DISGUISED SALES OF PARTNERSHIP INTERESTS: THE … · 2013-10-17 · DISGUISED SALES OF PARTNERSHIP...

DISGUISED SALES OF PARTNERSHIP INTERESTS: THE PROPOSED REGULATIONS

BRUCE A. MCGOVERN Professor of Law

South Texas College of Law 1303 San Jacinto Street

Houston, Texas 77002-7000 (713) 646-2920

[email protected]

State Bar of Texas 23RD ANNUAL ADVANCED TAX LAW COURSE

September 29-30, 2005 Dallas

CHAPTER 5

Bruce A. McGovern South Texas College of Law

1303 San Jacinto Street Houston, Texas 77002-7000

(713) 646-2920 ● [email protected]

EDUCATION University of Florida Levin College of Law, Gainesville, FL LL.M. (Taxation), 1996.

Fordham University School of Law, New York, NY J.D. cum laude, 1989. Managing Editor, Fordham Law Review.

Columbia University, Columbia College, New York, NY B.A. (Religion), 1984.

EXPERIENCE South Texas College of Law, Houston, TX Professor of Law, 2003–present Associate Professor of Law, 2000–2003 Assistant Professor of Law, 1997–2000 Teach in the areas of federal taxation and business organizations. Courses include Agency & Partnership, Corporations, Corporate Taxation, Federal Income Taxation, and

Partnership & Subchapter S Taxation. University of Florida Levin College of Law, Gainesville, FL Visiting Assistant Professor of Law, 1996–1997 Taught courses in both the Graduate Tax Program and the J.D. curriculum.

Covington & Burling, Washington, DC Associate (Tax), 1990–1995 The Hon. Thomas J. Meskill, U.S. Court of Appeals, Second Circuit Judicial Clerk, 1989–1990

PUBLICATIONS Liabilities of the Firm, Member Guaranties, and the At Risk Rules: Some Practical and Policy Considerations, 7 J. Small & Emerging Bus. L. 63 (2003). Fiduciary Duties, Consolidated Returns, and Fairness, 81 Neb. L. Rev. 170 (2002). An Obituary of the Federal Estate Tax, 43 Ariz. L. Rev. 625 (2001) (with M.C. Mirow). The New Provision for Tolling the Limitations Periods for Seeking Tax Refunds: Its History, Operation and Policy, and Suggestions for Reform, 65 Mo. L. Rev. 797 (2000). Tax Aspects of Environmental Liabilities and Insurance Recoveries, 7 Mealey’s Litigation Reports (Insurance) No. 23, at 21 (Apr. 20, 1993) (with William M. Paul).

PROFESSIONAL AFFILIATIONS AND ACTIVITIES Council Director, Houston Bar Association Section of Taxation. Consultant, Florida Bar Tax Certification Committee. Member, Garland Walker Chapter, American Inns of Court. Member, ABA Sections of Taxation, Business Law, and Legal Education.

AWARDS Outstanding Teaching Award, STCL Student Bar Association, 1999–2000 and 2000–2001. Professor of the Year Award, STCL Black Law Students’ Association, 1998–1999.

Disguised Sales of Partnership Interests Chapter 5

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TABLE OF CONTENTS

I. INTRODUCTION.................................................................................................................................................. 1

II. BACKGROUND ON TRANSACTIONS BETWEEN A PARTNERSHIP AND ITS PARTNERS .................... 1 A. Partners Can Deal With the Partnership as if They Were Not Partners......................................................... 1

1. Tax Consequences ................................................................................................................................ 1 a) In General ........................................................................................................................................ 1 b) Significant Exceptions ..................................................................................................................... 1

(1) Matching of Deduction and Income Under § 267 ................................................................. 1 (2) Sales/Exchanges of Property Between Partners and Controlled Partnerships....................... 1

2. Determining When a Partner Acts in a Non-Partner Capacity.............................................................. 2 a) Partner’s Provision of Services........................................................................................................ 2 b) Partner’s Sale of Property ................................................................................................................ 2

B. Certain Transfers Are Treated as Disguised Sales......................................................................................... 2 1. Congress Enacts Code § 707(a)(2)(B) .................................................................................................. 2

a) Background...................................................................................................................................... 2 b) Section 707(a)(2)(B) ........................................................................................................................ 3

2. Treasury Issues Regulations on Disguised Sales of Property ............................................................... 4 a) Brief Overview of General Rules .................................................................................................... 4

(1) Transfers Treated as a Sale.................................................................................................... 4 (2) Presumptions ......................................................................................................................... 4 (3) Effect of Liabilities................................................................................................................ 4

b) Required Disclosure of Transfers .................................................................................................... 4 3. The Service’s Rulings on Disguised Sales of Partnership Interests...................................................... 4 4. Treasury Asks for Input on Disguised Sales of Partnership Interests ................................................... 4

III. THE PROPOSED REGULATIONS ON DISGUISED SALES OF PARTNERSHIP INTERESTS .................... 4 A. Introduction.................................................................................................................................................... 4 B. Transfers Treated and Not Treated as the Selling Partner’s Sale of a Partnership Interest ........................... 5

1. General Rules........................................................................................................................................ 5 a) The Test ........................................................................................................................................... 5 b) Facts and Circumstances Relevant to Determining Whether Transfers Constitute a Sale .............. 5

(1) In General .............................................................................................................................. 5 (2) Facts and Circumstances that Tend to Prove the Existence of a Sale ................................... 5

2. Presumptions......................................................................................................................................... 6 a) Transfers Within Two Years Are Presumed to Be a Sale................................................................ 6 b) Transfers Presumed Not to Be a Sale .............................................................................................. 6

(1) Certain Normal Distributions ................................................................................................ 6 (2) Transfers More Than Two Years Apart ................................................................................ 6 (3) Liquidating Distributions of Money ...................................................................................... 6

3. Transfers Excluded from the Disguised Sale Rules .............................................................................. 7 a) Transfers Incident to Formation of a Partnership ............................................................................ 7 b) Deemed Transfers Resulting from Termination of a Partnership .................................................... 7 c) Transfers of Money by Service Partnerships ................................................................................... 7 d) Possible Future Exclusions .............................................................................................................. 7

4. Lack of Examples in the Proposed Regulations.................................................................................... 7 C. Tax Consequences of Treating Transfers as a Sale of a Partnership Interest ................................................ 7

1. In General.............................................................................................................................................. 7 a) Treatment as an Actual Sale for All Purposes ................................................................................. 7 b) Timing of Sale ................................................................................................................................. 8 c) Value of the Partnership Interest Transferred.................................................................................. 8

2. Methods of Determining Tax Consequences ........................................................................................ 8 a) Simultaneous Transfers.................................................................................................................... 8

(1) Same Consideration Transferred by Purchasing Partner and to Selling Partner ................... 8 (2) Different Consideration Transferred by Purchasing Partner and to Selling Partner.............. 8


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b) Transfers That Are Not Simultaneous ............................................................................................. 9 (1) Transfer to Selling Partner First ............................................................................................ 9 (2) Transfer by Purchasing Partner First ................................................................................... 10

c) Transfers to or by More Than One Partner.................................................................................... 11 (1) Simultaneous Transfers ....................................................................................................... 11 (2) Non-Simultaneous Transfers ............................................................................................... 11

d) Coordination of the Disguised Sale Rules With the Rules for Distributions and Contributions ... 11 (1) Distribution: Transfer to Selling Partner Exceeds Transfer by Purchasing Partner ........... 11 (2) Contribution: Transfer by Purchasing Partner Exceeds Transfer to Selling Partner .......... 12

e) Coordination of the Rules for Disguised Sales of Partnership Interests With the Rules for Disguised Sales of Property........................................................................................................... 12

3. Impact of Liabilities ............................................................................................................................ 13 a) Background.................................................................................................................................... 13

(1) Deemed Cash Distributions................................................................................................. 13 (2) Deemed Cash Contributions................................................................................................ 13 (3) Assumption of a Liability.................................................................................................... 13

b) Reallocations of Partnership Liabilities Do Not Give Rise to Disguised Sales............................. 13 c) Selling Partner Must Include in Amount Realized Any Reduction in Share of Partnership

Liabilities ....................................................................................................................................... 13 d) Assumptions of Liabilities Can Give Rise to Disguised Sales ...................................................... 14

(1) Determining a Partner’s Share of Liabilities ....................................................................... 14 (2) Reduction in a Partner’s Share of Liabilities....................................................................... 14 (3) Netting of Assumptions With Contributions and Distributions .......................................... 14

e) Debt-Financed Transfers to a Partner ............................................................................................ 15 (1) In General ............................................................................................................................ 15 (2) Special Rules ....................................................................................................................... 15

f) Anti-Abuse Rule ............................................................................................................................ 15 D. Disclosure of Transfers to the Service ......................................................................................................... 15

1. Disclosure Related to Potential Disguised Sales of Partnership Interests........................................... 15 a) In General ...................................................................................................................................... 15 b) Exceptions...................................................................................................................................... 15

2. Modification of Existing Disclosure Rules for Disguised Sales of Property ...................................... 16 a) Existing Rules................................................................................................................................ 16 b) Modification of Existing Rules...................................................................................................... 16

E. Effective Date .............................................................................................................................................. 16


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D I S G U I S E D S A L E S O F P A R T N E R S H I P I N T E R E S T S I. INTRODUCTION

This article discusses proposed Treasury regulations under section 707(a)(2)(B)1 of the Internal Revenue Code (the “Code”) that would treat certain transactions between a partnership and its partners as disguised sales of partnership interests between the partners.

