Contributing property to a partnership is usually tax-free. But when the partnership also transfers money or other property back to the contributing partner, Internal Revenue Code §707(a)(2)(B) and the related Treasury regulations may treat the two transfers as a sale, with gain recognized now rather than deferred.
Why the Disguised Sale Rules Exist
Under §721, a partner generally recognizes no gain or loss when contributing property to a partnership in exchange for a partnership interest. Under §731(a)(1), a partner generally recognizes gain on a distribution of money only to the extent the money exceeds the partner’s adjusted basis in the partnership interest.
Without a special rule, those two provisions could allow a partner to contribute appreciated property, receive cash shortly afterward, and achieve the economics of a sale while deferring much of the gain. Section 707(a)(2)(B) addresses this. When a transfer of property by a partner and a related transfer of money or other property by the partnership, viewed together, are properly characterized as a sale or exchange, they are treated that way for tax purposes.
The General Test
Treasury Regulation §1.707-3(b)(1) treats the transfers as a sale only if, based on all the facts and circumstances, (1) the partnership’s transfer of money or other consideration would not have been made but for the partner’s transfer of property, and (2) where the transfers are not simultaneous, the later transfer is not dependent on the entrepreneurial risks of partnership operations.
The regulations list facts that may tend to show a sale, such as a later transfer whose timing and amount were reasonably certain at the time of the earlier transfer, a legally enforceable or secured right to the later transfer, borrowing or other financing arranged to fund the transfer, and a transfer that is disproportionately large relative to the partner’s continuing interest in partnership profits.
The Two-Year Presumptions
Within two years. If a partner transfers property to a partnership and the partnership transfers money or other consideration to that partner within a two-year period, in either order, the transfers are presumed to be a sale unless the facts and circumstances clearly establish otherwise (Treas. Reg. §1.707-3(c)(1)).
More than two years apart. If the transfers are more than two years apart, they are presumed not to be a sale unless the facts and circumstances clearly establish that they are (Treas. Reg. §1.707-3(d)).
These are presumptions, not safe harbors. A distribution made more than two years after a contribution can still be treated as part of a sale if the facts clearly establish one.
Disclosure may also be required. When a partner contributes property and receives money or other consideration within two years, and the transfers are not treated as a sale, the regulations generally require disclosure to the IRS on Form 8275 or on a statement attached to the transferor’s return, unless an exception applies, such as for certain reasonable guaranteed payments, preferred returns, or operating cash flow distributions (Treas. Reg. §§1.707-3(c)(2) and 1.707-8).
Transfers within two years of each other are presumed to be a sale. Transfers more than two years apart are presumed not to be. Either presumption can be overcome by the facts and circumstances.
How Gain Is Computed
A disguised sale is treated as a sale for all purposes of the Code. When the consideration is less than the property’s fair market value, the partner is treated as selling part of the property and contributing the rest.
For example, assume a partner contributes property worth $2,000,000 with an adjusted basis of $500,000 and receives $800,000 in a transfer treated as part of a sale. The partner is treated as selling 40 percent of the property ($800,000 ÷ $2,000,000). The basis allocated to the portion sold is $200,000 (40 percent of $500,000), so the recognized gain is $600,000. The remaining 60 percent of the property is treated as a contribution. This follows the method illustrated in Example 1 of Treas. Reg. §1.707-3(f).
Important Exceptions
Treasury Regulation §1.707-4 provides several presumptions and exceptions.
Guaranteed payments for capital and preferred returns. Reasonable guaranteed payments for capital and reasonable preferred returns are generally presumed not to be part of a sale unless the facts and circumstances clearly establish otherwise.
Operating cash flow distributions. Distributions of operating cash flow, within limits defined in the regulations, are presumed not to be part of a sale unless the facts and circumstances clearly establish otherwise.
Reimbursement of preformation capital expenditures. A partnership may reimburse a partner for certain capital expenditures incurred during the two years before the contribution, such as partnership organization and syndication costs or expenditures with respect to the contributed property, without the reimbursement being treated as sale proceeds. For expenditures on the contributed property, the exception is generally limited to 20 percent of the property’s fair market value, but that limit does not apply if the property’s fair market value does not exceed 120 percent of the partner’s adjusted basis.
Liabilities. A partnership’s assumption of a partner’s liability, or its taking property subject to a liability, can be treated as consideration in a disguised sale. “Qualified liabilities,” such as a liability incurred more than two years before the transfer that has encumbered the property throughout that period, receive more favorable treatment. A liability incurred within two years before the transfer is generally presumed to have been incurred in anticipation of the transfer unless the facts and circumstances clearly establish otherwise (Treas. Reg. §1.707-5).
Related Rules: §704(c), §704(c)(1)(B), and §737
When a partner contributes property, the partner’s basis in the partnership interest equals the money contributed plus the adjusted basis of the contributed property (§722), and the partnership takes the partner’s adjusted basis in the property (§723). Neither is stepped up to fair market value. The difference between the property’s value and its tax basis is built-in gain or loss.
Section 704(c)(1)(A) requires items with respect to contributed property to be shared so as to take account of that difference, which generally keeps pre-contribution gain with the contributing partner.
Two other provisions can trigger that built-in gain. If the partnership distributes the contributed property to another partner within seven years of the contribution, the contributing partner generally recognizes the gain or loss that would have been allocated to that partner had the property been sold for its fair market value at the time of the distribution (§704(c)(1)(B)). If the contributing partner receives a distribution of other property within seven years, §737 may require the partner to recognize gain, generally equal to the lesser of the partner’s net precontribution gain or the excess of the distributed property’s value over the partner’s basis in the partnership interest (reduced by any money received in the distribution).
Planning Considerations
Before a partner contributes appreciated property, or before a partnership makes a distribution to a partner who recently contributed property, it is worth reviewing the timing of the transfers, whether any expected distribution is fixed or enforceable, whether an exception applies, the status of any liabilities on the property, any disclosure obligation, and the seven-year rules.
The Bottom Line
The disguised sale rules look at substance rather than labels. A contribution followed by a distribution, particularly within two years, may be treated in whole or in part as a sale, with gain recognized currently. These issues are best addressed before the transaction closes.
Contributing property to a partnership?
Tax attorney Cassra Minai, Esq. can review your transaction in a confidential consultation.