Families and Family Offices engaged in managing privately held capital often use partnerships to consolidate and aggregate capital from related and/or unrelated parties and trusts. This is true for family investment programs, joint ventures, and pooled capital and or club deals. In any case, those managing any partnership, whether a general partner of a limited partnership, a manager of a limited liability company taxed as a partnership or any variation on either of these structures (such as limited liability limited partnerships, series limited liability companies and other variations) need to be aware of developments and evolutions in the way the IRS reviews and audits partnerships. Since Family Offices may be in a position of management, this is a particularly sensitive issue for family office professionals.
In May 2022, we learned of renewed use of an old tool for federal IRS audit strategies of partnerships.
The Current Development: IRS Audits Employing the Partnership Anti-Abuse Rule
In early May 2022, an official from the IRS discussed an expected increase in the use of a particularly broad regulatory scheme applicable to partnerships. Specifically, Cliff Warren of the IRS Office of Associate Chief Counsel (Passthroughs and Special Industries), speaking at an April 29 Practising Law Institute conference, acknowledged that the broadly-worded regulation known as the “partnership anti-abuse rule” will be invoked in audits of partnerships more frequently than it historically has been.
This is a logical and potentially anticipated approach in the private client space following the 2019-2020 development around the IRS's Global High Wealth (“GHW”) Program. That program has been described by the IRS as formulating a holistic approach in addressing the high-wealth taxpayer population. In so doing, the IRS has created a deliberate and intentional process to review “the complete financial picture” of high-wealth individuals and the enterprises they control. Specifically, the IRS has already explained that the GHW enterprise case consists of a key case, generally an individual income tax return, and all related income tax returns, including related partnerships. There is some question about the appropriate scope and breadth of the GHW audits and review.
Putting the Rule into Context
The partnership anti-abuse rule, which is lengthy and contains a number of examples, was issued in 1994. Treas. Reg. § 1.701-2(a) sets forth the “intent of Subchapter K” of the Internal Revenue Code, and Treas. Reg. § 1.701-2(b) states in relevant part that “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… even though the transaction may fall within the literal words of a particular statutory or regulatory provision” (emphasis added). Treas. Reg. §1.701-2(a), in defining “the intent of Subchapter K,” states that implicit in the intent of subchapter K are the following requirements: (i) 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; (ii) the form of each partnership transaction must be respected under substance over form principles; and (iii) 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).
The partnership anti-abuse rule has been criticized by the partnership tax bar since its proposal and through significant revisions as the regulation moved toward final publication. Specifically, many practitioners view the rule as being so broadly worded and difficult to apply in practice that it likely would not survive judicial scrutiny. Since its publication, however, the rule has been used with vanishing rarity as a primary avenue to challenge transactions. The largely hypothetical relevance of the rule has been further eroded by the 2010 codification of the economic substance doctrine, which, unlike the partnership anti-abuse rule, was enacted by Congress rather than an agency of the executive branch.
Mr. Warren of the IRS acknowledged that “for many years [the partnership anti-abuse rule] was fairly dormant, and it was a big deal to get approval to use that rule.” However, Mr. Warren further noted that the use of the rule in audit situations has increased in frequency recently and is expected to be so going forward, acknowledging the controversial nature of the rule by stating, “we'll see how the courts deal with it.”
Timing: Starting Now, Review Structures
Mr. Warren acknowledged that the long-dormant partnership anti-abuse rule is currently “in play” by IRS staff; both the IRS and practitioners appear braced for significant litigation over the breadth of the rule. Investment partnership tax teams should be prepared for application of the rule in any audits for which the partnership or its transactions are selected.
Being Prepared: Next Steps
Regarding prior tax years that remain open for audit, partnership professionals should compile work papers documenting business purposes for large or complex transactions. Similarly, partnership professionals should move forward with transactions with an increased view to retaining and organizing work papers supporting business purpose considerations and may additionally consider the usefulness of contemporaneous analysis, including obtaining written advice from tax professionals to specially address how the anti-abuse rule might be applied to investment structuring, activities, and transactions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.