The Internal Revenue Service (“I.R.S.” or the “Service”) published the proposed regulations in the Federal Register on November 26, 2004. 69 Fed. Reg. 68,838 (Nov. 26, 2004). The principal proposed regulation that would govern these transactions is Proposed Treasury Regulation § 1.707-7. Under this proposed regulation, transactions that are treated as a disguised sale of a partnership interest are treated as an actual sale of a partnership interest for all purposes of the Code, and therefore can result in unexpected and adverse tax consequences for both the partners involved in the transactions and other partners in the partnership.

The proposed regulations also modify the existing final regulations under section 707(a)(2)(B) that apply to disguised sales of property to or by a partnership by expanding the circumstances under which a transfer of property between a partnership and one or more of its partners must be disclosed to the Service.

II. BACKGROUND ON TRANSACTIONS

BETWEEN A PARTNERSHIP AND ITS PARTNERS

A. Partners Can Deal With the Partnership as if They Were Not Partners When Congress enacted subchapter K of the

Internal Revenue Code in 1954, it attempted to resolve prior uncertainty concerning whether a partner could engage in a transaction with his partnership in a non-partner capacity, i.e., as if the partner were a third party. Congress enacted what is now section 707(a)(1), which provides as a general rule that, if a partner engages in a transaction with his partnership other than in his capacity as a partner, then the transaction is treated for federal income tax purposes as if it were a transaction between the partnership and one who is not a partner.

Transactions in which a partner might act in a non-partner capacity in a transaction with the partnership include the partner’s provision of services, loan of money, or rental or sale of property. Treas. Reg. § 1.707-1(a); see, e.g., Pratt v. Comm’r, 550 F.2d 1 Unless otherwise indicated, all references to a “section” or “sections” are to a section or sections of the Internal Revenue Code of 1986, as amended.

1023, 1027 (5th Cir. 1977) (permitting partnership to deduct interest on loans made to the partnership by the partners); Rev. Rul. 72-504, 1972-2 C.B. 90 (permitting partners to deduct rent paid to partnership for space that partners leased from partnership for use in their businesses that were unrelated to the partnership).

1. Tax Consequences a) In General

If a transaction is treated pursuant to section 707(a)(1) as one between the partnership and one who is not a partner, then, as a general rule, each party will determine the tax consequences of the transaction as if they were dealing with an unrelated, third party.

For example, if a partnership compensates a partner for services that the partner provides in a non-partner capacity, then the partnership will deduct the compensation in accordance with its method of accounting (assuming that the compensation does not constitute a capital expenditure), and the partner will include the payment in gross income as ordinary income in accordance with the partner’s method of accounting. See Rev. Rul. 81-301, 1981-2 C.B. 144 (concluding that partner acted in a non-partner capacity in providing investment advisory services to partnership, and therefore partnership could deduct payments for such services and partner must include payments in gross income).

b) Significant Exceptions (1) Matching of Deduction and Income Under § 267

Pursuant to section 267(e), payments between a partnership and its partners are subject to the limitation of section 267(a)(2), which provides that the payor’s deduction is allowed only as of the day on which the payment is includible in the recipient’s gross income. Thus, if both an accrual method partnership and its cash method partners use the calendar year as their taxable year, then the partnership cannot accrue a deduction in Year 1 for services provided by a partner in Year 1 if payment for the services will be made in Year 2.

(2) Sales/Exchanges of Property Between Partners

and Controlled Partnerships If a sale or exchange of property takes place

between a partnership and a partner who owns, directly or indirectly, more than 50 percent of the capital or profits interest in the partnership, then the following rules apply:

http://www.TexasBarCLE.com/CLE/PMCasemaker.asp?table=US_5thcircuit&volume=550&edition=F.2d&page=1&id=110020_01




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• Disallowance of Losses Under § 707(b)(1): Any loss realized on the sale or exchange is disallowed. I.R.C. § 707(b)(1).2

• Ordinary Income Treatment Under §§ 707(b)(2) and 1239: Any gain recognized by the transferor is characterized as ordinary income if the property is either other than a capital asset in the hands of the transferee (section 707(b)(2)) or depreciable in the hands of the transferee (section 1239).3

• Disallowance of Installment Sale Treatment Under § 453(g): The sale is ineligible for installment sale treatment unless the seller establishes to the satisfaction of the Service that the disposition did not have as one of its principal purposes the avoidance of federal income tax. I.R.C. § 453(g).

2. Determining When a Partner Acts in a Non-

Partner Capacity There are very few clear guidelines for

determining whether a partner is acting as a partner or instead in a non-partner capacity. The regulations provide that “the substance of the transaction will govern rather than its form.” Treas. Reg. § 1.701-1(a).

a) Partner’s Provision of Services

In situations in which a partner provides services to the partnership, certain factors tend to suggest that a partner is acting as a partner, such as the partner’s provision of services that are ongoing and integral to the partnership’s business. A partner’s provision of general managerial services would fall into this category. See Pratt v. Comm’r, 550 F.2d 1023, 1026-27 (5th Cir. 1977) (concluding that general partners who managed shopping center owned by partnership were acting in their capacity as partners). In contrast, a partner is more likely to be found not to be acting as a partner when the partner provides services that require the partner's special expertise, e.g., as a lawyer, accountant, or investment advisor. See Rev. Rul. 81-301, 1981-2 C.B. 144 (concluding that partner acted in a non-partner capacity in providing investment advisory services to partnership).

2 The same loss disallowance rule applies to a sale or exchange of property between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital or profits interests. I.R.C. § 707(b)(1). 3 Section 707(b)(2) also mandates ordinary income treatment in the case of a sale or exchange of property between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital or profits interests if the property is other than a capital asset in the hands of the transferee.

b) Partner’s Sale of Property If a partner sells property to the partnership, then

the partner is, by definition, acting other than in his capacity as a partner. The partner and the partnership each will determine the tax consequences of the sale (e.g., realization and recognition of gain or loss and basis in the asset) as if they were unrelated parties, subject to the exceptions that apply in the case of controlled partnerships, discussed above.

B. Certain Transfers Are Treated as Disguised

Sales 1. Congress Enacts Code § 707(a)(2)(B) a) Background

Prior to 1984, the government had unsuccessfully asserted in several cases that a partner’s contribution of appreciated property or money to the partnership, followed by the partnership’s distribution of money to that partner or another partner, were in substance disguised sales of property or an interest in the partnership. The courts rejected the government’s argument that these transactions were subject to the general rules of the Code that apply to sales, rather than the more favorable rules of subchapter K that govern contributions to and distributions from partnerships.4 See Otey v. Comm’r, 70 T.C. 312, 321-22 (1978) (alleged disguised sale of property by partner), aff’d, 634 F.2d 1046 (6th Cir. 1980) (per curiam); Communications Satellite Corp. v. United States, 625 F.2d 997, 1000-01 (Ct. Cl. 1980) (alleged disguised sale of partnership interest by partner); Jupiter Corp. v. United States, 2 Cl. Ct. 58, 78-82 (1983) (alleged disguised sale of partnership interest).

4 The government supported its argument by referring to two Treasury Regulations, both of which still contain the provisions on which the government relied. The first states that a partner’s sale of property to a partnership will be treated as a sale rather than a tax-free contribution of the property, and that “[i]n all cases, the substance of the transaction will govern rather than its form.” See Treas. Reg. § 1.721-1(a). The second provides that section 731, which governs distributions by a partnership, may not apply if there is a contribution of property to a partnership and, within a short period, “(i) [b]efore or after such contribution other property is distributed to the contributing partner and the contributed property is retained by the partnership, or (ii) [a]fter such contribution the contributed property is distributed to another partner.” Treas. Reg. § 1.731-1(c)(3). This same regulation further provides that “[s]ection 731 does not apply to a distribution of property if, in fact, the distribution was made to effect an exchange of property between two or more of the partners or between the partnership and a partner.” Id.





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Example—Disguised Sale of Property

A and B form the AB partnership. Several years later, C transfers to the partnership property with a fair market value of $60 and an adjusted basis in C’s hands of $40 in exchange for a partnership interest. The partnership simultaneously transfers to C cash of $30.

If the transaction is treated as C’s contribution of the property to the partnership followed by the partnership’s distribution of cash to C in C’s capacity as a partner, then C recognizes no gain from contributing the property pursuant to section 721 and acquires an initial basis in C’s partnership interest of $40 pursuant to section 722. Pursuant to section 731(a)(1), a partner generally recognizes gain from a cash distribution only to the extent that the distribution exceeds the partner’s basis in his partnership interest. Therefore, C would recognize no gain from the $30 distribution. The distribution would reduce C’s basis in his partnership interest to $10 pursuant to sections 733 and 705. The partnership would take C’s $40 adjusted basis in the property pursuant to section 723.

