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Attorney Comments on Proposed Regs on Disguised Sales of Partnership Interests

JAN. 31, 2005

Attorney Comments on Proposed Regs on Disguised Sales of Partnership Interests

DATED JAN. 31, 2005
DOCUMENT ATTRIBUTES
  • Authors
    Mollerus, Michael
  • Institutional Authors
    Davis, Polk & Wardwell
  • Cross-Reference
    For REG-149519-03, see Doc 2004-22588 [PDF] or 2004 TNT 228-

    3 2004 TNT 228-3: IRS Proposed Regulations.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-4297
  • Tax Analysts Electronic Citation
    2005 TNT 42-60

 

Agency: INTERNAL REVENUE SERVICE

 

 

Title: Section 707 Regarding Disguised Sales, Generally

 

 

Subject Category: Income taxes: Partnerships; disguised sales

 

 

Docket ID: REG-149519-03

 

 

CFR Citation: Nov 26 CFR 1

 

 

Published: November 26, 2004

 

 

Comments Due: February 24, 2005

 

 

Phase: PROPOSED RULES

 

 

Your comment has been sent. To verify that this agency has received your comment, please contact the agency directly. If you wish to retain a copy of your comment, print out a copy of this document for you.

Please note your REGULATIONS.GOV number.

Regulations. gov #: EREG -- 1 Submitted Feb 24, 2005

 

Author: Mr. Michael Mollerus

 

mollerus@dpw.com

 

 

Organization: Davis Polk & Wardwell

 

 

Mailing Address:

 

450 Lexington Avenue

 

New York, NY 10017 US

 

 

Attached Files:

 

04-26112-31972-ATT-1.pdf

 

 

Comment:

 

I incorporate herein by reference the attached

 

paper, which I prepared for use in a presentation to

 

my Tax Club in January 2005.

 

 

Disguised Sales of Partnership Interests and the

 

Proposed Section 707(a)(2)(B) Regulations

 

 

Working Paper

 

Presented to the Tax Club

 

January 31, 2005

 

 

Michael Mollerus

 

Davis Polk & Wardwell

 

 

I. Introduction1

A recurring question in partnership taxation is under what circumstances, if any, a distribution by the partnership to one or more partners will be recharacterized as a sale by such partner(s) of interests in the partnership to one or more other partners (existing or new). (The question usually arises in the context of non-pro rata distributions, but can arise even in the context of a pro rata distribution.) As the example below illustrates, transactions that are different in form, but which have identical economic consequences for the parties, can have very different tax consequences if the form of the transactions is respected.

 

Example 1. A and B are equal partners in Partnership AB. The value of A's interest in AB is 1000, and A's tax basis in its interest interest is 600. C contributes 500 in cash to AB in exchange for 20% interest in AB. AB distributes the 500 cash received from C to A, reducing A's interest in AB to 25%, and increasing C's interest to 25%. Assuming that the form of the transaction is respected, (i) C's contribution to AB is treated as a nontaxable contribution under Section 721;2 (ii) AB's distribution of cash to A is nontaxable to A under Section 731, because the amount of the distribution (500) is less than A's basis in its partnership interest (600), and (iii) A's basis in its partnership interest is reduced from 600 to 100.

By contrast, if A were to sell one-half of its partnership interest to C in exchange for 500, under Section 1001 A would recognize 200 of gain, equal to the difference between A's amount realized (500) and one-half of A's basis in its partnership interest (300).

 

The possibility that taxpayers could try to disguise sales of partnership interests as related contributions and distributions to and from partnerships, along with the possibility that taxpayers could similarly try to disguise sales of property to partnerships through related contributions and distributions, has long been recognized and addressed in regulations under Sections 721 and 731. In 1984, however, Congress added Section 707(a)(2)(B) to the Code, providing a statutory basis for regulations that permit recharacterization of related transfers of money or other property to and from a partnership as disguised sales of property, if such transfers when viewed together are "properly characterized" as a sale or exchange of property. The legislative history to the provision indicates that Congress believed that the existing regulations were insufficient, as evidenced by court decisions in which courts refused to recharacterize related partnership contributions and distributions as disguised sales, and that additional regulatory guidance was required.

