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A Financial Analysis of Disguised Sales of Partnership Interests

Posted on July 19, 2021
[Editor's Note:

This article originally appeared in the July 19, 2021, issue of Tax Notes Federal.

]

Bradley T. Borden is a professor of law at Brooklyn Law School and the principal at Bradley T. Borden PLLC. Douglas L. Longhofer is an assistant professor at the University of Central Missouri. Martin E. Connor Jr., a 2020 graduate of Brooklyn Law School, is a law clerk in the tax department at Debevoise & Plimpton LLP. Nastassia Shcherbatsevich is an associate in the corporate department of Cravath, Swaine & Moore LLP. An earlier version of this report was presented by Borden at the Tax Forum on October 7, 2019.

In this report, the authors examine the issues that arise in identifying disguised sales of partnership interests, and they explore whether a financial analysis can help in distinguishing disguised sales from recapitalizations.

Copyright 2021 Bradley T. Borden, Douglas L. Longhofer,
Martin E. Connor Jr., and Nastassia Shcherbatsevich.
All rights reserved.

Distinguishing routine partnership contribution and distribution transactions from disguised sales of partnership interests is challenging — so challenging that the government has been unable to craft workable rules nearly four decades after Congress enacted section 707(a)(2)(B) and tasked Treasury with issuing regulations on the issue.1 The language in section 707(a)(2)(B) provides the general rule that some related partnership contribution and distribution transactions will be recharacterized as a sale of property (or partnership interests). Congress enacted section 707(a)(2)(B) in response to three court cases in which the IRS argued unsuccessfully that taxpayers had engaged in a disguised sale.2

Treasury published final regulations in 1992 addressing the disguised sale of property. In 2004 Treasury tried — and failed — to develop regulations on the disguised sale of partnership interests. The regulations were issued in proposed form but were widely criticized by the tax community and were ultimately withdrawn. Recently, an IRS official announced that revised regulations on disguised sale of partnership interests had been drafted, but otherwise provided no timetable for their release.3

The government’s difficulty in issuing regulations on the disguised sale of partnership interests is not surprising. Many ordinary business transactions could, in theory, constitute a disguised sale of a partnership interest. The challenge is distinguishing abusive proximate contributions and distributions that the tax law should treat as a sale from the many non-abusive contributions and distributions (that is, recapitalizations) that occur in the ordinary course of business.

This report reviews the case law illustrating how taxpayers have tried to use the partnership tax law’s contribution and distribution rules to avoid tax on transactions that might otherwise be taxable. It also reviews Treasury’s effort to issue regulations governing disguised sales of partnership interests and its later withdrawal of those regulations. The report then examines whether a financial analysis can help distinguish between transactions that are sales of partnership interests and those that are recapitalizations. The examination illustrates that a financial analysis may be an important factor to help the tax law make that distinction, but it may be less effective with more complex transactions. That finding does not diminish the usefulness of exploring the application of a financial analysis to disguised sale transactions. Instead, it demonstrates the difficulty in crafting rules and factors for the law to adequately identify disguised sales of partnership interests.

I. Distributions vs. Sales

The partnership tax law treats distributions from partnerships differently from sales of partnership interests. Subject to some exceptions, distributions are generally tax free as long as the amount of a cash distribution does not exceed the partner’s basis in her partnership interest.4 Thus, a partner holding a partnership interest that has appreciated in value may receive a distribution in partial redemption of that interest that is not taxable. By contrast, a sale of a partnership interest that has appreciated in value results in taxable gain even if the partner sells only a portion of the interest.5

Beyond this fundamental difference — that sales are generally taxable, and distributions can be tax free — there are several rules treating partnership distributions and sales of partnership interests differently. For example, if a partnership has made a section 754 election, the method of basis adjustment will differ for sales of partnership interests and distributions under sections 743 and 734, respectively.6 For new partners, the adjustment under section 743 may qualify for bonus depreciation, but the section 734 adjustment does not.7 Under section 751, the tax treatment of a partner’s share of the partnership’s unrealized receivables and inventory items will vary depending on whether the transaction is treated as a partial redemption, a liquidation, or as a sale of a partnership interest.8 If a transaction is treated as a sale of a partnership interest, a look-through rule apportions the partnership’s unrecaptured section 1250 gain to the selling partner,9 but no analogous rule applies to distributions. In short, partners who are reducing their percentage interest in a partnership will generally prefer to structure that interest reduction as a distribution and redemption as opposed to a sale of the interest. The purchaser may, however, prefer sale treatment. Both parties would undoubtedly like to see certainty in this area of the tax law.

A. Disguised Sales Before 707(a)(2)(B)

Before the enactment of section 707(a)(2)(B), courts looked to sections 721 and 731 to analyze whether the law should respect contributions of property to a partnership and distributions of property from a partnership. Applicable regulations under those statutes provided that in all cases, the substance of a contribution and distribution transaction should govern, rather than its form.10 Accordingly, courts generally narrowed their focus to the substance of the transaction when deciding whether transfers to and from a partnership should be treated as disguised sales. In some cases, the IRS successfully challenged the circular flow of property from a partnership to a partner and back to the partnership as a taxable disguised sale.11 These cases provide a framework for considering other property-related transactions that could be treated as disguised sales of partnership interests. The IRS was less successful challenging transactions that involved flows of capital to and from a partnership.12 The disguised sale case law before the enactment of section 707(a)(2)(B) generally falls into two categories: (1) transactions involving property contributions, distributions, and exchanges; and (2) recapitalization transactions.

B. Property Transactions

In Crenshaw,13 the transaction at issue was a complicated step transaction that included a liquidating partnership distribution, a section 1031 exchange, and a transfer of the distributed property back to the partnership. The taxpayer held a two-ninths interest in a partnership that owned an apartment complex. The remaining partners sought to acquire the taxpayer’s interest in the partnership, but the taxpayer was not interested in a taxable sale. Instead, the parties orchestrated a step transaction to accomplish their objectives. First, the taxpayer received a liquidating distribution of a tenancy-in-common interest in the apartment complex. Second, the taxpayer executed a section 1031 exchange of the distributed interest in the apartment complex for a shopping center owned by the estate of her dead husband. Third, the taxpayer, who was also the executor of her husband’s estate and was acting in that capacity, executed a sale of the interest in the apartment complex to a newly formed corporation owned by the remaining partners. Finally, the corporation transferred the interest in the apartment complex back to the partnership in exchange for the two-ninths partnership interest originally owned by the taxpayer.

When the series of transactions was completed, the taxpayer had relinquished her interest in the partnership and received a shopping center; the newly formed corporation held the taxpayer’s partnership interest; and the partnership continued to own the same property after the transaction that it had owned before. The taxpayer argued that each step in the series of transactions should be treated independently. Thus, the initial distribution was tax free under section 731, and the exchange with the estate was tax free under section 1031.

The Fifth Circuit framed the critical issue as whether the series of transactions constituted a sale or liquidation of the taxpayer’s partnership interest. Ultimately, the court held that the substance of the transactions was a sale of a partnership interest consisting of multiple discrete steps, each of which, when viewed alone, was permissible under relevant tax law, but when executed collectively incurred tax liability. Importantly, the court viewed the corporation formed by the continuing partners as a mere alter ego of the continuing partners. Thus, the last step, wherein the corporation acquired the same partnership interest previously held by the taxpayer, was crucial to the court’s decision.

