[Code of Federal Regulations]
[Title 26, Volume 8]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.701-2]

[Page 344-354]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
Determination of Tax Liability--Table of Contents
 
Sec. 1.701-2  Anti-abuse rule.

    (a) Intent of subchapter K. Subchapter K is intended to permit 
taxpayers to conduct joint business (including investment) activities 
through a flexible economic arrangement without incurring an entity-
level tax. Implicit in the intent of subchapter K are the following 
requirements--
    (1) The partnership must be bona fide and each partnership 
transaction or series of related transactions (individually or 
collectively, the transaction) must be entered into for a substantial 
business purpose.
    (2) The form of each partnership transaction must be respected under 
substance over form principles.
    (3) Except as otherwise provided in this paragraph (a)(3), the tax 
consequences under subchapter K to each partner of partnership 
operations and of transactions between the partner and the partnership 
must accurately reflect the partners' economic agreement and clearly 
reflect the partner's income (collectively, proper reflection of 
income). However, certain provisions of subchapter K and the regulations 
thereunder were adopted to promote administrative convenience and other 
policy objectives, with the recognition that the application of those 
provisions to a transaction could, in some circumstances, produce tax 
results that do not properly reflect income. Thus, the proper reflection 
of income requirement of this paragraph (a)(3) is treated as satisfied 
with respect to a transaction that satisfies paragraphs (a)(1) and (2) 
of this section to the extent that the application of such a provision 
to the transaction and the ultimate tax results, taking into account all 
the relevant facts and circumstances, are clearly contemplated by that 
provision. See, for example, paragraph (d) Example 6 of this section 
(relating to the value-equals-basis rule in Sec. 1.704-
1(b)(2)(iii)(c)), paragraph (d) Example 9 of this section (relating to 
the election under section 754 to adjust basis in partnership property), 
and paragraph (d) Examples 10 and 11 of this section (relating to the 
basis in property distributed by a partnership under section 732). See 
also, for example, Sec. Sec. 1.704-3(e)(1) and 1.752-2(e)(4) (providing 
certain de minimis exceptions).
    (b) Application of subchapter K rules. The provisions of subchapter 
K and the regulations thereunder must be applied in a manner that is 
consistent with the intent of subchapter K as set forth in paragraph (a) 
of this section (intent of

[[Page 345]]

subchapter K). Accordingly, if a partnership is formed or availed of in 
connection with a transaction a 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 the intent of subchapter 
K, the Commissioner can recast the transaction for federal tax purposes, 
as appropriate to achieve tax results that are consistent with the 
intent of subchapter K, in light of the applicable statutory and 
regulatory provisions and the pertinent facts and circumstances. Thus, 
even though the transaction may fall within the literal words of a 
particular statutory or regulatory provision, the Commissioner can 
determine, based on the particular facts and circumstances, that to 
achieve tax results that are consistent with the intent of subchapter 
K--
    (1) The purported partnership should be disregarded in whole or in 
part, and the partnership's assets and activities should be considered, 
in whole or in part, to be owned and conducted, respectively, by one or 
more of its purported partners;
    (2) One or more of the purported partners of the partnership should 
not be treated as a partner;
    (3) The methods of accounting used by the partnership or a partner 
should be adjusted to reflect clearly the partnership's or the partner's 
income;
    (4) The partnership's items of income, gain, loss, deduction, or 
credit should be reallocated; or
    (5) The claimed tax treatment should otherwise be adjusted or 
modified.
    (c) Facts and circumstances analysis; factors. Whether a partnership 
was formed or availed of with a principal purpose to reduce 
substantially the present value of the partners' aggregate federal tax 
liability in a manner inconsistent with the intent of subchapter K is 
determined based on all of the facts and circumstances, including a 
comparison of the purported business purpose for a transaction and the 
claimed tax benefits resulting from the transaction. The factors set 
forth below may be indicative, but do not necessarily establish, that a 
partnership was used in such a manner. These factors are illustrative 
only, and therefore may not be the only factors taken into account in 
making the determination under this section. Moreover, the weight given 
to any factor (whether specified in this paragraph or otherwise) depends 
on all the facts and circumstances. The presence or absence of any 
factor described in this paragraph does not create a presumption that a 
partnership was (or was not) used in such a manner. Factors include:
    (1) The present value of the partners' aggregate federal tax 
liability is substantially less than had the partners owned the 
partnership's assets and conducted the partnership's activities 
directly;
    (2) The present value of the partners' aggregate federal tax 
liability is substantially less than would be the case if purportedly 
separate transactions that are designed to achieve a particular end 
result are integrated and treated as steps in a single transaction. For 
example, this analysis may indicate that it was contemplated that a 
partner who was necessary to achieve the intended tax results and whose 
interest in the partnership was liquidated or disposed of (in whole or 
in part) would be a partner only temporarily in order to provide the 
claimed tax benefits to the remaining partners;
    (3) One or more partners who are necessary to achieve the claimed 
tax results either have a nominal interest in the partnership, are 
substantially protected from any risk of loss from the partnership's 
activities (through distribution preferences, indemnity or loss guaranty 
agreements, or other arrangements), or have little or no participation 
in the profits from the partnership's activities other than a preferred 
return that is in the nature of a payment for the use of capital;
    (4) Substantially all of the partners (measured by number or 
interests in the partnership) are related (directly or indirectly) to 
one another;
    (5) Partnership items are allocated in compliance with the literal 
language of Sec. Sec. 1.704-1 and 1.704-2 but with results that are 
inconsistent with the purpose of section 704(b) and those regulations. 
In this regard, particular scrutiny will be paid to partnerships in 
which income or gain is specially allocated to

