The IRS and Treasury issued final regulations on June 8 to provide that the Sec. 704(c) anti-abuse rule takes into account the tax liabilities of both partners and certain owners of partners (T.D. 9485). The regulations also provide that partnerships cannot use an allocation method to achieve tax results that are inconsistent with the intent of the partnership rules in the Internal Revenue Code.
The final regulations adopt without any changes proposed regulations that were issued in 2008 (REG-100798-06). (For more on the proposed regulations, see Tax Trends, “IRS Issues New Rules on Allocation of Partnership Items,” 39 The Tax Adviser 540 (August 2008).) The regulations respond to a recommendation by the Joint Committee on Taxation in the wake of the Enron scandal that the anti-abuse rule of Regs. Sec. 1.704-3(a)(10) be strengthened 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” (Joint Committee on Taxation, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS-3-03) (February 2003), p. 29).
Under the anti-abuse rule, a method (or combination of methods) for allocating contributed partnership property 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 way that substantially reduces the present value of the partners’ aggregate tax liability. According to the IRS, 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 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 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 a 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.
The 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 to contributions that are otherwise respected. Thus, even though a transaction may satisfy the literal language of Sec. 704(c) and the regulations, the IRS may recast the transaction to avoid tax results that are inconsistent with the intent of subchapter K. The regulations 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.
During the comment period, the IRS received requests that the final regulations contain specific examples describing the types of transactions to which the regulations apply as well as specific examples of types of transactions that would not be abusive under these regulations but would be abusive under the general partnership anti-abuse rules of Regs. Sec. 1.701-2. The IRS declined to provide such examples due to the “factually intensive analysis needed to determine whether this regulation is applicable” (Preamble to T.D. 9485, p. 2).
The IRS declined to adopt a de minimis rule to exclude partners who own less than 10% of the capital and profits of a partnership or who are allocated less than 10% of each partnership item. They also declined to adopt a rule that owners would have to be related to the lookthrough entity (within the meaning of Sec. 267 or Sec. 707) in order to be considered indirect partners for purposes of the regulations.
However, the final regulations did adopt the proposed regulations’ rule that 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 regulations are effective for tax years that begin after June 9, 2010.