Service Issues Final Regulations Under the Anti-Abuse Rule to Section 704(c)
On June 8, 2010, the Service issued final regulations providing that the section 704(c) anti-abuse rule takes into account the tax liabilities of both the partners in the partnership as well as certain direct and indirect owners of the partnership. T.D. 9485 (Treas. Reg. §1.704-3). The regulations apply to tax years commencing after June 9, 2010.
Section 704(c) provides that a entity taxable as a partnership for federal income tax purposes is required to allocate income, gain, loss, and deductions for property contributed by a partner or member of the entity, e.g., a member of a limited liability company having more than one member, to take into account variations between the property's adjusted tax basis and its fair market value (FMV) at the time of contribution. The allocations must be made using a reasonable method which is consistent with the policy underlying section 704(c). There are three methods set forth in the regulations; to-wit: (i) the traditional method; (ii) the traditional method with curative allocations; and (iii) the remedial method.
Under an anti-abuse rule contained in Treas. Reg. § 1.704-3(a)(10) an allocation method (or combination of methods) would be treated as unreasonable if the allocation, either in a direct or reverse section 704(c) context, results in a shifting of 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' (or members’) aggregate tax liability.
Under the general anti-abuse of the partnership provisions rule contained in Treas. Reg. §1.701-2(b), where 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, the Service may recast the transaction as appropriate to achieve tax results that are consistent with the intent of subchapter K. The general anti-abuse rule allows the Service to disregard: (i) purported partnerships, in whole or in part, so that partnership assets are treated as owned by partner(s) as would prevent the abuse from occurring.
In a report issued 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) it was noted that the anti-abuse rule of Treas. Reg. § 1.704-3(a)(10) needed to be strengthened for partnership allocations for property contributed to a partnership, especially for partners that are members of a consolidated group of corporations, to ensure that the allocation rules are not used to obtain unwarranted tax benefits.
The final regulations just issued amend the anti-abuse rule of Treas.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 must be considered. Treas. 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 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 per Treas. Reg. § 1.1502-1(h). However, a CFC shareholder 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 section. 951(a) for the CFC; (2) enter into any person's income attributable to a U.S. shareholder's inclusion under section 951(a); or (3) would enter into these computation if the items were allocated to the CFC. Treas. Reg. § 1.704-3(a)(10)(ii).
The final regulations also provide that the principles of section 704(c), together with the allocation methods set forth in Treas. 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 is 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. Treas. Reg. § 1.704-3(a)(1).