If the transaction instead is treated as a disguised sale, then C would be treated as selling one-half of the property to the partnership and contributing the remaining half in exchange for a partnership interest. With respect to the one-half of the property sold, C would realize and recognize gain of $10 (the amount by which the $30 transferred by the partnership exceeds one-half of C’s basis in the property). With respect to the one-half of the property contributed to the partnership, C would recognize no gain pursuant to section 721 and would acquire an initial basis in C’s partnership interest of $20 pursuant to section 722. The partnership would acquire a $30 cost basis in the portion of the property that C is treated as selling and, pursuant to section 723, would acquire C’s $20 adjusted basis in the portion of the property that C is treated as contributing. The partnership’s total basis in the property thus would be $50.

Example—Disguised Sale of Partnership Interest

A and B form the equal AB partnership.

Subsequently, when the partnership interests of A and B each are worth $50 and have an adjusted basis of $40, C transfers to the partnership cash of $25 for a 25 percent partnership interest and the partnership transfers $25 to A, whose interest in the partnership is reduced to a 25 percent interest.

If the transaction is treated as C’s contribution of cash for a partnership interest and as the partnership’s distribution of cash to A in A’s capacity as a partner, then C would acquire a $25 basis in C’s partnership interest and, pursuant to section 731(a)(1), A would recognize no gain because the $25 cash distribution does not exceed A’s $40 basis in A’s partnership

interest. The distribution would reduce A’s basis in his partnership interest to $15 pursuant to sections 733 and 705.

If the transaction instead is treated as a disguised sale by A of one-half of A’s partnership interest, then, among other possible recharacterizations, C could be treated as purchasing one-half of A’s partnership interest directly from A. Under this approach, C would acquire a $25 cost basis in C’s partnership interest. A would realize and recognize gain of $5 (the amount by which the $25 A is treated as receiving from C exceeds one-half of A’s basis in A’s partnership interest). A would have a $20 basis in the portion of the partnership interest that A retains. There would be no tax consequences for B.

b) Section 707(a)(2)(B)

As part of the Deficit Reduction Act of 1984, Congress enacted section 707(a)(2)(B), which provides that, under regulations to be prescribed by the Treasury Department:

“If— (i) there is a direct or indirect transfer of money

or other property by a partner to a partnership,

(ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and

(iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property, such transfers shall be treated either as a transaction [between the partnership and one who is not a partner] or as a transaction between 2 or more partners acting other than in their capacity as members of the partnership.”

In the legislative history accompanying section 707(a)(2)(B), Congress specifically disapproved of the results in Otey, Communications Satellite Corp. and Jupiter Corp., supra. The reports accompanying the legislation indicated that taxpayers had “deferred or avoided tax on sales of property (including partnership interests) by characterizing sales as contributions of property (including money) followed (or preceded) by a related partnership distribution.” S. Prt. No. 169, 98th Cong., 2d Sess. (1984); see also H.R. Rep. No. 432, 98th Cong., 2d Sess. 1218 (1984). They further noted that, despite existing Treasury Regulations,5 “court decisions ha[d] allowed tax-free treatment in cases which are economically indistinguishable from sales of property to a partnership or another partner.”

5 See supra note 4.


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S. Prt. No. 169, supra. Such transactions, the reports indicated, “should be treated for tax purposes in a manner consistent with their underlying economic substance.” Id.

2. Treasury Issues Regulations on Disguised Sales of

Property In 1992, pursuant to section 707(a)(2)(B),

Treasury issued final regulations on disguised sales of property to and by a partnership. T.D. 8439, 1992-2 C.B. 126 (issuing Treas. Reg. §§ 1.707-3 through 1.707-9). These regulations do not address disguised sales of partnership interests.

a) Brief Overview of General Rules (1) Transfers Treated as a Sale

The regulations treat a partner’s transfer of property to a partnership and the partnership’s transfer of money or other consideration to the partner as a sale if two conditions are met:

• The partnership’s transfer of money or other

consideration would not have been made but for the partner’s transfer of property, and

• If the transfers are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership. Treas. Reg. § 1.707-3(b)(1).

The same rules apply if the partnership, rather than a partner, is the transferor of property and the partner transfers money or other consideration, i.e., the transfers will constitute a sale if the two conditions listed above are satisfied.

(2) Presumptions

If a partner transfers property to the partnership and, within a two-year period before or after the transfer, the partnership transfers money or other consideration to the partner, then the transfers are presumed to constitute a sale. Treas. Reg. § 1.707-3(c)(1). Transfers that occur more than two years apart are presumed not to constitute a sale. Treas. Reg. § 1.707-3(d). In either case, the presumption is rebutted if the facts and circumstances clearly establish to the contrary. The same presumptions apply when the partnership, rather than a partner, is the transferor of property. Treas. Reg. § 1.707-6(a).

(3) Effect of Liabilities

A partner’s contribution to a partnership of property encumbered by a liability can give rise to a deemed distribution of cash to the partner under section 752(b), and therefore can result in the partner’s transfer being treated as a disguised sale of the property. The regulations set forth several rules that

determine the extent to which a contribution of encumbered property is treated as a disguised sale. Treas. Reg. §§ 1.707-5, 1.707-6(b).

b) Required Disclosure of Transfers

Subject to some exceptions, transfers of property by a partner to a partnership and transfers of money or other consideration by the partnership to the partner that occur within two years of each other must be reported to the Service if the transfers are not treated as a sale. Treas. Reg. § 1.707-3(c)(2). Similarly, if a partner incurs a liability within the two-year period prior to transferring property to a partnership and the partnership assumes or takes the property subject to the liability, then the transfer generally must be reported to the Service if it is not treated as a sale. Treas. Reg. § 1.707-5(a)(7)(ii). These disclosures also are required if the partnership, rather than the partner, is the transferor of property. Treas. Reg. § 1.707-6(c). The required disclosures are made on Form 8275. Treas. Reg. § 1.707-8(b).

3. The Service’s Rulings on Disguised Sales of

Partnership Interests As noted above, section 707(a)(2)(B) provides

that certain transactions can be treated as disguised sales of partnership interests “[u]nder regulations prescribed by the Secretary.” Although the Service had not yet issued regulations on point, it took the position in three written determinations that it could recharacterize specific transactions as disguised sales of partnership interests. I.R.S. Field Serv. Adv. 200024001 (Feb. 8, 2000); I.R.S. Tech. Adv. Mem. 200037005 (May 18, 2000); ILM 200250013 (Aug. 30, 2002).

4. Treasury Asks for Input on Disguised Sales of

Partnership Interests In 2001, the Service announced that it was

considering issuing proposed regulations under section 707(a)(2)(B) regarding disguised sales of partnership interests, and asked for comments on the scope and substance of the proposed regulations. I.R.S. Notice 2001-64, 2001-2 C.B. 16.

III. THE PROPOSED REGULATIONS ON

DISGUISED SALES OF PARTNERSHIP INTERESTS

A. Introduction The proposed regulations generally attempt to

provide guidance on the circumstances under which a transfer of consideration by one partner (the “purchasing partner”) to the partnership and the partnership’s transfer of consideration to another partner (the “selling partner”) will be treated as the selling partner’s sale of all or a portion of his partnership interest to the purchasing partner. The


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proposed regulations also set forth in detail how the tax consequences of transfers that constitute a sale should be determined.

B. Transfers Treated and Not Treated as the

Selling Partner’s Sale of a Partnership Interest 1. General Rules a) The Test

A purchasing partner’s transfer of consideration to the partnership and the partnership’s transfer of consideration to the selling partner constitute a sale of all or a portion of the selling partner’s partnership interest if:

• The partnership would not have transferred

consideration to the selling partner but for the purchasing partner’s transfer of consideration to the partnership, and

• If the transfers are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations. Prop. Treas. Reg. § 1.707-7(b)(1).

Under this test, simultaneous transfers will be treated as a sale if the first condition is satisfied, i.e., if the “but for” test is satisfied. If the transfers are not simultaneous, then both the first and second conditions must be satisfied. Thus, transfers that are not simultaneous will not be treated as a sale, even when the “but for” test is satisfied, if the subsequent transfer is subject to the entrepreneurial risks of operations.

Comment: The second prong of the test, which Treasury borrowed from the existing final regulations on disguised sales of property discussed above, seems to make little sense when the purchasing partner’s transfer is the subsequent transfer. For example, if the AB partnership transfers cash to partner A in year 1, and in year 2 individual C becomes a partner by transferring cash to the partnership, how does one determine whether C’s transfer is dependent on the entrepreneurial risks of partnership operations? Is the subsequent transfer never dependent on the partnership’s entrepreneurial risks when the purchasing partner is the subsequent transferor?

b) Facts and Circumstances Relevant to Determining Whether Transfers Constitute a Sale

(1) In General Whether the test set forth above is satisfied, i.e.,

whether the transfers by the purchasing partner and to the selling partner constitute a sale, depends on all of the facts and circumstances. Prop. Treas. Reg. § 1.707-7(b)(2). Generally, the facts and circumstances considered are those that exist on the date of the earliest of the transfers involved. Id.

