7767 / What is the Subchapter K (partnership) anti-abuse rule?

Subchapter K provides rules governing the formation of partnerships to conduct business transactions without incurring an entity-level tax. The partnership must be bona fide, and transactions must be entered into for a substantial business purpose. The transactions must be respected under substance over form principles, and the tax consequences of the transactions must accurately reflect the partners’ economic agreement and clearly reflect the partner’s income.¹ The anti-abuse rule provides that if a partnership is involved in a transaction with a principal purpose of substantially reducing the present value of the partners’ aggregate tax liability in a manner that is inconsistent with the intent of subchapter K, the IRS can recast the transaction for federal tax purposes to achieve tax results that are consistent with subchapter K.² The anti-abuse rule applies only to income taxes, which are governed under IRC subtitle A. It does not apply to transfer taxes, such as estate and gift taxes, which are governed under IRC subtitle B.³

The determination as to whether a partnership has violated the anti-abuse rule will be based on an analysis of all of the facts and circumstances, including a comparison of the purported business purpose of the transaction and the claimed tax benefits resulting therefrom. Factors to be considered include whether: (1) the present value of the partners’ aggregate federal tax liability is substantially less than (a) if the assets were owned and business conducted directly, or (b) if separate transactions were integrated and treated as a single transaction; (2) necessary partners either have a nominal interest in the partnership, are substantially protected from any risk of loss from the partnership’s activities, or have little or no participation in the profits from the partnership’s activities other than a preferred return; (3) substantially all of the partners are related to one another, either directly or indirectly; (4) partnership items are allocated in compliance with Treasury Regulation Sections 1.704-1 and 1.704-2, but the results are inconsistent with the purpose of IRC Section 704(b) and these regulations (see Q 7740); (5) the benefits and burdens of ownership of partnership property are either substantially retained by the contributing partner or substantially shifted to a distributee partner.⁴ These regulations generally apply to transactions occurring after May 11, 1994.⁵

Further, the regulations allow the IRS to treat a partnership as an aggregate of its partners, unless IRC provisions prescribe the treatment of a partnership as an entity and that treatment and resulting tax implications are clearly contemplated by those IRC provisions.⁶ This provision is effective for transactions occurring after December 28, 1994.⁷

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1.  Treas. Reg. § 1.701-2(a).

2.  Treas. Reg. § 1.701-2(b).