Property Contributions: Options and Disguised Sales

What are the two rebuttable presumptions in the regulations that apply to a transaction between a partner and the partnership?

(1) Under § 1.707-3(c)(1), a transfer is presumed to be a sale where the transfers, in whatever order, occur within a two-year period. Where the time interval between transfer of a note and the receipt of partnership funds was eight days, the substance of the transaction was a disguised sale of a note under § 707(a)(2)(B). (2) Under § 1.707-3(d), where transfers occur more than two years apart, it is presumed that the transfer is not a sale. See § 1.707-3(f), example 7: Operation of Presumption for Transfers More than Two Years Apart. Where there is a significant risk that improvements to contributed property will not be completed, the transfer to the partnership will not be treated as part of a sale because the lender is required to make the permanent loan if the improvements are not completed. Where there is a significant risk that the cost of constructing improvements will exceed the amount of the loan secured by the partnership, the transfers will not be treated as part of a sale because the transfer of cash to the partner would be dependent on the entrepreneurial risks of the partnership operations.

A owns a Business A worth $175,000, which B would like to purchase and combine with its own, complementary Business B, worth $225,000. B's bank is willing to lend $150,000 of the purchase price, but A, whose adjusted basis in Business A is only $25,000, is unwilling to proceed with a taxable sale. So A and B form AB LLC, a limited liability company taxed as a partnership, to which they contribute Business A and Business B. AB LLC borrows $150,000 and immediately distributes that amount to A. Assume that the operating agreement of AB LLC provides that all partnership profits and losses will be allocated 10% to A and 90% to B. How much gain, if any, does A recognize on these formation transactions?

A is contributing business worth $175,000 with an adjusted basis of $25,000 in return for the distribution of borrowed funds by AB LLC of $150,000 and a 10% interest. Nonrecourse debt is due to LLC status. Liability focus runs both ways: - Borrowing by partnership and distribution similar to pre-contribution borrowing by partner followed by distribution. - Here, prior negotiations occurred. § 1.707-5(b). - If the partnership incurs debt within 90 days of contributing the property and makes a distribution to the contributing partner, the transaction is treated as a disguised sale to the extent that the distribution exceeds share of debt. For nonrecourse liability, the partner's share is a percentage employed for Tier 3 (i.e., profits ratio). - Here, 10% x $150,000 liability = $15,000 share. - Excess ($150,000 - $15,000 = $135,000) is the amount of disguised sale. - Basis for property is $135,000 / $175,000 x $25,000= $19,286. - Gain is $115,714 ($135,000 - $19,286). - A's basis in the partnership is $5,714 ($25,000 - $19,286) + $15,000 liability - Partnership distribution $15,000 ($150,000 cash received - $135,000 sale). Partnership AB's purchase amount ($135,000 liability) and contribution amount ($5,714) totals $140,714. ·If A guarantees the repayment of $150,000 on the nonrecourse debt: - The goal would be to have all of the liability constitute A's share. - If A is allocated 100% of the liability, no liability relief because the distribution of $150,000 would not exceed his share of debt ($150,000). - Thus, no disguised sale. Economically, this is a bold step to reduce tax consequences. - The ability to pay/satisfy an obligation can be taken into account. - Note that the guaranty of nonrecourse is fundamentally different from such on recourse debt.

What is a non compensatory option?

A non compensatory option is an option issued by partnerships for consideration other than services rendered. Typically a non compensatory option is found in the form of convertible debt (giving the holder an option to exchange it for an equity stake in the partnership) or warrants (issued to a lender as part of an investment unit that includes debt).

What is a disguised sale?

A partnership may make a disguised sale of its own property to one partner by transferring appreciated or depreciated property to a partner in exchange for cash. This may also involve a transfer of non-cash consideration by both the partnership and the partner, so that both the partner and partnership are engaged in taxable transactions. The partnership may be used as a conduit through which to flow the transfers of property and cash between the selling partner and buying partner. Absent regulations, the service may only challenge the transaction under the step-transaction doctrine. For example, a partner transfers appreciated property to the partnership and the partnership makes a related transfer of cash to the partner. Partner has a basis of $2,500 in his 20% interest in the partnership. Partner transfers property valued at $1,000 with an adjusted basis of $400 and the partnership transfers $1,000 cash to him. There is no change in the partner's interest in the partnership as a result of the transaction. Under ordinary partnership rules, the partner's outside basis is increased by $400, and the partner's basis in the transferred property becomes $2,900 under § 722. The cash distribution of $1,000 would not be taxable under § 731(a)(1) because it does not exceed the partner's $2,900 outside basis, although the distribution reduces his basis to $1,900. Under § 723, the partnership takes a $400 basis in the transferred property equal to the partner's former basis. If transaction is treated as a sale of transferred property: - Partner's taxable gain is determined by applying the $400 basis of the property sold against the $1,000 cash received from the partnership. - Thus, taxable gain of $600 for the partner. - The partnership takes a $1,000 cost basis in the transferred asset under § 1012. - The $600 difference from the non-sale setting reflects the $600 gain realized by the partner. If instead of distributing $1,000 cash to the partner, the partnership duplicates the economic effect of the transaction by assuming indebtedness incurred by the partner prior to making the contribution, the regulations may treat the transaction as a disguised sale.

Upon the issuance of a non compensatory option, what is required by the regulations?

A partnership must revalue its assets immediately after the exercise of a non-compensatory option and adjust the book capital account of the exercising partner to reflect his claim on the partnership's assets. Exercising partner's book capital account reflects the value that he has obtained through the exercise option and, to the extent that such value exceeds the amount paid (in option premium and exercise price), it creates more book/tax disparity to be addressed by future reverse § 704(c) allocations.

Does the disguised sale provision apply where a partner contributes appreciated property to the partnership and receives a distribution of money or property before or after the contribution, and the distribution is approximately equal in value to the portion of contributed property given up?

A transaction is subject to the disguised sale provision under § 707(a)(2)(B) where a partner contributes appreciated property to the partnership and receives a distribution of money or property before or after the contribution, and the distribution is approximately equal in value to the portion of contributed property given up. Note that the statute does not guide in making the determination of whether a transfer between a partnership and a partner is a sale, rather, the regulations provide this criteria.

Where a qualified liability is transferred to a partnership by a partner, what amount of the qualified liability is treated as consideration?