[[Page 346]]

one or more partners that may be legally or effectively exempt from 
federal taxation (for example, a foreign person, an exempt organization, 
an insolvent taxpayer, or a taxpayer with unused federal tax attributes 
such as net operating losses, capital losses, or foreign tax credits);
    (6) The benefits and burdens of ownership of property nominally 
contributed to the partnership are in substantial part retained 
(directly or indirectly) by the contributing partner (or a related 
party); or
    (7) The benefits and burdens of ownership of partnership property 
are in substantial part shifted (directly or indirectly) to the 
distributee partner before or after the property is actually distributed 
to the distributee partner (or a related party).
    (d) Examples. The following examples illustrate the principles of 
paragraphs (a), (b), and (c) of this section. The examples set forth 
below do not delineate the boundaries of either permissible or 
impermissible types of transactions. Further, the addition of any facts 
or circumstances that are not specifically set forth in an example (or 
the deletion of any facts or circumstances) may alter the outcome of the 
transaction described in the example. Unless otherwise indicated, 
parties to the transactions are not related to one another.

    Example 1. Choice of entity; avoidance of entity-level tax; use of 
partnership consistent with the intent of subchapter K. (i) A and B form 
limited partnership PRS to conduct a bona fide business. A, the 
corporate general partner, has a 1% partnership interest. B, the 
individual limited partner, has a 99% interest. PRS is properly 
classified as a partnership under Sec. Sec. 301.7701-2 and 301.7701-3. 
A and B chose limited partnership form as a means to provide B with 
limited liability without subjecting the income from the business 
operations to an entity-level tax.
    (ii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. 
Although B has retained, indirectly, substantially all of the benefits 
and burdens of ownership of the money or property B contributed to PRS 
(see paragraph (c)(6) of this section), the decision to organize and 
conduct business through PRS under these circumstances is consistent 
with this intent. In addition, on these facts, the requirements of 
paragraphs (a)(1), (2), and (3) of this section have been satisfied. The 
Commissioner therefore cannot invoke paragraph (b) of this section to 
recast the transaction.
    Example 2. Choice of entity; avoidance of subchapter S shareholder 
requirements; use of partnership consistent with the intent of 
subchapter K. (i) A and B form partnership PRS to conduct a bona fide 
business. A is a corporation that has elected to be treated as an S 
corporation under subchapter S. B is a nonresident alien. PRS is 
properly classified as a partnership under Sec. Sec. 301.7701-2 and 
301.7701-3. Because section 1361(b) prohibits B from being a shareholder 
in A, A and B chose partnership form, rather than admit B as a 
shareholder in A, as a means to retain the benefits of subchapter S 
treatment for A and its shareholders.
    (ii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. The 
decision to organize and conduct business through PRS is consistent with 
this intent. In addition, on these facts, the requirements of paragraphs 
(a)(1), (2), and (3) of this section have been satisfied. Although it 
may be argued that the form of the partnership transaction should not be 
respected because it does not reflect its substance (inasmuch as 
application of the substance over form doctrine arguably could result in 
B being treated as a shareholder of A, thereby invalidating A's 
subchapter S election), the facts indicate otherwise. The shareholders 
of A are subject to tax on their pro rata shares of A's income (see 
section 1361 et seq.), and B is subject to tax on B's distributive share 
of partnership income (see sections 871 and 875). Thus, the form in 
which this arrangement is cast accurately reflects its substance as a 
separate partnership and S corporation. The Commissioner therefore 
cannot invoke paragraph (b) of this section to recast the transaction.
    Example 3. Choice of entity; avoidance of more restrictive foreign 
tax credit limitation; use of partnership consistent with the intent of 
subchapter K. (i) X, a domestic corporation, and Y, a foreign 
corporation, form partnership PRS under the laws of foreign Country A to 
conduct a bona fide joint business. X and Y each owns a 50% interest in 
PRS. PRS is properly classified as a partnership under Sec. Sec. 
301.7701-2 and 301.7701-3. PRS pays income taxes to Country A. X and Y 
chose partnership form to enable X to qualify for a direct foreign tax 
credit under section 901, with look-through treatment under Sec. 1.904-
5(h)(1). Conversely, if PRS were a foreign corporation for U.S. tax 
purposes, X would be entitled only to indirect foreign tax credits under 
section 902 with respect to dividend distributions from PRS. The look-
through rules, however, would not apply, and pursuant to section 
904(d)(1)(E) and Sec. 1.904-4(g), the

[[Page 347]]

