What Is It?
Assume that X and Y agree to the following: X will transfer ownership of Prop to Y, and Y will transfer cash to X.
What just happened? No, this is not a trick question. Obviously, X has sold Prop to Y. If the amount of cash that X receives is greater than his adjusted basis in Prop, then X will realize a taxable gain.
What if X borrowed money secured by Prop just before transferring Prop to Y, with Y taking subject to the mortgage?
Again, X will be treated as having sold Prop to Y for an amount of cash equal to the amount of the indebtedness.
Now assume that Y is a partnership. X transfers ownership of Prop to Y as a capital contribution in exchange for a partnership interest in Y; Y borrows cash from an unrelated lender and “distributes” some of the cash to X “in respect of” X’s partnership interest.
Has X sold Prop to Y? Well, the contribution of property to a partnership in exchange for an equity interest therein is not treated as a taxable exchange. The distribution of cash by a partnership to a partner is taxable to the partner only if, and to the extent that, the amount distributed exceeds the partner’s adjusted basis in his partnership interest. In general, when a partnership borrows money, each of its partners includes his “share” of the indebtedness in the adjusted basis of his partnership interest. Thus, Y’s cash distribution may not be taxable to X.
The Disguised Sale Rules – In General
The Code provides special rules to prevent parties from characterizing a sale or exchange of property as a contribution to a partnership followed by a distribution from the partnership, thereby deferring or avoiding tax on the transaction. Under the so-called “disguised sale rules” (“DSR”), related transfers to and by a partnership that, when viewed together, are more properly characterized as a sale or exchange of property, will be treated as a transaction between the partnership and one who is not a partner. https://www.law.cornell.edu/uscode/text/26/707
Depending upon the size of the transferor’s partnership interest and the nature of the property transferred, the gain realized may be treated as ordinary income for tax purposes.
Generally speaking, a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner will be treated as a sale of property by the partner to the partnership if, based on all the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of property and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.
Facts & Circumstances
The weight to be given each of the facts and circumstances will depend on the particular case. In general, the facts and circumstances existing on the date of the earliest of such transfers are the ones considered in determining whether a sale exists. Among the facts and circumstances that may tend to prove the existence of a sale are the following:
(i) the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer;
(ii) the transferor has a legally enforceable right to the subsequent transfer;
(iii) the partner’s right to receive the transfer of money or other consideration is secured in any manner;
(iv) any person has made a contribution to the partnership in order to permit the partnership to make the transfer of money or other consideration;
(v) any person has loaned the partnership the money or other consideration required to enable the partnership to make the transfer;
(vi) a partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer;
(vii) the partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be available to make the transfer;
(viii) partnership distributions, allocation or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property;
(ix) the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and
(x) the partner has no obligation to return or repay the money or other consideration to the partnership.
If within a two-year period, a partner transfers property to a partnership and the partnership transfers money or other consideration to the partner (without regard to the order of the transfers), the transfers are presumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale. Conversely, if a transfer of money or other consideration to a partner by a partnership and the transfer of property to the partnership by that partner are more than two years apart, the transfers are presumed not to be a sale of the property to the partnership unless the facts and circumstances clearly establish otherwise.
The existing DSR provide a number of practical exceptions that recognize the realities of partnership operations, including exceptions for a reasonable preferred return on a partner’s capital contribution, or reasonable guaranteed payments for the use of a partner’s capital; some of the other exceptions are described below.
Transfers of money or other consideration from a partnership to reimburse a partner for certain capital expenditures and costs incurred by the partner are not treated as part of a disguised sale of property by the partner. The exception for preformation capital expenditures generally applies only to the extent that the reimbursed capital expenditures do not exceed 20 percent of the fair market value (“FMV”) of the property transferred by the partner to the partnership, and the FMV of the transferred property does not exceed 120 percent of the partner’s adjusted basis in the property at the time of the transfer.
Another exception generally provides that if a partner transfers property to a partnership, the partnership incurs a liability (i.e., borrows money), and all or a portion of the proceeds of that liability are traceable to a transfer of money or other consideration to the partner, the transfer of money or other consideration is taken into account under the DSR as part of a sale of property only to the extent that the amount of money or the FMV of other consideration exceeds the partner’s allocable share of the partnership liability incurred to fund the distribution.
In general, a partnership’s assumption of a liability, or a partnership’s taking property subject to a liability, in connection with a transfer of property by a partner to the partnership, is treated as a distribution of cash to the contributing partner (i.e., as part of a disguised sale of the property) to the extent the liability is allocated away from the partner under the debt allocation rules applicable to partnerships.
The DSR rules provide further that a partner’s share of a liability assumed or taken subject to by a partnership is determined by taking into account certain subsequent reductions in the transferor-partner’s share of the liability under an “anticipated reduction” rule.
However, “qualified liabilities” are generally excluded from disguised sale treatment. The regulations define several types of “qualified liability,” the “transfer” of which is not treated as a distribution of sale proceeds under the DSR unless the contributing partner also receives a cash distribution from, or “transfers” a nonqualified liability to, the partnership .
One type of qualified liability is a liability that is allocable to capital expenditures with respect to the property transferred to the partnership. Another type is one incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all of the assets that are material to that trade or business are transferred to the partnership, and the liability encumbers the transferred property. Yet another is a liability incurred more than two years before the transfer of the property to the partnership. https://www.law.cornell.edu/cfr/text/26/1.707-5
Applying the Exceptions – Revised Rules
Over the years, the IRS and taxpayers encountered certain issues in interpreting or applying the above exceptions to the DSR. In 2014, the IRS proposed changes to those areas of the existing rules that it identified as requiring clarification or revision.