Amount of qualified liability treated as consideration is the lesser of: (1) The amount of a qualified liability that would be treated as consideration if the liability were not a qualified liability (the difference between the amount of the liability assumed, and the partner's portion of that liability after the transfer); or (2) The amount of the qualified liability multiplied by the partner's net equity percentage with respect to the property transferred. - The net equity percentage determined by dividing the total consideration treated as received for the sale (not including the amount attributable to the qualified liability) by the FMV of the transferred property, reduced by the qualified liabilities encumbering or allocated to it. - The amount treated as a qualified liability is consideration in a transaction is treated as a sale because other consideration was transferred. - See Reg. § 1.707-5(f), example (6). The practical effect is that generally, the transferring partner's gain will be limited to the percentage determined by dividing cash received upon the transfer (without regard to the qualified liability) by the fair market value of the property net of liabilities, multiplying that amount by the qualified liability.

C contributes $135,000 for a partnership interest and $67,500 is distributed to A immediately thereafter in reduction of his partnership interest. What are the results to the parties?

C contributes cash of $135, of which $67,500 is distributed to A in reduction of his partnership interest. This could be a contribution by C to the partnership and independent distribution to A. - Instead, this could be a disguised sale of a partnership interest by A to C. Service issued proposed regulations, and then withdrew. Key ingredients: - use of same cash for contribution and distribution, - proximity in time, - lack of entrepreneurial risk, - simultaneous increase and decrease in ownership interest - Most important, possible that prior negotiations existed. If this is a sale, treat A as selling one half of his interest for $67,500. As to C, view this as a purchase of one-half $67,500 and contribution of $67,500 for the other half.

C contributes property with a value of $135,000 and a basis of $20,000 in exchange for an interest in the partnership, followed by a distribution of $67,5000 to A. What are the results to the parties?

C contributes property worth $135,000 with an adjusted basis of $20,000 and A receives a distribution of $67,500 cash. This is unlikely to be considered a disguised sale. There is not a reduction of A's ownership interest? The same property not being transferred from C to the partnership and from the partnership to A. § 1.731-1(c) seems to fall without these factors.

Does the disguised sale provision apply to contributions of encumbered property?

Contributions of encumbered property are treated as disguised sales only to the extent that responsibility for the debt is shifted, directly or indirectly, to the partnership or its assets, or to the non-contributing partners. Depending on the underlying economic substance of the transaction, regulations treat these transactions as a sale of property among the partners, or as a partial sale and partial contribution of the property to the partnership. Thus, disguised sale provision also applies where: (1) The transferor receives the proceeds of a loan related to the property to the extent responsibility for the repayment of the loan rests, directly or indirectly, with the partnership or its assets, or other partners; or (2) The partner receives a loan related to the property in anticipation of the transaction and responsibility for the repayment of the loan is transferred, directly or indirectly, to the partnership or its assets or other partners.

What is the result where the partnership incurs a liability on property transferred to it by a partner, and then transfers the proceeds to the partner?

Disguised sale can be generated by the transfer of property to the partnership, which incurs the liability and transfers the proceeds to a partner. See Otey v. Commissioner (1978), where the taxpayer received a portion equal to his portion of the debt of the partnership, and the debt-financed distribution did not exceed the amount of the partnership's liabilities that were allocated to the transferor, and thus no disguised sale. Under § 1.707-5(b)(1) and § 1.163-8T, in this circumstance, the portion of the borrowed funds that are allocated to the transferring partner within 90 days of the borrowing are treated as consideration for the disguised sale to the extent that the transferred funds exceed the partner's share of the liability. For this purpose, partner's allocable share of the liability is his share of the liability as determined under the regulations multiplied by the percentage obtained by dividing the portion of the liability allocated to the money or property transferred to the partner by the total amount of the liability. § § 1.707-5(b)(2), § 1.707-5(a)(2), § 1.163-8T. Example: - A transfers unencumbered property to the partnership for a 25% interest. - Partnership incurs a liability of $80,000. - Within 90 days of the borrowing, the partnership transfers $30,000 to A, which is attributable to the borrowing. - A must take excess of $30,000 transferred to her over her $20,000 share of the liability (20% of $80,000) into account. - A would take the $10,000 transfer as consideration in a disguised sale to the partnership. - Under § 1.707-5(f), examples (10) and (11), the remainder portion of the distribution is insulated because A continues to possess liability through her partnership affiliation for that amount and only the excess amount is viewed as a disguised sale.

What facts may indicate that the transfer of cash to a contributing partner is not part of a sale?

Facts indicating that the transfer of cash to the contributing partner is not part of a sale may be offset by other factors: - Where certain conditions on the permanent loan are likely to be waived by the lender because of the creditworthiness of the partners, or the value of the partnership's other assets, although this may offset that the permanent loan is to be a recourse loan. - Where no lender has committed to fund the transfer of cash to the contributing partner, although this may be offset by facts that establish that the partnership is obligated to attempt to obtain the loan, and its ability to obtain the loan is not significantly dependent on the value that will be added by successful completion of the building, or that the partnership reasonably anticipates that it will have and utilize an alternative source to fund the transfer of cash to the contributing partner if the permanent loan proceeds are inadequate. Under Regs. §§ 1.7078-3(b)(2)(i) - 1.707-3(b)(2)(x), factors indicating a disguised sale are provided. Ten facts and circumstances used to determine whether a transaction constitutes as a sale. - Rely on the facts that exist on the date of the first transfer in the transaction. - Like-kind exchange rules are available where the initial transfer is of property, followed by the subsequent transfer of property. - If subsequent transfer of money is delayed by over six months, the imputed interest rules could be applicable.

What are the requirements for inbound versus outbound transfers of property subject to a liability between a partner and a partnership?

For outbound transfers from the partnership to a partner the liability need not encumber the property throughout two-year period in order to constitute qualified property. For inbound transfers from partner to partnership, in order to constitute a qualified liability, the liability must have been incurred at least two years prior to the transfer to the partnership.

When do the regulations permit the partnership to shift book capital to the exercising partner from the other partners without immediate recognition of tax gain or loss?

If at the time the non compensatory option issued by the partnership is exercised, there has been no subsequent appreciation in the value of the partnership's assets, there will not be sufficient book gain to give the exercising partner a book capital account that fully reflects his economic stake in the partnership. Here, regulations permit the partnership to shift book capital to the exercising partner from the other partners without immediate recognition of tax gain or loss. The partnership must make "corrective allocations" of tax income or gain to the exercising partner and of tax loss to the other partners in order to take into account the capital account reallocation.