dividends and associated taxes would be subject to a separate foreign 
tax credit limitation for dividends from PRS, a noncontrolled section 
902 corporation.
    (ii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. The 
decision to organize and conduct business through PRS in order to take 
advantage of the look-through rules for foreign tax credit purposes, 
thereby maximizing X's use of its proper share of foreign taxes paid by 
PRS, is consistent with this intent. In addition, on these facts, the 
requirements of paragraphs (a)(1), (2), and (3) of this section have 
been satisfied. The Commissioner therefore cannot invoke paragraph (b) 
of this section to recast the transaction.
    Example 4. Choice of entity; avoidance of gain recognition under 
sections 351(e) and 357(c); use of partnership consistent with the 
intent of subchapter K. (i) X, ABC, and DEF form limited partnership PRS 
to conduct a bona fide real estate management business. PRS is properly 
classified as a partnership under Sec. Sec. 301.7701-2 and 301.7701-3. 
X, the general partner, is a newly formed corporation that elects to be 
treated as a real estate investment trust as defined in section 856. X 
offers its stock to the public and contributes substantially all of the 
proceeds from the public offering to PRS. ABC and DEF, the limited 
partners, are existing partnerships with substantial real estate 
holdings. ABC and DEF contribute all of their real property assets to 
PRS, subject to liabilities that exceed their respective aggregate bases 
in the real property contributed, and terminate under section 
708(b)(1)(A). In addition, some of the former partners of ABC and DEF 
each have the right, beginning two years after the formation of PRS, to 
require the redemption of their limited partnership interests in PRS in 
exchange for cash or X stock (at X's option) equal to the fair market 
value of their respective interests in PRS at the time of the 
redemption. These partners are not compelled, as a legal or practical 
matter, to exercise their exchange rights at any time. X, ABC, and DEF 
chose to form a partnership rather than have ABC and DEF invest directly 
in X to allow ABC and DEF to avoid recognition of gain under sections 
351(e) and 357(c). Because PRS would not be treated as an investment 
company within the meaning of section 351(e) if PRS were incorporated 
(so long as it did not elect under section 856), section 721(a) applies 
to the contribution of the real property to PRS. See section 721(b).
    (ii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. The 
decision to organize and conduct business through PRS, thereby avoiding 
the tax consequences that would have resulted from contributing the 
existing partnerships' real estate assets to X (by applying the rules of 
sections 721, 731, and 752 in lieu of the rules of sections 351(e) and 
357(c)), is consistent with this intent. In addition, on these facts, 
the requirements of paragraphs (a)(1), (2), and (3) of this section have 
been satisfied. Although it may be argued that the form of the 
transaction should not be respected because it does not reflect its 
substance (inasmuch as the present value of the partners' aggregate 
federal tax liability is substantially less than would be the case if 
the transaction were integrated and treated as a contribution of the 
encumbered assets by ABC and DEF directly to X, see paragraph (c)(2) of 
this section), the facts indicate otherwise. For example, the right of 
some of the former ABC and DEF partners after two years to exchange 
their PRS interests for cash or X stock (at X's option) equal to the 
fair market value of their PRS interest at that time would not require 
that right to be considered as exercised prior to its actual exercise. 
Moreover, X may make other real estate investments and other business 
decisions, including the decision to raise additional capital for those 
purposes. Thus, although it may be likely that some or all of the 
partners with the right to do so will, at some point, exercise their 
exchange rights, and thereby receive either cash or X stock, the form of 
the transaction as a separate partnership and real estate investment 
trust is respected under substance over form principles (see paragraph 
(a)(2) of this section). The Commissioner therefore cannot invoke 
paragraph (b) of this section to recast the transaction.
    Example 5. Special allocations; dividends received deductions; use 
of partnership consistent with the intent of subchapter K. (i) 
Corporations X and Y contribute equal amounts to PRS, a bona fide 
partnership formed to make joint investments. PRS pays $100x for a share 
of common stock of Z, an unrelated corporation, which has historically 
paid an annual dividend of $6x. PRS specially allocates the dividend 
income on the Z stock to X to the extent of the London Inter-Bank 
Offered Rate (LIBOR) on the record date, applied to X's contribution of 
$50x, and allocates the remainder of the dividend income to Y. All other 
items of partnership income and loss are allocated equally between X and 
Y. The allocations under the partnership agreement have substantial 
economic effect within the meaning of Sec. 1.704-1(b)(2). In addition 
to avoiding an entity-level tax, a principal purpose for the formation 
of the partnership was to invest in the Z common stock and to allocate 
the dividend income from the stock to provide X with a floating-rate 
return based on LIBOR, while permitting X and Y to claim the dividends 
received deduction under

[[Page 348]]