The court held that “the tax consequences of an interrelated series of transactions are not to be determined by viewing each in isolation but by considering them together as component parts of an overall plan.”14 Moreover, the court stated that the permissibility of each step is irrelevant when together those transactions “amount to no more than a single transaction” in purpose and effect. Ultimately, the court viewed the series of transactions as a sale of the taxpayer’s partnership interest to the corporation followed by a purchase by the taxpayer of the shopping center. Again, key to the court’s conclusion was that, when the corporation transferred the interest in the apartment complex back to the partnership, the parties were in the identical situation that they would have been in with a direct sale of the taxpayer’s partnership interest to the corporation.15

In Otey,16 the Tax Court considered whether the contribution of real property to a partnership followed by a distribution of cash to the partners contributing the property constituted a disguised sale. The taxpayer and another individual formed a partnership, with the taxpayer contributing property at an agreed value of $65,000. The purpose of the partnership was to construct a building on the contributed property. After formation, the partnership took out a loan to construct the building and used a portion of the loan proceeds to pay the taxpayer $65,000. After the payment, the taxpayer and the other partner each owned a 50 percent partnership interest. The taxpayer characterized his receipt of cash as a distribution from the partnership under section 731, but the IRS recharacterized this distribution as part of a taxable sale of the contributed property.

The court in Otey held in favor of the taxpayer, finding that the transactions should be characterized according to their form as a tax-free contribution under section 721 followed by a tax-free distribution under section 731. Specifically, the court found that the transaction was a distribution rather than a sale because a partnership would not exist without the taxpayer’s transfer of property to the partnership; the taxpayer had no guarantee by the partnership that he would be paid the $65,000; and the taxpayer was at risk of having to repay the distribution to the lender. The court found that pattern to be “a usual and customary partnership capitalization arrangement, under which the partner who put up a greater share of the capital than his share of partnership profits is to receive preferential distributions to equalize capital accounts.”17

The Crenshaw and Otey holdings provide a reasonable framework for identifying disguised sales in the property contribution, distribution, and exchange contexts. The Crenshaw court’s unwillingness to recognize a series of interconnected transactions as individual events free of tax liability suggests that multistage transactions involving partnership distributions, contributions, and section 1031 exchanges may be recharacterized as disguised sales. Two revenue rulings, discussed in Section III, provide further insight into using section 1031 exchanges in multistage transactions.18 Collectively, these holdings and rulings provide a framework for considering when transactions involving real property contributions, distributions, and exchanges will be classified as disguised sales of partnership interests.

C. Recapitalization Transactions

In Communications Satellite, the taxpayer (Comsat) was a partner in a partnership (Intelsat) that operated a global commercial communications satellite system.19 Intelsat’s partnership agreement provided that each partner was required to make a capital contribution in exchange for a percentage interest that corresponded to the partner’s pro rata projected use of the satellite system. Thus, when a new partner joined the partnership, the partnership interest of the existing partners was reduced such that each partner’s interest would reflect its pro rata share of the use of the satellites.

Comsat held an initial 61 percent interest in the partnership. When six new partners joined, Intelsat made a distribution to Comsat with funds that were directly traceable to the funds that the new members contributed. Comsat characterized its receipt of funds as a tax-free distribution from the partnership under section 731, but the IRS recharacterized this distribution as a taxable sale of a portion of Comsat’s partnership interest.

The Court of Claims, however, held in favor of the taxpayer. The court noted that the purpose of admitting new partners was to promote global satellite network use and not to generate a financial gain for the existing partners. Among the facts deemed most relevant to the court’s conclusion was that there were no financial negotiations or contracts of sale between the incoming partners and the existing partners, and there was no attempt at appraising the value of the partnership interests at any time. In short, the facts indicated a contribution by the new partners under section 721 and a distribution to the existing partners that was tax free under section 731. The court found no indication that the new partners were acquiring a portion of the existing partners’ partnership interests.

In Jupiter,20 the claims court again considered whether a transaction should be characterized as a tax-free distribution to existing partners or as a taxable disguised sale of a partnership interest. The taxpayer initially owned a 77.5 percent general partnership interest in the partnership, which was formed to develop a real estate project. Later, the partnership issued a 20 percent limited partnership interest to new partners in exchange for cash contributions. The proceeds from the contributions were immediately distributed to the taxpayer in partial redemption of its interest in the partnership. After the distribution, the taxpayer’s general partnership interest was reduced by 20 percent. Thus, the taxpayer’s general partnership interest was reduced by the amount of the interest acquired by the new partners.

Similar to the Intelsat case, the taxpayer claimed that the distribution was a nontaxable distribution under section 731, and the IRS recharacterized the distribution as a taxable sale of 20 percent of the taxpayer’s partnership interest. The claims court again held in favor of the taxpayer. The court focused on the intent of the parties and found that the intent was to reorganize the partnership and admit new limited partners — not sell a portion of the taxpayer’s general partnership interest.

The court specifically noted that the parties had legitimate business reasons for structuring the transaction as a contribution and distribution. First, the taxpayer in Jupiter would not have sold its 20 percent interest in the partnership, because it was unwilling to give up its control as the sole general partner. Second, the reorganization was necessary to create the types of unique partnership interests desired by the parties. For example, the new partners received limited partnership interests with a priority right to income but no obligation to advance funds beyond the initial contribution. No such partnership interests existed before the transaction. Finally, the reorganization of the partnership was necessary to change the rights and obligations that existed between the original partners. Under the amended operating agreement after the contributions, the taxpayer was the only partner that had a continuing obligation to advance additional funds.

D. Governmental Response

In 1984 Congress responded to the results in Otey, Communications Satellite, and Jupiter by enacting section 707(a)(2)(B).21 The statute reflected Congress’s concern that taxpayers were abusing sections 721 and 731 by claiming that transactions were tax-free contributions or distributions when the substance of the transactions was identical to a taxable sale of property or partnership interests.22 The legislative history for section 707(a)(2)(B) illustrates that Congress anticipated that a transaction was a disguised sale of a partnership interest if the transaction involved (1) a transfer of money or property from the partnership to the partner; (2) a related transfer of money or other property to the partnership; and (3) taking into account all the facts and circumstances, the transactions substantially resembled a sale or exchange of a partnership interest.23

In 1992 Treasury promulged regulations under section 707(a)(2)(B) that addressed disguised sales of property.24 These property regulations, however, did not address the disguised sale of partnership interests. Instead, Treasury reserved the issue for future consideration — presumably because of the challenges involved in crafting workable rules for disguised sales of partnership interests. Twelve years later, in 2004, Treasury published prop. reg. section 1.707-7 to define what should constitute a disguised sale of a partnership interest.25 It noted that these regulations were intended to be narrower in scope than the property regulations.26 Relative to property transactions, partnerships generally have far more transactions that involve cash contributions and distributions, which meant that “applying the same format [as the property regulations] to cash contributions to and cash distributions by a partnership would have a much broader sweep” than Congress intended.27

Under prop. reg. section 1.707-7(b)(1), if a partner transferred consideration to a partnership and the partnership then transferred consideration to another partner, this was deemed a sale of the selling partner’s interest if, based on all the facts and circumstances (1) the transfer of consideration by the partnership to the selling partner would not have been made but for the transfer of consideration to the partnership by the purchasing partner; and (2) in cases in which the transfers were not made simultaneously, the subsequent transfer did not depend on the entrepreneurial risks of partnership operations.28 The proposed regulations included a series of facts and circumstances that tended to prove the existence of a disguised sale,29 as well as several rebuttable presumptions that specific types of transactions constituted a disguised sale of a partnership interest.