What is the result where property is contributed to a partnership, accompanied by a distribution to the contributing partner or to another partner within a short time of the contribution?

If property is contributed to a partnership, accompanied by a distribution to the contributing partner or the distribution of the contributed property to another partner within a short time of the contribution, § 731 may not apply to the distribution. Where § 731 does not apply to the distribution, so that gain or loss is recognized on the transaction.

What is the effect of a bottom dollar guarantee?

In a bottom dollar guarantee, the transferring partner can guarantee only the bottom layer of the debt, which is the last amount to be lost (rather than guaranteeing the entire obligation). For example: - Partnership XYZ incurs a nonrecourse liability of $1,000 with respect to its assets. - X could guarantee that he would pay to the lender, the amount, if any, by which the fair market value of the assets dropped below $500. - In this event, X would be allocated $500 of the liability as a result of the guarantee, and the balance of the liability would be shares by the partners in accordance with their percentage interests, even though X was not taking a substantial economic risk with respect to the guaranteed portion of the liability. Note: Proposed Regs. §§ 1.752-3(b) and 1.752-3(c) impose additional restrictions on bottom-dollar guarantees. In summary, with a bottom dollar guarantee: - The partner is deemed to receive cash to the extent that the liability incurred prior to a transfer to the partnership exceeds his share of the liability, whether recourse or nonrecourse, in the hands of the partnership. - Application of the rule depends on how partnership's liabilities are allocated. - This is where opportunities for tax planning arise.

In a sale by a partnership to a partner, where does concern arise>

In a sale by a partnership to a partner, concern may arise where: - Partnership transfers property to a partner, followed by a subsequent cash transfer by the partner to the partnership. · See § 1.707-6(d), example (1). - Partnership distributes encumbered property to the partner, where the attendant liabilities were incurred within the two-year period before the transfer. See § 1.707-6(d), example (2); § 1.707-6(b)(2)(iii)(B); § 1.707-5(a)(6)(i)(A).

What is the result where C purchases for $10,000 an option to acquire a 1/3 partnership interest for $125,000 at any time in the next three years, where the value of the partnership's land appreciates to $600,000 and C exercises the option through the payment of $125,000 to the partnership?

In essence, C pays $135,000 for 1/3 interest worth $286,333. Whether to utilize a revaluation on issuance of option is optional. Given the uncertainty of exercise, we will probably avoid revaluation other than as a method of determining partner status for C. Upon exercise, regulations may require a revaluation after exercise. The exercise of the option is treated as a § 721 contribution for property, and no gain or loss arises for either party. Differences in post-revaluation accounts reflect allocations of the first $100,000 of appreciation in the land to A and B, and the rest equally due to the post-option issuance of appreciation. Book gain is allocated to reflect the FMV of interest. For C, 1/3 of $805,000 = $268,333 - $135,000 = $133,333 The regulations prioritize the option holder in ensuring that he receives the benefit for this bargain (i.e., his book account should equal its fair market value).

When is part sale-part contribution treatment applied to a transaction between a partner and the partnership?

Part sale- part contribution treatment applies where the transfer of property from the partnership to the partner is considered to be a sale of less than the value of the property transferred by the partner to the partnership. Gain must be computed on the portion of property considered to be sold. The basis of the property is allocated between portion of property sold and portion contributed. Under § 1.707-3(f), example 1, a transaction transaction with simultaneous transfer is treated as a sale: - A transfers property to the AB partnership with a basis of $1,200,000 and FMV of $4,000,000 in exchange for a partnership interest. - Immediately after the transfer, the partnership transfers $3,000,000 to A. - Under the facts and circumstances test, this would be treated as a sale of part of the property by A. - A recognizes gain of $2,100,000 ($3,000,000 cash received, less basis of $900,000 on the portion of property sold [($3,000,000/$4,000,000) x $1,200,000]). - A is also considered as having contributed property to the partnership with a value of $1,000,000 and a basis of $300,000.

Are reimbursements of pre-formation expenditures considered to be part of a disguised sale?

Reimbursements of pre-formation expenditures are not considered to be part of a disguised sale, and are not subject to potential challenge by the service. However, the reimbursement transaction still must be disclosed on tax filings.

What is the possible effect of revaluation after issuance of a non-compensatory option, but before the option is exercised?

Revaluation after issuance of the option but before its exercise could have effect of capturing the entire value of the partnership's assets in the book capital accounts of the existing partners , even if the option holder has a claim to a portion of that value under the terms of the option contract. So, revaluations could have the effect of increasing the chance of a capital shift and of the corrective allocations upon options exercise. The regulations require the partnership to adjust the value of its property in the revaluation to take into account the value of the outstanding non-compensatory option. For example, if exercise of the option would entitle the option holder to a share of the value of its assets in the revaluation by the option, the partnership must decrease the value of its assets in liquidation that is greater than the consideration paid to the partnership to acquire the option, the partnership must decrease the value of its assets in the revaluation by the amount of the excess. The purpose of this provision is to create reserved book gain that can be allocated to the options holder upon exercise and thereby reduce or eliminate capital shifts and corrective allocations.

In what settings may a revaluation not produce enough book gain to afford an option holder, on exercise of the option, the appropriate book capital account?

Revaluation may not produce enough book gain for the option holder upon exercise of the option where: - A capital shift from old partners to new partners is occurring. - The intent of the revaluation is to afford old partners equivalent of a deduction. In settings where there is insufficient book gain to make option holder whole: - Regulations require a reallocation of book capital from prior partners to new partners. - A disparity between book and tax accounts exists. To eliminate disparity, Reg. § 1.704-1(b)(4)(x) requires corrective allocations (similar to curative) to equalize tax with book. See Reg. § 1.704-1(b)(5), example (32).

C contributes property with a value of $135,000 and a basis of $20,000 in return for a 20% interest in the partnership, followed immediately by a distribution of $67,500 to C.