section 243 on the dividends allocated to each of them.
    (ii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. The 
decision to organize and conduct business through PRS is consistent with 
this intent. In addition, on these facts, the requirements of paragraphs 
(a)(1), (2), and (3) of this section have been satisfied. Section 704(b) 
and Sec. 1.704-1(b)(2) permit income realized by the partnership to be 
allocated validly to the partners separate from the partners' respective 
ownership of the capital to which the allocations relate, provided that 
the allocations satisfy both the literal requirements of the statute and 
regulations and the purpose of those provisions (see paragraph (c)(5) of 
this section). Section 704(e)(2) is not applicable to the facts of this 
example (otherwise, the allocations would be required to be 
proportionate to the partners' ownership of contributed capital). The 
Commissioner therefore cannot invoke paragraph (b) of this section to 
recast the transaction.
    Example 6. Special allocations; nonrecourse financing; low-income 
housing credit; use of partnership consistent with the intent of 
subchapter K. (i) A and B, high-bracket taxpayers, and X, a corporation 
with net operating loss carryforwards, form general partnership PRS to 
own and operate a building that qualifies for the low-income housing 
credit provided by section 42. The project is financed with both cash 
contributions from the partners and nonrecourse indebtedness. The 
partnership agreement provides for special allocations of income and 
deductions, including the allocation of all depreciation deductions 
attributable to the building to A and B equally in a manner that is 
reasonably consistent with allocations that have substantial economic 
effect of some other significant partnership item attributable to the 
building. The section 42 credits are allocated to A and B in accordance 
with the allocation of depreciation deductions. PRS's allocations comply 
with all applicable regulations, including the requirements of 
Sec. Sec. 1.704-1(b)(2)(ii) (pertaining to economic effect) and 1.704-
2(e) (requirements for allocations of nonrecourse deductions). The 
nonrecourse indebtedness is validly allocated to the partners under the 
rules of Sec. 1.752-3, thereby increasing the basis of the partners' 
respective partnership interests. The basis increase created by the 
nonrecourse indebtedness enables A and B to deduct their distributive 
share of losses from the partnership (subject to all other applicable 
limitations under the Internal Revenue Code) against their 
nonpartnership income and to apply the credits against their tax 
liability.
    (ii) At a time when the depreciation deductions attributable to the 
building are not treated as nonrecourse deductions under Sec. 1.704-
2(c) (because there is no net increase in partnership minimum gain 
during the year), the special allocation of depreciation deductions to A 
and B has substantial economic effect because of the value-equals-basis 
safe harbor contained in Sec. 1.704-1(b)(2)(iii)(c) and the fact that A 
and B would bear the economic burden of any decline in the value of the 
building (to the extent of the partnership's investment in the 
building), notwithstanding that A and B believe it is unlikely that the 
building will decline in value (and, accordingly, they anticipate 
significant timing benefits through the special allocation). Moreover, 
in later years, when the depreciation deductions attributable to the 
building are treated as nonrecourse deductions under Sec. 1.704-2(c), 
the special allocation of depreciation deductions to A and B is 
considered to be consistent with the partners' interests in the 
partnership under Sec. 1.704-2(e).
    (iii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. The 
decision to organize and conduct business through PRS is consistent with 
this intent. In addition, on these facts, the requirements of paragraphs 
(a) (1), (2), and (3) of this section have been satisfied. Section 
704(b), Sec. 1.704-1(b)(2), and Sec. 1.704-2(e) allow partnership 
items of income, gain, loss, deduction, and credit to be allocated 
validly to the partners separate from the partners' respective ownership 
of the capital to which the allocations relate, provided that the 
allocations satisfy both the literal requirements of the statute and 
regulations and the purpose of those provisions (see paragraph (c)(5) of 
this section). Moreover, the application of the value-equals-basis safe 
harbor and the provisions of Sec. 1.704-2(e) with respect to the 
allocations to A and B, and the tax results of the application of those 
provisions, taking into account all the facts and circumstances, are 
clearly contemplated. Accordingly, even if the allocations would not 
otherwise be considered to satisfy the proper reflection of income 
standard in paragraph (a)(3) of this section, that requirement will be 
treated as satisfied under these facts. Thus, even though the partners' 
aggregate federal tax liability may be substantially less than had the 
partners owned the partnership's assets directly (due to X's inability 
to use its allocable share of the partnership's losses and credits) (see 
paragraph (c)(1) of this section), the transaction is not inconsistent 
with the intent of subchapter K. The Commissioner therefore cannot 
invoke paragraph (b) of this section to recast the transaction.

[[Page 349]]

    Example 7. Partner with nominal interest; temporary partner; use of 
partnership not consistent with the intent of subchapter K. (i) Pursuant 
to a plan a principal purpose of which is to generate artificial losses 
and thereby shelter from federal taxation a substantial amount of 
income, X (a foreign corporation), Y (a domestic corporation), and Z (a 
promoter) form partnership PRS by contributing $9,000x, $990x, and $10x, 
respectively, for proportionate interests (90.0%, 9.9%, and 0.1%, 
respectively) in the capital and profits of PRS. PRS purchases offshore 
equipment for $10,000x and validly leases the equipment offshore for a 
term representing most of its projected useful life. Shortly thereafter, 
PRS sells its rights to receive income under the lease to a third party 
for $9,000x, and allocates the resulting $9,000x of income $8,100x to X, 
$891x to Y, and $9x to Z. PRS thereafter makes a distribution of $9,000x 
to X in complete liquidation of its interest. Under Sec. 1.704-
1(b)(2)(iv)(f), PRS restates the partners' capital accounts immediately 
before making the liquidating distribution to X to reflect its assets 
consisting of the offshore equipment worth $1,000x and $9,000x in cash. 
Thus, because the capital accounts immediately before the distribution 
reflect assets of $19,000x (that is, the initial capital contributions 
of $10,000x plus the $9,000x of income realized from the sale of the 
lease), PRS allocates a $9,000x book loss among the partners (for 
capital account purposes only), resulting in restated capital accounts 
for X, Y, and Z of $9,000x, $990x, and $10x, respectively. Thereafter, 
PRS purchases real property by borrowing the $8,000x purchase price on a 
recourse basis, which increases Y's and Z's bases in their respective 
partnership interests from $1,881x and $19x, to $9,801x and $99x, 
respectively (reflecting Y's and Z's adjusted interests in the 
partnership of 99% and 1%, respectively). PRS subsequently sells the 
offshore equipment, subject to the lease, for $1,000x and allocates the 
$9,000x tax loss $8,910x to Y and $90x to Z. Y's and Z's bases in their 
partnership interests are therefore reduced to $891x and $9x, 
respectively.
    (ii) On these facts, any purported business purpose for the 
transaction is insignificant in comparison to the tax benefits that 
would result if the transaction were respected for federal tax purposes 
(see paragraph (c) of this section). Accordingly, the transaction lacks 
a substantial business purpose (see paragraph (a)(1) of this section). 
In addition, factors (1), (2), (3), and (5) of paragraph (c) of this 
section indicate that PRS was used with a principal purpose to reduce 
substantially the partners' tax liability in a manner inconsistent with 
the intent of subchapter K. On these facts, PRS is not bona fide (see 
paragraph (a)(1) of this section), and the transaction is not respected 
under applicable substance over form principles (see paragraph (a)(2) of 
this section) and does not properly reflect the income of Y (see 
paragraph (a)(3) of this section). Thus, PRS has been formed and availed 
of with a principal purpose of reducing substantially the present value 
of the partners' aggregate federal tax liability in a manner 
inconsistent with the intent of subchapter K. Therefore (in addition to 
possibly challenging the transaction under judicial principles or the 
validity of the allocations under Sec. 1.704-1(b)(2) (see paragraph (h) 
of this section)), the Commissioner can recast the transaction as 
appropriate under paragraph (b) of this section.
    Example 8. Plan to duplicate losses through absence of section 754 
election; use of partnership not consistent with the intent of 
subchapter K. (i) A owns land with a basis of $100x and a fair market 
value of $60x. A would like to sell the land to B. A and B devise a plan 
a principal purpose of which is to permit the duplication, for a 
substantial period of time, of the tax benefit of A's built-in loss in 
the land. To effect this plan, A, C (A's brother), and W (C's wife) form 
partnership PRS, to which A contributes the land, and C and W each 
contribute $30x. All partnership items are shared in proportion to the 
partners' respective contributions to PRS. PRS invests the cash in an 
investment asset (that is not a marketable security within the meaning 
of section 731(c)). PRS also leases the land to B under a three-year 
lease pursuant to which B has the option to purchase the land from PRS 
upon the expiration of the lease for an amount equal to its fair market 
value at that time. All lease proceeds received are immediately 
distributed to the partners. In year 3, at a time when the values of the 
partnership's assets have not materially changed, PRS agrees with A to 
liquidate A's interest in exchange for the investment asset held by PRS. 
Under section 732(b), A's basis in the asset distributed equals $100x, 
A's basis in A's partnership interest immediately before the 
distribution. Shortly thereafter, A sells the investment asset to X, an 
unrelated party, recognizing a $40x loss.
    (ii) PRS does not make an election under section 754. Accordingly, 
PRS's basis in the land contributed by A remains $100x. At the end of 
year 3, pursuant to the lease option, PRS sells the land to B for $60x 
(its fair market value). Thus, PRS recognizes a $40x loss on the sale, 
which is allocated equally between C and W. C's and W's bases in their 
partnership interests are reduced to $10x each pursuant to section 705. 
Their respective interests are worth $30x each. Thus, upon liquidation 
of PRS (or their interests therein), each of C and W will recognize $20x 
of gain. However, PRS's continued existence defers recognition of that 
gain indefinitely. Thus, if this arrangement is respected, C and W 
duplicate for their benefit A's built-in loss in the land prior to its 
contribution to PRS.