The IRS issued final regulations on disguised sales of property to partnerships in 1992 (referred to herein as the "Property Regulations"),3 but reserved guidance on issues relating to disguised sales of partnership interests.4 Twelve years later, following the receipt of comments, the IRS issued proposed regulations on disguised sales of partnership interests.5 As the IRS states in the preamble to the PI Regulations, the PI Regulations are modeled on, and in most respects mirror, the Property Regulations.

The IRS should be commended for issuing the PI Regulations, if for no other reason than to address the argument that the statute was not self-executing in the absence of regulations.6 As currently drafted, however, the PI Regulations contain a number of flaws. Most seriously, the PI Regulations rely on a deceptively simple "but for" test (also used in the Property Regulations) for determining whether a transfer of money or property by one partner to a partnership and a transfer of money or property by the partnership to a second partner will be treated as a sale of a partnership interest from the second partner to the first partner. The use of this test renders the PI Regulations troublingly overinclusive in some cases, treating as disguised sales of partnership interests a number of transactions that most reasonable observers would agree should not be treated as disguised sales. In other respects, the PI Regulations are underinclusive, for example, by excluding from their scope transfers incident to the formation of a partnership.

The purposes of this paper are to highlight these and certain other significant aspects of the PI Regulations, and to suggest improvements to the PI Regulations, assuming that the IRS determines to proceed with its current approach to the regulations. This paper begins by discussing the history of Section 707(a)(2)(B) and the Property Regulations in Part II. Part III provides a summary of the PI Regulations, followed in Part IV by a discussion of some (but by no means all) of the principal issues raised by the PI Regulations. Part V contains concluding remarks and recommendations, including a recommendation that the IRS consider reproposing the PI Regulations in much simpler and abbreviated form, primarily for the purpose of avoiding arguments that Section 707(a)(2)(B) does not apply to disguised sales of partnership interests in the absence of regulations.

II. Background to the Proposed Regulations

 

A. The Statute

 

Section 707(a)(2)(B) does not specifically refer to transfers of partnership interests, although the language of the statute is arguably broad enough to encompass such transfers. Section 707(a)(2)(B) provides that 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) [ i.e., a transaction occurring between the partnership and one who is not a partner] or as a transaction between 2 or more partners acting other than in their capacity as members of the partnership. The reference in (ii) to a transfer to "another partner," coupled with an explicit reference in the legislative history to disguised sales of partnership interests, makes it clear that the provision was intended to apply, where appropriate, to disguised sales of partnership interests.

The legislative history to Section 707(a)(2)(B) indicates that the provision was added to the Code in response to a series of court decisions rejecting IRS attempts to recharacterize transactions involving one or more related contributions to and distributions from a partnership as either a disguised sale of property to a partnership or a disguised sale of a partnership interest by an existing partner to a new partner. Interestingly, the IRS's losses in these cases did not stem from a lack of authority to recharacterize transactions involving related contributions and distributions,7 but rather from the IRS's failure to convince the courts that recharacterization of the transactions at issue in such cases was appropriate.

Two of these cases involved transactions in which the IRS asserted that a disguised sale of a partnership interest had occurred. In the first of these cases, Communications Satellite Corp. v. United States, 223 Ct. Cl. 253 (1980) ("Comsat"), the taxpayer was an original member of a governmentally-established, international joint venture that operated a global commercial communications satellite system. Pursuant to the agreements governing the joint venture, additional governments or their designees could join the joint venture after its formation by making a monetary contribution, determined pursuant to a fixed formula, to the joint venture, which monies were then distributed to the existing partners to reflect the reduction in their percentage interests in the joint venture.

The taxpayer treated the distributions it received from the joint venture as a result of the admission of new members as distributions governed by Section 731. On audit, the IRS, relying on Treas. Reg. § 1.731-1(c)(3), asserted that taxpayer should be treated as if it had sold a portion of its interest in the joint venture to each of the new members in exchange for its share of the cash contributed by these new members.

The Court of Claims held for the taxpayer, finding that the substance of the transactions whereby taxpayer's interest in the joint venture was reduced were distributions of partnership property to taxpayer, rather than sales by taxpayer of a portion of its partnership interest to the new partners. The Court of Claims emphasized at the outset that the arrangements for the admission of new members to the joint venture "reflected considerations of international comity and cooperation rather than the commercial interests customarily involved in organizing a partnership to operate a business venture." The Court also found that these arrangements exhibited several important characteristics not typically associated with sales transactions, including (i) the lack of financial negotiations between the new members and the joint venture or the existing partners, (ii) the absence of any contract of sale between the new and existing members, (iii) the absence of any control by the partnership or the existing members over who joined the joint venture, or the terms under which new members joined, and (iv) the fact that the amounts contributed by the new members for their joint venture interests bore no relationship to the actual value of those interests. While the Court did not find any of these facts determinative, it found that in combination, "viewed in the context of the unique and special nature and purpose of th[e] partnership," these facts were inconsistent with treating the transactions as a sale by taxpayer of a portion of its partnership interest.

