Oftenin the establishment of a new partnership, one partner (the contributing partner) contributes an asset such as land or a building and other partners contribute cash. This is especially common in the real estate industry and is a nontaxable transaction under Internal Revenue Code (IRC) Section 721.
However, a red flag should go up when the contributing partner receives cash from the partnership; this can be construed as a disguised sale and can create unintended tax consequences. Although one of the most common scenarios is a property contribution by a partner to a partnership with a distribution of cash from the partnership to the contributing partner (a disguised sale by the partner to the partnership), a disguised sale can take other forms:
a cash contribution by a partner to a partnership with a property distribution from the partnership to the contributing partner (a disguised sale by the partnership to the partner), and
a property contribution by one partner and cash by another partner with a cash distribution from the partnership to the partner contributing property and a property distribution to the partner contributing cash (a disguised sale between the partners).
At its root, IRC Section 707 provides if a partner transfers money or other property to a partnership and there is a related transfer of money or property to the partner (or any other partner), the transaction is considered a sale. And it does not matter the order in which the transaction occurs, i.e., the distribution of cash can occur before the contribution of property. Specifically, to be considered a sale, both of the following criteria must be met:
The money, or other consideration, would not have been transferred if the property were not transferred.
If the transfers are not made simultaneously, the later transfer is made without regard to the results of partnership operations.
For non-simultaneous transfers, within a two-year period, if a partner transfers property to a partnership and the partnership transfers consideration to the partner, the transfers are presumed to be part of a disguised sale unless the facts and circumstances clearly prove otherwise.
There are exceptions under the safe harbor rules, in which certain types of distributions are not considered to be payments in exchange for property, and therefore are not considered a disguised sale.
There are also rules for liabilities incurred or transferred in connection with a disguised sale. Qualified liabilities are not used to determine if the transfer is a disguised sale, while unqualified liabilities are, e.g., debt incurred within two years of the transfer is generally considered an unqualified liability and part of a disguised sale. Liability rules exist to prevent transactions in which a partner incurs debt in anticipation of the transfer of property and the partnership subsequently assumes the debt.
The entirety of the disguised sale rules are complex and can be a trap for the unwary, resulting in unintended tax consequences. But, as with any tax scenario, there are also generally opportunities, such as additional deferrals or deductions, to uncover if appropriate and strategic tax planning is conducted early on in the process.
For more information on disguised sale rules and their application to your partnership or particular situation, contact Kim Palmer at 330.255.4324 or firstname.lastname@example.org.
This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.
Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.