Proposed Rules Address Disguised Sales and Partnership Liabilities

On Wednesday, the IRS issued proposed regulations on disguised sales of property to or by a partnership under Sec. 707 and the treatment of partnership liabilities under Sec. 752 (REG-119305-11). The IRS says the proposed regulations are designed to address “deficiencies and technical ambiguities” in the current regulations.

Disguised sales

Sec. 707 is intended to prevent partners from recharacterizing a sale or exchange of property as a contribution to the partnership followed by a distribution by the partnership and thereby avoid or defer tax on the transaction. Regulations under Sec. 707(a)(2) were issued in 1992 (T.D. 8439), and proposed regulations addressing certain issues in those regulations were withdrawn in 2009 before being reproposed today.

Existing Regs. Sec. 1.707-3 provides that a partner’s transfer of property to a partnership followed by the partnership’s transfer of money or other consideration to the partner is treated as a sale of property to the partnership by the partner if, based on all the facts and circumstances, the payment of money or other consideration would not have been made but for the transfer of the property (a disguised sale). An entrepreneurial-risks test applies for nonsimultaneous transfers of property.

There are several exceptions to this disguised-sale rule, including the debt-financed-distribution exception, which provides an exception for a distribution to the extent it is traceable to a partnership borrowing that is allocable to the partner. Other exceptions from disguised-sale treatment are found in Regs. Sec. 1.707-4, which, among other things, excludes from disguised-sale treatment payments that qualify as reasonable guaranteed payments to a partner. The proposed regulations introduce an ordering rule for determining which payments may be excluded from disguised-sale treatment by providing that the debt-financed exemption applies first, with any remaining amounts tested under Regs. Sec. 1.707-4.

Another change in the proposed rules is to the treatment of preformation capital expenditures under Regs. Sec. 1.707-4(d), which is proposed to be amended to address three issues. First, the proposed regulations provide how the exception for preformation capital expenditures applies in the case of multiple property transfers. In addition, the proposed rules clarify the meaning of “capital expenditures” for purposes of this exception. And finally, the proposed regulations provide a rule coordinating the exception for preformation capital expenditures and the rules regarding liabilities traceable to capital expenditures. To the extent a partner financed a capital expenditure with a borrowing, and economic responsibility for that borrowing has shifted to another partner, the exception for preformation capital expenditures should not apply.

The proposed rules also clarify certain other exceptions to the disguised-sale rules, as well as how those rules apply to tiered partnerships and disregarded entities.

Partnership liabilities

The Sec. 752 rules determine the treatment of partnership liabilities, including the treatment of a partner’s share of either nonrecourse or recourse liabilities. For recourse liabilities, the partner’s share is determined to be the portion for which the partner bears the risk of economic loss. A partner bears the economic risk of loss to the extent it would be obligated to pay if the partnership’s assets were worthless and the obligation became due. This rule applies even if the partnership’s assets are sufficient to pay the liability. The IRS is concerned the rule encourages arrangements whereby partners enter into “payment obligations that are not commercial” to obtain an allocation of basis in the liability. To be allocated a liability, under the proposed regulations a partner must satisfy new net-worth and other requirements that are intended to establish that the terms of the payment obligation are commercially reasonable and are not designed solely to obtain tax benefits.

Effective date

The proposed regulations will generally be effective for transactions occurring after the final rules are published in the Federal Register. They include a special transition rule that applies for any partner whose allocable share of partnership liabilities under Regs. Sec. 1.752-2 exceeds its adjusted basis in its partnership interest on the date the proposed regulations are finalized.