Recent regs. significantly change taxation of certain partnership contributions

By Sean Austin, J.D., New York City; Richard Blumenreich, J.D., LL.M., Washington; and Morgan Holtman, J.D., LL.M., Washington

Editor: Mary Van Leuven, J.D., LL.M.

On Jan. 18, 2017, Treasury and the IRS issued final and temporary regulations under Sec. 721(c) that generally override Sec. 721(a) nonrecognition treatment for certain contributions of property to partnerships (T.D. 9814). The Sec. 721(c) regulations build on and replace the rules set forth in Notice 2015-54, which was issued on Aug. 6, 2015.

The IRS issued the Sec. 721(c) regulations in response to certain taxpayer positions relating to the allocation of income or gain from property contributed to a partnership. According to the preamble, some taxpayers have taken the position that income or gain associated with property contributed by a U.S. person can be allocated to a related foreign partner that is not subject to U.S. federal income tax in a manner that is consistent with Secs. 704(b), 704(c), and 482 (T.D. 9814, preamble). In those situations, the preamble notes that the applicable partnerships may have adopted Sec. 704(c) methods other than the remedial method or applied valuation techniques that do not reflect arm's-length principles.

Sec. 721(c) regs. generally

Sec. 721(a) generally provides that when a partner contributes property to a partnership in exchange for an interest in the partnership, the partner and the partnership do not recognize gain or loss. The Sec. 721(c) regulations effectively turn off the general nonrecognition rule and require immediate gain recognition if a U.S. person (a U.S. transferor) transfers certain appreciated property (Sec. 721(c) property) to a domestic or foreign partnership in which the U.S. transferor and related persons, including at least one related foreign person, own 80% or more of the interests in the partnership's capital, profits, deductions, or losses following the transfer and any related transactions (a Sec. 721(c) partnership). The requirement that a U.S. transferor recognize gain on a transfer of Sec. 721(c) property to a Sec. 721(c) partnership is referred to in this item as the gain-recognition rule.

Sec. 721(c) property generally includes any property that has built-in gain at the time it is contributed to the partnership, other than (1) a cash equivalent; (2) a "security" within the meaning of Sec. 475(c)(2); (3) tangible property that has either built-in gain of $20,000 or less or built-in loss; and (4) an interest in a partnership that holds property 90% or more of the value of which consists of the items described in clauses (1) through (3). A "related person" for this purpose is a person that is related to the U.S. transferor within the meaning of Sec. 267(b) or 707(b)(1), and a "related foreign person" is any related person that is a non-U.S. person. A special lookthrough rule applies if an upper-tier partnership (UTP) in which a U.S. transferor is a direct or indirect partner contributes property to a lower-tier partnership (LTP). In that case, and for purposes of determining whether the LTP is a Sec. 721(c) partnership, the U.S. transferor is treated as contributing directly to the LTP its pro rata share of the property actually contributed by the UTP to the LTP.

There are two exceptions to the gain-recognition rule of Sec. 721(c). Under a de minimis rule, the gain-recognition rule does not apply to contributions of Sec. 721(c) property so long as the sum of the built-in gain for all Sec. 721(c) property contributed to the Sec. 721(c) partnership during the partnership's tax year does not exceed $1 million. The gain-recognition rule also does not apply to a contribution of Sec. 721(c) property to a Sec. 721(c) partnership if the partnership adopts the gain-deferral method with respect to that property. In that situation, and in lieu of immediate gain recognition, the U.S. transferor effectively is required to recognize a portion of the built-in gain in the Sec. 721(c) property each year over the property's recovery period through allocations of remedial income.

Gain-deferral method

The gain-deferral method has many requirements. Some requirements relate to procedural and reporting aspects, while other requirements affect the partners' federal income tax consequences and their economic arrangement. In particular, the gain-deferral method requires that a Sec. 721(c) partnership adopt the remedial method as described in the regulations under Sec. 704(c) with respect to the contributed Sec. 721(c) property. As a general matter, the remedial method ensures that built-in gain in contributed property is allocated to the contributor over the property's recovery period by way of allocations of remedial income to the contributor that offset allocations of remedial depreciation or amortization to noncontributing partners to reflect the noncontributing partners' allocable share of the economic depreciation or amortization of the property under Sec. 704(b).

For example, if the subject Sec. 721(c) property is an amortizable intangible with zero tax basis and a Sec. 704(b) book value in excess of zero, and the partnership adopts the remedial method with respect to that amortizable intangible, the partnership would amortize the Sec. 704(b) value as if the property were newly placed in service, allocate remedial tax amortization deductions to the noncontributing partners to match their allocable share of the Sec. 704(b) amortization, and allocate an offsetting remedial income amount to the U.S. transferor.

