A Continuing Investment
In the last two posts, we saw how a Taxpayer who transfers Property A to a partnership (“Partnership”) in exchange for an equity interest therein will not be required to recognize the gain realized on the transfer. This gain will not be included in Taxpayer’s gross income because Taxpayer is viewed under the Code as continuing his investment in Property A, albeit indirectly, through his interest in Partnership; thus, the theory goes, it would not be appropriate to tax him on the gain realized.
We also saw that, because the Code views Taxpayer’s investment in Partnership as a continuation of his investment in Property A, Taxpayer’s basis for his interest in Partnership will be the same basis that he had in Property A at the time of the contribution. In this way, the gain realized by Taxpayer on his transfer of Property A is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.
In what may be characterized as the other side of the same coin (I may have mentioned in some earlier post that I am “idiom-challenged”), we saw that Partnership will take Property A with a basis equal to the basis that Taxpayer had in Property A at the time of its contribution to Partnership. Thus, the gain inherent in Property A at the time it was contributed by Taxpayer (the “pre-contribution gain”) will also be preserved in the hands of Partnership, and such gain will be taxed to Taxpayer on Partnership’s taxable disposition of Property A.
An In-Kind Distribution
Distribution to Taxpayer
Instead of selling Property A, what if Partnership simply distributes Property A to Taxpayer? Taxpayer is thereby restored to his pre-contribution position, even if Property A has appreciated in value after its contribution to Partnership (as, presumably, has Taxpayer’s interest in Partnership). Thus, the distribution is not taxable.
Distribution to Another Partner
What if Partnership, instead, distributes Property A to another partner (“Partner”)? At that point, Taxpayer’s indirect interest in Property A is terminated, and Taxpayer no longer has to be concerned that the gain realized by Partnership on a later sale of Property A (to the extent of its pre-contribution gain) will be specially allocated, and taxed, to him. Rather, Partner will now be taxed on his subsequent sale of Property A; without more, and provided the distribution to Partner is not in liquidation of his interest in Partnership, he will take Property A with the same basis that Partnership had in the property. Thus, Taxpayer’s pre-contribution gain may be shifted to Partner. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain at that time?
Distribution of Another Property to Taxpayer
What if Partnership retains Property A, but distributes other property (“Property B”) to Taxpayer? Taxpayer continues to have an indirect interest in Property A, but he has also acquired a property other than the one that he originally contributed to Partnership. Taxpayer’s basis in Property B will be the same basis that Partnership had in the property. If that basis is greater than Partner’s pre-contribution basis in Property A, Taxpayer may sell Property B and realize less gain than if he had sold Property A. In addition, it follows that Taxpayer’s interest in Property A is somewhat reduced as a result of the distribution of Property B to Taxpayer, while Partner’s interest therein has increased. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain in Property A at that time?
A “Deemed” Exchange
In general, a partner who receives a distribution of property from a partnership will not recognize gain on the distribution, except to the extent that the amount of money distributed exceeds the partner’s adjusted basis for his interest in the partnership immediately before the distribution. Likewise, no gain will be recognized to the partnership on the distribution of property to a partner. In short, an in-kind distribution of property will generally not be taxable to the distributee partner or to any other partner.
There are exceptions to this general nonrecognition rule that encompass the situations described above, and that seek to prevent the shifting of the tax consequences attributable to a property’s pre-contribution gain away the contributing partner, and to another partner.
In order to accomplish this goal, these rules – often referred to as the “mixing bowl” rules – effectively treat a partnership’s in-kind distribution of a property to a partner as the second step of a taxable exchange, the first step being that partner’s, or another partner’s, contribution of another property to the partnership. The partnership is treated as a vehicle through which the exchange is effected.
Distribution to Taxpayer
Under the first exception, if property that was contributed by a partner to a partnership is then distributed by the partnership to another partner within seven years of its contribution, then the contributing partner will be required to recognize gain in an amount equal to the gain that would have been allocated to him if the property had been sold at its fair market value at the time of the distribution (the pre-contribution gain). (Congress decided that a seven-year period was necessary in order to ensure that the contribution to, and distribution from, the partnership were independent of one another, and not steps or parts of planned exchange.)
Thus, in the first scenario described above, if Property A is distributed to Partner within seven years of Taxpayer’s contribution of the property to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.
Distribution to Another Partner
Under the second exception, if a partnership distributes property to a partner who, within the preceding seven years, contributed other property to the partnership (which the partnership still owns at the time of the distribution – meaning that its pre-contribution gain has not yet been recognized), then such partner shall be required to recognize the pre-contribution gain of the contributed property.
This is the same gain that would have been recognized by the contributing partner if the property which had been contributed to the partnership by such partner within seven years of the distribution, and is held by such partnership immediately before the distribution, had been distributed by the partnership to another partner (as in the first scenario described above).
Thus, in the second scenario described above, if Property B (which had been contributed to Partnership by Partner) is distributed to Taxpayer within seven years of Taxpayer’s contribution of Property A to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.
A “Like-Kind” Exchange?
We stated earlier that the above “anti-gain-shifting” rules effectively treat a partnership’s distribution of a property to a partner as the second step of a taxable exchange, with the first step being that partner’s, or another partner’s, contribution of another property to the partnership.
These rules implicitly assume that the properties that are deemed to have been exchanged are not of like-kind and, so, the exchange is taxable. However, what if the properties are, in fact, of “like-kind”? In other words, what if the like-kind properties had exchanged directly, without first passing them through the partnership? In that case, the exchange may have qualified as a “tax-free” exchange under the like-kind exchange rules.
Following this line of thinking, the mixing bowl rules generally provide that if pre-contribution gain property is distributed to a partner other than the contributing partner, and other property of like-kind to the contributed property is distributed from the partnership to the contributing partner within a specified period of time, then the amount of gain that the contributing partner would otherwise have recognized under the above mixing bowl rules is reduced by the amount of built-in gain in the distributed like-kind property in the hands of the contributing partner immediately after the distribution.
Thus, if Property A and Property B are of like-kind to one another and, within seven years of Taxpayer’s contribution of Property A to Partnership, Partnership distributes Property B to Taxpayer and Property A to Partner, then Taxpayer will not have to recognize the pre-contribution gain in Property A to the extent of the gain inherent in Property B after the distribution; at least some of the pre-contribution gain in Property A is preserved in Taxpayer’s hands.
Advice to the Contributing Partner?
Last week we stated that Taxpayer would be well-advised to negotiate for a prohibition, for a period of time, on Partnership’s sale of any property contributed by Taxpayer.
Based upon this week’s discussion, it may behoove Taxpayer to also negotiate for a period of time (say, seven years) during which Partnership will not distribute Property to another partner, at least not without Taxpayer’s prior consent.
Taxpayer may also want to request that, in the event that Partnership has to distribute its properties (e.g., in liquidation), it will do so in a way that minimizes any adverse tax consequences to Taxpayer under the mixing bowl rules. This may include a provision that requires the “return” of Property A to Taxpayer, if feasible (and provided it makes sense from a business perspective).
Alternatively, Taxpayer may try to negotiate for a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.
As always, it is important that Taxpayer be aware of, and that he consider the potential economic effect of, the foregoing rules prior to his contributing Property to Partnership in exchange for a partnership interest. Armed with this knowledge, Taxpayer may be able to negotiate a more tax-favorable agreement regarding the disposition of his contributed property by the Partnership.