Safeguards against use of the partnership vehicle and rules of § 721 and § 731 apply to transactions intended to effectuate a sale of property with no or limited recognition. Where such a transaction is present, resort to part sale, part contribution treatment and basis allocation. These rules apply on formation of partnership or contributions to ongoing partnership. If this is a distribution under § 731: - Hain of $47,500 ($67,500 - $20,000). -The partnership has an adjusted basis of $20,000 for property. -C's adjusted basis for his partnership interest is $0. If this is a sale: - $67,500 / $135,000 x $20,000 = $10,000 adjusted basis for the sale portion of $67,500. - Gain of $67,500 - $10,000 = $57,500. - Remaining portion of transaction is conceptualized as a contribution of the property with an adjusted basis of $10,000 and FMV of $67,500. - The Partnership has an adjusted basis of $77,500 (purchase $67,500 + contribution $10,000) for property. - C's partnership interest has an adjusted basis of $10,000 (i.e., that of the contributed property). Sale treatment arises if transfer of cash was dependent on transfer of property. If the transfer is not simultaneous, it is still a sale if the subsequent transfer is not subject to entrepreneurial risks of the partnership. Facts and circumstances are determinative. Presumption: two year rule. If the property is sold within two years of continuation to the partnership, the transfer is a presumed disguised sale to the partnership. If not, presumed to be a contribution. Presumptions are overcome only if facts and circumstances clearly establish the contrary. Here, C is presumed to have engaged in a disguised sale.

Generally, when do the regulations treat a transaction between a partner and the partnership as a disguised sale?

Sale treatment where the transfers to and from the partnership result in the withdrawal of all or parts of the contributing partner's equity in the property transferred. No sale treatment where the contributing partner retains an entrepreneurial interest in the partnership capital.

Where a partner transfers property subject to a liability to the partnership, what is the partner's share of liabilities?

The contributing partner's share of liabilities is determined the same manner regardless of whether liabilities are qualified or non-qualified. Under § 707(a)(2)(B), the method of determining partner's share depends on whether liability is recourse or nonrecourse. Under § 1.752-1(a)(1) and (2), a partnership recourse liability is one in which a partner or related person bears the economic risk of loss; not the case for nonrecourse liabilities. Under § 752, the character of liability is determined pursuant to the general rules for the allocation of liabilities among partners. § 1.707-5(a)(2)(i): determines partner's share of a recourse liability Generally, under § 1.752-2(a), a partner's share of a recourse liability will be the portion for which he bears the economic risk of loss. Allocation of nonrecourse liabilities under the regulations: based on a three-tier system: (1) The partner's share of the minimum gain attributable to the encumbered property; (2) The partner's share of § 704(c) minimum gain attributable to the encumbered property; and (3) The partner's share of the excess non-recourse liability. - Allocation is permitted based on the partner's share of the § 704(c) gain attributable to the encumbered property to the extent that it exceeds the partner's share of the § 704(c) minimum gain. - Note that under § 1.707-5(a)(2)(ii), when multiple properties are subject to a single liability, the liability may be allocated among the properties in any reasonable manner, provided that the allocated amount does not exceed the property's fair market value. - Reverse § 704(c) gain are included under § 1.704-1(b)(2)((iv)(f) (built-in-gain attributable to property revaluations). Two other methods for allocating excess non-recourse liability under the regulations: (1) By partnership agreement specifying the partner's interest in the partnership profits, provided that the specified interests are reasonably consistent with an allocation of some other significant item of partnership income that has substantial economic effect; or (2) In accordance with the way it is reasonably expected the deductions with respect to those liabilities will be allocated.

What type of transactions do the disguised sales rules not apply to?

The disguised sales provision does not apply where: - Partner contributes property and receives a partnership interest entitling him to priorities and preferences on distributions; - Partner contributes property, followed by a distribution of money to the contributor, creating a deficit capital account, which the contributor is liable to repay as a sale. - Transferee is related to a partner (unlike § 707(b).

What are the issues that arise with non-compensatory options?

The granting of a non-compensatory option is not a compensatory transaction. - Is it a speculative investment? - Is it an option or a capital contribution from day 1? Issues presented: (1) What happens to partnership on issuance of non-compensatory option? (2) What is the result to the recipient of the option on issuance? (3) What is the result if the option is in-kind? (4) What is the result on exercise of the option? (5) What is the result of the failure to exercise the option?

How can a partnership be used to make a potentially taxable transaction non-taxable?

The transfer of property by a partner to the partnership and by the partnership to the partner can be accomplished in various ways with different tax and economic results. Even where parties are in the same economic position as a result of the transaction, gain may be recognized as a result of the structure of the transaction. The partner will recognize gain where the transaction is structured and treated as a sale. The partner will not recognize gain where the transaction is structured and treated as a contribution / distribution where the distribution does not exceed the basis of the partner's partnership interest. The transaction will be treated as a sale between the partnership and the partner not acting in the capacity of a partner where the transfer of property by a partner results in the receipt by the partner of money, other consideration, or an obligation fixed in amount and time of payment, essentially taking a substance over form approach for the tax consequences of the transaction. If property is contributed to a partnership, accompanied by a distribution to the contributing partner or the distribution of the contributed property to another partner within a short time of the contribution, § 731 may not apply to the distribution.

C contributes property with a value of $135,000 and a basis of $20,000, subject to an encumbrance of $67,500, which C incurred 60 days before the contribution, for a 20% interest in the partnership. What is the result? Does it matter whether the encumbrance is recourse or nonrecourse?