For example, under the proposed regulations, if a contribution was made to a partnership within two years of a distribution to a selling partner, the transfer was presumed to be a sale unless the facts and circumstances clearly established that the transfers were not a sale.30 On the other hand, if a contribution was made over two years from a distribution, the transaction was presumed not to be a sale unless the facts and circumstances clearly established otherwise.31 To enforce these presumptions, the proposed regulations required disclosure for every transfer that a partner made to a partnership that was accompanied by the partnership transferring consideration to another partner within a seven-year period.32

The proposed regulations also created safe harbors for some transactions that would not be considered disguised sales of partnership interests. Safe harbor transactions included “transfers of money in liquidation of a partner’s interest,”33 “guaranteed payments, preferred returns, operating cash flow distributions, and reimbursements of preformation expenditures,”34 and “transfers to and by service partnerships.”35 The proposed regulations included special rules concerning liabilities, which generally provided that deemed contributions and distributions resulting from reallocations of partnership liabilities under section 752 were not transfers of consideration for purposes of the disguised sale of partnership interest rules.36

Despite Treasury’s intention to keep these regulations narrow in scope, commentators criticized them for being ambiguous and “overly broad in potential application.”37 For example, the New York State Bar Association Tax Section expressed concerns that, among other things, (1) the proposed regulations failed to adopt a “directly related” test for contributions and distributions; (2) the regulations were overly broad in application by presuming that transfers made within two years of each other constituted a disguised sale of a partnership interest; and (3) the disclosure rules were too burdensome for taxpayers. In 2009 Treasury withdrew the proposed regulations, explaining that until new regulations were issued, disguised sales of partnership interests would be governed by the statutory language of section 707, legislative history, and case law.38 Treasury has not yet provided further guidance on this matter.39

II. Valid Transactions and Sales

Arguably, taxpayers should be unable to achieve a tax result using a partnership that they could not achieve without the partnership rules.40 For complex transactions, the partnership tax law often overlaps with the rules in other areas of the tax law. For example, in Crenshaw,41 the Fifth Circuit found a disguised sale as part of a step transaction involving a valid section 1031 exchange. Two revenue rulings addressing complex section 1031 exchanges are also relevant to making a disguised sale determination. Both rulings address section 1031 exchanges that involve multiple parties, and both conclude that the transactions are tax free under section 1031.

Rev. Rul. 73-476, 1973-2 C.B. 300, involved a like-kind exchange among three taxpayers. Each taxpayer owned a one-third undivided interest in three separate properties. The taxpayers engaged in a series of simultaneous section 1031 exchanges whereby each taxpayer exchanged its interest in two of the properties for outright ownership of one of the three properties. All three taxpayers held the properties for investment purposes both before and after the exchanges. The IRS ruled that the exchanges were tax-free swaps under section 1031.

Figure 1. Revenue Ruling 73-476 — Simultaneous 1031 Exchanges of Real Property Interests

In Rev. Rul. 57-244, 1957-1 C.B. 247, three taxpayers (A, B, and C) purchased a 25-acre lot. That lot was then divided into three slightly unequal lots, with each taxpayer acquiring ownership of one of the lots. Each taxpayer then exchanged its lot for one of the others, such that C acquired B’s lot, B acquired A’s lot, and A acquired C’s lot, with any difference in acreage compensated with cash. The IRS ruled that the exchanges were valid section 1031 exchanges, with the bases of the properties decreased by any money received and increased by any gain recognized in the exchanges.

Figure 2. Revenue Ruling 57-244: Simultaneous Three-Way 1031 Exchanges of Real Property Interests

A. Distributions and Section 1031

The following example illustrates the application of the tax law involving partnership distributions and section 1031 exchanges.

Example: A, B, and C are equal partners in three separate real estate partnerships of equal value (P1, P2, and P3). The partners plan to go their separate ways, with each partner taking sole control of the property owned by one of the partnerships. Thus, A takes sole control of the P1 real estate, B takes sole control of the P2 real estate, and C takes sole control of the P3 real estate. The parties could reach this result with at least three different structures: (1) an exchange of partnership interests, (2) a drop-and-swap workaround, or (3) a swap-and-drop workaround. As the discussion demonstrates, the chosen form can affect the tax consequences of the transaction.

1. Exchange of interests.

Under the first structure, the partners engage in simultaneous exchanges of their partnership interests such that A becomes the sole owner of P1, B becomes the sole owner of P2, and C becomes the sole owner of P3. The result is a constructive liquidation of each partnership, resulting from a single member acquiring all the interests in each entity. In this structure, the parties do not appear to meet the requirements for nonrecognition to avoid tax on the exchanges.

Rev. Rul. 99-6, 1999-1 C.B. 432, Situation 1 would appear to apply to the constructive liquidation of each partnership. In short, Rev. Rul. 99-6 addresses the tax consequences when one partner (or a third party) acquires all the interests in a partnership, thereby converting the partnership to a disregarded entity for tax purposes. Focusing on the P1 partnership and applying the Rev. Rul. 99-6 construct, A would be treated as receiving a liquidating distribution of one third of the P1 property. A would then be deemed to acquire the remaining two thirds of the P1 property in exchange for his interests in P2 and P3. A would recognize gain on this part of the transaction as a result of exchanging partnership interests for the P1 property. B and C, on the other hand, would be treated as selling (or exchanging) their P1 partnership interests to A in exchange for interests in the P2 and P3 property. These exchanges of partnership interests for deemed interests in real property would appear to be taxable to B and C.

Before the enactment of section 1031(a)(2)(D), the parties could have argued that the exchange of partnership interests qualified for nonrecognition under section 1031.42 Section 1031(a)(2)(D), however, explicitly stated that section 1031 nonrecognition does not apply to exchanges of partnership interests. This provision was repealed in 2017, but recently promulgated regulations adopt the old standard, providing that partnership interests do not come within the definition of real property.43 Thus, A, B, and C can expect that a swap of partnership interests for deemed interests in real property will be recognition transactions.

2. Drop-and-swap workaround.

Under the second structure, each partnership distributes its property in equal undivided interests to A, B, and C. Then A, B, and C each exchange their interest in the distributed assets from two of the partnerships to two of the other partners, such that each partner would own the real property of one of the original partnerships outright. Assuming the tax law respects the distribution, the tenancy-in-common status of the distributed property, and the exchange, Rev. Rul. 73-476 provides support for nonrecognition on the exchange of properties. This structure is not, however, without potential tax peril. The parties would need to be comfortable that they satisfy the holding and use requirements of section 1031, that the law respects their transitory tenancy-in-common interests, and that the analysis of Bolker applies.44 The parties could increase the likelihood of the tenancy-in-common arrangement being respected by ensuring that they hold the property in that form for sufficient time to establish that the arrangement is a tenancy in common. The parties might also be concerned that a court would apply Crenshaw and view the distribution and exchange together as a single-step transaction.

