On October 5, 2016, the IRS issued final, temporary and proposed regulations on partnership disguised sales and allocation of liabilities. Under these regulations (and consistent with the prior regulations), when a partner contributes property to a partnership and receives a distribution within two years, these steps are treated together as a sale of property. There are, however, some exceptions to the potentially harsh result of the disguised sale rules, namely the preformation expenditures exception.
Background of Disguised Sale Rules
Here’s a typical example of what the disguised sale rules were implemented to prevent:
Partners A, B & C form a partnership.
A & B each contribute cash, and C contributes property with a fair market value (FMV) in excess of its basis.
Using the property contributed by C as security, the partnership would then borrow money (increasing C’s partnership basis) and distribute most (or all) of it to C and reduce C’s partnership percentage.
Under other general partnership rules, i.e., absent the disguised sale rules, C’s contribution of property and the subsequent receipt of cash distribution would, as long as the distribution does not exceed C’s tax basis, result in no gain — although C effectively has sold some interest in the property. The disguised sale rules ignore the two-step form of C’s transaction and instead treat it as a sale of property often resulting in a taxable gain to C.
Additionally, the regulations create additional filing requirements by imposing disclosure obligations in certain situations.
Exception to the Rules
The preformation expenditures exception offers an exception to the often unfavorable disguised sale rule treatment. What this means is that transfers to reimburse a partner for certain organization, syndication and capital expenditures incurred within two years prior to contributing the property to the partnership are not treated as a disguised sale. This exception is generally limited to 20% of the FMV of the property at the time of contribution. However, note that this limitation does not apply if the FMV of the contributed property does not exceed 120% of the partner’s adjusted basis in the property at the time of the contribution.
The regulations also clarify that the preformation expenditures exception applies on a property-by-property basis, meaning the values of all property contributed to the partnership are not aggregated for purposes of determining the limitation.
Aggregation is permitted, however, in the following limited circumstances:
The total FMV of the aggregated property (of which no single property’s FMV exceeds 1% of the total FMV of the aggregated property) is no greater than the lesser of either 10% of the total FMV of all property transferred by the partner to the partnership (excluding money and marketable securities), or $1 million;
The partner uses a reasonable aggregation method that is consistently applied; and
The aggregation of property is not part of a plan aimed at avoiding IRC Code Sections 1.707-3 through 1.707-5.
“Step in the Shoes” Rules/Transactions
Another provision allows a partner who previously acquired the contributed property in a tax-deferred exchange to “step in the shoes” of the prior owner who incurred qualifying capital expenditures with regard to the property. Specifically, a partner steps into the shoes of a person (who was not previously reimbursed) with respect to capital expenditures the person incurred when the property first transferred to the partnership. This is allowed if the partner acquired the property from the person in a nonrecognition transaction described in Section 351, 381(a), 721 or 731.
The regulations also provide a step-in-the-shoes application in a tiered partnership setting. This situation applies when a person:
Incurs capital expenditures for property,
Transfers the property to a partnership (lower-tier partnership), and
Transfers an interest in the lower-tier partnership to an upper-tier partnership in a nonrecognition transaction under Section 721 within two years of incurring the expenditure.
The person is deemed to have transferred the capital expenditures property to the upper-tier partnership for purposes of the preformation expenditures exception and, therefore, may be reimbursed by the upper-tier partnership to the extent they could have been reimbursed by the lower-tier partnership.
Coordination with Qualified Liability Exception
In the past, some taxpayers have tried to obtain a double benefit, arguing that they could receive a cash distribution from a partnership in reimbursement of preformation expenditures, even though these same preformation expenditures were made using the proceeds of a “qualified liability” assumed by the partnership.
The regulations provide that if capital expenditures were funded by the proceeds of a qualified liability, a transfer of money or other consideration by the partnership to the partner will not qualify for the preformation expenditures exception, if the amount exceeds the partner's share of the qualified liability. Tracing rules will determine whether capital expenditures were, in fact, funded though qualified liabilities.
Protecting Your Interests
It’s always best to involve your advisors in any sort of transaction before it occurs so planning can be done to mitigate negative results. However, if the transaction already has been executed, the good news is there is still plenty your tax team can do to add value post-execution. They can analyze whether or not the transaction amounts to a disguised sale, review expenditures to determine if they qualify for the preformation exception, evaluate the possibility of aggregation and analyze the calculation, and advise on whether or not disclosure is required. Regardless of what stage you are in, get your advisors involved as soon as possible to help navigate these disguised partnership sale rules.
Contact a member of your service team or Kim Palmer at firstname.lastname@example.org for more information.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.