The liability is assumed by the partnership. Same general concerns of "cashing out" on contribution through transfer of encumbered property. Here, C received cash and then transferred the debt. Possible distinctions from this transaction versus a transaction where C transfers unencumbered property and gets the receipt of cash: - Intent (good or bad) when incurred liability. - Contributor at some level continues to have some responsibility for the liability if it is recourse. - Unique issues arise where there is a non-recourse liability. -- Regulations take into account and distinguish between qualified and non-qualified liabilities. -- Distinction is two-year period between encumbrance and transfer unless we can establish lack of anticipation, capital expenditure, or ordinary course of business. § 1.707-5(a)(6) A qualified liability typically is not treated as part of a disguised sale. A non-qualified liability is part of the sale to the extent that it exceeds the partner's share of liability. This problem involves a recourse liability of $67,500≥ -- C's share, determined by risk of loss, is 20% ($67,500 x 20% = $13,500) -- Liability is non-qualified; thus we have a disguised sale of property for $54,000 ($67,500 - $13,500). -- Adjusted basis for portion of property sold is $20,000 x $54,000/$135,000 = $8,000. -- Thus, gain on sale is $46,000 ($54,000 - $8,000). -- Remainder of transaction is a property contribution of $81,000 ($135,000 - $54,000) subject to a liability of $13,500 with a carryover basis of $12,000 ($20,000 - $8,000 - $13,500 (constructive cash distribution) + $13,500 (liability share through partnership)). -- Capital account is $67,500 ($81,000 - $13,500). -- Partnership has adjusted basis for property of $66,000 ($54,000 sale + $12,000 contributed). Non-recourse Liabilities: -- Same procedure for determining whether qualified or non-qualified: two year presumption. -- § 1.707-5(a)(2): use risk of loss for recourse and third-tier profits ratio for nonrecourse in determining post-transfer share of liability via partnership. (See Regs. § 1.752-3(a)(3)). -- Here, the profits ratio is 20% (i.e., continued share of liability). Accordingly, same result. Note the difference in result if we applied normal rules for allocation of nonrecourse liability of $67,500. -- First tier minimum gain: $0 -- Second-tier § 704(c) - liability - basis ($67,500 - $20,00) = $47,500 -- Third-tier excess $20,000 ($67,500 - $47,500) x 20% = $4,000 -- Share of liability = $51,500. -- If applicable, this would greatly reduce the amount of deemed sale from $54,000 to $16,000 ($67,500 - $51,500).

In a transaction between a partner and the partnership, when will the partner recognize gain on the transaction?

The partner will recognize gain where the transaction is structured and treated as a sale. The partner will not recognize gain where the transaction is structured and treated as a contribution / distribution where the distribution does not exceed the basis of the partner's partnership interest.

Where the rebuttable presumptions under § 1.707-3(c)(2) or § 1.707-3(d) applies to a transactions, what is required to establish that the presumption is wrong?

The preponderance of the evidence standard does not suffice in this situation. Clear and convincing evidence may be necessary to overcome presumption. Regulations § 1.707-3(f), examples (3)-(8) provide instances for establishing that the presumption is wrong.

What approach do the regulations use for treating disguised sales?

The regulations treat transactions as disguised sales where there has been a cash distribution to contributing partner in excess of assumed indebtedness over the contributing partner's share of such indebtedness following the contribution. The contributing partner has an incentive to increase his debt share, decreasing the amount of the deemed cash distribution and thus recognized gain. Note that as of 2016, the rules provided in § 1.752-3(a)(3) for optional methods for allocating excess nonrecourse debt for purposes of applying disguised sales rule is disallowed.

Upon the issuance of a non compensatory option, what is required by the service?

The service permits revaluation of a partnership's assets and capital accounts upon the issuance of a non-compensatory option. If made, effect of revaluation is to capture the existing gain or loss that has accrued in the partnership's assets prior to the option issuance and is reflected in the book accounts of the existing partners. Reverse § 704(c) allocations will then direct corresponding tax gains and losses to such partners when realized. Revaluation must occur immediately before the issuance of the option.

What is the issue that arises when a partnership issues a non-compensatory option?

The terms of the noncompensatory option give the holder the right to share in pre-issuance gain, because the option is "in-the-money" when issued. The revaluation at option issuance captures the gain in the book capital accounts of the other partners. If at the time this option is exercised there has been no subsequent appreciation in the value of the partnership's assets, there will not be sufficient book gain to give the exercising partner a book capital account that fully reflects his economic stake in the partnership. Here, regulations permit the partnership to shift book capital to the exercising partner from the other partners without immediate recognition of tax gain or loss. The partnership must make "corrective allocations" of tax income or gain to the exercising partner and of tax loss to the other partners in order to take into account the capital account reallocation.

When is a transaction between a partner and the partnership treated as occurring between a partnership and a person not acting in the capacity of a partner?

The transaction will be treated as a sale between the partnership and the partner not acting in the capacity of a partner where the transfer of property by a partner results in the receipt by the partner of money, other consideration, or an obligation fixed in amount and time of payment, essentially, a substance over form approach is used.

What is the effect where a pre-entry revaluation is made upon the grant of the documents for a non compensatory option to a person in exchange for cash?

The use of pre-entry revaluation upon grant documents the ownership rights of C confirms his future partner status upon exercise. But we could treat as a partner if the purpose was tax savings by shifting taxable income to other partners prior to entry. Where the exercise price is "at the money" or "out of the money," the price paid by C for the option is recorded as an asset, offset by a partnership liability, and C is not a partner. C may be treated as a partner where there is virtual certainty that the option will be exercised (where the option exercise price is "in the money," such that C exercises the option for acquiring the partnership interest when it is worth less than the fair value of the interest C is acquiring. In determining whether C is afforded partner status before the exercise of the option, under § 1.761-3(d), the issue is whether the option is reasonably certain to be exercised. For this purpose, focus on C's distribution and participation rights in profits and losses.

C contributes property with a value of $135,000 and a basis of $20,000 in return for a 1/3 interest in the partnership, and transfers $6,750 to C for each year for ten years (for a total of $67,500). What are the results to the parties? What result if the annual payments reduced C's capital account and percentage interest?

This annual cash transfer is characterized in the partnership agreement as a guaranteed payment for capital and is determined without regard to the partnership's income. - All partners share in the corresponding deduction in accordance with their interests in the partnership. - The payments do not reduce C's capital account and his percentage interest in the partnership remains at 33.3%. Initially, the presumption that this is a guaranteed payment applies only to the first two payments. - If an actual guaranteed payment, this is not applicable. - Payments are clearly subject to entrepreneurial risk of the partnership. - Far from certain that the payment will be made, as the future economic health of the partnership is less than certain. Regulations create a safe harbor for "guaranteed payments." - The key is 150% of the applicable federal rate. - Under the facts that the date problem created, $6,156 would fall within the safe harbor. - De minimis excess should be able to rebut presumption. If capital accounting and percentage interest is reduced, there is a more difficult issue. - This is like a disguised sale, but subject to entrepreneurial risk. - But payments for the first two years, less so. - Do we bifurcate only for two years?

C has an option with a payment of $1,000 for 1/3 interest for $15,000, which was out of the money at the time of the grant. The subsequent sale of the existing option eliminated the pre-existing tax/book disparity (i.e., A and B were taxed on the gain). The partnership has property worth $40,000 with a basis of $40,000. A and B have a basis of $20,000 each. C exercises the option when property is worth $41,000.

