Recognizing When a Disguised Sale of Property Takes Place

Editor: Albert B. Ellentuck, Esq.

Generally, no gain or loss is recognized when money or unencumbered property is contributed to a partnership (Sec. 721), but this nonrecognition rule does not apply if the transaction is a sale. Disguised sale issues usually arise in the context of a property transfer from a partner to a partnership followed by a cash distribution from the partnership to a partner (or vice versa). If these were treated as separate events, under Secs. 721 and 731 the partner and partnership would not recognize gain or loss on the contribution and distribution. However, this transaction is considered to be a taxable sale of the property under certain circumstances. The transfer constitutes a sale only if both of the following conditions are met (Regs. Sec. 1.707-3(b)(1)):

  1. The transfer of money or other consideration would not have been made but for the transfer of the property; and
  2. If the transfers are not simultaneous, the subsequent transfer (either of money or property) does not depend on the entrepreneurial risks of partnership operations.

The following facts and circumstances may prove the existence of a disguised sale (Regs. Sec. 1.707-3(b)(2)):

  1. The timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of the earlier transfer;
  2. The transferor has a legally enforceable right to the subsequent transfer;
  3. The partner's right to receive the transfer of money or other consideration is secured in any manner (taking into account the period during which it is secured);
  4. Any person has made or is legally obligated to make contributions to the partnership to permit the partnership to make the transfer of money or other consideration;
  5. Any person has loaned or has agreed to loan the partnership the money or other consideration necessary to permit it to make the transfers, taking into account whether any such lending obligation is subject to contingencies related to the results of partnership operations;
  6. The partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer, taking into account the likelihood that the partnership will be able to incur the debt (considering such factors as whether any person has agreed to guarantee or otherwise assume personal responsibility for the debt);
  7. The partnership holds money or other liquid assets, beyond the reasonable needs of the business, which are expected to be available to make the transfer (taking into account the income that will be earned from those assets);
  8. Partnership distributions, partnership allocations, or control of partnership operations is designed to effect an exchange of the burdens and benefits of property ownership;
  9. The transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner's general and continuing interest in partnership profits;or
  10. The partner has no obligation to return or repay the money or other consideration to the partnership or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner.

Caution: Note that the disguised sale regulations apply to deemed sales from the partner to the partnership, from the partnership to a partner, and among the partners.

Transfers can be bifurcated or aggregated. If the consideration transferred to a partner is less than the fair market value (FMV) of the contributed property, the transfer is treated as part sale and part contribution (Regs. Sec. 1.707-3(a)(2)). The regulations clarify that for purposes of applying the disguised sale rules, transfers resulting from the technical termination of a partnership under Sec. 708(b)(1)(B) are disregarded (Regs. Sec. 1.707-3(a)(4)).

Example. Contribution and simultaneous distribution treated as a disguised sale: K transfers a tract of raw land to M Investors Partnership in exchange for a partnership interest. On the same day, M transfers $2 million cash to K. At the time of the transfer, the land has an FMV of $3 million and an adjusted basis to K of $1.5 million.

The contribution and distribution are treated as a partial sale by a third party to the partnership rather than as a contribution of property by K and a distribution of cash by M. Because the cash K receives is less than the property's FMV, the transfer is treated as a partial sale (of two-thirds of the land) and partial contribution (of one-third). K allocates her $1.5 million basis in the transferred property between the sale and the contribution and recognizes a $1 million gain from the partial sale ($2,000,000 - [$1,500,000 × $2,000,000 ÷ $3,000,000]). K's initial basis in her partnership interest is $500,000—the remaining basis allocable to the land deemed contributed.

Effect on Other Code Sections

If a transaction is treated as a disguised sale under Sec. 707, it is treated as a sale under all other Code provisions, such as Secs. 453 (installment sales), 483 (unstated interest rule), 1001 (determination of gain or loss), 1012 (basis), 1031 (like-kind exchange), and 1274 (the original issue discount (OID) rules) (Regs. Sec. 1.707-3(a)(2)). For instance, a disguised sale that otherwise meets the requirements of Sec. 1031 is provided nonrecognition treatment. In addition, the recharacterization of the transaction from a contribution to a disguised sale affects the partner's basis in his or her partnership interest and the partnership's basis in the property.  

This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 30th Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, and Twila Bollinger, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).

 

Contributor

Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.

 

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