(2) Facts and Circumstances that Tend to Prove the Existence of a Sale The proposed regulations provide a non-exclusive

list of ten facts and circumstances that tend to prove the existence of a sale of all or a portion of the selling partner’s partnership interest. Prop. Treas. Reg. § 1.707-7(b)(2). The weight given to each fact and circumstance will depend on the particular situation. Id. These facts and circumstances are as follows:

1. Certainty of Subsequent Transfer. At the

time of the earlier transfer, the timing and amount of all or a portion of the subsequent transfer can be determined with reasonable certainty.

2. Legally Enforceable or Secured Rights to Transfer. The person to receive the subsequent transfer has a right to that transfer that is legally enforceable or secured in any manner, taking into account the period for which it is secured.

3. Same Property Changes Hands. The same property that the purchasing partner transfers to the partnership is transferred by the partnership to the selling partner. For this purpose, the term “property” does not include money or marketable securities that are treated as money under section 731(c)(1).

4. Structuring to Effect an Exchange of Property. Partnership distributions, allocations or control of operations are designed to effect an exchange of the benefits and burdens of ownership of transferred property, including a partnership interest. For this purpose, the term “property” does not include money or marketable securities that are treated as money under section 731(c)(1).

5. Limited Holding Period or Risk for Transferred Property. The partnership holds transferred property for a limited period of time or, during the period that the partnership holds transferred property, the risk of gain or loss associated with the property is not significant. For this purpose, the term “property” does not include money or marketable securities that are treated as money under section 731(c)(1).

6. Disproportionately Large Transfer to Selling Partner. The consideration that the partnership transfers to the selling partner is disproportionately large in comparison to the selling partner’s general and continuing interest in partnership profits.

7. Lack of Selling Partner’s Obligation to Repay. The selling partner has no obligation to repay to the partnership the consideration


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it receives, or has an obligation to repay it at such a distant point in the future that the present value of the obligation is small in comparison to the consideration that the selling partner receives from the partnership.

8. Non-Pro Rata Transfers. The transfer of consideration by the purchasing partner or to the selling partner is not made pro rata.

9. Negotiations Concerning Transfers. There were negotiations between the purchasing and selling partner concerning any transfer of consideration, or there were negotiations between the partnership and each of these partners separately with each partner being aware of the partnership’s negotiations with the other.

10. Agreement Concerning Transfers. The purchasing and selling partner enter into one or more agreements relating to the transfers. For this purpose, an agreement includes any amendment to the partnership agreement other than an amendment for the purpose of admitting the purchasing partner.

2. Presumptions a) Transfers Within Two Years Are Presumed to Be

a Sale If a purchasing partner transfers consideration to

the partnership and, within a two-year period before or after the transfer, the partnership transfers consideration to the selling partner, then the transfers are presumed to constitute a sale of all or a portion of the selling partner’s partnership interest to the purchasing partner. Prop. Treas. Reg. § 1.707-7(c). The presumption is rebutted if the facts and circumstances clearly establish that the transfers do not constitute a sale. Id.

Comment: To establish that transfers within two years of each other do not constitute a sale, taxpayers can, among other approaches, seek to demonstrate the absence of the facts and circumstances that tend to prove the existence of a sale, listed above.

b) Transfers Presumed Not to Be a Sale (1) Certain Normal Distributions

Applied literally, the two-year presumption described above would mean that a partner would be presumed to have sold a portion of his partnership interest whenever the partner receives a distribution within two years of another partner’s contribution to the partnership. To help alleviate this concern, the proposed regulations adopt (by cross-reference) rules similar to the rules of existing Reg. § 1.707-4, which applies to disguised sale of property. Prop. Treas. Reg. § 1.707-7(f). Under Reg. § 1.707-4, the following categories of transfers by the partnership are presumed

not to be part of a sale, unless the facts and circumstances clearly establish to the contrary:

• “Reasonable” guaranteed payments for

capital. Treas. Reg. § 1.707-4(a)(1). • “Reasonable” preferred returns, i.e.,

preferential distributions of cash flow, matched by allocations of partnership income or gain. Treas. Reg. § 1.707-4(a)(1).

• Operating cash flow distributions. Treas. Reg. § 1.707-4(b).

In addition, transfers by the partnership to reimburse a partner for certain pre-formation expenditures are not treated as part of a sale. Treas. Reg. § 1.707-4(d). (2) Transfers More Than Two Years Apart

If a purchasing partner’s transfer of consideration to the partnership and the partnership’s transfer of consideration to the selling partner occur more than two years apart, then the transfers are presumed not to constitute a sale of all or a portion of the selling partner’s partnership interest to the purchasing partner. Prop. Treas. Reg. § 1.707-7(d). The presumption is rebutted if the facts and circumstances clearly establish that the transfers constitute a sale. Id.

(3) Liquidating Distributions of Money

A partnership’s transfer of money (or marketable securities treated as money under section 731(c)(1)) to a selling partner in liquidation of that partner’s interest in the partnership is presumed not to constitute a sale of all or a portion of the selling partner’s partnership interest to the purchasing partner. Prop. Treas. Reg. § 1.707-7(e). For this purpose, a partnership’s transfer of money includes a deemed distribution of money resulting from the partnership’s assumption of the partner’s liability. Id. The presumption is rebutted if the facts and circumstances clearly establish that the transfer is part of a sale. Id.

Comment: According to the preamble to the proposed regulations, one situation in which the presumption concerning liquidating distributions of money might be rebutted is “when the tax consequences of a liquidating distribution are significantly different from those of a sale of a partnership interest.” 69 Fed. Reg. at 68,841. This approach conflicts with judicial decisions that specifically permit partners to choose either sale or liquidation treatment by adopting one form rather than the other. See, e.g., Foxman v. Commissioner, 41 T.C. 535 (1964), aff’d, 352 F.2d 466 (3d Cir. 1965).



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3. Transfers Excluded from the Disguised Sale Rules a) Transfers Incident to Formation of a Partnership

Section 707(a)(2)(B) and the rules on disguised sales of partnership interests do not apply to transfers incident to the formation of a partnership. Prop. Treas. Reg. § 1.707-7(a)(8). Such transfers, however, are subject to the existing final regulations on disguised sales of property. Id.

b) Deemed Transfers Resulting from Termination of

a Partnership Under section 708(b)(1)(B), a partnership

terminates if, within a twelve-month period, there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits. When a partnership terminates by virtue of this provision, the partnership is treated as contributing all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership, and then distributing this interest proportionately to the purchasing partner and the remaining partners in liquidation. Treas. Reg. § 1.708-1(b)(4).

Section 707(a)(2)(B) and the rules on disguised sales of partnership interests do not apply to deemed transfers that result from termination of a partnership under section 708(b)(1)(B). Prop. Treas. Reg. § 1.707-7(a)(8). The rules on disguised sales of partnership interests do apply, however, to transfers to and from a partnership that constitute a sale even if the result of treating them as a sale is that the partnership is terminated under section 708(b)(1)(B). Id. § 1.707-7(a)(7).

c) Transfers of Money by Service Partnerships

Section 707(a)(2)(B) and the rules on disguised sales of partnership interests do not apply to transfers of money (or marketable securities treated as money under section 731(c)(1)) to and by a partnership that would meet the definition of a qualified personal service corporation in section 448(d)(2) if the partnership were a corporation. Prop. Treas. Reg. § 1.707-7(g). According to the preamble to the proposed regulations, this exclusion “takes into account that partners frequently enter and exit service partnerships and, in most cases, those transactions are factually unrelated to each other and should not be treated as a disguised sale of a partnership interest. 69 Fed. Reg. at 68,841. The Service has requested comments on whether other partnerships, such as securities partnerships, should be subject to favorable presumptions or safe harbors. Id.

To be a qualified personal service corporation, a corporation must meet two basic requirements: (i) substantially all of the activities of the corporation must involve the provision of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and

(ii) substantially all of the stock must be held by employees performing services for the corporation in the relevant field, retired employees, estates of deceased employees or retired employees, or certain other persons who acquired stock by reason of the death of an employee or retired employee. I.R.C. § 448(d)(2).

Comment: The proposed regulations do not exclude transfers of property to or by service partnerships from the rules of section 707(a)(2)(B) or the rules on disguised sales of partnership interests. Thus, a transfer of property to or by a service partnership might be treated as a disguised sale of property under the existing final regulations on that subject or as part of a disguised sale of a partnership interest. For most service partnerships, however, transfers of property are relatively infrequent events.

d) Possible Future Exclusions

The proposed regulations give the Service authority to provide additional published guidance that excludes other transfers to or by a partnership from section 707(a)(2)(B) and the rules on disguised sales of partnership interests. Prop. Treas. Reg. § 1.707-7(h).