[[Page 350]]

    (iii) On these facts, any purported business purpose for the 
transaction is insignificant in comparison to the tax benefits that 
would result if the transaction were respected for federal tax purposes 
(see paragraph (c) of this section). Accordingly, the transaction lacks 
a substantial business purpose (see paragraph (a)(1) of this section). 
In addition, factors (1), (2), and (4) of paragraph (c) of this section 
indicate that PRS was used with a principal purpose to reduce 
substantially the partners' tax liability in a manner inconsistent with 
the intent of subchapter K. On these facts, PRS is not bona fide (see 
paragraph (a)(1) of this section), and the transaction is not respected 
under applicable substance over form principles (see paragraph (a)(2) of 
this section). Further, the tax consequences to the partners do not 
properly reflect the partners' income; and Congress did not contemplate 
application of section 754 to partnerships such as PRS, which was formed 
for a principal purpose of producing a double tax benefit from a single 
economic loss (see paragraph (a)(3) of this section). Thus, PRS has been 
formed and availed of with a principal purpose of reducing substantially 
the present value of the partners' aggregate federal tax liability in a 
manner inconsistent with the intent of subchapter K. Therefore (in 
addition to possibly challenging the transaction under judicial 
principles or other statutory authorities, such as the substance over 
form doctrine or the disguised sale rules under section 707 (see 
paragraph (h) of this section)), the Commissioner can recast the 
transaction as appropriate under paragraph (b) of this section.
    Example 9. Absence of section 754 election; use of partnership 
consistent with the intent of subchapter K. (i) PRS is a bona fide 
partnership formed to engage in investment activities with contributions 
of cash from each partner. Several years after joining PRS, A, a partner 
with a capital account balance and basis in its partnership interest of 
$100x, wishes to withdraw from PRS. The partnership agreement entitles A 
to receive the balance of A's capital account in cash or securities 
owned by PRS at the time of withdrawal, as mutually agreed to by A and 
the managing general partner, P. P and A agree to distribute to A $100x 
worth of non-marketable securities (see section 731(c)) in which PRS has 
an aggregate basis of $20x. Upon distribution, A's aggregate basis in 
the securities is $100x under section 732(b). PRS does not make an 
election to adjust the basis in its remaining assets under section 754. 
Thus, PRS's basis in its remaining assets is unaffected by the 
distribution. In contrast, if a section 754 election had been in effect 
for the year of the distribution, under these facts section 734(b) would 
have required PRS to adjust the basis in its remaining assets downward 
by the amount of the untaxed appreciation in the distributed property, 
thus reflecting that gain in PRS's retained assets. In selecting the 
assets to be distributed, A and P had a principal purpose to take 
advantage of the facts that A's basis in the securities will be 
determined by reference to A's basis in its partnership interest under 
section 732(b), and because PRS will not make an election under section 
754, the remaining partners of PRS will likely enjoy a federal tax 
timing advantage (i.e., from the $80x of additional basis in its assets 
that would have been eliminated if the section 754 election had been 
made) that is inconsistent with proper reflection of income under 
paragraph (a)(3) of this section.
    (ii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. The 
decision to organize and conduct business through PRS is consistent with 
this intent. In addition, on these facts, the requirements of paragraphs 
(a)(1) and (2) of this section have been satisfied. The validity of the 
tax treatment of this transaction is therefore dependent upon whether 
the transaction satisfies (or is treated as satisfying) the proper 
reflection of income standard under paragraph (a)(3) of this section. 
A's basis in the distributed securities is properly determined under 
section 732(b). The benefit to the remaining partners is a result of PRS 
not having made an election under section 754. Subchapter K is generally 
intended to produce tax consequences that achieve proper reflection of 
income. However, paragraph (a)(3) of this section provides that if the 
application of a provision of subchapter K produces tax results that do 
not properly reflect income, but application of that provision to the 
transaction and the ultimate tax results, taking into account all the 
relevant facts and circumstances, are clearly contemplated by that 
provision (and the transaction satisfies the requirements of paragraphs 
(a)(1) and (2) of this section), then the application of that provision 
to the transaction will be treated as satisfying the proper reflection 
of income standard.
    (iii) In general, the adjustments that would be made if an election 
under section 754 were in effect are necessary to minimize distortions 
between the partners' bases in their partnership interests and the 
partnership's basis in its assets following, for example, a distribution 
to a partner. The electivity of section 754 is intended to provide 
administrative convenience for bona fide partnerships that are engaged 
in transactions for a substantial business purpose, by providing those 
partnerships the option of not adjusting their bases in their remaining 
assets following a distribution to a partner. Congress clearly 
recognized that if the section 754 election were not made, basis 
distortions may result. Taking into account all the facts and 
circumstances of the transaction, the