Comsat was followed by another case brought before the Claims Court. In Jupiter Corp. v. United States, 2 Cl. Ct. 58 (1983) ("Jupiter"), the taxpayer was the general partner in a limited partnership, initially with one limited partner. To help finance construction of the partnership's real estate, taxpayer made a loan to the partnership. After construction was complete, the taxpayer, as general partner of the partnership, brought in new investors as limited partners, with the intention of using the newly- obtained funds to repay the loan from taxpayer. Pursuant to an amended partnership agreement, the new investors contributed cash to the partnership in exchange for limited partnership interests representing a 20% interest in the partnership. (Because the initial limited partner refused to agree to the admission of the new investors if its interest was diluted, taxpayer's general partnership interest was reduced from 77.5% to 57.5%, while the initial limited partner's percentage interest remained unchanged.) The new investors' limited partnership interests had a complicated preferred return entitlement, and other terms and conditions, which made the interests unique from any of the existing interests in the partnership. The partnership used the newly-contributed funds first to repay the loan to taxpayer, and then to make distributions to taxpayer and the initial limited partner in proportion to their original percentage interests. The taxpayer treated the distribution as a distribution under Section 731, while the Commissioner treated the admission of the new limited partners and the distribution to the taxpayer as a purchase and sale of 20% of the taxpayer's partnership interest.

The Claims Court held for the taxpayer. The Court found that the intent of the parties was to reorganize the partnership and admit the new investors as limited partners, rather than to effect a sale of a portion of taxpayer's general partnership interest. In addition, because the parties could not have placed themselves in the same relative economic and legal position through a direct sale of a portion of taxpayer's general partnership interest to the new investors (who insisted on being limited partners with special rights and obligations), the court was convinced that the form of the transaction, undertaken for legitimate business reasons, was consistent with its substance, and therefore that the transaction should be respected as a contribution and distribution rather than recharacterized as a sale of a partnership interest between partners.

Although it is difficult to see the threat to the integrity of subchapter K presented by the decisions in Comsat and Jupiter,8 Congress nonetheless thought the threat sufficient to warrant a legislative response. For example, after noting the existence of Treas. Reg. §§ 1.721-1(a) and 1.731-1(c)(3), the House Ways and Means Committee stated that

 

[t]he rules above do not always prevent de facto sales of property to a partnership or another partner from being structured as a contribution to the partnership, followed (or preceded) by a tax-free distribution from, the partnership. . . . Case law has permitted this result, despite the regulations described above, in cases which are economically indistinguishable from a sale of all or part of the property. See, Otey v. Commissioner, 70 T.C. 312 (1978), aff'd per curiam 634 F.2d 1046 (1980); Communications Satellite Corp. v. United States, 223 Ct. Cl. 253 (1980); Jupiter Corp. v. United States, No. 83-842 (Ct. Cl. 1983).
Reasons for Change

 

 

. . . .

In the case of disguised sales, the committee is concerned that individuals have deferred or avoided tax on sales of property by characterizing sales as contributions of property followed (or preceded) by a related tax-free partnership distribution. Although Treasury regulations provide that the substance of the transaction should govern, court decisions have allowed tax-free treatment in cases which are economically indistinguishable from sales of property to a partnership. The committee believes that these transactions should be treated for tax purposes in a manner consistent with their underlying economic substance.

 

House Report, at 1218.9 The House version of Section 707(a)(2)(B) would have treated as a sale of property any transaction in which there was (i) a transfer of money or other property by a partner to a partnership and (ii) a "related" direct or indirect transfer of money or other property to such partner or another partner by the partnership.10 The Senate version, which was ultimately adopted by the Conference Committee, added a third requirement, that the transfers described in (i) and (ii) above are, when viewed together, "properly characterized" as a sale or exchange or property.11 This requirement, described as an "explicit[] limit[ation]" on the scope of the provision in the Conference Report,12 means that it is not sufficient for the two transfers to be related, but rather than they must also be "properly characterized" as a sale or exchange of property.