4. Lack of Examples in the Proposed Regulations

Unfortunately, the proposed regulations fail to provide examples that illustrate when transfers will and will not be treated as a disguised sale of a partnership interest. Thus, none of the examples in the proposed regulations illustrate how the facts and circumstances of a specific situation suggest that transfers should or should not be treated as a disguised sale. Treasury attorneys have stated publicly that the final regulations will likely include such examples.

C. Tax Consequences of Treating Transfers as a

Sale of a Partnership Interest 1. In General a) Treatment as an Actual Sale for All Purposes

If a purchasing partner’s transfer to the partnership and the partnership’s transfer to the selling partner are treated as a sale of all or a portion of the selling partner’s partnership interest to the purchasing partner, then the transfers are treated as an actual sale of a partnership interest for all purposes of the Code. Prop. Treas. Reg. § 1.707-7(a)(2)(i). Thus, treatment as a sale might raise, among other issues, questions regarding ordinary income treatment for the selling partner under section 751, adjustments to the basis of partnership assets pursuant to sections 754 and 743, termination of the partnership under section 708, eligibility of the selling partner for installment sale treatment under section 453, and imputed interest under sections 483 and 1274. Id.


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b) Timing of Sale If transfers are treated as the selling partner’s sale

of all or a portion of his partnership interest to the purchasing partner, the sale is treated as occurring on the date of the earliest transfer. Prop. Treas. Reg. § 1.707-7(a)(2)(ii)(A). On this date, the purchasing partner is treated as acquiring the partnership interest for all purposes of the Code. Id. Transfers are treated as occurring on the date of the actual transfer or, if earlier, the date on which the transferor agrees in writing to make the transfer. Id.

c) Value of the Partnership Interest Transferred

If transfers are treated as a sale, then the selling partner is treated as selling to the purchasing partner a partnership interest with a value equal to the lesser of the consideration that the purchasing partner transfers to the partnership and the consideration that the partnership transfers to the selling partner. Prop. Treas. Reg. § 1.707-7(a)(3)(i).

2. Methods of Determining Tax Consequences a) Simultaneous Transfers (1) Same Consideration Transferred by Purchasing

Partner and to Selling Partner If the purchasing partner’s transfer of

consideration to the partnership and the partnership’s transfer of consideration to the selling partner are simultaneous, and if the consideration transferred is the same, then the purchasing partner is treated as transferring his consideration directly to the selling partner in exchange for all or a portion of the selling partner’s partnership interest. Prop. Treas. Reg. § 1.707-7(a)(2)(ii)(B).

Example #1

Facts: A and B are equal partners in the AB

partnership and each have an adjusted basis in their partnership interest of $80. The partnership, which uses the cash method of accounting, has three assets with an aggregate fair market value of $400: cash of $100, accounts receivable with a fair market value of $100 and an adjusted basis of $0, and land that the partnership purchased, Blackacre, which is section 1231 property with a fair market value of $200 and an adjusted basis in the partnership’s hand of $60. C transfers to the partnership cash of $100 for a partnership interest and, on the same date, the partnership transfers cash of $100 to A. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 1). Analysis:

Treatment as a Sale. Because the transfers by C

and to A occur within two years of each other, they are presumed to constitute a sale of a portion of A’s

partnership interest to C unless the facts and circumstances clearly establish to the contrary. This example will assume that no facts rebut this presumption. Further, this example will assume that no facts support treating the transfer to A as a normal distribution (i.e., as a guaranteed payment, preferred return or operating cash flow distribution) or liquidating distribution, and that AB is not a service partnership. Therefore, the transfers by C and to A are treated as a sale.

Tax Consequences of the Sale. Because the transfers are simultaneous, and because the consideration transferred by C and to A is the same, C is treated as transferring cash of $100 directly to A in exchange for a portion of A’s partnership interest with a value of $100. Assuming A’s partnership interest is worth $200 before the transfers, A is treated as selling one-half of his partnership interest, and therefore recognizes gain of $60 (excess of $100 amount realized over one-half of A’s $80 basis in his partnership interest). Of A’s total $60 gain, $50 is ordinary income pursuant to section 751(a) and $10 is capital gain pursuant to section 741.6 C acquires a $100 cost basis in C’s partnership interest. If the partnership has a section 754 election in effect, it must adjust the basis of the accounts receivable and Blackacre pursuant to section 743(b). There are no tax consequences for B.

(2) Different Consideration Transferred by

Purchasing Partner and to Selling Partner If the purchasing partner’s transfer of

consideration to the partnership and the partnership’s transfer of consideration to the selling partner are simultaneous, but the consideration transferred is not the same, then the purchasing partner is treated as: (i) transferring his consideration to the partnership in exchange for the consideration received by the selling partner, and (ii) transferring the consideration deemed received from the partnership to the selling partner in exchange for all or a portion of the selling partner’s partnership interest. Prop. Treas. Reg. § 1.707-7(a)(2)(ii)(B).

Example #2

Facts: Same facts as example #1, except that C

transfers to the partnership equipment that C used in C’s business as a sole proprietor, rather than cash. The

6 Pursuant to the regulations under section 751(a), A must treat as ordinary income an amount equal to the ordinary income that would be allocated to A from the partnership’s hypothetical sale of the accounts receivable, which in this case would be $50. See Treas. Reg. § 1.751-1(a)(1)-(2).


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equipment has a fair market value of $100 and an adjusted basis in C’s hands of $20. Analysis:

Treatment as a Sale. Same analysis as example

#1. Tax Consequences of the Sale. Because the

transfers are simultaneous, but the consideration transferred by C and to A is not the same, C is treated as transferring the equipment to the partnership in exchange for the $100 of cash that A ultimately receives, and then as transferring the $100 of cash to A in exchange for a portion of A’s partnership interest with a value of $100. On C’s deemed transfer of the equipment in exchange for cash, C recognizes $80 of gain, some or all of which likely will be characterized as ordinary income under section 1245. The partnership acquires a $100 cost basis in the equipment it receives from C. On C’s deemed transfer of the $100 cash to A, the results are the same as in example #1, i.e., A is treated as selling one-half of his partnership interest to C and therefore will recognize gain of $60 (of which $50 is ordinary income and $10 is capital gain), C acquires a $100 cost basis in C’s partnership interest, the partnership must adjust the basis of the accounts receivable and Blackacre pursuant to section 743(b) if it has a section 754 election in effect, and there are no tax consequences for B.

Example #3

Facts: Same facts as example #2, except that

instead of transferring cash to A, the partnership transfers to A the accounts receivable, which have a fair market value of $100 and an adjusted basis in the partnership’s hands of $0. Analysis:



transfers are simultaneous, but the consideration transferred by C and to A is not the same, C is treated as transferring the equipment to the partnership in exchange for the $100 of accounts receivable that A ultimately receives, and then as transferring the $100 of accounts receivable to A in exchange for a portion of A’s partnership interest with a value of $100. On C’s deemed transfer of the equipment in exchange for the accounts receivable, C recognizes $80 of gain, some or all of which likely will be characterized as ordinary income under section 1245, and the partnership recognizes ordinary income of $100, which is allocated equally to A and B, thereby increasing the

outside basis of both A and B to $130. The partnership acquires a $100 cost basis in the equipment it receives from C. On C’s deemed transfer of the $100 of accounts receivable to A, assuming A’s partnership interest is worth $200 before the transfer, A is treated as selling one-half of his partnership interest to C and therefore will recognize gain of $35 (excess of A’s $100 amount realized over one-half of his $130 basis in his partnership interest), all of which is capital gain under section 741. C acquires a $100 cost basis in C’s partnership interest. The partnership must adjust the basis of Blackacre pursuant to section 743(b) if it has a section 754 election in effect. Both A and B have $50 of ordinary income from the partnership’s deemed transfer of the accounts receivable to C.

b) Transfers That Are Not Simultaneous (1) Transfer to Selling Partner First

If the partnership’s transfer of consideration to the selling partner occurs before the purchasing partner’s transfer of consideration to the partnership, then, on the date of the partnership’s transfer, the purchasing partner is treated as: (i) transferring to the partnership the purchasing partner’s obligation to deliver the consideration that the purchasing partner later transfers in exchange for the consideration received by the selling partner, and (ii) transferring the consideration deemed received from the partnership to the selling partner in exchange for all or a portion of the selling partner’s partnership interest. Prop. Treas. Reg. § 1.707-7(a)(2)(ii)(C). When the purchasing partner subsequently transfers his consideration to the partnership, the purchasing partner and the partnership are treated as if the purchasing partner had satisfied his obligation to transfer consideration. Id.

