Partnership Anti-abuse Provisions
The Internal Revenue Service has the authority to disregard the partnership form of an entity if the operations of the business are found to be inconsistent with the intent of the partnership tax statutes and the partnership form is being used for tax-avoidance purposes. According to Treasury regulations, the intent of the partnership laws is to allow taxpayers to conduct a joint business activity through a flexible economic arrangement without incurring an entity-level tax.
General Requirements
There are three general requirements implicit in this intent. First, the partnership must be bona fide, and each partnership transaction must be engaged in for a substantial business purpose. Second, the form of each partnership transaction must be respected under substance-over-form rules. Finally, the tax consequences to each partner must accurately reflect the partners' economic agreement and clearly reflect each partner's income.
If the IRS finds that a partnership transaction was entered into for an improper purpose, it has a choice of remedial measures, including the following:
- Disregard the partnership form in whole or in part, and consider the partnership assets and activities as owned and conducted by one or more of the partners;
- Determine that one of more of the partners should not be treated as a partner for income tax purposes;
- Adjust the method of accounting used either by the partnership or by a partner to more clearly reflect income of the business or the partner;
- Reallocate the partnership's items of income, gain, loss, deduction or credit; or
- Otherwise recast the claimed tax treatment of the transaction.
The IRS determines whether a partnership was formed or availed of with an improper purpose by considering the facts and circumstances of each case. Among the factors that the IRS looks at are:
- Whether the partners' combined federal tax liability is substantially less than it would have been if the partnership assets had been owned by the partners and if they had conducted the activities directly;
- Whether the partners' combined federal tax liability is substantially less than it would have been if separate transactions designed to accomplish a particular goal were integrated and treated as steps in a single transaction;
- Whether a partner who is necessary to achieve the claimed tax result is substantially protected from any risk of loss;
- Whether substantially all of the partners are directly or indirectly related to one another;
- Whether partnership items are allocated in a way that is inconsistent with the purpose of the allocation rules;
- Whether a contributing partner retains a substantial portion of the benefits and burdens of property contributed to the partnership;
- Whether the benefits and burdens of ownership of partnership property are substantially shifted to a distributee partner either before of after the property is actually distributed.
The IRS does not assign any weight to these factors, nor does their presence or absence create a presumption of abuse. The factors are simply illustrative of the kinds of facts and circumstances that will be considered.