The drop-and-swap in this second structure is distinguishable from Crenshaw on several grounds. First, the section 1031 exchanges in the drop-and-swap structure include no third parties. Second, there is no exchange of real property for money. Third, in Crenshaw, one of the steps consisted of a contribution of the distributed real property back to the partnership in exchange for the partnership interest formerly held by the taxpayer. In our scenario, each partnership has liquidated into a sole proprietorship, and no equivalent of this final contribution step exists. With the dissolution of the partnerships there can be no sale of a partnership interest. By contrast, in Crenshaw the original partnership continued with a change in ownership and one partner receiving cash.

Figure 3. Drop-and-Swap Work-Around

3. Swap-and-drop workaround.

Under the third structure, each partnership transfers a one-third interest in its property to each of the other partnerships. That transaction would be the inverse of Rev. Rul. 73-476 — instead of swapping out of tenancy-in-common structures, the partnerships would be swapping into those structures. Arguably, a reverse Rev. Rul. 73-476 transaction should qualify for section 1031 nonrecognition. Under this third structure, the partnerships distribute the undivided interests in the properties to the partners immediately after the exchanges. The tax concern with this third structure is whether the partnerships satisfy the holding and use requirements of section 1031.45 Industry practice suggests that many practitioners believe the partnerships will satisfy the holding and use requirements even if the partnerships distribute the properties immediately after the exchange. Importantly, for the exchanges to qualify for nonrecognition, the law must recognize the tenancy-in-common ownership before the exchanges.46 Similar to the drop-and-swap structure, the swap-and-drop structure is distinguishable from Crenshaw because no partner cashes out and the partnerships cease to exist.

Figure 4. Swap-and-Drop Work-Around

B. Use of a Mixing Bowl Partnership

Instead of working exclusively with the existing partnerships and property, the parties in our example could consider using a mixing bowl partnership to reconfigure ownership of the properties. The parties could use two different structures to accomplish their transaction. In the first mixing bowl structure, P1, P2, and P3 each contribute their respective properties to the mixing bowl partnership in exchange for interests therein. The mixing bowl partnership then distributes one-third undivided interests in the properties to each of the partnerships, and the partnerships liquidate. In the second structure, A, B, and C each contribute their partnership interests in P1, P2, and P3 to the new mixing bowl partnership. The mixing-bowl partnership then distributes the P1 interests to A, the P2 interests to B, and the P3 interests to C. Similar to the analysis above regarding section 1031 exchanges and partnership distributions, the chosen structure appears to affect the tax consequences.

1. Property mixing bowl.

In the property mixing bowl structure, P1, P2, and P3 contribute their respective properties to the mixing bowl partnership in exchange for partnership interests therein. The mixing bowl partnership then distributes one-third interests in each property to P1, P2, and P3, respectively. The partnerships then distribute the property interests to the partners in liquidation of their partnership interests in the P1, P2, and P3 partnerships. Because the P1, P2, and P3 partnerships contribute and receive property that is like-kind, they would appear to qualify for nonrecognition under section 704(c)(2) — an exception to the anti-mixing-bowl rules in sections 704(c)(1)(B) and 737.

In short, section 704(c)(1)(B) provides that if contributed property is distributed to any partner, other than the contributing partner, within seven years of the original contribution, the contributing partner must recognize the built-in gain or loss inherent in the property as if it had been sold to the distributee for its fair market value. Section 737 provides a corollary rule that triggers gain recognition to a contributing partner if, within seven years of a contribution, the contributing partner receives a distribution of property other than the property the partner contributed. Section 704(c)(2) provides an exception to the anti-mixing-bowl rules when a partnership distributes contributed property to a noncontributing partner and distributes “other property of a like kind (within the meaning of section 1031)” to the contributing partner. The statute adopts the like-kind property standard and a version of the 180-day exchange period from section 1031, but it does not adopt the other provisions of section 1031. Therefore, the holding and use requirements do not apply to section 704(c)(2) transactions, and neither the partnership nor the contributing partners must hold or plan to hold the properties for use in a trade or business or for investment.47

Here, when P1, P2, and P3 contribute their respective properties to the mixing bowl partnership and then receive distributions of one-third interests in each property, this would ordinarily trigger gain under the anti-mixing-bowl rules. But because the contributed and distributed properties are interests in real property, the like-kind exception in section 704(c)(2) appears to apply. As a result, the parties might be able to use the property mixing bowl transaction to accomplish the planned exchanges tax free. The tax law would have to respect the transfers to and from the partnership for the transaction to qualify for nonrecognition and avoid classification as a disguised sale (or exchange) of the partnership interests.

Figure 5. Property Mixing Bowl

2. Partnership interest mixing bowl.

At first blush, the partnership interest mixing bowl transaction would appear to create taxable gain under the anti-mixing-bowl rules. In this transaction, the partnership interests would appear to constitute contributed property for purposes of section 704(c), and thus the contributing partners would appear to recognize gain on the distributions of those interests to other partners under section 704(c)(1)(B).48 In other words, if A contributes interests in P1, P2, and P3 to the mixing bowl partnership and those interests are then distributed back out to the other partners, this would appear to trigger gain recognition under the anti-mixing-bowl rules. The same analysis would appear to result in gain recognition for B and C.

Figure 6. Partner Interest Mixing Bowl

The twist with a partnership interest mixing bowl transaction is that the contribution of the P1, P2, and P3 interests to the mixing bowl partnership appears to constitute a partnership merger. Although tax law does not provide a definition of partnership merger, the rules suggest that when more than one partnership enters into a transaction or series of transactions that results in the combination of those partnerships, a merger has occurred. If a merger occurs that does not adopt either the assets-up form or the assets-over form, the rules apply the assets-over form of merger.49 Lacking a technical term for the form of transaction resulting from the partnership interest mixing bowl transaction, it could be termed an interests-over, interests-up, or interests-down form, depending upon one’s perception of direction, but it is neither an assets-over nor assets-up form recognized by the partnership merger rules.50 Thus, the rules would treat the transaction as an assets-over merger.

Under the assets-over merger, P1, P2, and P3 would be treated as contributing their assets to the mixing bowl partnership in exchange for interests therein, and then P1, P2, and P3 would be treated as distributing the mixing bowl interests to A, B, and C in complete liquidation of their interests in P1, P2, and P3.51 The mixing bowl partnership could then distribute the properties to the respective partners in liquidation. The contributors in the assets-over merger transaction would be the former partnerships, but the mixing bowl partnership would ultimately be the distributor of the property to the partners. If the tax law respects the merger and later liquidation of the mixing bowl partnership as separate transactions, the parties may qualify for tax-free treatment. On the other hand, if tax law disregards the merger because of the transitory status of the mixing bowl partnership or otherwise viewed the substance of the transaction as an exchange of partnership interests, section 704(c)(2) would not apply, and the partners would probably recognize gain.