Example #4

Facts: Same facts as example #1, except that the

partnership’s transfer of $100 cash to A occurs on March 25, 2005, and C’s transfer of $100 to the partnership occurs on May 25, 2006. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 2). Analysis:



partnership’s transfer of consideration to A occurred before C’s transfer to the partnership, on the date of the partnership’s transfer, March 25, 2005, C is treated as transferring to the partnership C’s obligation to pay $100 on May 25, 2006 in exchange for the $100 of cash that A ultimately receives, and then as transferring the $100 of cash to A in exchange for a portion of A’s partnership interest with a value of $100. On C’s


10

deemed transfer of the $100 cash to A, the results are the same as in example #1, i.e., A is treated as selling one-half of his partnership interest to C and therefore will recognize gain of $60 (of which $50 is ordinary income and $10 is capital gain), C acquires a $100 cost basis in C’s partnership interest, the partnership must adjust the basis of the accounts receivable and Blackacre pursuant to section 743(b) if it has a section 754 election in effect, and there are no tax consequences for B. When C transfers $100 to the partnership on May 25, 2006, C and the partnership will be treated as if C had satisfied C’s obligation to transfer $100. Unanswered Questions: • Conceptual Difficulties. As discussed in Part

III.C.1.b., above, if transfers by the purchasing partner and to the selling partner are treated as a sale of the selling partner’s partnership interest, then the sale is treated as occurring on the date of the earliest transfer. This raises several questions when the selling partner receives consideration from the partnership before the purchasing partner transfers consideration to the partnership. As an illustration, in example #4 above, C does not acquire an equity interest in the partnership until May 25, 2006, yet the proposed regulations would treat C as acquiring a portion of A’s partnership interest on March 25, 2005. Under this approach, C presumably has a share of the partnership’s items of income and deduction during this fourteen-month period and the partnership will have to reallocate its tax items retroactively among the partners. What result if C was not in existence for part or all of this period? Effectively, the proposed regulations make C in this example a partner retroactively. This approach presumably will require an incoming partner to perform due diligence by examining partnership distributions for previous years to assess the likelihood of retroactively becoming a partner, and/or to request warranties and indemnification against such a possibility. If the purchasing partner does become a partner retroactively, he might be at a disadvantage if the partnership did not have a section 754 election in effect for the date of the deemed purchase of the partnership interest. On the other hand, those interested in aggressive tax planning might view retroactive partnership status as an opportunity to circumvent the restrictions of section 706(d).

• Uncertainty Concerning Imputed Interest. The examples in the proposed regulations neither mention nor illustrate the effect of various provisions, such as sections 1274 and 7872, that

provide for imputed interest. Presumably the purchasing partner’s obligation to transfer consideration to the partnership can give rise to imputed interest. For example, if the partnership is treated as transferring appreciated property to the purchasing partner in exchange for the purchasing partner’s obligation to transfer cash in the future, then to the extent that section 1274 applies, the partnership presumably should be treated as receiving a debt instrument with an imputed principal amount smaller than the face amount of the purchasing partner’s obligation and will have to include in gross income pursuant to section 1272 the difference between the imputed principal amount and the face amount of the obligation as original issue discount. See Prop. Treas. Reg. § 1.707-7(a)(2)(E) (stating that deemed transfers are treated as actual transfers for all purposes of the Code, including sections 453 and 1274); cf. Treas. Reg. § 1.707-3(f) (example 2) (applying sections 1274 and 1272 to disguised sale of property). There are several unanswered questions here, including whether the consideration that the purchasing partner transfers is equal to the imputed principal amount, rather than the face amount, of the purchasing partner’s obligation. The Service should provide guidance in the final regulations on how the tax consequences of non-simultaneous transfers are determined, taking into account the rules for imputed interest.

(2) Transfer by Purchasing Partner First

If the purchasing partner’s transfer of consideration to the partnership occurs before the partnership’s transfer of consideration to the selling partner, then, on the date of the purchasing partner’s transfer, the purchasing partner is treated as: (i) transferring to the partnership the purchasing partner’s consideration in exchange for the partnership’s obligation to deliver the consideration received by the selling partner, and (ii) transferring the partnership’s obligation to the selling partner in exchange for all or a portion of the selling partner’s partnership interest. Prop. Treas. Reg. § 1.707-7(a)(2)(ii)(D). When the partnership subsequently transfers its consideration to the selling partner, the partnership and the selling partner are treated as if the partnership had satisfied its obligation to transfer consideration. Id.

Example #5

Facts: Same facts as example #1, except that C’s

transfer of $100 to the partnership occurs on March 25, 2005, and the partnership’s transfer of $100 cash to A occurs on May 25, 2006. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 2).


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Analysis: Treatment as a Sale. Same analysis as example

#1. Tax Consequences of the Sale. Because C’s

transfer to the partnership occurred before the partnership’s transfer of consideration to A, on the date of C’s transfer, March 25, 2005, C is treated as transferring $100 to the partnership in exchange for the partnership’s obligation to pay $100 on May 25, 2006, and then as transferring the partnership’s obligation to A in exchange for a portion of A’s partnership interest. The proposed regulations do not indicate whether the partnership’s obligation should be discounted to present value. Assuming it need not be discounted, then, on C’s deemed transfer of the obligation to A, the results are the same as in example #1, i.e., A is treated as selling one-half of his partnership interest to C for $100 and therefore will recognize gain of $60 (of which $50 is ordinary income and $10 is capital gain), C acquires a $100 cost basis in C’s partnership interest, the partnership must adjust the basis of the accounts receivable and Blackacre pursuant to section 743(b) if it has a section 754 election in effect, and there are no tax consequences for B. When the partnership transfers $100 to A on May 25, 2006, A and the partnership will be treated as if the partnership had satisfied its obligation to transfer $100. Unanswered Questions:

The approach of the proposed regulations raises

questions in this context similar to those discussed above in connection with the previous example. As an illustration, in example #5, although A did not receive a transfer from the partnership until May 25, 2006, A would be treated as having sold a portion of his partnership interest to C on March 25, 2005. Presumably, retroactive allocations of partnership items for this interval are required. Further, the examples in the proposed regulations neither mention nor illustrate whether or to what extent the partnership’s obligation to transfer consideration might give rise to imputed interest. See the discussion of imputed interest above.

c) Transfers to or by More Than One Partner (1) Simultaneous Transfers

If more than one purchasing partner transfers consideration simultaneously, the transfers are aggregated and each purchasing partner is treated as acquiring a proportionate part of each partnership interest sold. Prop. Treas. Reg. § 1.707-1(a)(3)(ii)(A). Similarly, if more than one selling partner receives consideration simultaneously from the partnership, then each selling partner is treated selling a

proportionate part of the total partnership interests sold. Prop. Treas. Reg. § 1.707-1(a)(3)(ii)(B).

Example #6


partnership does not transfer $100 to A, but rather transfers $50 to A and $50 to B. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 4). Analysis:



transfers to A and B are simultaneous, the partnership’s transfers to A and B are aggregated, and each is treated as selling a proportionate part of the total partnership interests sold. The total value of the partnership interests sold is $100, and therefore A and B each are treated as selling a partnership interest worth $50. Because the partnership’s transfers of consideration to A and B occurred simultaneously with C’s transfer to the partnership, C is treated as transferring $50 directly to A and $50 directly to B. On C’s deemed transfers to A and B, A and B each recognize gain of $30 (amount realized of $50 less one-quarter of each partner’s $80 basis in their partnership interest). Of the $30 of gain that A and B each recognize, $25 is ordinary income under section 751(a) and $5 is capital gain under section 741. C acquires an aggregate basis in C’s partnership interest of $100. The partnership must adjust the basis of the accounts receivable and Blackacre pursuant to section 743(b) if it has a section 754 election in effect.

(2) Non-Simultaneous Transfers

Transfers by more than one purchasing partner or to more than one selling partner that do not occur simultaneously are not aggregated. Instead, such transfers are considered in the order in which they are made. See Prop. Treas. Reg. § 1.707-7(l) (example 5).

d) Coordination of the Disguised Sale Rules With

the Rules for Distributions and Contributions If the transfers by the purchasing partner and to

the selling partner are treated as a sale, but the transfers differ in value, then the transfers will be subject to both the rules for disguised sales of partnership interests and the normal rules of subchapter K that apply to distributions from or contributions to the partnership.

(1) Distribution: Transfer to Selling Partner Exceeds

Transfer by Purchasing Partner As discussed earlier, the value of the partnership

interest that the selling partner is treated as selling is equal to the lesser of the consideration that the


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purchasing partner transfers to the partnership and the consideration that the partnership transfers to the selling partner. Prop. Treas. Reg. § 1.707-7(a)(3)(i). Accordingly, if the partnership’s transfer to the selling partner exceeds the purchasing partner’s transfer to the partnership, then the selling partner is treated as selling to the purchasing partner a portion of his partnership interest equal in value to the consideration transferred by the purchasing partner, and as receiving from the partnership a distribution of the excess amount.

When the selling partner is treated as selling a portion of his partnership interest and also as receiving a distribution, the distribution is treated as occurring immediately after the sale. Prop. Treas. Reg. § 1.707-7(a)(5).

Example #7

Facts: Same facts as example #1, except that C

transfers to the partnership $90 rather than $100. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 2). Analysis:



partnership’s transfer of $100 to A exceeds C’s transfer of $90 to the partnership, A is treated as selling to C a portion of A’s partnership interest worth $90 and as receiving from the partnership a distribution of $10.

