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take aim at partnerships

Anti-Abuse Regulations
take aim at partnerships

For example, the case of concern to the IRS was Brown Group Inc. v. Commissioner. The case involved a U.S. corporation that had a wholly owned subsidiary operating in the Cayman Islands. The tax law clearly provides that a U.S. corporation that controls a foreign corporation must pay tax on certain types of income earned by that foreign corporation. The intent of the statute is to prevent U.S. taxpayers from escaping U.S. tax on their income by shifting it overseas.
It was very clear that the income of the foreign subsidiary would have been taxable to the domestic parent if it had been earned directly by the subsidiary. However, the subsidiary formed a partnership with two of its employees to conduct its business. The subsidiary owned 88 percent of the partnership, the employees 12 percent.
The subsidiary successfully argued in U.S. Tax Court that the income of the partnership flowing through to it did not meet the technical definition of the type of income that should be taxable to the U.S. parent. Thus, simply by inserting a partnership in its structure, it avoided the foreign tax rules.
The IRS felt that the income of the partnership should have been taxed as though earned directly by the corporation. Although the IRS did not expressly argue this in the case, in essence it felt that the partnership was so inconsistent with the purposes of the statute that it should be disregarded. The foreign corporation should be treated as directly conducting its business, with the small interest owned by the employees treated as additional compensation.
This Tax Court originally sided with the taxpayer in the Brown Group case, but the decision has been appealed and subsequently withdrawn by the Tax Court. However, at the time the regulations were proposed, this controversy appeared to create an enormous loophole in the tax laws relating to foreign corporations. The Anti-Abuse Regulations responded by creating in the IRS broad powers to disregard partnership transactions that are inconsistent with the purposes of the statute.
The Anti-Abuse Regulations state that partnerships are intended to permit taxpayers to conduct joint business activities through a flexible economic arrangement without incurring entity-level tax. In order for a partnership to be consistent with this intended purpose, the partnership must be bona fide and each partnership transaction or series of transactions must be entered into for a substantial business purpose. This determination is made under the facts and circumstances in each situation.
However, under the regulations, the IRS can recharacterize a matter if: 1) a partnership is formed or engages in a transaction with a principal purpose of substantially reducing the present value of the partners’ aggregate federal tax liability; and 2) the transaction is inconsistent with the intended purposes of partnership taxation. Thus, even if the partnership complies with the literal language of the Internal Revenue Code and the regulations, if the IRS concludes that the partnership or a transaction is not consistent with the intended purpose of partnership taxation, the IRS may recharacterize the situation.
The IRS may take a number of steps under these regulations. These include: disregarding the partnership; treating certain individuals with limited economic interests as not being partners; treating partners as directly owning the partnership property; disregarding and reallocating partnership items of income and loss; and adjusting the accounting method used by the partnership.
As proposed, the Anti-Abuse Regulations were heavily criticized. Tax professionals felt they were too vague and uncertain, and gave the IRS possible authority to recharacterize common transactions. The concern was that ordinary business activities could not be conducted due to the uncertainty created by the regulations.
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In response, the IRS modified the regulations by inserting additional examples intended to demonstrate to practitioners that “typical” business transactions would be respected. However, the IRS did not back away from the essential concept of the regulations, preserving its recharacterization powers.
There is continuing concern with the regulations in two areas. First is the IRS’ authority to even issue such regulations. Many believe that the IRS does not have such broad recharacterization powers, and cannot create them by regulation. If certain transactions fit the literal language of the Code but are problematic in practice, then, these commentators feel that only Congress can fix the problem by amending the Code.
The second concern with the regulations focuses on their fundamentally subjective nature. The two essential tests for application of the regulations are “a principal purpose” of tax reduction and a transaction that is inconsistent with “the purposes” of partnership taxation. The problem is that taxpayers and the IRS rarely agree on what the “principal purpose” of a transaction is. Taxpayers will, of course, point to the business purposes served by the transaction, while the IRS will point to the tax savings.
Similarly, judging when a transaction is inconsistent with “purposes” of partnership taxation is tremendously difficult. There is no handy reference manual describing what the purposes of the partnership sections of the Code are. The purpose must be deduced from the rules of the Code, albeit with some legislative history.
In short, despite the added comfort provided by the new examples blessing some common transactions, considerable uncertainty remains under the Anti-Abuse Regulations. While the IRS has always had some power under various tax doctrines (step transaction, substance over form, sham transaction and others) created by the IRS and the courts to recharacterize abusive transactions, the Anti-Abuse Regulations create additional uncertainty in the partnership area.
Until further clarification develops as the regulations are applied in practice, any transaction involving a partnership should be carefully reviewed. While application of the regulations often will be uncertain, they must at least be considered before the transaction goes forward. Difficult judgments will be required, and many transactions will involve an element of risk that cannot be eliminated without contacting the IRS for a private-letter ruling at considerable time and expense.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters. He was assisted in the preparation of this article by his associate, Christopher Potash.)

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