The partnership anti-abuse rules
The partnership anti-abuse rules are getting broader use by the IRS.
IRS regulations warn that the IRS will deny tax benefits whenever a partnership is “formed or availed of in connection with a transaction the principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with” partnership tax rules.
The authority the IRS has reserved for itself is so broad — and so vague — that many tax advisers assume the IRS will not invoke this rule unless a transaction falls into one of 14 fact patterns in its regulations.
However, Paul Kugler, the associate IRS chief counsel for partnerships, warned when he left the government last summer that the agency had rulings in the works that would invoke the rule in other settings.
The first such ruling may be a “field service advice” the agency released in late October.
Two foreign banks held notes from insolvent borrowers. Since the foreign banks could not benefit in their own countries from bad debt deductions, they contributed the notes with built-in losses to a limited liability company treated as a partnership for US tax purposes, and later sold their membership interests in the LLC to an unrelated US taxpayer. The partnership did not have in place a “section 754 election,” and the notes in the partnership’s hands retained the built-in loss. The unrelated partner tried to make use of its share of losses when the LLC later sold the notes at a loss.
The IRS invoked the anti-abuse rules to disallow the transaction. The transaction does not exactly fit in any of the examples. The one example to which the IRS pointed involved a case where losses were duplicated. In that example, the partner who contributed the loss property claimed a loss when his partnership interest was later redeemed, and the new unrelated partners again claimed the losses when the partnership sold the property at a loss.
In this case, there was no evidence that the losses were duplicated. The IRS itself pointed out this broader application: “We note that the anti-abuse arguments would be even stronger if additional evidence could be developed with respect to the benefit the [foreign banks] received as a result of the [transaction]. If the [foreign banks] received some tax benefit, either foreign or domestic, from the loss, the facts would more closely resemble the doubling of losses found in [the example cited] . . . and would strengthen the anti-abuse arguments.”
The IRS ruling discussing the transaction is FSA 200242004.