• Sale of the Partnership Interest. With respect

to A’s sale of the partnership interest, C is treated as transferring $90 directly to A because the transfers occurred simultaneously and the consideration transferred by C and to A is the same. Assuming A’s partnership interest is worth $200 before the sale, A is treated as selling 45 percent of A’s partnership interest to C for $90 and therefore will recognize gain of $36 (excess of A’s $90 amount realized over 45 percent of A’s $80 basis in A’s partnership interest). A portion of A’s gain is ordinary income under section 751(a) and a portion is capital gain under section 741. C acquires a $90 cost basis in C’s partnership interest. The partnership must adjust the basis of the accounts receivable and Blackacre pursuant to section 743(b) if it has a section 754 election in effect, and there are no tax consequences for B.

• Distribution to A. The $10 distribution to A occurs immediately after A’s sale of the partnership interest. After the sale, A’s remaining basis in his partnership interest is

$44. Because the cash distribution does not exceed A’s basis in his partnership interest, A recognizes no gain pursuant to section 731(a)(1) and must reduce his basis in his partnership interest to $34 pursuant to section 733.

(2) Contribution: Transfer by Purchasing Partner

Exceeds Transfer to Selling Partner As discussed earlier, the selling partner is treated

as selling a partnership interest equal in value to the lesser of the consideration that the purchasing partner transfers to the partnership and the consideration that the partnership transfers to the selling partner. Accordingly, if the purchasing partner transfers to the partnership consideration that exceeds that transferred by the partnership to the selling partner, then the purchasing partner is treated as making a contribution of the excess amount. As an illustration, if, in example #7, supra, C had transferred $100 to the partnership and the partnership had transferred $90 to A, then C would be treated as purchasing a partnership interest from A with a value of $90 and as making a $10 contribution to the partnership in C’s capacity as a partner. C’s $10 contribution would increase C’s outside basis by $10 pursuant to section 722. For an illustration of this same principle in a more complex factual situation, see Prop. Treas. Reg. 1.707-1(l) (example 3).

e) Coordination of the Rules for Disguised Sales of

Partnership Interests With the Rules for Disguised Sales of Property To the extent that a transfer of consideration by

the purchasing partner or to the selling partner is treated as a part of a disguised sale of property under the rules of the existing final regulations on disguised sales of property (Treas. Reg. § 1.707-3(a)), then: (i) the rules on disguised sales of property apply before the rules on disguised sales of partnership interests, and (ii) the transfer that is treated as part of a disguised sale of property is not taken into account in applying the rules that govern disguised sales of partnership interests. Prop. Treas. Reg. § 1.707-7(a)(6).

Example #8

Facts: Same facts as example #1, except that, on

the same date that the partnership transfers $100 to A, A transfers to the partnership Whiteacre, which is land that A held as an investment with a fair market value of $60 and an adjusted basis in A’s hands of $45. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 7).


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Analysis: Treatment as a Sale. Same analysis as example

#1. Tax Consequences of the Sale. Assume that,

under the existing final regulations on disguised sales of property, A is treated as selling Whiteacre to the partnership for $60. A therefore recognizes gain of $15, which is characterized as capital gain. Because $60 of the partnership’s transfer to A is treated as part of A’s disguised sale of Whiteacre, that portion of the transfer is not taken into account in applying the rules for disguised sales of partnership interests. Accordingly, only $40 of the partnership’s transfer to A is treated as part of a disguised sale of A’s partnership interest. Because the partnership’s $40 transfer to A is less than C’s $100 transfer to the partnership, A is treated as selling to C a partnership interest with a value of $40. Assuming that A’s partnership interest is worth $200 before the transfer, A is treated as selling 20 percent of A’s partnership interest to C for $40. C is treated as purchasing a portion of A’s partnership interest for $40, and also as making a $60 contribution to the partnership in C’s capacity as a partner.

3. Impact of Liabilities a) Background

Under section 752, reallocation of a partnership liability among the partners or assumption of a liability by a partner or the partnership results in a deemed cash contribution to or distribution from the partnership.

(1) Deemed Cash Distributions

If a partner’s share of a partnership liability decreases, or if the partnership assumes a liability of the partner, then the partner receives a deemed cash distribution from the partnership equal to the amount of the decrease or the amount of the liability that the partnership assumed. I.R.C. § 752(b).

(2) Deemed Cash Contributions

If a partner’s share of a partnership liability increases, or if the partner assumes a liability of the partnership, then the partner makes a deemed cash contribution to the partnership equal to the amount of the increase or the amount of the liability that the partner assumed. I.R.C. § 752(a).

(3) Assumption of a Liability

By the Partnership. A partnership is treated as assuming a liability of a partner in two general circumstances. First, a partnership assumes a liability of a partner if the partnership becomes personally obligated to pay it. Treas. Reg. § 1.752-1(d)(1). Second, if a partner contributes to the partnership property that is subject to a liability of the partner, then

the partnership is treated as assuming the liability to the extent that the liability does not exceed the fair market value of the property on the date of the contribution. Treas. Reg. § 1.752-1(e).

By a Partner. A partner is treated as assuming a liability of a partnership in the same two circumstances described above, i.e., if the partner becomes personally obligated to pay a partnership liability or if the partnership transfers to the partner property subject to a liability, with one exception: a partner is treated as assuming a partnership liability by becoming personally obligated to pay it only if the person to whom the liability is owed knows of the assumption and can directly enforce the partner’s obligation to pay it, and no other partner (or related person) bears the economic risk of loss for the liability immediately after the assumption.

b) Reallocations of Partnership Liabilities Do Not

Give Rise to Disguised Sales Deemed cash contributions to or distributions

from a partnership that result from reallocations of partnership liabilities among the partners are not treated as transfers of consideration for purposes of the rules on disguised sales of partnership interests. Prop. Treas. Reg. § 1.707-7(j)(1). Accordingly, such deemed cash contributions and distributions do not result in a disguised sale of a partnership interest.

c) Selling Partner Must Include in Amount Realized

Any Reduction in Share of Partnership Liabilities If a selling partner is treated as selling a portion of

his partnership interest to the purchasing partner, then the selling partner must include in his amount realized on the sale any reduction in his share of partnership liabilities that results from the sale. Prop. Treas. Reg. § 1.707-7(a)(4). If a contribution to or distribution from the partnership occurs on the same date as the sale because the consideration transferred by the purchasing partner and to the selling partner differ in amount (see Part III.C.2.d, above), the reduction in liabilities is determined before determining the tax consequences of the contribution or distribution. Id.

Example #9

Facts: Same facts as example #1, except that

Blackacre is subject to a nonrecourse liability of $100, C transfers to the partnership cash of $50, and on the same date the partnership transfers cash of $50 to A. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 8). Analysis:


#1.


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Tax Consequences of the Sale. Because the transfers are simultaneous, and because the consideration transferred by C and to A is the same, C is treated as transferring cash of $50 directly to A in exchange for a portion of A’s partnership interest with a value of $50. Assuming A’s partnership interest is worth $150 before the transfers, A is treated as selling one-third of his partnership interest. Although the reallocation of the $100 liability among the partners does not result in a transfer of consideration, A must include in his amount realized on the sale the reduction in his share of the $100 liability. Before the sale, under the sharing rules discussed below, A had a 50 percent share of the liability, or $50, and immediately after the sale A has a one-third share of the liability, or roughly $33, and therefore the reduction in A’s share of the liability is $17. A’s amount realized on the sale therefore is $67. A recognizes gain of approximately $40 (excess of $67 amount realized over one-third of A’s $80 basis in his partnership interest). A portion of A’s gain is ordinary income pursuant to section 751(a) and a portion is capital gain pursuant to section 741. C acquires a $67 basis in C’s partnership interest ($50 cash transferred plus $17 share of the partnership’s liability). If the partnership has a section 754 election in effect, it must adjust the basis of the accounts receivable and Blackacre pursuant to section 743(b). There are no tax consequences for B.

d) Assumptions of Liabilities Can Give Rise to

Disguised Sales If a partnership assumes a liability of a partner

under the rules discussed above (e.g., because the partner contributes property subject to a liability), the partnership is treated as transferring consideration to the partner to the extent that the liability exceeds the partner’s share of the liability immediately after the partnership assumes it. Prop. Treas. Reg. § 1.707-7(j)(2). Conversely, if a partner assumes a partnership liability under the rules discussed above, the partner is treated as transferring consideration to the partnership to the extent that the liability exceeds the partner’s share of the liability immediately before the partner’s assumption. Prop. Treas. Reg. § 1.707-7(j)(3). Because these assumptions of liabilities are treated as transfers of consideration, they can result in a disguised sale of a partnership interest if they are related to another transfer of consideration by a partnership or a partner in such a way that the transfers constitute a disguised sale under the rules discussed in Part III.B.

