Disguised Sale Transaction Regulations

Look! It’s a Bird, It’s a Plane, It’s a Disguised Sale: IRS Releases Final Regulations Pertaining to Disguised Sale Transactions between Partners and Partnerships

 

On October 14, 2016, the Internal Revenue Service (IRS) released Treasury Decision 9787 finalizing regulations pertaining to “disguised sale” transactions between partners and partnerships.

Background

Under general principles of partnership taxation, partnership contributions or distributions of property (other than cash) do not result in the immediate recognition of a gain or loss. Instead, the partnership receives or distributes the property at its carry-over tax basis.   However, Internal Revenue Code (IRC) §707 sets forth rules potentially applicable to transfers of property between a partner and the partnership that more in substance resemble a sale rather than a contribution or distribution (so-called “disguised sales”).

Example:  A taxpayer owns land with a fair market value of $2M and a tax basis of $1M.  The taxpayer contributes the land to a partnership for a 1% interest. The next day the partnership distributes $1M in cash to the taxpayer.

In this very simple example, the IRS will almost certainly assert that the events in tandem represent a disguised sale under IRC §707 of 50% of the asset resulting in the taxpayer’s immediate recognition of a $500K gain. In other words, the partner contributed half an interest in the asset and sold the other half interest at its fair market value of $1M.  Thus, the IRC §707 rules represent a statutory application of the “substance over form” doctrine.

However, the rules contain several exceptions to the disguised sale treatment which the new regulations clarify.

Preformation Capital Expenditures Exception

This exception exempts certain payments to a partner in reimbursement of preformation capital expenditures.  These include partnership organization and syndication costs incurred by the partner or other property transferred subject to the following limits:

  1. The partner must have incurred the costs during the two years preceding the transfer.
  1. With respect to property other than organization and syndication costs, the reimbursed capital expenditures cannot exceed 20% of the fair market value of the transferred property if the fair market value of the transferred property exceeds 120% of the partner’s adjusted basis in that property.

The final regulations apply the 20% limitation and 120% fair market test on a property by property basis but allow for the aggregation of property in certain cases. A taxpayer can aggregate assets under the following circumstances:

  1. The total fair market value of the aggregated property does not exceed the lesser of 10% of the total market value of all property transferred (excluding money and marketable securities) or $1,000,000.
  1. No single property’s fair market value exceeds 1% of the total fair market value of such aggregated property.
  1. The method is consistently applied and is not part of a plan whose principal purpose is to avoid the disguised sale rules.

The final regulations deny the exception if the partner uses qualified liabilities (see definition below) to fund the expenditures to the extent another partner assumes economic responsibility for those liabilities.

Debt-Financed Distributions

The general principles of partnership taxation view a partnership’s net assumption of a partner’s liability as a distribution of money to that partner. For example, if a partner contributes property to a partnership encumbered by a $200,000 liability in exchange for a 25% interest the other partners are viewed as relieving the contributing partner of 75% of that debt. Thus the contributing partner retains liability on $50,000 of its share of the now partnership debt (= $200,000 x 25%).

The debt-financed distribution exception employs this concept when a partner transfers property to a partnership and subsequently receives a distribution directly financed by new partnership debt (traced debt).  The exception restricts the portion of the distribution attributable to the disguised sale to that in excess of the contributing partner’s allocable share of the partnership’s liability.

Example: The taxpayer, X, contributes property worth $400,000, with a tax basis of $200,000, to a partnership for a 25% equity interest.  In conjunction with the transfer the partnership borrows $200,000 which it immediately distributes to X.  X’s share of the new partnership debt therefore equals $50,000 (= $200,000 x 25%).  The debt-financed distribution exception therefore views X as having received disguised-sale proceeds of $150,000 (= $200,000 distribution less X’s remaining share of the partnership liability of $50,000).  Therefore, the rule views X as having sold 37.5% of the property to the partnership (= $150,000 in deemed disguised sale proceeds divided by the total fair market value of the property equal to $400,000). Absent the debt-financed distribution exception the disguised sales rules would view X as having sold 50% of the property (= $200,000 total distribution divided by the $400,000 fair market value).