The legislative history to the Senate version of Section 707(a)(2)(B) confirms the importance of the "proper characterization" requirement, referring in various places to transactions that "attempt to disguise a sale of property", that "substantially resemble[ ]" a sale or exchange of property, or that are "in substance a disguised sale":

 

[Section 707(a)(2)(B)] is intended to prevent the parties from characterizing a sale or exchange of property as a contribution to the partnership followed by a distribution from the partnership to defer or avoid tax on the transaction.

To accomplish this, the bill authorizes the Treasury Department to prescribe such regulations as may be necessary or appropriate to carry out the purposes of this provision. In prescribing these regulations, the Treasury should be mindful that the committee is concerned with transactions that attempt to disguise a sale of property and not with non-abusive transactions that reflect the various economic contributions of the partners. . . .

It is anticipated that the regulations will apply the provision when the transfer of money or other property from the partnership to the partner is related to the transfer of money or other property to the partnership in such manner that, taking into account all the facts and circumstances, the transaction substantially resembles a sale or exchange of all or part of the property (including an interest in the partnership). . . .

Although the rule applies to sales of property to the partnership, the committee does not intend to prohibit a partner from receiving a partnership interest in return for contributing property which entitles him to priorities or preferences as to distributions, but is not in substance a disguised sale.13

B. The Property Regulations

 

Eight years after Section 707(a)(2)(B) was added to the Code, the IRS issued the Property Regulations.14

General Rule. Under the Property Regulations, a transfer of property (excluding money or an obligation to contribute money) by a partner to a partnership, and a transfer of money or other consideration (including the assumption of or the taking subject to a liability) by the partnership to the partner,15 constitute a sale of property, in whole or in part, by the partner to the partnership only if, based on all of the facts and circumstances, (i) the transfer of money or other consideration would not have been made but for the transfer of property (referred to herein as the "but for" test), and (ii) in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations (referred to herein as the "entrepreneurial risk" test). The Property Regulations contain a nonexclusive list of the facts and circumstances that may tend to prove the existence of a sale under the tests stated above (but do not contain a similar list of facts and circumstances that may tend to disprove the existence of a sale). Generally, the facts and circumstances existing on the date of the earliest of the transfers are the ones considered in determining whether a sale exists under the "but for" test.

Transfers made within two years of each other (without regard to the order of the transfers) are presumed to be a sale, in whole or in part, of the property transferred to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale. Conversely, transfers more than two years apart are presumed not to be a sale of the property transferred to the partnership unless the facts and circumstances clearly establish that the transfers constitute a sale. The Property Regulations include a series of examples that contain specific analyses of the operation of the "but for" and "entrepreneurial risk" tests and the presumptions for transfers made within a two-year period and transfers made more than two years apart.

Presumptions and Safe Harbors for Certain Partnership Transfers. The Property Regulations also contain a series of presumptions for various transfers by the partnership to the partner, pursuant to which "reasonable" guaranteed payments for capital, payments of "reasonable" preferred returns, and certain distributions of operating cash flow are presumed not to be part of a sale of property to the partnership unless the facts and. circumstances clearly establish that such payments or distributions are part of a sale. In addition, transfers of money or other consideration by the partnership to a partner to reimburse the partner for certain preformation capital expenditures are not treated as part of a sale of property by the partner to the partnership.

Rules Relating to Liabilities. With certain exceptions, a partnership that assumes a liability of a partner is treated as transferring consideration to the partner to the extent that the liability exceeds the partner's share of that liability immediately after the partnership assumes the liability. However, a partnership's assumption of a "qualified liability"16 in connection with a transfer of property is not treated as part of a sale (unless the transfer of property is otherwise treated as a sale, and then only to the extent specified in the regulations). Finally, if a partner transfers property to a partnership, and the partnership incurs a liability part or all of the proceeds of which are transferred to the partner within 90 days after the partnership incurs the liability, the transfer of the proceeds to the partner is taken into account only to the extent that the amount so transferred exceeds the partner's allocable share of the liability.

