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The IRS has issued final regulations providing that the Code §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 the partners. The regulations, which apply to tax years beginning after June 9, 2010, also provide that a Code §704(c) allocation method cannot be used to achieve tax results inconsistent with the intent of subchapter K of the Code.

Background. Code §704(c) requires partnerships to allocate income, gain, loss, and deductions for property contributed by a partner so as to take into account variations between the property’s adjusted tax basis and its fair market value at the time of contribution. The allocations must be made using a reasonable method that’s consistent with Code §704 ‘s purpose. Reg. §1.704-3 provides three allocation methods: the traditional method, the traditional method with curative allocations, and the remedial method.

Under the anti-abuse rule of Reg. §1.704-3(a)(10) (as in effect before amendment by T.D. 9485, 06/08/2010), an allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in reverse Code Sec. 704(c) allocations) and the corresponding allocation of tax items for 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 (PV) of the partners’ aggregate tax liability.

Under the anti-abuse rule of Reg. §1.701-2(b), if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the PV of the partners’ federal tax liability in a manner inconsistent with the intent of subchapter K, IRS may recast the transaction as appropriate to achieve tax results that are consistent with the intent of subchapter K. Thus, IRS may disregard: (a) purported partnerships, in whole or part, so that partnership assets are treated as owned by the partner; (b) one or more contributions; or (c) one or more purported partners.

In 2003, the Staff of the Joint Committee on Taxation issued “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). Although the Enron Report noted that the anti-abuse rule of Reg. §1.704-3(a)(10) (as in effect before amendment by T.D. 9485, 06/08/2010 ), was an effective tool, it recommended strengthening the reg for partnership allocations for property contributed to a partnership, especially for partners that are members of the same consolidated group, to ensure that the allocation rules are not used to obtain unwarranted tax benefits.

The final regs address the recommendation in the Enron Report by clarifying certain aspects of the anti-abuse rule.

Final regulations. The regulations amend the anti-abuse rule of Reg. § 1.704-3(a)(10) to provide that the tax effect of an allocation method (or combination of methods) on both direct and indirect partners is considered. (Reg. § 1.704-3(a)(10)(i)) An indirect partner is any direct or indirect owner of a partnership, S corporation, or controlled foreign corporation (CFC, as defined in Code §957(a) or Code §953(c)), 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 (under Reg. §1.1502-1(h)). However, a CFC owner is treated as an indirect partner only for allocation of items that: (1) enter into the computation of a U.S. shareholder’s inclusion under Code §951(a) for the CFC; (2) enter into any person’s income attributable to a U.S. shareholder’s inclusion under Code §951(a) for the CFC; or (3) would enter into these computation if the items were allocated to the CFC. (Reg. §1.704-3(a)(10)(ii))

The final regs also provide that the principles of Code §704(c), together with the allocation methods in Reg. §1.704-3(b) (the traditional method, the traditional method with curative allocations, and the remedial method) only apply to contributions of property to the partnership. Further, in determining if a purported contribution of property to a partnership should be recast to avoid results that are inconsistent with subchapter K, one factor that might be relevant 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. (Reg. §1.704-3(a)(1))

For more information on these Final Regulations or other partnership tax matters, contact Moore McLaughlin, Esq. at 401-421-5115 ext 212 or by e-mail at MMcLaughlin@McLaughlinQuinn.com.