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electivity of section 754 in the context of the distribution from PRS to 
A, and the ultimate tax consequences that follow from the failure to 
make the election with respect to the transaction, are clearly 
contemplated by section 754. Thus, the tax consequences of this 
transaction will be treated as satisfying the proper reflection of 
income standard under paragraph (a)(3) of this section. The Commissioner 
therefore cannot invoke paragraph (b) of this section to recast the 
transaction.
    Example 10. Basis adjustments under section 732; use of partnership 
consistent with the intent of subchapter K. (i) A, B, and C are partners 
in partnership PRS, which has for several years been engaged in 
substantial bona fide business activities. For valid business reasons, 
the partners agree that A's interest in PRS, which has a value and basis 
of $100x, will be liquidated with the following assets of PRS: a 
nondepreciable asset with a value of $60x and a basis to PRS of $40x, 
and related equipment with two years of cost recovery remaining and a 
value and basis to PRS of $40x. Neither asset is described in section 
751 and the transaction is not described in section 732(d). Under 
section 732 (b) and (c), A's $100x basis in A's partnership interest 
will be allocated between the nondepreciable asset and the equipment 
received in the liquidating distribution in proportion to PRS's bases in 
those assets, or $50x to the nondepreciable asset and $50x to the 
equipment. Thus, A will have a $10x built-in gain in the nondepreciable 
asset ($60x value less $50x basis) and a $10x built-in loss in the 
equipment ($50x basis less $40x value), which it expects to recover 
rapidly through cost recovery deductions. In selecting the assets to be 
distributed to A, the partners had a principal purpose to take advantage 
of the fact that A's basis in the assets will be determined by reference 
to A's basis in A's partnership interest, thus, in effect, shifting a 
portion of A's basis from the nondepreciable asset to the equipment, 
which in turn would allow A to recover that portion of its basis more 
rapidly. This shift provides a federal tax timing advantage to A, with 
no offsetting detriment to B or C.
    (ii) Subchapter K is intended to permit taxpayers to conduct joint 
business activity through a flexible economic arrangement without 
incurring an entity-level tax. See paragraph (a) of this section. The 
decision to organize and conduct business through PRS is consistent with 
this intent. In addition, on these facts, the requirements of paragraphs 
(a)(1) and (2) of this section have been satisfied. The validity of the 
tax treatment of this transaction is therefore dependent upon whether 
the transaction satisfies (or is treated as satisfying) the proper 
reflection of income standard under paragraph (a)(3) of this section. 
Subchapter K is generally intended to produce tax consequences that 
achieve proper reflection of income. However, paragraph (a)(3) of this 
section provides that if the application of a provision of subchapter K 
produces tax results that do not properly reflect income, but the 
application of that provision to the transaction and the ultimate tax 
results, taking into account all the relevant facts and circumstances, 
are clearly contemplated by that provision (and the transaction 
satisfies the requirements of paragraphs (a)(1) and (2) of this 
section), then the application of that provision to the transaction will 
be treated as satisfying the proper reflection of income standard.
    (iii) A's basis in the assets distributed to it was determined under 
section 732 (b) and (c). The transaction does not properly reflect A's 
income due to the basis distortions caused by the distribution and the 
shifting of basis from a nondepreciable to a depreciable asset. However, 
the basis rules under section 732, which in some situations can produce 
tax results that are inconsistent with the proper reflection of income 
standard (see paragraph (a)(3) of this section), are intended to provide 
simplifying administrative rules for bona fide partnerships that are 
engaged in transactions with a substantial business purpose. Taking into 
account all the facts and circumstances of the transaction, the 
application of the basis rules under section 732 to the distribution 
from PRS to A, and the ultimate tax consequences of the application of 
that provision of subchapter K, are clearly contemplated. Thus, the 
application of section 732 to this transaction will be treated as 
satisfying the proper reflection of income standard under paragraph 
(a)(3) of this section. The Commissioner therefore cannot invoke 
paragraph (b) of this section to recast the transaction.
    Example 11. Basis adjustments under section 732; plan or arrangement 
to distort basis allocations artificially; use of partnership not 
consistent with the intent of subchapter K. (i) Partnership PRS has for 
several years been engaged in the development and management of 
commercial real estate projects. X, an unrelated party, desires to 
acquire undeveloped land owned by PRS, which has a value of $95x and a 
basis of $5x. X expects to hold the land indefinitely after its 
acquisition. Pursuant to a plan a principal purpose of which is to 
permit X to acquire and hold the land but nevertheless to recover for 
tax purposes a substantial portion of the purchase price for the land, X 
contributes $100x to PRS for an interest therein. Subsequently (at a 
time when the value of the partnership's assets have not materially 
changed), PRS distributes to X in liquidation of its interest in PRS the 
land and another asset with a value and basis to PRS of $5x. The second 
asset is an insignificant part of the economic transaction but is 
important to