This discussion illustrates that because of regulations governing property transactions, section 1031 rulings governing transfers of property to and from partnerships and among co-owners, and the like-kind exception to the anti-mixing-bowl rules, taxpayers can generally predict the tax outcome of transfers of property to and from partnerships. They know the types of transactions that qualify for nonrecognition treatment and may be able to structure transactions to come within nonrecognition provisions. That is not the case with disguised sales of partnership interests. Consequently, additional tools are needed to address those transactions.

III. Financial Analysis

With no definition of disguised sale of partnership interests and an apparent failure of qualitative methods to adequately distinguish sales from recapitalizations, this report turns to a quantitative financial analysis for insight into what might constitute a disguised sale of a partnership interest. Partnership interests have become increasingly complex financial instruments, with some arrangements granting differing rights to distributions, allocations, and voting for interests held by any given partner. Indeed, many partnership interests now include components, such as preferred returns, that are familiar in the corporate context.

A. Analogy to Corporate Stock

The equity structure of many modern partnerships grants varying economic rights to the members based on the class of membership interest held. These differences in economic rights are often comparable to the differences in economic rights granted by classes of corporate stock. For example, a manager’s promote52 in a partnership has economic attributes that are similar to rights granted by common stock in a corporation — both provide the holder a right to share in the residual equity (that is, equity remaining after the entity pays liabilities and satisfies preferred returns). An investor’s rights to a return of capital and a preferred return are similar to the rights bestowed by preferred stock. A purchase of either common stock or preferred stock would transfer the specific rights of the stock to the purchaser. By contrast, if a party transfers money to a corporation for preferred stock and the corporation uses those funds to buy back common stock, that transaction should not be characterized as a sale of stock, because the acquirer has rights that differ from those forfeited by the redeemed shareholder. Thus, the economic rights of parties can help inform whether a transaction is a sale of interests or a contribution followed by a distribution.

The claims court recognized this distinction in Jupiter, holding that a transaction was not a disguised sale of a partnership interest when the contributing member received a limited partner interest and the diluted member remained the sole general partner but gave up some economic interests in the partnership in exchange for a distribution. The comparison to corporate stock further suggests that financial distinctions between relinquished and acquired interests should also affect the analysis. Notably, however, the flexibility available to partnerships in structuring classes of interests may disguise the economic effects of a contribution and distribution transaction.

B. Bond Pricing as a Model

This report now turns to principles of finance as a means of informing the disguised-sale-versus-recapitalization analysis. Generally, the price of a bond is inversely related to market fluctuations of interest rates. That is, if market interest rates increase, bond prices decrease; if market interest rates decrease, the value of a bond increases. Interest rates should similarly affect the value of interests in partnerships. If a partnership interest grants the holder a preferred return, the value of that interest should be inversely related to changes in market interest rates. Thus, if the partnership interest provides a 10 percent preferred return, the amount that a purchaser would pay for that interest would be less when market interest rates are 12 percent, and it would be more when market interest rates are 8 percent.

To illustrate, assume that a partner contributes $100,000 for an interest in a partnership that provides the partner will receive a 10 percent preferred return on the contributed amount plus a return of the contributed capital. If the partnership has paid the preferred returns that have accrued to date but has not yet distributed any of the contributed capital, a person would pay less than $100,000 for the partnership interest if the market interest rate is 12 percent, and pay more than $100,000 if market interest rates are 8 percent. Applying these concepts to partnership interests is challenging, but in some transactions, it can help establish whether the transaction is a recapitalization or a sale of an interest.

C. Complexity of Interests

The financial attributes of partnership interests can be complex. In many real estate partnerships, one or more investors contribute the bulk of the equity. Those investors receive a return of their contributed capital plus a preferred return. In turn, the partnership typically allocates the investors a share of the excess profits that is less than the investors’ proportionate share of the total partnership contributions. Meanwhile, the manager contributes a small percentage of the total capital contributions and receives a promote for managing the partnership’s investments and capital. The promote is typically paid after the partnership has distributed contributed capital, and the preferred return on that contributed capital, to the investor partners. The manager’s promote is generally an allocation and distribution of profits exceeding the investors’ preferred return, and the percentage of the promote typically exceeds the manager’s proportionate share of the contributed capital.

Using a corporate analogy, the investors effectively own preferred stock in proportion to their capital contributions. They receive distributions in proportion to those contributions until they have recovered their contributed capital and received a preferred return. The partnership interests that provide the rights to those distributions resemble preferred stock. The investor members own that preferred stock portion of their interests in proportion to the amount of their contributions. On the other hand, the portions of the members’ interests that grant the right to receive residual equity resemble common stock of a corporation. The manager’s share of the common stock portion of the interests (that is, the residual equity) is typically greater than the manager’s proportionate share of contributions.

In theory, members of these partnerships could transfer all (or a portion) of the preferred stock portion of their partnership interests (or common stock portion) and retain the common portion of their interests (or the preferred stock portion).53 By focusing on the preferred stock portion of a partnership interest, the analysis can consider the financial aspects of those interests and consider whether transfers of money are a disguised sale or a recapitalization. If a member were to sell only the preferred stock portion of its interest, the cost of that interest would take into account the amount of capital the member is selling, the preferred return rate, and the market interest rate. If the amount paid by the acquirer and received by the transferor reflects the market value for the interest, the transaction would appear to be a sale of the interest. By contrast, a redemption would occur if the amount received by the transferor equaled the contribution plus the cumulative preferred return, even though the market interest rates differ from the preferred return rate. The acquirer is able to negotiate returns with the partnership, so presumably, it would never pay more or less than the market value for an interest, whether acquired by purchase or contribution. Thus, the amount received by the transferor should prove most instructive under the financial analysis.

D. Application to Partnerships

Under a financial analysis, a redemption should generally equal the amount of the contribution plus the cumulative preferred return. The contribution amount, however, should reflect the market rate of interest. In short, the cost of capital for the partnership is determined by the market rate of interest, but redemption obligations are determined by the partnership agreement. If the market rate of interest is down, the cost of capital would decrease, and the partnership would expect to transfer a smaller share of partnership interests in exchange for contributions.

Partnerships have various mechanisms at their disposal to accomplish these financial objectives related to grants of partnership interests. For instance, the partnership could provide that the cost per percentage interest is less or more than the cost that the transferring member paid. That mechanism would allow the partnership to return capital based on the amount of capital contributions and pay the preferred return based on percentage interests. A member acquiring a percentage interest after the original contributions could receive a preferred return that differed from the original contributors’ preferred return.

That arrangement would be evidence of a recapitalization — and not a disguised sale — because the partnership would redeem the transferor member based on the stated preferred return, not the market rate, and the contribution would be based on the market rate. The law should recognize that transaction as a recapitalization because the partnership has an interest in redeeming the more expensive capital and attracting cheaper capital. Moreover, these transactions are not the result of arm’s-length negotiations between the transferor and the acquiring member but are the result of negotiations between the acquiring partner and the partnership and between the partnership and the transferor partner.

