When it comes to partnerships, there is relative flexibility in contributing and distributing property without incurring tax. But there are limits to that flexibility, and this blog looks at a few property contribution situations that can result in an unexpected tax liability.
By Mark L. Lubin, CPA, JD, LLM
One benefit of partnerships is relative flexibility in contributing and distributing property without incurring tax.1 However, there are limitations on such flexibility. This blog reviews situations involving property contributions that can unexpectedly result in tax liability, particularly when a contribution is followed by a distribution of cash or other property to the contributing partner or there is a subsequent distribution of the contributed property to one or more other partners.2
Generally speaking, the federal disguised sale rules are intended to prevent taxpayers from circumventing income recognition through transactions where a partner contributes property to a partnership and receives actual or deemed distributions but the transaction economically amounts to a sale or exchange (as distinguished from situations where a partner retains an indirect stake in contributed property through a capital interest subject to entrepreneurial risk). Because there are various ways to provide a “purchasing” partner with benefits and burdens associated with property and a “selling” partner with purchase consideration, the disguised sale rules apply broadly and employ a factual analysis for determining when contributions and distributions will be treated as a disguised sale.3
Here are a few fundamental points regarding disguised sales:
Similar to disguised sales, “mixing bowl” transactions are subject to rules designed to prevent circumventing income recognition in certain situations where property is contributed to a partnership.8 These anti-mixing-bowl rules generally apply when contributed property either is distributed to one or more noncontributing partners within seven years of the contribution9 or has appreciated in value and the contributing partner receives a distribution of other property within seven years of the contribution.10
In the first situation, the contributing partner generally recognizes gain or loss under Section 704(c)(1)(B) to the extent it has precontribution gain or loss that was not previously recognized.11 Character is generally determined as if the property had been sold at the time of the distribution.
In the second situation, the contributing partner is generally required to recognize gain under Section 737 equal to the lesser of the “excess distribution” (generally, the excess of the fair market value of the distributed property over the partner’s adjusted basis in the partnership interest) or the “net pre-contribution gain” (generally, the net gain the distributee partner would have recognized under Section 704(c)(1)(B) and Reg. Section 1.704-4 had all the property it contributed been distributed to another partner).12
From a planning perspective, it is important to keep track of the Section 704(c)(1)(B) and Section 737 “seven-year clock” following property contributions. Income recognition can sometimes be avoided by delaying distributions. Transactions such as partnership mergers that might involve an actual or deemed contribution that restarts the seven-year clock or otherwise trigger recognition should be avoided.
Practitioners should be vigilant whenever a partnership receives or has received property contributions. Through an awareness of the disguised sale and anti-mixing bowl rules and appropriate planning, partners and their advisers can often avoid or minimize unexpected tax liability under those provisions.
1 See Internal Revenue Code (IRC) Sections 721 and 731. Corporate tax-free contributions are subject to greater restrictions, and corporate distributions are generally taxable.
2 This discussion is not comprehensive, and it primarily addresses situations involving contributions of appreciated property. Other provisions not discussed in this article (including IRC Sections 721(b) and (c), 731(b)(1), 751, and 752) can also cause a contribution or distribution to result in tax liability.
3 IRC Section 707(a)(2)(B); Reg. Sections 1.707-3–5. Although this article focuses on potential disguised sales by partners, disguised sales can also apply to transfers by partnerships to partners. (See Reg. Section 1.707-6.)
4 Reg. Section 1.707-3(c)(2) requires IRS disclosure of certain transactions, including transfers treated as not involving a sale despite meeting the “within two years” presumption.
5 Gain recognition can also occur under general IRC Sections 731(a)(1) and 752(b) principles if a contributing partner is relieved (or considered to be relieved) of liabilities exceeding its basis in property contributed.
6 See Reg. Section 1.707-5.
7 Reg. Sections 1.707-4 and 1.707-5(b)(1).
8 Those rules are generally intended to promote the purposes of IRC Section 704(c) and policies similar to those behind the disguised sale rules.
9 IRC Section 704(c)(1)(B); Reg. Section 1.704-4.
10 IRC Section 737 and regulations thereunder.
11 Exceptions apply to certain nonrecognition transactions and distributions to a partner of property that it previously contributed.
12 Such recognition is in addition to any gain recognized under Section 731.
Mark L. Lubin, CPA, JD, LLM, is a tax attorney and special counsel to Chamberlain Hrdlicka. He has extensive experience in mergers and acquisitions, international tax, joint ventures, restructurings, alternative investment vehicles, and other areas of taxation relevant to complex and growing businesses. He can be reached at mlubin@chamberlainlaw.com.
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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.
Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of PICPA officers or members. The information contained in herein does not constitute accounting, legal, or professional advice. For professional advice, please engage or consult a qualified professional.