consider partnerships the perfect vehicle for tax shelter activity: the rules are flexible, but also technical, and the entity is less likely to be audited than its transactional counterparts. (9)

Thus, it is no surprise that partnerships played a central role in the most recent generation of tax shelters. (10) Enron, General Electric, Colgate-Palmolive, and many other corporations all used partnerships to structure abusive transactions during the last decade. (11) Although the government ultimately eliminated many of these specific abuses, (12) tax shelters remain a perennial problem of the federal income tax system, ebbing and flowing over the years with devastating effect. (13) Most immediately, the cost of tax shelters is borne by the public at large, with some estimates suggesting that corporations avoided paying federal income taxes of roughly $10 billion in 1999, and that such numbers grew dramatically thereafter. (14) The non-monetary costs of tax shelters are also destructive. Tax shelters create a perception that the federal income tax system rewards the wealthy, the well advised, and taxpayers who are sufficiently lucky or skilled to discover new tax-saving techniques. (15) In so doing, tax shelters undermine the foundational notion that similarly situated taxpayers should be treated similarly. And when the federal tax system's integrity is compromised, taxpayers are less likely to comply with its rules and are more likely to enter into abusive transactions. (16)

There exists a growing modern literature analyzing tax shelters and how to prevent future generations of abusive transactions. One strand focuses on enforcement and disclosure regimes. (17) Another examines substantive law, particularly the various judicial doctrines applied in challenging tax shelter transactions. (18) Absent from the literature, however, is much discussion of subchapter K itself. Considering its unique standing as the preeminent breeding ground for tax shelters, one would expect a more spirited dialogue among scholars and practitioners about the relationship between subchapter K and tax shelters.

Perhaps the reason for this omission is a grim perception that subchapter K is beyond repair. From this viewpoint, there is only one question that really matters--should Congress kill subchapter K? Commentators have occasionally addressed this question, (19) but Congress is not yet prepared to consider subchapter K's fate. Thus, fundamental reform of partnership taxation is unlikely to happen anytime soon.

With the most pressing question about subchapter K indefinitely tabled, we must consider second-best alternatives that might prevent the tax shelters that have become endemic to partnership taxation. This Article suggests that Treasury regulation section 1.701-2, commonly referred to as the partnership anti-abuse rule ("PAAR"), (20) may provide subchapter K with the support it so desperately requires. The PAAR, in basic terms, authorizes the Internal Revenue Service ("Service") to recast a partnership transaction if the transaction has a principal purpose of substantially reducing the partners' federal income tax liability in a manner inconsistent with the intent of subchapter K. (21) The PAAR's goal is simple--to remind taxpayers that the literal language of subchapter K cannot be manipulated to generate results contrary to the legislative intent underlying subchapter K. To many observers, the PAAR seemed self-evident, but the Treasury feared that subchapter K's unique combination of flexibility, complexity, and low enforcement caused some taxpayers to believe that partnerships were special and, thus, not subject to the tax system' s first principles. (22)

The PAAR's short history is as colorful and intriguing as any soap opera. (23) The Treasury proposed the PAAR in 1994, (24) and practitioners responded venomously, displaying a level of anger and outrage rarely seen in the tax world. (25) In response, the Treasury significantly reworked the PAAR before its final issuance six months later. (26)

To this day, the PAAR remains controversial, drawing visceral reactions from scholars and practitioners alike. (27) But the passion stirred by the PAAR is remarkably puzzling because the regulation has had virtually no impact on subchapter K. Indeed, the PAAR is a complete failure. Practitioners, the Service, and the courts regularly disregard the regulation when structuring and analyzing transactions. And despite the PAAR's prohibitions, a new generation of tax shelters has proliferated at exorbitant public cost. (28)

The PAAR might thus seem like an improbable candidate to sustain subchapter K until Congress considers fundamental reform of the partnership tax rules. Yet that is precisely what this Article suggests. Specifically, the Treasury should revise the PAAR and return the regulation to its roots as a broad anti-abuse rule. In doing so, the Treasury would finally free the regulation to combat the abusive partnership transactions that justified its issuance sixteen years ago. Likewise, there is little downside to revitalizing the PAAR. At a minimum, revising the regulation would send an important signal regarding the Treasury's and the Service's continued commitment to preventing abuse in subchapter K.

Part I provides a uniquely comprehensive history of the PAAR, tracing its journey from proposed regulation to final regulation to failed regulation. The dynamic relationship between the Treasury and practitioners shaped the PAAR's story, and this part highlights the interplay of these two oppositional forces. Part II explores the causes of the PAAR's distinctive failure and what lessons may be learned. Although numerous factors contributed to the PAAR's failure, the period between the regulation's proposal and finalization was transformative, corrupting the PAAR beyond repair. Correcting the mistakes of that six-month period is the subject of Part HI, which sketches the path to a better PAAR and, in turn, a better subchapter K. Part HI suggests that the Treasury streamline the PAAR, thus liberating the regulation to effectively challenge abusive partnership transactions. Part HI concludes by examining several objections to revising the PAAR, ultimately finding that such objections are premature and factually uncertain. What is certain, however, is subchapter K's pressing crisis and the final PAAR's inability to prevent the proliferation of tax shelters. It seems very possible, if not likely, that revising the PAAR could be part of the solution.

1. HISTORY OF THE PARTNERSHIP ANTI-ABUSE RULE

   The PAAR is unique in the federal income tax system, confounding its proponents and opponents alike. The Treasury proposed the regulation in hopes of halting the proliferation of abusive partnership transactions. (29) Practitioners responded with unprecedented venom, and argued that the Treasury should withdraw the regulation. (30) But they failed in this campaign against the PAAR; the Treasury issued the final regulation six months later. (31) Still, these practitioners set in motion a chain of events that ultimately led to the PAAR's demise. Most importantly, the firestorm surrounding the PAAR's proposal led the Treasury to make numerous changes to the regulation that are...