Earlier this month, final regulations were issued that generally tracked these proposed rules, with some changes. Some of these final rules are described below.
Preformation Capital Expenditures
As explained above, transfers of money or other consideration from a partnership to reimburse a partner for certain capital expenditures and costs incurred by the partner are excepted from being treated as part of a disguised sale of property.
The proposed regulations provided that the determination of whether the “20- percent limitation” and the “120-percent test” apply to reimbursements of capital expenditures is to be made, in the case of multiple property transfers, separately for each property that qualifies for the exception.
The final regulations adopt this clarification. However, in order to reduce the burden of separately accounting for each property under the property-by-property rule, the final regulations also permit a limited aggregation of property provided it is not part of a plan a principal purpose of which is to avoid the DSR.
In addition to the property-by-property rule, the proposed rules provided a rule coordinating the exception for preformation capital expenditures with the rule regarding qualified liabilities.
As stated above, a partnership’s assumption of a qualified liability, or a partnership’s taking property subject to a qualified liability, in connection with a transfer of property by a partner to the partnership is generally not treated as part of a disguised sale.
In order to coordinate the exception for preformation capital expenditures and the capital expenditure qualified liability rule, the final regulations provide that to the extent any qualified liability is used by a partner to fund capital expenditures, and economic responsibility for that borrowing shifts to another partner, the exception for preformation capital expenditures will not apply, and the “transfer” of the liability may trigger a disguised sale.
Capital expenditures will be treated as funded by the proceeds of a qualified liability to the extent the proceeds are either traceable to the capital expenditures or are actually used to fund the capital expenditures.
Debt-financed Distribution – Partner’s Share of Partnership Liabilities
In determining a partner’s share of a partnership liability for DSR purposes, the regulations formerly prescribed separate rules for a partnership’s recourse liability and a partnership’s nonrecourse liability. Under the prior rules, a transferor-partner’s guarantee of a liability permitted the allocation to that partner of 100 percent of the liability for purposes of the DSR. This allowed the partner to defer gain on the transfer of the debt-encumbered property to the partnership.
The final regulations now provide that, solely for purposes of the DSR, partners are to determine their share of any liability, whether recourse or nonrecourse, using the same percentage used to determine the partner’s share of the partnership’s excess nonrecourse liabilities under the debt allocation rules applicable to partnerships based upon the partner’s share of partnership profits. Generally, a partner’s share of excess nonrecourse liabilities is determined in accordance with the partner’s share of partnership profits, taking into account all facts and circumstances relating to the economic arrangement of the partners, and – for purposes of the DSR – without regard to any partner guarantee.
Because a partner’s share of a partnership liability for DSR purposes is based on the partner’s share of partnership profits, a partner can no longer be allocated 100 percent of any liability for purposes of the DSR. As a result, some portion of both qualified liabilities and nonqualified liabilities will shift among the partners, which can cause a portion of a qualified liability to be treated as consideration under the DSR.
To mitigate the effect of this allocation method for disguised sales, the final regulations also include a rule that does not take into account qualified liabilities as consideration in transfers of property treated as a sale when the total amount of all liabilities, other than qualified liabilities that the partnership assumes or takes subject to, is equal to the lesser of 10 percent of the total amount of all qualified liabilities the partnership assumes or takes subject to, or $1 million. This is likely to be of limited benefit to larger ventures.
As stated above, for purposes of the DSR, a partner’s share of a liability assumed or taken subject to by a partnership is determined by taking into account certain subsequent reductions in the partner’s share of the liability. However, the final rules clarify that a reduction will not be treated as anticipatory under the DSR if it is subject to the entrepreneurial risks of partnership operations.
The final rules provide that the treatment of a transfer should first be determined under the debt-financed distribution exception (above), and any amount not excluded from the DSR under that exception should then be tested to see if such amount would be excluded under a different exception (for example, because the transfer of money is also properly treated as a reasonable guaranteed payment). This ordering rule ensures that the application of one of the other exceptions does not minimize the application of the debt-financed distribution exception.
Preformation Capital Expenditures and Liabilities Incurred by Another Person
For purposes of applying the exception for preformation capital expenditures and determining whether a liability is a qualified liability, the final regulations clarify how the DSR apply if the transferor-partner acquired the transferred property in a nonrecognition transaction, assumed a liability in a nonrecognition transaction, or took property subject to a liability in a nonrecognition transaction, from a person who incurred the preformation capital expenditures or the liability.
Under the final rules, a partner that acquires property, assumes a liability, or takes property subject to a liability from another person in connection with certain nonrecognition transactions under the Code will succeed to the status of the other person for purposes of applying the exception for preformation capital expenditures and determining whether a liability is a qualified liability.
The final rules expand the scope of qualified liabilities to include a liability that was not incurred in anticipation of the transfer of the property to a partnership, but that was incurred in connection with a trade or business (rather than incurred in the ordinary course of the trade or business) in which the property transferred to the partnership was used, but only if all the assets related to that trade or business are transferred to the partnership (other than assets that are not material to a continuation of the trade or business). The liability does not have to encumber the transferred property.
The IRS is clearly focused on any transfer that may implicate the DSR. With the adoption of the clarifications described above, however, taxpayers have been provided with a set of guidelines that should enable them to navigate the rules without surprises.
That being said, a taxpayer that is planning to transfer property to a partnership of which he is already a partner, or in exchange for which he will receive a partnership interest, must consult his tax advisers to ensure that he does not run afoul of the DSR.
Failing to do so may lead to unexpectedly scary results (couldn’t help myself).