Disguised Sale Gain Without and With Debt-financed
 Distribution Exception
 Without  With
 Fair Market Value of Property  400,000  400,000
 Total Distribution to X  200,000  200,000
 X’s Assumed Partnership Liability  n/a  (50,000)
 Deemed Sales Proceeds  200,000  150,000
 % of Fair Market Value  50.00%  37.50%
 Deemed Sales Proceeds  200,000  150,000
 Property Basis  200,000  200,000
 % Deemed Sold  50.00%  37.50%
 Basis of Sold Property  100,000  75,000
 Disguised Sale Gain  100,000  75,000

 

Qualified Liabilities Exception

The regulations under IRC §707 generally exclude a partnership’s assumption of a partner’s “qualified liability” attendant to the partnership’s receipt of the property. There are four types of qualified liabilities:

  1. A liability allocable to capital expenditures related to the contributed property.
  1. A liability incurred in the ordinary course of a trade or business transferred to the partnership but only if the partner also transfers all of the material trade or business assets.
  1. Liabilities that encumber the property incurred more than two years before the transfer of property to the partnership.
  1. Liabilities that encumber the property incurred within two years of the transfer but not incurred in anticipation of the transfer.

Example: D and E have consulting businesses. They decide to combine their businesses by forming a partnership.  They contribute substantially all of their business assets to the partnership.  The partnership also assumes all of their respective businesses’ accounts payable.  The accounts payable therefore meet the definition of qualified liabilities under the final regulations (see item 2 directly above).  As such, the regulations do not view the partnership’s assumption of their separate trade payables as disguised sales proceeds.

These exceptions basically apply the standard partnership taxation rules to a partnership’s assumption of liabilities not incurred with the intent to disguise a sale of property to the partnership.  The net assumption of a partner’s liabilities still results in a deemed distribution of money to the partner but this typically only reduces the partner’s basis in its partnership interest rather than results in the deemed receipt of immediately taxable disguised sale proceeds.

Partnership Assumption of Partner Liabilities as a Deemed Payment of Disguised Sale Proceeds

As described above, the net assumption by the partnership of a partner’s liability results in a deemed payment of money to the partner.  Under the general partnership taxation rules a payment of money to a partner in the form of a distribution typically does not result in an immediately taxable event. However, as also described above, the assumption of a contributing partner’s debt can constitute immediately taxable sales proceeds when disguised sale treatment applies.  Thus, in determining the total amount of disguised sale consideration one must discern the partner’s share of recourse, nonrecourse and excess nonrecourse liabilities.

Recourse liabilities exist to the extent any partner bears the economic risk of loss should the partnership default on its obligation to pay. For example, under state law the general partner must personally satisfy any trade payables that the partnership cannot pay due to insolvency.  Consequently, the general partner bears the ultimate economic risk of loss on those liabilities. Nonrecourse liabilities exist to the extent that no partner bears personal economic risk. For example, in a limited liability company none of the members are personally liable for the company’s unpaid liabilities.  Speaking very generally, nonrecourse liabilities are determined in accordance with the partner’s share of income assuming the partnership disposed of the property encumbered by the liability in satisfaction of that liability and for no other consideration. There also several other methods that allocate nonrecourse liabilities including the significant item method, alternative method, and addition method.

“Step-in-the-Shoes” Rule

The final regulations under IRC §707 allow a partner who acquires property or assumes a liability in a non-recognition transaction to meet the preformation capital expenditures and qualified liability exceptions to the extent those items would otherwise qualify if incurred directly.

Rules pertaining to Tiered Partnerships

The final regulations generally treat a contributing partner’s share of a lower-tier partnership’s qualified liability as such.  In order to meet this exception, the liability must continue to qualify assuming the lower tier hypothetically transferred its assets and liabilities to the upper tier.

Disguised Sales of Property by a Partnership to a Partner

Taxpayers should also keep in mind that the rules apply symmetrically in that property distributed by a partnership in tandem with a payment by the recipient partner to the partnership can also result in immediate gain recognition under the disguised sale rules.

The final regulations under IRC §§ 707 and 752 went into effect for all transactions occurring on or after October 5, 2016. To find out more about these regulations and the possible ramifications for your particular situation please contact a tax professional.

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas.
https://www.linkedin.com/in/drquintana