(1) Determining a Partner’s Share of Liabilities

A partner’s share of a recourse liability generally is determined under the normal rules for doing so in Treas. Reg. § 1.752-2. Prop. Treas. Reg. § 1.707-7(j)(4)(i). Accordingly, a partner’s share of a recourse liability is the portion of it for which the partner bears

the economic risk of loss. Treas. Reg. § 1.752-2(a). A partner’s share of a nonrecourse liability is not determined under the three-tier system of Treas. Reg. § 1.752-3(a), but rather is determined by applying to the liability the percentage used to determine the partner’s share of excess nonrecourse liabilities. Prop. Treas. Reg. § 1.707-7(j)(4)(ii). Therefore, partners generally share nonrecourse liabilities for purposes of the rules on disguised sales of partnership interests in accordance with their shares of profits.

(2) Reduction in a Partner’s Share of Liabilities

In determining a partner’s share of a liability immediately after the partnership assumes it, the partner’s share is reduced by any anticipated reduction in the partner’s share of it if the reduction is part of a plan that has as one of its principal purposes minimizing the extent to which the partnership’s assumption of the liability is treated as part of a disguised sale. Prop. Treas. Reg. § 1.707-7(j)(5).

(3) Netting of Assumptions With Contributions and

Distributions If a partnership assumes a liability of a partner

and the partner contributes money to the partnership, and if the assumption and contribution are part of a plan, only the net amount is treated as the partnership’s assumption of the partner’s liability. Prop. Treas. Reg. § 1.707-7(j)(7). Similarly, if a partner assumes a liability of the partnership and the partnership distributes money to the partner, and if the assumption and distribution are part of a plan, only the net amount is treated as the partner’s assumption of the partnership’s liability. Id.

Comment: Note that the approach of the proposed regulations is different from that of the existing final regulations on disguised sales of property, which create a category of “qualified liabilities” that generally do not result in disguised sales. In the preamble to the proposed regulations, the Service requested comments on whether the proposed regulations should include a category of qualified liabilities similar to that in the existing regulations and, if so, the extent to which the existing rules should be modified to apply to disguised sales of partnership interests. 69 Fed. Reg. at 68,842.

Example #10


partnership does not transfer $100 to A. Instead, the partnership assumes a $100 personal liability of A. Assume that, after the partnership’s assumption of the liability, only B and C bear the economic risk of loss for the debt, i.e., A bears no economic risk of loss for the liability. Cf. Prop. Treas. Reg. § 1.707-7(l) (example 9).


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Analysis: Treatment as a Sale. The partnership’s

assumption of A’s liability is treated as the partnership’s transfer of consideration to A to the extent that the liability exceeds A’s share of the liability immediately after the assumption. Here, because A has no share of the liability immediately after the partnership’s assumption of it, the entire $100 is treated as consideration that the partnership transfers to A. Therefore, the analysis of whether the transfers to A and by C constitute a sale is the same as in example #1.

Tax Consequences of the Sale. The result is the same as in example #1.

e) Debt-Financed Transfers to a Partner (1) In General

If a partnership incurs a liability and, pursuant to Treas. Reg. § 163-8T, the proceeds of the liability are allocable to a transfer of consideration made to a partner within 90 days of the date on which the partnership incurs the liability, then the transfer is treated as a transfer of consideration for purposes of the rules on disguised sales of partnership interests to the extent that the transfer exceeds the partner’s allocable share of the liability. Prop. Treas. Reg. § 1.707-7(j)(6)(i). A partner’s allocable share of a liability is determined by multiplying the partner’s share of the liability by a fraction:

Portion of transfer allocable to the liability

Total amount of the liability Id. § 1.707-7(j)(6)(ii)(A). This approach, which also is the approach taken in the existing final regulations on disguised sales of property, reaches the same result as if the partner had incurred the liability and the partnership had assumed it. Example #11

Assume the same facts as in example #10 above, except that the partnership does not assume a personal liability of A. Instead, the partnership incurs a $100 liability and, within 90 days, transfers $100 to A. Assume that the entire $100 received by A is allocable to the liability. If, as in example 10, A has no share of the liability, then A’s allocable share of the liability is $0. Because the transfer of consideration to A exceeds A’s allocable share by $100, the entire $100 is treated as a transfer of consideration for purposes of the rules on disguised sales of partnership interests. The result is the same as in example 10.

(2) Special Rules The proposed regulations provide special rules

that address transfers of loan proceeds to more than one partner and transfers of the proceeds of more than one loan, as well as reductions of a partner’s share of a liability to reflect anticipated decreases in the partner’s share. Prop. Treas. Reg. § 1.707-7(j)(6)(B)-(C).

f) Anti-Abuse Rule

The proposed regulations include an anti-abuse rule that modifies the general rule discussed above that reallocations of partnership liabilities among the partners are not treated as transfers of consideration for purposes of the rules on disguised sales of partnership interests. According to the preamble, the anti-abuse rule is intended “to address cases in which the rules of the proposed regulations do not adequately capture the substance of an integrated set of transactions.” 69 Fed. Reg. at 68,842. The anti-abuse rule provides that an increase in a partner’s share of a partnership liability may be treated as a transfer of consideration to the partnership by that partner as part of a sale of a partnership interest if two conditions are met: (i) within a short period of time after the partnership incurs or assumes the liability (or another liability), one or more partners (or related persons) in substance bear an economic risk of loss for the liability that is disproportionate to the partner’s interest in partnership capital or profits, and (ii) the transactions are undertaken pursuant to a plan that has as one of its principal purposes minimizing the extent to which the partner who has an increase in his share of a partnership liability is treated as making a transfer of consideration to the partnership that may be taken into account as part of a disguised sale. Prop. Treas. Reg. § 1.707-7(a)(8). The Service has requested comments on this anti-abuse rule, including examples of situations where application of the rule would be appropriate.

D. Disclosure of Transfers to the Service 1. Disclosure Related to Potential Disguised Sales of

Partnership Interests a) In General

The proposed regulations generally require that a transfer of consideration by a partner to a partnership and a transfer of consideration by the partnership to another partner that occur within seven years of each other must be reported to the Service if the transfers are not treated as a sale of a partnership interest. Prop. Treas. Reg. § 1.707-7(k). The required disclosure is made on Form 8275. Prop. Treas. Reg. § 1.707-7(k) (referring to Treas. Reg. § 1.707-8 for method of disclosure).

b) Exceptions

For purposes of the disclosure rule, a transfer by a partnership to a partner that is treated under the


16

existing final regulations on disguised sales of property as a reasonable preferred return or operating cash flow distribution, or that is presumed to be a guaranteed payment for capital, is not taken into account. Id.; see Part II.B.2.b.i, above (discussing these rules). The disclosure rule also does not apply to transfers that are excluded from the rules on disguised sales of partnership interests, i.e., transfers incident to formation of a partnership, transfers that result from the termination of a partnership, and transfers to or by service partnerships. Prop. Treas. Reg. § 1.707-7(k); see Part II.B.3, above (discussing these exclusions).

Comment: Because partnerships frequently receive and distribute cash, this seven-year reporting obligation creates a significant burden for partnerships and presumably will result in tax advisors spending significant time assessing whether particular transfers fall within one of the categories that need not be disclosed.

2. Modification of Existing Disclosure Rules for

Disguised Sales of Property a) Existing Rules

As discussed earlier, the existing final regulations on disguised sales of property generally require transfers of property by a partner to a partnership and transfers of money or other consideration by the partnership to the partner that occur within two years of each other to be reported to the Service if the transfers are not treated as a sale. Treas. Reg. § 1.707-3(c)(2). Similarly, if a partner incurs a liability within the two-year period prior to transferring property to a partnership and the partnership assumes or takes the property subject to the liability, then the transfer generally must be reported to the Service if it is not treated as a sale. Treas. Reg. § 1.707-5(a)(7)(ii). These disclosures also are required if the partnership, rather than the partner, is the transferor of property. Treas. Reg. § 1.707-6(c). The required disclosures are made on Form 8275. Treas. Reg. § 1.707-8(b).

b) Modification of Existing Rules

In response to the recommendation of the Joint Committee on Taxation in its report on Enron and in its written testimony on the Enron report, the proposed regulations expand the measuring period for disclosure to seven years in each of the situations described above. Prop. Treas. Reg. §§ 1.707-3(c)(2), 1.707-5(a)(8), 1.707-6(c). The proposed regulations also provide that the obligation to disclose falls on any person who makes a transfer that is required to be disclosed. Prop. Treas. Reg. § 1.707-8(c). Parties who are required to disclose can designate by written agreement a single person to make the disclosure, but doing so does not relieve a party of the obligation to disclose if the designated person fails to disclose. Id.

E. Effective Date The proposed regulations on disguised sales of

partnership interests generally apply to any transaction with respect to which all transfers that are treated as part of a sale of a partnership interest occur on or after the date on which final regulations are published in the Federal Register. Prop. Treas. Reg. § 1.707-9(a)(1).

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DISGUISED SALES OF PARTNERSHIP INTERESTS: THE … · 2013-10-17 · DISGUISED SALES OF PARTNERSHIP...

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