The IRS has issued proposed regulations under Sec. 704(c) that provide that the Sec. 704(c) anti-abuse rule takes into account the tax liabilities of both the partners in a partnership and certain direct and indirect owners of such partners. The proposed regulations further provide that a Sec. 704(c) allocation method cannot be used to achieve tax results inconsistent with the intent of subchapter K of the Code.
In the wake of the Enron Corporation meltdown, the Joint Committee on Taxation produced The Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS-3-03), February 2003 (Enron Report). Based on its findings, the Joint Committee made recommendations for both legislative and regulatory changes in the area of partnership taxation. One of the Enron Report’s recommendations was to strengthen the anti-abuse rule (Regs. Sec. 1.704-3(a)(10)) with respect to “partnership allocations for property contributed to a partnership, especially in the case of partners that are members of the same consolidated group to ensure that the allocation rules are not used to obtain unwarranted tax benefits.”
The IRS has implemented the Joint Committee’s recommendation by issuing proposed regulations (which will be effective when published as final regulations) that clarify certain aspects of the anti-abuse rule. Under the anti-abuse rule, an allocation method (or combination of methods) is not reasonable if the contribution of property and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability. According to the Service, a substantial reduction in the present value of an indirect partner’s tax liability must be considered when analyzing the reasonableness of an allocation method because allowing a partnership to adopt a tax-advantaged allocation method under which the tax advantages accrue to an indirect partner rather than a direct partner would be inconsistent with the purposes of Sec. 704(c).
Therefore, the proposed regulations amend Regs. Sec. 1.704-3(a)(10) to provide that, for purposes of applying the anti-abuse rule, the tax effect of an allocation method (or combination of methods) on both direct and indirect partners is considered. An indirect partner is defined as any direct or indirect owner of a partnership, S corporation, or controlled foreign corporation (CFC), or direct or indirect beneficiary of a trust or estate that is a partner in the partnership, and any consolidated group of which the partner in the partnership is a member.
However, an owner of a CFC is treated as an indirect partner only with respect to the allocation of items that (1) enter into the computation of a U.S. shareholder’s inclusion under Sec. 951(a) with respect to the CFC, (2) enter into any person’s income attributable to a U.S. shareholder’s inclusion under Sec. 951(a) with respect to the CFC, or (3) would enter into the computations described in (1) or (2) if such items were allocated to the CFC.
The proposed regulations also provide that the principles of Sec. 704(c), together with the allocation methods described in Regs. Secs. 1.704-3(b), (c), and (d), apply only with respect to the contributions that are otherwise respected. Thus, even though a transaction may satisfy the literal words of Sec. 704(c) and the regulations, the IRS may recast a transaction to avoid tax results that are inconsistent with the intent of subchapter K. The proposed regulations also state that one factor that may be relevant in determining whether a contribution of property should be recast is the use of the remedial method, in which allocations of remedial items of income, gain, loss, or deduction are made to one partner and allocations of offsetting remedial items are made to a related partner.
The proposed changes to Regs. Sec. 1.704-3 are intended to prevent related parties from using the Sec. 704(c) partnership allocation rules to shift basis among assets. Several of Enron’s structured transactions relied on these rules to shift basis to assets that would be depreciated or sold in order to maximize depreciation deductions or minimize taxable gain on sale. The tax benefits of these transactions depended on the application of the rules requiring allocation of tax attributes associated with contributed assets and the rules that allow basis to be shifted to partnership assets when the partnership makes distributions. These transactions included the use of tax-free corporate liquidations to generate tax deductions without any economic outlay.
While recommending in the Enron Report that the allocation anti-abuse regulations be strengthened, the Joint Committee stated that it believed that the existing version of these regulations precluded the tax benefits the basis-shifting transactions were purported to generate. However, the IRS never had the chance to test the efficacy of the existing regulations in the Enron case, and the actual effect that these proposed regulations will have, if finalized, is also open to question.