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achieve the desired tax results. Under section 732 (b) and (c), X's 
$100x basis in its partnership interest is allocated between the assets 
distributed to it in proportion to their bases to PRS, or $50x each. 
Thereafter, X plans to sell the second asset for its value of $5x, 
recognizing a loss of $45x. In this manner, X will, in effect, recover a 
substantial portion of the purchase price of the land almost 
immediately. In selecting the assets to be distributed to X, the 
partners had a principal purpose to take advantage of the fact that X's 
basis in the assets will be determined under section 732 (b) and (c), 
thus, in effect, shifting a portion of X's basis economically allocable 
to the land that X intends to retain to an inconsequential asset that X 
intends to dispose of quickly. This shift provides a federal tax timing 
advantage to X, with no offsetting detriment to any of PRS's other 
partners.
    (ii) Although section 732 recognizes that basis distortions can 
occur in certain situations, which may produce tax results that do not 
satisfy the proper reflection of income standard of paragraph (a)(3) of 
this section, the provision is intended only to provide ancillary, 
simplifying tax results for bona fide partnership transactions that are 
engaged in for substantial business purposes. Section 732 is not 
intended to serve as the basis for plans or arrangements in which 
inconsequential or immaterial assets are included in the distribution 
with a principal purpose of obtaining substantially favorable tax 
results by virtue of the statute's simplifying rules. The transaction 
does not properly reflect X's income due to the basis distortions caused 
by the distribution that result in shifting a significant portion of X's 
basis to this inconsequential asset. Moreover, the proper reflection of 
income standard contained in paragraph (a)(3) of this section is not 
treated as satisfied, because, taking into account all the facts and 
circumstances, the application of section 732 to this arrangement, and 
the ultimate tax consequences that would thereby result, were not 
clearly contemplated by that provision of subchapter K. In addition, by 
using a partnership (if respected), the partners' aggregate federal tax 
liability would be substantially less than had they owned the 
partnership's assets directly (see paragraph (c)(1) of this section). On 
these facts, PRS has been formed and availed of with a principal purpose 
to reduce the taxpayers' aggregate federal tax liability in a manner 
that is inconsistent with the intent of subchapter K. Therefore (in 
addition to possibly challenging the transaction under applicable 
judicial principles and statutory authorities, such as the disguised 
sale rules under section 707, see paragraph (h) of this section), the 
Commissioner can recast the transaction as appropriate under paragraph 
(b) of this section.

    (e) Abuse of entity treatment--(1) General rule. The Commissioner 
can treat a partnership as an aggregate of its partners in whole or in 
part as appropriate to carry out the purpose of any provision of the 
Internal Revenue Code or the regulations promulgated thereunder.
    (2) Clearly contemplated entity treatment. Paragraph (e)(1) of this 
section does not apply to the extent that--
    (i) A provision of the Internal Revenue Code or the regulations 
promulgated thereunder prescribes the treatment of a partnership as an 
entity, in whole or in part, and
    (ii) That treatment and the ultimate tax results, taking into 
account all the relevant facts and circumstances, are clearly 
contemplated by that provision.
    (f) Examples. The following examples illustrate the principles of 
paragraph (e) of this section. The examples set forth below do not 
delineate the boundaries of either permissible or impermissible types of 
transactions. Further, the addition of any facts or circumstances that 
are not specifically set forth in an example (or the deletion of any 
facts or circumstances) may alter the outcome of the transaction 
described in the example. Unless otherwise indicated, parties to the 
transactions are not related to one another.

    Example 1. Aggregate treatment of partnership appropriate to carry 
out purpose of section 163(e)(5). (i) Corporations X and Y are partners 
in partnership PRS, which for several years has engaged in substantial 
bona fide business activities. As part of these business activities, PRS 
issues certain high yield discount obligations to an unrelated third 
party. Section 163(e)(5) defers (and in certain circumstances disallows) 
the interest deductions on this type of obligation if issued by a 
corporation. PRS, X, and Y take the position that, because PRS is a 
partnership and not a corporation, section 163(e)(5) is not applicable.
    (ii) Section 163(e)(5) does not prescribe the treatment of a 
partnership as an entity for purposes of that section. The purpose of 
section 163(e)(5) is to limit corporate-level interest deductions on 
certain obligations. The treatment of PRS as an entity could result in a 
partnership with corporate partners issuing those obligations and 
thereby circumventing the purpose of section 163(e)(5), because the 
corporate partner would deduct its distributive share of the interest on 
obligations that would have been deferred until