Thus, at a fundamental level, the financial analysis asks whether the transaction affects the financial situation of the partnership (that is, the continuing partners) or the exiting partner. If the transaction affects the financial situation of the exiting partner, the transaction would appear to be between the party acquiring the interest and the exiting partner, which would constitute a sale of the partnership interest. On the other hand, if the transaction affects the partnership’s financial situation, the transaction would appear to be between the acquiring partner and the partnership, which would suggest a recapitalization.

To illustrate the financial analysis of contributions and distribution transactions, the examination begins with a simple fact pattern:

Example: Adrian and Brett form a limited liability company, Adrett LLC, by contributing $70 and $30, respectively. The LLC agreement provides that Adrett will distribute available cash to the members in accordance with their percentage interests until they have received a 10 percent compounding preferred return and a return of their capital contribution. Following those distributions, the LLC will distribute available cash equally to Adrian and Brett. The parties anticipate that over the next three years the LLC will make annual payments of the preferred return and be able to return contributions by the end of the third year. Adrett does not anticipate generating any profits exceeding those amounts during the three-year period. The analysis therefore isolates the economic performance of Adrett and examines only the preferred return portion of the member interests.

Assume that the market interest rate was 10 percent on the date Adrett was formed. Now, a few years after formation, Adrett has paid preferred returns annually but has yet to return any contributed capital. Brett plans to separate from Adrett, and Carlos expresses an interest in joining the LLC. Assume that at the time Brett plans to leave the LLC the market rate of interest has increased to 12 percent. Based on the preferred return and the market rate of interest, and assuming a three-year hold, Carlos would be willing to pay Brett approximately $28.56 for his interest.54

If the LLC agreement granted Brett the right to require a redemptive distribution, he would require Adrett to distribute $30 (his unreturned capital) to him. But if Adrett looked to the market to raise the capital needed to redeem Brett’s interest, a market investor would not pay $30 for an interest that provided only a 10 percent return. Instead, a market investor such as Carlos would pay only $28.56 for the interest, and Carlos would require that the preferred return be paid 30 percent to Carlos and 70 percent to Adrian until Adrian had received a 10 percent return. A $28.56 investment followed by such payments would provide Carlos the 12 percent market rate.

If Adrett needed to raise $30 of capital to redeem Brett’s interest, and Carlos was the source of that capital, Adrett would need to provide Carlos a percentage interest that exceeded 30 percent to ensure that the combination of the preferred return and the return of contributed capital provided the 12 percent return. Based on a $30 contribution, Carlos would expect to receive $3.60 per year based on a 12 percent return. Assuming Adrett has $10 to distribute each year, it would distribute $3.60 of that amount to Carlos and the remaining $6.40 to Adrian. Thus, Carlos’s share of the available cash must be 36 percent to entice him to join Adrett. That would dilute Adrian’s percentage interest to 64 percent, requiring more time for Adrian to obtain the 10 percent preferred return provided for in the LLC agreement.

From Carlos’s perspective, paying $28.56 for the distributions Brett would have received is no different than paying $30 for 36 percent of Adrett’s total distributions. Thus, from a financial perspective, Carlos paying $30 for the 36 percent interest in the profits is equivalent to him paying $28.56 for a 30 percent interest, because both amounts provide Carlos with a 12 percent return. Nonetheless, the amount Carlos pays reflects whether he is negotiating with the LLC or with Brett. If Carlos is negotiating with Brett, he would pay only $28.56 because Brett can offer only the interest he owns. If he is negotiating with the LLC, Carlos would pay $30 if the LLC were to grant him the right to receive more than Brett would have received on Brett’s $30 contribution. Thus, the payment by the acquiring member of an amount that differs from the market value of the distributee’s interest appears to suggest that the transaction would be a recapitalization and not a sale of a partnership interest.

The analysis to this point has shown how the difference between a return provided by a partnership and the market rate may affect the amounts the parties will accept or pay in exchange for transferring or acquiring an interest in a partnership and how that difference may suggest that the transaction is a disguised sale or a recapitalization. The financial analysis should also consider the effect that a transaction has on other variables, such as the following: (1) Adrian’s capital interest, (2) Adrian’s percentage interest, (3) the amount of consideration Brett receives, (4) the amount Carlos pays for his interest, (5) Carlos’s percentage interest, and (6) the amount of Adrett’s total capital. If the market rate of interest differs from the rate provided by the partnership, the transaction will alter at least one of those variables. If the market rate of interest is identical to the return rate provided by the partnership, the transaction will affect only the name of the partner — all other variables will remain the same.

Returning to the example, if at the time of the transaction, the market rate of interest equals the preferred return rate of 10 percent provided in the LLC agreement, the transaction simply substitutes one partner for another — the financial variables do not change. Carlos would contribute $30 to the LLC for a 30 percent partnership interest, and Brett would receive a $30 liquidating distribution. The financial analysis indicates that the transaction is a sale because Carlos steps into the financial position that Brett formerly held and effectively acquires the same interest that Brett previously owned (unless there are qualitative differences in the interests, such as a redemption of a managing-member interest from Brett and acquisition of a passive-member interest by Carlos). Further, the transaction does not affect Adrian’s interest in Adrett or her capital account.

If the market rate of interest is 12 percent at the time of the transaction and the LLC’s preferred-return rate remains 10 percent, at least one financial variable will change. In this situation, Carlos would pay $28.56 for Brett’s interest based on a present value calculation. If Carlos contributes $30 to the LLC as a means of contributing sufficient capital to liquidate Brett’s interest, the LLC will need to pay Carlos a larger percentage of profits as the contributing member. As a result, Adrian’s right to a return of capital would decrease, indicating that the transaction is a recapitalization. Alternatively, Carlos could contribute capital to the partnership to step into Brett’s economic shoes and receive the partnership distributions that Brett would otherwise be entitled to receive. Again, Carlos would contribute only $28.56 for the right to receive those payments. That contribution would leave Adrett with only $98.56 of capital after it redeemed Brett’s interest, and Adrian’s distribution rights would decrease. Because Adrian’s rights to distributions change under both situations, the transactions are not analogous to a sale by Brett. Accordingly, these transactions would appear to be recapitalization transactions and not disguised sales.

Finally, Brett could agree to accept less than the amount he was entitled to receive under the LLC agreement. If Carlos will pay only $28.56 for an interest that has the return that Brett would otherwise receive, Brett could agree to receive only $28.56 as a liquidating distribution — effectively paying Carlos $1.44 as an incentive payment. This reduced distribution would ensure that Adrett has $100 of capital remaining after redeeming Brett’s interest and accounting for Carlos’s contribution. As a result, the transaction would not affect Adrian’s right to a return of capital. This transaction is financially equivalent to Carlos paying Brett $28.56, which would place the parties in the same financial position that they would have been in if Carlos had directly purchased Brett’s interest. Accordingly, the financial analysis indicates that the transaction is a disguised sale.