This is Reg. § 1.704-1(b)(5), example (32). Upon revaluation, the partnership only has an extra $1,000, which pre regulations goes to C in attempt to afford a book account equal to value. Given the particulars, there is an insufficient amount of appreciation, thus a capital account reallocation is required. We must book up $2,000 for C and decrease A and B by $1,000 each, similar to a remedial allocation. In the final step, the regulations mandate corrective allocations, similar to curative allocations under § 704(c). Assume $3,000 of gross income, book $1,000 to A, B, and C, but for tax purposes, all goes to C. Gain of $1,000 remaining in the property under § 704(c) principals will be allocated to C.

What certain transactions, not treated as a sale by the partnership, must be disclosed to the service?

Transactions occurring within a two-year period, not treated as a sale for tax purposes, must be disclosed to the service on the partner's return. More than one transfer of property by partners to the partnership pursuant to a plan must be disclosed on behalf of all transferors. Reimbursement of pre-formation expenditures are not treated as disguised sales, but must also be disclosed in filings.

What is the effect of a transfer of property to a partnership by a partner in exchange for relief from liability?

Transfer of property to a partnership by a partner in exchange for relief from a liability has the same effect as the partnership making a distribution to the contributing partner. Under § 707(a)(2)(B), treatment as a disguised sale will apply where the property is transferred subject to a liability incurred in anticipation of the transfer with proceeds of the loan retained by the partner, or if the partnership incurs a liability in anticipation of the transfer and distributes the proceeds to the contributor. Once transaction has been characterized as a sale, regulations determine if liability relief is to be treated as part of the consideration paid by the partnership, and the amount of that consideration.

Is the transfer to a partnership of capital expenditures financed by a qualified liability considered a transaction for which § 1.704-4 exempts from sale treatment?

Under Prop. Reg. § 1.707-4(d), capital expenditures financed by a qualified liability do not qualify for the exception from sale treatment to the extent any responsibility for the qualified liability is shifted to others.

When is there a disguised sale of a partnership interest?

Under Prop. Reg. § 1.7070-7(b)(1), the critical factor in finding a disguised sale of a partnership interest was that "the transfer by the partnership would not have been made but for the transfer to the partnership," and if not made simultaneously, "the subsequent transfer is not dependent upon the entrepreneurial risk of a partnership operations." If a sale was found, deemed to occur on the date of the earliest transfer. Under Prop. Reg. § 1.707-7(b)(2)(i)-(b)(2)(x), determinative factors are provided for identifying a disguised sale. Other factors, such as whether the same property contributed to the partnership was distributed in a later transfer, and whether distributed in-kind property had been held briefly were also added to determining factors. Rebuttable presumptions: - Transfers within a two-year period deemed to constitute a sale; - Transfers occurring more than two years apart presumed not to constitute a sale. As a practice note, although proposed regulations were withdrawn in 2009, we must still be wary of the contribution of property to a partnership resulting in a disguised sale of a partnership interest, if the contributed property is distributed to another partner shortly after contribution.

When does a transfer of property by a partner to the partnership in exchange for consideration to the partner constitute a sale, in whole or in part?

Under Reg. § 1.707-3(b)(1), a transfer of property (other than money or an obligation to contribute property) by a partner to the partnership and a transfer of money or other consideration to the partner constitute a sale, in whole or in part, of the property transferred, only if: (1) But for the transfer by the partner, the partnership would not have made the transfer; and (2) If the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership's operation. Note that entrepreneurial risk is not defined by the regulations, but examples provide guidance. See § 1.707-3(f), example 3 (operation of presumptions for transfers within two years). Under § 1.707-6(a), similar rules apply to the transfer of property by the partnership to a partner and a transfer of consideration by the partner to the partnership.

What is the result where a partnership assumes or takes property subject to a qualified liability?

Under Reg. § 1.707-5(a)(1), if a partnership assumes or takes property subject to a qualified liability of a partner, the partnership is treated as transferring consideration to the partner only to the extent provided in (a)(5). - If the partnership assumes or takes property subject to a liability of the partner other than a qualified liability, the partnership is treated as transferring consideration to the partner to the extent that the amount of the liability exceeds the partner's share of that liability immediately after the partnership assumes or takes subject to the liability. Under Reg. § 1.707-5(a)(2), the partner's share of liability depends on whether the liability is recourse or non-recourse. (i) The partner's share of the recourse liability of the partner equals the partner's share of the liability under § 752 and the corresponding regulations. -- A partnership liability is a recourse liability to the extent that the obligation is a recourse liability under § 1.751-1(a)(1). (ii) The partner's share of the nonrecourse liability of the partner equals the partner's share of the liability is determined by applying the same percentage used to determine the partner's share of the nonrecourse liability under § 1.752-1(a)(3). -- A partnership liability is a nonrecourse liability under § 1.752-1(a)(2) or would be treated as a partnership liability for purposes of that section.

How is a transaction determined to be a disguised sale treated?

Under the disguised sale provision of § 707(a)(2)(B), where money or property is directly or indirectly transferred to the partnership by a partner and there is a related direct or indirect transfer of money or other property to that partner or another partner in the partnership, and the transfers, viewed together are characterized as a sale of property to the partnership, the transactions are treated as a sale to the partnership by a non-partner. Under § 707(a)(2)(A), the transfer of property or services to a partnership in exchange for an allocation and distribution from the partnership is treated as a non-partner transaction. Because the transaction in this case is between the partnership and a non-partner, it will not be a tax-free contribution and distribution. These provisions only apply to transactions that are determined to be sales.

Are transfers by a partnership to a partner of guaranteed payments, preferred returns, and operating cash flow distributions exempt from sale treatment?

Under § 1.707-4(c), guaranteed payments, preferred returns, and operating cash flow distributions are exempt from sale treatment even if made within two years of the transfer of property, and even if they are not subject to the entrepreneurial risks of the partnership, so long as properly structured. This is a favorable presumption, which can only be rebutted where facts and circumstances clearly indicate that the payments are a part of a sale. Note that the presumption is not lost because the item is not distributed in the current taxable year.

What is an exempt transfer?