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paid or disallowed had the corporation issued its share of the 
obligation directly. Thus, under paragraph (e)(1) of this section, PRS 
is properly treated as an aggregate of its partners for purposes of 
applying section 163(e)(5) (regardless of whether any party had a tax 
avoidance purpose in having PRS issue the obligation). Each partner of 
PRS will therefore be treated as issuing its share of the obligations 
for purposes of determining the deductibility of its distributive share 
of any interest on the obligations. See also section 163(i)(5)(B).
    Example 2. Aggregate treatment of partnership appropriate to carry 
out purpose of section 1059. (i) Corporations X and Y are partners in 
partnership PRS, which for several years has engaged in substantial bona 
fide business activities. As part of these business activities, PRS 
purchases 50 shares of Corporation Z common stock. Six months later, 
Corporation Z announces an extraordinary dividend (within the meaning of 
section 1059). Section 1059(a) generally provides that if any 
corporation receives an extraordinary dividend with respect to any share 
of stock and the corporation has not held the stock for more than two 
years before the dividend announcement date, the basis in the stock held 
by the corporation is reduced by the nontaxed portion of the dividend. 
PRS, X, and Y take the position that section 1059(a) is not applicable 
because PRS is a partnership and not a corporation.
    (ii) Section 1059(a) does not prescribe the treatment of a 
partnership as an entity for purposes of that section. The purpose of 
section 1059(a) is to limit the benefits of the dividends received 
deduction with respect to extraordinary dividends. The treatment of PRS 
as an entity could result in corporate partners in the partnership 
receiving dividends through partnerships in circumvention of the intent 
of section 1059. Thus, under paragraph (e)(1) of this section, PRS is 
properly treated as an aggregate of its partners for purposes of 
applying section 1059 (regardless of whether any party had a tax 
avoidance purpose in acquiring the Z stock through PRS). Each partner of 
PRS will therefore be treated as owning its share of the stock. 
Accordingly, PRS must make appropriate adjustments to the basis of the 
Corporation Z stock, and the partners must also make adjustments to the 
basis in their respective interests in PRS under section 705(a)(2)(B). 
See also section 1059(g)(1).
    Example 3. Prescribed entity treatment of partnership; determination 
of CFC status clearly contemplated. (i) X, a domestic corporation, and 
Y, a foreign corporation, intend to conduct a joint venture in foreign 
Country A. They form PRS, a bona fide domestic general partnership in 
which X owns a 40% interest and Y owns a 60% interest. PRS is properly 
classified as a partnership under Sec. Sec. 301.7701-2 and 301.7701-3. 
PRS holds 100% of the voting stock of Z, a Country A entity that is 
classified as an association taxable as a corporation for federal tax 
purposes under Sec. 301.7701-2. Z conducts its business operations in 
Country A. By investing in Z through a domestic partnership, X seeks to 
obtain the benefit of the look-through rules of section 904(d)(3) and, 
as a result, maximize its ability to claim credits for its proper share 
of Country A taxes expected to be incurred by Z.
    (ii) Pursuant to sections 957(c) and 7701(a)(30), PRS is a United 
States person. Therefore, because it owns 10% or more of the voting 
stock of Z, PRS satisfies the definition of a U.S. shareholder under 
section 951(b). Under section 957(a), Z is a controlled foreign 
corporation (CFC) because more than 50% of the voting power or value of 
its stock is owned by PRS. Consequently, under section 904(d)(3), X 
qualifies for look-through treatment in computing its credit for foreign 
taxes paid or accrued by Z. In contrast, if X and Y owned their 
interests in Z directly, Z would not be a CFC because only 40% of its 
stock would be owned by U.S. shareholders. X's credit for foreign taxes 
paid or accrued by Z in that case would be subject to a separate foreign 
tax credit limitation for dividends from Z, a noncontrolled section 902 
corporation. See section 904(d)(1)(E) and Sec. 1.904-4(g).
    (iii) Sections 957(c) and 7701(a)(30) prescribe the treatment of a 
domestic partnership as an entity for purposes of defining a U.S. 
shareholder, and thus, for purposes of determining whether a foreign 
corporation is a CFC. The CFC rules prevent the deferral by U.S. 
shareholders of U.S. taxation of certain earnings of the CFC and reduce 
disparities that otherwise might occur between the amount of income 
subject to a particular foreign tax credit limitation when a taxpayer 
earns income abroad directly rather than indirectly through a CFC. The 
application of the look-through rules for foreign tax credit purposes is 
appropriately tied to CFC status. See sections 904(d)(2)(E) and 
904(d)(3). This analysis confirms that Congress clearly contemplated 
that taxpayers could use a bona fide domestic partnership to subject 
themselves to the CFC regime, and the resulting application of the look-
through rules of section 904(d)(3). Accordingly, under paragraph (e) of 
this section, the Commissioner cannot treat PRS as an aggregate of its 
partners for purposes of determining X's foreign tax credit limitation.

    (g) Effective date. Paragraphs (a), (b), (c), and (d) of this 
section are effective for all transactions involving a partnership that 
occur on or after May 12, 1994. Paragraphs (e) and (f) of this section 
are effective for all transactions

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involving a partnership that occur on or after December 29, 1994.
    (h) Scope and application. This section applies solely with respect 
to taxes under subtitle A of the Internal Revenue Code, and for purposes 
of this section, any reference to a federal tax is limited to any tax 
imposed under subtitle A of the Internal Revenue Code.
    (i) Application of nonstatutory principles and other statutory 
authorities. The Commissioner can continue to assert and to rely upon 
applicable nonstatutory principles and other statutory and regulatory 
authorities to challenge transactions. This section does not limit the 
applicability of those principles and authorities.

[T.D. 8588, 60 FR 27, Jan. 3, 1995; T.D. 8588, 60 FR 9776, 9777, Feb. 
22, 1995, as amended by T.D. 8592, 60 FR 18741, April 13, 1995]