The comparison of the different financial results demonstrates that financial principles can help inform the analysis of whether a contribution and distribution constitute a disguised sale of a partnership interest. The financial analysis suggests that the transaction is a disguised sale if the amount paid by the acquiring partner and received by the selling partner are the same and the continuing partner is unaffected. The financial analysis thus appears to turn on how the continuing partner, which is representative of the partnership, is affected. If the financial situation of the continuing partner (that is, the partnership) changes because of a partnership contribution and a distribution, the transaction appears to be a recapitalization and not a disguised sale. On the other hand, if the financial situation of the continuing partner (that is, the partnership) does not change, the transaction may be a disguised sale.

The following table summarizes the analysis. It shows that when the transaction affects Brett’s situation as the selling partner, the transaction looks like a sale. When it affects Adrian’s financial situation as the continuing partner, the transaction looks like a recapitalization.

Summary of Financial Analysis

 

Form of Transaction

Adrian

Brett

Carlos

Adrett LLC

Disguised Sale or Recapitalization

10 percent preferred-return rate and 10 percent market rate

Direct sale

70%

$70 capital

0%

$0 capital

$30 payment from Carlos

30%

$30 capital

($30) payment to Brett

100%

$100 capital

Sale

Contribution or distribution

70%

$70 capital

0%

$0 capital

$30 distribution

30%

$30 capital

($30) contribution

100%

$100 capital

($30) distribution to Brett

$30 contribution from Carlos

Disguised sale

10 percent preferred-return rate and 12 percent market rate

Direct sale

70%

$70 capital

0%

$0 capital

$28.56 payment from Carlos

30%

$30 capital

($28.56) payment to Brett

100%

$100 capital

Sale

Contribution or distribution

64%

$70 capital

0%

$0 capital

$30 distribution

36%

$30 capital

($30) contribution

100%

$100 capital

($30) distribution to Brett

$30 contribution from Carlos

Recapitalization — no disguised sale

Incentivized recapitalization

70%

$70 capital

0%

$0 capital

$28.56 distribution

30%

$30 capital

($28.56) contribution

100%

$100 capital

($28.56) distribution to Brett

$30 contribution from Carlos

Apparent disguised sale

Market recapitalization

70%

$70 capital

0%

$0 capital

$30 distribution

30%

$28.56 capital

$28.56 contribution

100%

$98.56 capital

($30) distribution to Brett

$28.56 contribution from Carlos

Recapitalization

Thus far, the analysis has relied on a simple fact pattern with simplifying assumptions. More complex fact patterns may present scenarios that undermine the potential benefits of the financial analysis. Returning to the example, Adrett may end up with profits that exceed the preferred return, so Brett may have a right to a share of residual equity. Consequently, in a sale, Brett would most likely charge Carlos some amount for that share of the residual equity. If, when the market rate was 12 percent, Brett charged Carlos $1.44 for the right to Brett’s share of the residual equity, Carlos would pay $30 for the partnership interest and the transaction would look very similar to a transaction with the market rate equaling the LLC’s preferred rate. Also, the transaction would not appear to affect Adrian’s interest. Because Carlos would effectively be acquiring the same interest that Brett previously owned and the transaction would not affect Adrian, the financial analysis suggests that the transaction is a disguised sale.

The interest in the residual equity offsets the discount based on the market interest rate, so the disguised sale conclusion is reasonable. The parties appear to have negotiated the market price of the interest. The challenge the financial analysis faces, however, is that preferred returns can vary significantly from arrangement to arrangement, so the market rate may be difficult to determine. This challenge mirrors the broader challenge the law faces in adequately distinguishing transactions that are sales of partnership interests from those that are non-abusive contributions and distributions. The discussion above illustrates that if the financial situation of the continuing partner (that is, the partnership) does not change, the transaction may be a disguised sale. Conversely, if the financial situation of the continuing partner (that is, the partnership) does change, the transaction tends to look more like a recapitalization. The overall analysis must, however, also consider nonfinancial factors such as whether there were negotiations between the exiting and incoming partner and whether there are qualitative differences in the interests the exiting partner gives up and the interests the incoming partner obtains.

Even if the financial analysis clearly suggests that an arrangement is a recapitalization, the parties may prefer to obtain sale treatment. For instance, assume that Carlos is willing to pay $31 for Brett’s interest because the market interest rate was below Adrett’s preferred return. If Carlos pays the sum directly to Brett, the transaction would undoubtedly look like a sale of the interest. If Carlos instead paid the $31 as a contribution and distribution, it would look like a recapitalization because the partnership would have an additional $1 of capital. The parties may, however, wish that the transaction be treated as a part-purchase, part-contribution, intending for Carlos to purchase Brett’s interest for $30 and make a $1 capital contribution. This is another situation in which the financial analysis by itself may not be sufficient to characterize the transaction. The parties’ interactions and demonstrated intent should also be considered in determining the nature of the transaction.

IV. Conclusion

It is difficult to distinguish disguised sales of partnership interests from ordinary contribution and distribution transactions. The IRS, Treasury, commentators, and practitioners have all struggled with how to craft workable rules to make the disguised sale determination. Using a financial analysis can be a helpful tool in making that determination. In effect, any distribution and contribution transaction that alters the financial situation of a continuing partner would appear to be a recapitalization because the changed financial situation indicates that the partnership had to pay an amount for new capital that differed from the amount it was paying for the retired capital. The complexity of the equity structure in many modern partnerships may frustrate both the financial analysis discussed in this report and the overall determination of whether a transaction should be treated as a disguised sale of a partnership interest. Nevertheless, any set of rules for determining disguised sale of partnership interests will need to include several factors to avoid being too broad in application — a financial analysis may be one such factor to help determine whether a transaction is a disguised sale.

FOOTNOTES

1 This report uses the term “partnership” to refer to any entity that is taxed as a partnership for federal income tax purposes.

2 See, e.g., Richard M. Lipton, “Controversial Prop. Regs. on Disguised Sale of Partnership Interests — IRS Jumps Into the Deep End,” 102 J. Tax’n 71, 72 (Feb. 2005).

3 Eric Yauch, “Revamped Disguised Sale Rules Are in Draft Form, IRS Says,” Tax Notes Federal, Feb. 8, 2021, p. 1007.

4 See section 731(a)(1). But see sections 704(c)(1)(B) and 737 (requiring gain or loss recognition on a distribution to a partner who previously contributed property to the partnership); section 736 (treating some distributions as a guaranteed payment); and section 751(b) (recharacterizing disproportionate distributions as a sale or exchange).

5 See section 741; and Rev. Rul. 84-53, 1984-1 C.B. 159 (apportioning the partner’s basis in her partnership interest between the sold and retained interests).

6 See sections 754, 734, and 743.

7 See reg. section 1.168(k)-2(b)(3)(iv)(C) and (D).

8 See sections 751 and 736.

9 See reg. section 1.1(h)-1(b)(3)(i).

10 See, e.g., reg. section 1.721-1(a) (“Section 721 shall not apply to a transaction between a partnership and a partner not acting in his capacity as a partner since such a transaction is governed by section 707. Rather than contributing property to a partnership, a partner may retain the ownership of property and allow the partnership to use it. In all cases, the substance of the transaction will govern, rather than its form. . . . Thus, if the transfer of property by the partner to the partnership results in the receipt by the partner of money or other consideration . . . the transaction will be treated as a sale or exchange under section 707 rather than as a contribution under section 721.”).