The gain-deferral method also requires that a Sec. 721(c) partnership satisfy the consistent-allocation method when allocating Sec. 704(b) items with respect to Sec. 721(c) property. The consistent-allocation method applies on a property-by-property basis and generally requires that the partnership allocate the same percentage of each item of Sec. 704(b) income, gain, deduction, and loss relating to Sec. 721(c) property to the U.S. transferor. In other words, special allocations of those items would violate the requirements of the gain-deferral method. The Sec. 721(c) regulations provide some guidance on determining which of the partnership's Sec. 704(b) items relate to Sec. 721(c) property.

There are a handful of exceptions to the consistent-allocation method. In particular, the regulations exclude allocations of creditable foreign tax expenditures described in regulations under Sec. 704(b), so they need not be allocated pro rata. In addition, certain Sec. 704(b) "regulatory allocations"—namely, allocations pursuant to minimum gain chargebacks, partner minimum gain chargebacks, and qualified income offsets, as well as allocations of partner nonrecourse deductions, partnership-level ordinary income or loss described in Regs. Sec. 1.751-1(a)(3), and allocations with respect to certain noncompensatory options—effectively are deemed to satisfy the consistent-allocation method. However, if a regulatory allocation results in a greater allocation of loss or deduction to the U.S. transferor or a greater allocation of income or gain to another partner than would have been the case if the allocation had been subject to the consistent-allocation method, the U.S. transferor generally is required to recognize a portion of the remaining built-in gain in the Sec. 721(c) property equal to the excess amount of the allocation. Importantly, allocations of partnership nonrecourse deductions are not considered "regulatory allocations" for purposes of this exclusion. Accordingly, if an allocation of partnership nonrecourse deductions causes a disproportionate allocation of income, gain, loss, or deduction with respect to Sec. 721(c) property, the partnership would fail the consistent-allocation method requirement with respect to that property.

If Sec. 721(c) property is effectively connected with a U.S. trade or business (effectively connected income, or ECI, property) and certain other requirements are satisfied, the Sec. 721(c) partnership does not need to adopt the remedial method or comply with the consistent-allocation method with respect to that property. Property is ECI property for this purpose so long as (1) all distributive shares of income or gain with respect to the property for all direct and indirect partners that are related foreign persons are subject to tax as ECI, and (2) neither the Sec. 721(c) partnership nor a direct or indirect partner claims benefits under an income tax treaty that would exempt the income or gain from tax or reduce the rate of tax on the income or gain.

In addition to the allocation requirements described above, the U.S. transferor must agree to extend the period of limitation for assessment of tax on certain items related to the Sec. 721(c) property, including the built-in gain, through the end of the eighth full tax year following the property's contribution to the partnership. Both the U.S. transferor and the Sec. 721(c) partnership also must satisfy certain reporting requirements. Special rules apply if the subject Sec. 721(c) property is described in Sec. 197(f)(9) (generally referred to as "anti-churned" property) and if the U.S. transferor holds an indirect interest in Sec. 721(c) property through tiered partnerships.

Last but not least, the gain-deferral method requires the U.S. transferor to recognize the remaining built-in gain with respect to Sec. 721(c) property on the occurrence of an acceleration event, which generally is any event that would reduce or defer the U.S. transferor's recognition of any remaining built-in gain. The term "acceleration event" for this purpose includes a failure to comply with any of the requirements of the gain-deferral method, unless the failure relates to the procedural or reporting requirements, the failure was not willful, and relief is sought under prescribed procedures.

Despite the broad definition of an acceleration event, the Sec. 721(c) regulations identify several events that meet the definition but do not necessarily trigger the recognition of remaining built-in gain. These include "termination events," in which case the gain-deferral method ceases to apply entirely; "successor events," such as certain technical terminations under Sec. 708(b)(1)(B), in which case the gain-deferral method continues to apply but only if the Sec. 721(c) partnership or its successor continues to comply with the requirements; "partial acceleration events," in which case a U.S. transferor recognizes only a portion of the remaining built-in gain and the gain-deferral method continues to apply to the remainder; and fully taxable dispositions of a portion of an interest in a Sec. 721(c) partnership, in which case the gain-deferral method continues to apply to the retained interest.

Effective dates

The Sec. 721(c) regulations generally apply to contributions occurring on or after Aug. 6, 2015, and to contributions occurring before Aug. 6, 2015, resulting from an entity-classification election filed on or after Aug. 6, 2015. Additions and substantive changes to the rules outlined in Notice 2015-54 (as specified in the Sec. 721(c) regulations) generally apply to contributions occurring on or after Jan. 18, 2017, or to contributions occurring before Jan. 18, 2017, resulting from an entity-classification election that is filed on or after that date.


Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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