Under § 1.707-4, transfers by a partnership to a partner that are guaranteed payments for the use of capital, preferred returns, operating cash flow distributions, or reimbursement of pre-formation expenses are exempt from sale treatment. Capital expenditures include expenses which the taxpayer elects to deduct, but excludes deductible expenses for which the taxpayer elects to capitalize. Under Prop. Reg. § 1.707-4(d), the exception does not apply to capital expenditures financed by a qualified liability that do not qualify for the exception to the extent any responsibility for the qualified liability is shifted to others. Under § 1.707-4(c), guaranteed payments, preferred returns, and operating cash flow distributions are exempt from sale treatment even if made within two years of the transfer of property, and even if they are not subject to the entrepreneurial risks of the partnership, so long as properly structured. This is a favorable presumption, which can only be rebutted where facts and circumstances clearly indicate that the payments are a part of a sale. Note that the presumption is not lost because the item is not distributed in the current taxable year. Reimbursements of pre-formation expenditures are not considered to be part of a disguised sale, and are not subject to potential challenge by the service, however the expenditures still must be disclosed on tax filings.

What is the result where a partner transfers property subject to a non-qualified liability to the partnership?

Under § 1.707-5(a)(1), where a partner transfers property to the partnership in a transaction treated as a sale and in connection with the transfer the partnership assumes or takes property subject to a liability, it will not be treated as a qualified liability and the amount of liability relief is treated as a transfer of consideration as part of the sale transaction. The amount of consideration is the excess of the liability assumed or taken subject to over the partner's share of that liability immediately after the transfer when it has become the partnership's liability.

What is the result where C transfers property with adjusted basis of $2,000 and FMV of $10,000 in return for an option to acquire a 1/3 partnership interest for $125,000 at any time in the next 3 years?

Where C transfers property with adjusted basis of $2,000 and FMV of $10,000 in return for the option to acquire a 1/3 interest in the partnership at any time in the next three years for $125,000. See § 1.721-2(h) example. Result to option holder: · (1) Taxable event · (2) Gain of $8,000 ($10,000 - $2,000) Results to partnership on transfer: · (1) No gain or loss · (2) Adjusted basis is $10,000 since C is taxable · (3) Asset is offset by corresponding liability If C, upon exercise of option, contributes property with basis of $60,000 and fair market value of $125,000, the transaction is governed by § 721 If exercised, this is treated as a delayed contribution by C. If C forfeits the option, loss for holder and income to partnership of $10,000.

What is the result where a partner transfers property subject to a qualified liability to the partnership?

Under § 1.707-5(a)(1), where a transfer of property is treated as a sale because for example, the partnership also transfers money to the partner, the qualified liability transferred to the partnership will be treated as a transfer of consideration pursuant to a sale of the transferred property to the partnership. The Qualified Liability must meet two criteria: (1) Qualify as one of the following: -- (a) Liability is incurred by the partner more than two years before the earlier of the date on which the partner agrees in writing to transfer the property or the date on which the property is transferred, and the liability has encumbered the property during the entire period; -- (b) Liability is incurred within the two-year period described in (a), but not in anticipation of the transfer of property to the partnership, it has encumbered the property since it was incurred, and it is not described in (c) or (d). -- (c) Liability is allocable under Temp. Reg. § 1.163-8T to capital expenditures with respect to the property; or -- (d) Liability is incurred in the ordinary course of the trade or business in which the transferred property was used or held, provided that all of the assets related to and material in continuing that trade or business are transferred. Note that under § 1.707-5(f), example 4, this would include the transfer by a partner to the partnership of trade payables of a business transferred to the partnership, even though the liabilities do not encumber any of the property transferred. (2) Under § 1.707-5(a)(6)(ii), if the liability is recourse, it may not exceed the value (reduced by the amount of any senior liabilities that encumber the property or fall within the category (c) or (d) of the transferred property at the time of the transfer. Amount of qualified liability treated as consideration is the lesser of: (1) The amount of a qualified liability that would be treated as consideration if the liability were not a qualified liability (the difference between the amount of the liability assumed, and the partner's portion of that liability after the transfer); or (2) The amount of the qualified liability multiplied by the partner's net equity percentage with respect to the property transferred. - The net equity percentage determined by dividing the total consideration treated as received for the sale (not including the amount attributable to the qualified liability) by the FMV of the transferred property, reduced by the qualified liabilities encumbering or allocated to it. - The amount treated as a qualified liability is consideration in a transaction is treated as a sale because other consideration was transferred. - See Reg. § 1.707-5(f), example (6). The practical effect is that generally, the transferring partner's gain will be limited to the percentage determined by dividing cash received upon the transfer (without regard to the qualified liability) by the fair market value of the property net of liabilities, multiplying that amount by the qualified liability.

How do the regulations prevent abuse by partners planning for an additional reduction in the contributing partner's share of the liability to occur at some time after the transfer of property?

Under § 1.707-5(a)(3), the contributing partner's share immediately after the transfer is determined by taking into account any subsequent reduction in that share that was anticipated at the time of the transfer, and that was part of a plan with one of its principal purposes being to minimize the amount treated as part of a sale. - See § 1.707-5(f), example (3): where the partner's reduction in share of liability is anticipated at the time of the transfer of the property, and if it was part of a plan to minimize the contributing partner's consideration at the time of the transfer, the reduction is deemed to occur at the time of the transfer. Under § 1.707-5(a)(4), if pursuant to a plan, more than one partner transfers property to a partnership which assumes or takes the properties subject to liabilities, a partner's share of such liabilities is the sum of his share of all of the non-qualified liabilities. o See § 1.707-5(f), example (7). o This provision does not apply where liability is assumed or taken subject to, with a principal purpose of reducing the extent to which any other liability so included is treated as a transfer of consideration. - § 1.707-5(f), example (8). Under § 1.707-5(d), the amount of a partner's non-qualified liability that the partnership assumes or takes subject to is reduced by any money paid or contributed to the partnership by the partner pursuant to a plan.- § 1.707-5(f), example (8). Under § 1.707-5(c), a new liability created to re-finance the liability (either qualified or non-qualified) of either a partner or the partnership is treated as the old liability to the extent that the proceeds of the new liability are allocable to the payment of the old liability. - See § 1.163-8T.

What are the two criteria that must be met in order to have a qualified liability under § 1.1707-5(a)?