11 See, e.g., Crenshaw v. United States, 450 F.2d 472 (5th Cir. 1971); and Foxman v. Commissioner, 41 T.C. 535 (1964).

12 See Otey v. Commissioner, 70 T.C. 312 (1978), aff’d per curiam, 634 F.2d 1046 (6th Cir. 1980); Communications Satellite Corp. v. United States, 223 Ct. Cl. 253 (1980); and Jupiter Corp. v. United States, 2 Ct. Cl. 58 (1983).

13 Crenshaw, 450 F.2d 472.

14 Id. at 476.

15 One might question whether the taxpayer could have accomplished her desired result with an in-kind distribution of the interest in the shopping center. With that transaction, the partnership would first acquire the property the taxpayer wants to own (i.e., the shopping center) and then transfer it to the taxpayer in redemption of her interest in the partnership. For the transaction to be tax free, the parties would need to ensure that the partnership became the tax owner of the shopping center and that a court would respect the individual steps of the transaction. The transaction would be distinguished from the facts in Crenshaw because there was no circular flow of property.

16 Otey, 70 T.C. 312.

17 Id. at 321.

18 Rev. Rul. 73-476, 1973-2 C.B. 300; and Rev. Rul. 57-244, 1957-1 C.B. 247.

19 Communications Satellite, 223 Ct. Cl. 253.

20 Jupiter, 2 Ct. Cl. 58.

21 The statutory language of section 707(a)(2)(B) provides: “Under regulations prescribed by the Secretary — if (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property, such transfers shall be treated either as a transaction described in paragraph (1) or as a transaction between 2 or more partners acting other than in their capacity as members of the partnership.”

22 See, e.g., Jeffrey N. Bilsky and William J. Hodges, “Disguised Sales of Partnership Interests: A Framework for Analyzing Transactions,” 127 J. Tax’n 246, 248 (Dec. 2017) (citing H.R. Rep. No. 98-861 (1984)); see also Lipton, supra note 2, at 72.

23 See S. Rep. No. 98-169 (1984); and H.R. Rep. No. 98-861.

26 See preamble to REG-149519-03, 69 F.R. 68838, 68840 (Nov. 26, 2004).

27 Lipton, supra note 2, at 72.

28 Prop. reg. section 1.707-7(b)(1).

29 Prop. reg. section 1.707-7(b)(2).

30 Prop. reg. section 1.707-7(c).

31 Prop. reg. section 1.707-7(d).

32 Prop. reg. section 1.707-7(k).

33 Prop. reg. section 1.707-7(e).

34 Prop. reg. section 1.707-7(f).

35 Prop. reg. section 1.707-7(g).

36 Prop. reg. section 1.707-7(j).

37 See, e.g., Bilsky and Hodges, supra note 22, at 250. Both the New York State Bar Association Tax Section and the American Bar Association Section of Taxation commented that the proposed regulations were too broad. SeeNYSBA Tax Section Comments on Proposed Regs on Disguised Sales of Partnership Interests,” Tax Notes Federal, May 2, 2005, p. 585; and “ABA Members Comment on Proposed Regs on Disguised Sales of Partnership Interests,” Tax Notes Federal, Aug. 8, 2005, p. 651; see also Blake D. Rubin and Andrea Macintosh Whiteway, “Disguised Sales of Partnership Interests: An Analysis of the Proposed Regulations,” Tax Notes, May 30, 2005, p. 1149.

38 See Announcement 2009-4, 2009-8 IRB 597.

39 After the withdrawal of the proposed regulations, many commentators addressed the legal issue of whether section 707(a)(2)(B) was self-executing — in other words, whether the IRS and Treasury can assert that there is a disguised sale of a partnership interest in the absence of regulations. The IRS contended in FSA 200024001 and TAM 200037005 that it had that authority. Commentators have reached different conclusions. For a more detailed discussion on the issue, see, e.g., Bilsky and Hodges, supra note 22, at 251; and Samuel Grilli, “Can the IRS Currently Contend That There Has Been a Disguised Sale of a Partnership Interest?” 123 J. Tax’n 289 (Dec. 2015).

40 Congress has directly addressed this concern in some instances. For example, the anti-mixing-bowl rules in sections 704(c)(1)(B) and 737 recharacterize some contributions and distributions as taxable transactions because the substance of the underlying transaction mirrors a taxable transaction outside the partnership context.

41 Crenshaw, 450 F.2d 472.

42 See, e.g., Pappas v. Commissioner, 78 T.C. 1078 (1982); Long v. Commissioner, 77 T.C. 1045 (1981); and Gulfstream Land & Development Corp. v. Commissioner, 71 T.C. 587 (1979); but see Estate of Meyer v. Commissioner, 503 F.2d 556 (9th Cir. 1974) (holding that a general partnership interest is not like-kind to a limited partner interest). See also Vincent John Piazza, “The Like-Kind Exchange of Partnership Interests Under IRC Section 1031(a)(2)(D): An Historical Analysis of Alternative Approaches,” 26 U. Rich. L. Rev. 145 (1991); and Karen C. Burke, “An Aggregate Approach to Indirect Exchanges of Partnership Interests: Reconciling Section 1031 and Subchapter K,” 6 Va. Tax Rev. 459 (1987).

43 Reg. section 1.1031(a)-3(a)(5)(i)(C).

44 See Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985) (concluding that the holding and use requirements of section 1031 are met by an absence of intent to liquidate the property or by use thereof for personal pursuits); see also Bradley T. Borden, “Code Sec. 1031 Drop-and-Swaps Thirty Years After Bolker,” 18 J. Passthrough Ent. 21 (2015).

45 See, e.g., Bolker, 760 F.2d 1039; and Maloney v. Commissioner, 93 T.C. 89 (1989) (holding that the holding and use requirements for a valid section 1031 exchange are not frustrated by an intent to liquidate the property received).

46 See Borden, “Code Sec. 1031 Swap-and-Drops Thirty Years After Magneson,” 19 J. Passthrough Ent. 11 (2016).

47 For an in-depth discussion of the section 704(c)(2) rules, see Borden and Douglas L. Longhofer, “The Effect of Like-Kind Property on the Section 704(c) Anti-Mixing Bowl Rules,” 27 Tax Mgmt. Real Est. J. 131 (Mar. 2011).

48 See section 704(c)(1)(B).

49 Reg. section 1.708-3(c)(3)(i).

50 Reg. section 1.708-3(c)(3).

51 A “manager’s promote” is a profit share paid to real estate venture managers similar to carried interest paid to other ventures' managers.

52 Mechanisms such as a promote crystallization may allow partners to do an accounting of their respective interests in both the preferred and residual equity of a partnership, establish their respective percentages of partnership equity, and share in profits based on those percentages prospectively. Those mechanisms would not appear to create any taxable gain or loss because the parties are simply accounting for unrealized gains that accrued and for their respective interests in those accrued but unrealized gains. When a recognition event occurs, the gains should be allocated to the partners based on how the parties accounted for the unrealized gains.

53 This is the present value of the payments that the partnership is expected to make on Brett’s interest — $3 at the end of year 1, $3 at the end of year 2, and $33 at the end of year 3.

END FOOTNOTES

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