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Families and Family Offices engaged in managing private 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, joint ventures and/or club agreements. In any event, the managers of any partnership, whether a general partner of a limited partnership, a manager of a limited liability company taxed as a partnership or any variation of either of these structures (such as limited liability partnerships, serial limited liability partnerships and other variations) should be aware of developments and changes in the way in which the IRS reviews and audits partnerships. As Family Offices can occupy a managerial position, this is a particularly sensitive issue for Family Office professionals.
In May 2022, we learned of the renewed use of a legacy tool for Federal Partnership IRS Audit Strategies.
The Current Development: IRS Audits Using the Partnership Anti-Abuse Rule
In early May 2022, an IRS official spoke of an expected increase in the use of a particularly broad regulatory regime applicable to partnerships. Specifically, Cliff Warren of the Office of the Associate Chief Counsel for the IRS (Passthroughs and Special Industries), speaking at an April 29 Practicing Law Institute conference, acknowledged that the regulation broadly known as the “partnership anti-abuse rule” will be invoked in partnership checks more frequently than before.
This is a logical and potentially anticipated approach in the private client space following the 2019-2020 development around the IRS’ Global High Wealth (“GHW”) program. This program has been described by the IRS as formulating a holistic approach to addressing the affluent taxpayer population. In doing so, the IRS has created a deliberate and intentional process to examine the “full financial picture” of high net worth individuals and the businesses they control. Specifically, the IRS has previously explained that the GHW business case consists of a key case, typically an individual tax return, and all related tax returns, including related partnerships. There is some question as to the appropriate scope and extent of GHW audits and review.
Put the rule in context
The Partnership Anti-Abuse Rule, which is lengthy and contains a number of examples, was published in 1994. Treas. Reg. § 1.701-2(a) states “the intent of Subchapter K” of the Internal Tax Code, and Treas. Reg. § 1.701-2(b) states in relevant part that “if a partnership is formed or used in a transaction the primary purpose of which is to substantially reduce the present value of the partners’ aggregate federal tax in a manner that is inconsistent with the intent of subchapter K, the Commissioner may recast the transaction for federal tax purposes, if necessary to achieve tax results consistent with the intent of subchapter K , in light of the applicable laws and regulations and the facts and circumstances… even if the operation may come under a specific legal or regulatory provision in the literal sense” (emphasis added). Treasures. Reg. §1.701-2(a), in the definition of “Intent of Subchapter K”, states that the following requirements are implicit in the intent of Subchapter K: (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 adhered to on the principles of substance rather than form; and (iii) the tax consequences under Subchapter K for each partner of the operations of the partnership and of the transactions between the partner and the partnership must accurately reflect the economic arrangement of the partners and clearly reflect the associate’s income (collectively, a correct reflection of income).
The partnership anti-abuse rule has been criticized by the partnership tax bar since its proposal and by significant revisions as the rule moved toward final publication. Specifically, many practitioners consider the rule to be so vaguely worded and difficult to apply in practice that it would likely not survive judicial scrutiny. Since its publication, however, the rule has been used with evanescent rarity as a primary means of challenging transactions. The rule’s largely hypothetical relevance was further eroded by the 2010 codification of the economic substance doctrine, which, unlike the anti-abuse partnership rule, was enacted by Congress rather than an agency of the United States. executive.
Mr Warren of the IRS acknowledged that “for many years [the partnership anti-abuse rule] was quite dormant, and it was a big deal to get approval to use this rule. However, Mr. Warren further noted that the use of the rule in audit situations has recently increased in frequency and is likely to do so in the future, acknowledging the controversial nature of the rule saying, “we’ll see how the courts will deal with it”.
Timing: From now on, revise the structures
Mr Warren acknowledged that the long-dormant anti-abuse partnership rule is currently “in play” by IRS staff; both the IRS and practitioners seem poised to face significant litigation over the scope of the rule. Investment partnership tax teams should be prepared for the application of the rule in all audits for which the partnership or its transactions are selected.
Getting ready: next steps
For prior tax years that remain open to audit, partnership professionals should compile working papers documenting the business objectives of large or complex transactions. Similarly, partnership professionals should pursue transactions with a view to preserving and organizing working papers in support of business objective considerations and may additionally consider the usefulness of contemporaneous analysis, including including obtaining written advice from tax professionals to specifically address how the anti-abuse rule might apply to investment structuring, operations and transactions.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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