Under § 1.707-5(a), a qualified liability must meet two criteria: (1) Qualify as one of the following: o (a) Liability is incurred by the partner more than two years before the earlier of the date on which the partner agrees in writing to transfer the property or the date on which the property is transferred, and the liability has encumbered the property during the entire period; o (b) Liability is incurred within the two-year period described in (a), but not in anticipation of the transfer of property to the partnership, it has encumbered the property since it was incurred, and it is not described in (c) or (d). o (c) Liability is allocable under Temp. Reg. § 1.163-8T to capital expenditures with respect to the property; or o (d) Liability is incurred in the ordinary course of the trade or business in which the transferred property was used or held, provided that all of the assets related to and material in continuing that trade or business are transferred. -- Under § 1.707-5(f), example 4, this would include the transfer by a partner to the partnership of trade payables of a business transferred to the partnership, even though the liabilities do not encumber any of the property transferred. (2) Under § 1.707-5(a)(6)(ii), if the liability is recourse, it may not exceed the value (reduced by the amount of any senior liabilities that encumber the property or fall within the category (c) or (d) of the transferred property at the time of the transfer.

When is a liability transferred to a partnership deemed to be a recourse liability and allocated to the contributing partner?

Under § 1.752-1(a)(1), a liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability. For example, under § 1.752-2(b), if a partner has a guaranteed portion of the liability, that portion would be treated as a recourse liability of the guaranteeing partner and that portion of the liability would be allocated to the partner. Example: - A owns property with a basis of $400, and FMV of $1,000 and wants to cash out a portion of his economic position in the property transaction with B. - A incurs a nonrecourse debt of $600 on the property and transfers the property to Partnership AB in exchange for a 50% interest in the partnership. - B transfers an amount equal to the net equity on the property ($400) to partnership AB. - If nothing else happened, A would be treated as receiving $300 from a disguised sale. - Debt proceeds of $600 exceed A's share of $300. - A would be required to treat 30% of this amount as the proceeds of a disguised sale. - A is treated as having sold 3/10 of his interest in the property. - A may avoid disguised sale treatment of the 3/10 property by guaranteeing the entire debt of $600. - In this case, because A's share of the debt would be equal to the amount A received, the regulations would not apply.

A owns a Business A worth $175,000, which B would like to purchase and combine with its own, complementary Business B, worth $225,000. B's bank is willing to lend $150,000 of the purchase price, but A, whose adjusted basis in Business A is only $25,000, is unwilling to proceed with a taxable sale. So A and B form AB LLC, a limited liability company taxed as a partnership, to which they contribute Business A and Business B. AB LLC borrows $150,000 and immediately distributes that amount to A. Assume that the operating agreement of AB LLC provides that A will receive a 4% preferred return on his unreturned capital for the life of the partnership, in addition to a 5% interest in partnership profits and losses. On the basis that this preferred return is a significant item of partnership income or gain which accrues entirely to A, the operating agreement provides that excess nonrecourse liabilities will be allocated entirely to A. If this allocation prevails as to the allocation of excess nonrecourse liabilities under Reg. § 1.752-3(a)(3), how much gain, if any, would A's ability to make good on this guarantee have on the analysis?

Under § 1.752-3(a)(3), the partnership is prohibited from using significant item designation for profits ratio for purposes of § 707. This is a facts and circumstances issue. Somewhere above a 5% interest in profits is required for a significant item designation. Another issue is the treatment of preferred returns. Preferred returns are limited to reasonable amount, and assumes a valuable income stream.

Where C transfers land to the partnership in exchange for a transfer of cash on completion of the building, will the transfer receive sale treatment?

Where C transfers land to the partnership in exchange for a transfer of cash on completion of the building, and will receive sale treatment for the transfer unless: - The partnership can show that the transfer of cash to C is dependent on the extent to which the permanent loan proceeds exceed the cost to complete the building to evidence that the transfer is not part of a sale; or - If a substantial portion of the building is leased, and the partnership's ability to transfer cash to C depends on the partnership's receipt of rent proceeds; or - Or, if at the time the land is transferred to the partnership, no lender has committed to make a permanent loan to fund the transfer of cash to C. Facts indicating that the transfer of cash to the contributing partner is not part of a sale may be offset by other factors: - Where certain conditions on the permanent loan are likely to be waived by the lender because of the creditworthiness of the partners, or the value of the partnership's other assets, although this may offset that the permanent loan is to be a recourse loan. - Where no lender has committed to fund the transfer of cash to the contributing partner, although this may be offset by facts that establish that the partnership is obligated to attempt to obtain the loan, and its ability to obtain the loan is not significantly dependent on the value that will be added by successful completion of the building, or that the partnership reasonably anticipates that it will have and utilize an alternative source to fund the transfer of cash to C if the permanent loan proceeds are inadequate. See § 1.707-3(f), example 3 (operation of presumptions for transfers within two years).

What is the effect of agreements relating to substantial economic effect, maintenance of capital accounts, and adjustments on the exercise of a non-compensatory option?

Where agreements relating to substantial economic effect, maintenance of capital accounts, and adjustments on the exercise of a non-compensatory option exist, capital accounts will not be considered to be determined and maintained in accordance with the rules of this paragraph Reg. § 1.704-1(b)(2)(iv) unless the 4 requirements are met: (1) In lieu of revaluating partnership property immediately before the exercise of the option, the partnership revalues partnership property immediately after the exercise of the option. (2) Any unrealized income, gain, or loss in partnership property is first allocated to exercising partner to extent necessary to reflect that partner's right to share in partnership capital under the partnership agreement. - Any remaining unrealized income, gain, or loss in partnership property is then allocated among those partners. (3) Capital account reallocation so that the exercising partner's capital account reflects the exercising partner's right to share in partnership capital under the partnership agreement. (4) Partnership agreement requires corrective allocations.

What is the effect where the § 704(c) gain allocation method is not used for allocating excess non-recourse liability?

Where excess § 704(c) gain allocation method is not used, excess § 704(c) gain is still relevant in determining the partner's interest in partnership profits. Rev. Ruling 95-41: clarifies the allocation of a nonrecourse liability among multiple properties. See Reg. § 1.752-3(c), example (3). If the method is utilized, but the amount allocated is less than a partner's excess § 704(c) gain, the partner may not double count any amount in determining the partner's share of profits for purposes of the third-tier allocation of non-recourse liabilities. Note: A partner's third-tier share of a nonrecourse liability is determined by reference only to the partner's share of profits or his share of reasonably certain deductions.