Consequences of a Disguised Sale. To the extent that a transfer of property by a partner to a partnership is treated as a sale of property under the Property Regulations, the transfer is treated as a sale or exchange of that property, in whole or in part, to the partnership by the partner acting in a capacity other than as a partner in the partnership, rather than a contribution and distribution to which Sections 721 and 731, respectively, apply. A transfer that is treated as a sale or exchange is treated as a sale for all purposes of the Code, including for purposes of Sections 453, 483, 1001, 1012, 1031 and 1274. The sale is generally considered to have taken place on the date that, under general principles of federal tax law, the partnership is considered the owner of the property. If the transfer of money or other consideration from the partnership to the partner occurs after the transfer of property to the partnership, the parties are treated as if the partnership, on the date of the sale, transferred to the partner an obligation to transfer to the partner money or other consideration.

Reporting Rules. Transfers of property by a partner to a partnership and of money or other property by the partnership to the partner (other than transfers that are not reasonable guaranteed payments for capital, payments of reasonable preferred returns or operating cash flow distributions described in the Property Regulations) occurring within a two-year period are generally required to be reported to the IRS on Form 8275 or on a statement attached to the transferor's tax return for the year of the transfer, if the partner treats the transfers other than as a sale for tax purposes.17 A similar rule applies where a partnership, in connection with a transfer of property by a partner to the partnership, assumes or takes the property subject to a liability incurred by a partner within two years prior to the transfer, and the partner treats the liability as a "qualified liability" because it was not incurred in anticipation of the transfer.

Focus of the Property Regulations. A review of the Property Regulations, and the preambles to the proposed and final version of the Property Regulations, makes it clear that, in promulgating the regulations, the IRS's focus was on the nature of the consideration transferred by the partnership to the partner in exchange for the partner's transfer of property to the partnership. For example, in the preamble to the proposed Property Regulations the IRS explained its approach to drafting the regulations as follows:

 

After review of the statute and the legislative history, the Service and the Treasury Department have determined that when a partner transfers property to a partnership, nominally as a contribution, and receives a transfer, nominally as a distribution, the two transfers should be viewed as related and properly characterized as components of a disguised sale only to the extent their combined effect is to allow the transferring partner to withdraw all or a part of his or her equity in the transferred property. . . . Under this equity-withdrawal approach, a contribution of property to the partnership will not be treated as part of a disguised sale if the transferring partner is merely converting his or her equity in the subject to the entrepreneurial risks of partnership operations. Thus, if a partner contributes property to a partnership and, as a result, the partner's equity in the contributed property is converted into a genuine entrepreneurial interest in partnership capital, any subsequent distributions that liquidate that capital interest should not be treated as related to the contribution. If, on the other hand, a partner's equity in contributed property is not converted, in substance as well as in form, into a genuine interest in partnership capital that is subject to the entrepreneurial risks of partnership operations, any distributions that represent a withdrawal of the partner's equity in the transferred property are properly characterized as part of a disguised sale of the property under section 707(a)(2). Accordingly, the proposed regulations require that all the facts and circumstances be considered in determining when a partner's equity is being withdrawn and when the transfer is properly viewed as a sale.18

 

In other words, the IRS is primarily concerned, in determining whether transfers between the partnership and a partner are "related" and "properly characterized as components of a disguised sale," with whether the transferring partner is subject to "entrepreneurial risk" with respect to its rights to distributions from the partnership. (The IRS is obviously focusing here on non-simultaneous transfers; in the case of simultaneous transfers, the transfer by the partnership to the partner is clearly not subject to the entrepreneurial risk of the partnership, in which case the analysis pretty much begins and ends with the "but for" test.) That the two transfers are in fact related to each other, in the sense that the partnership's transfer is a quid pro quo for the transfer by the partner, is treated as being easily discerned using the "but for" test. And, given that in many cases all of a partner's entitlement to distributions from a partnership will be attributable to property contributed by the partner to the partnership (except where the partner is providing services to the partnership), it will be relatively easy to conclude that distributions by the partnership to a partner would not have occurred "but for", and are therefore properly viewed as consideration for, one or more contributions of property by the partner to the partnership.

It is interesting to note, however, that there is one other place in the Property Regulations where a similar issue presents itself, but where the IRS did not adopt a "but for" test. In the case of a liability that is assumed by a partnership in connection with a transfer of property by a partner, which liability was incurred by the partner within two years prior to the transfer and has encumbered the property since the date it was incurred, the liability is a "qualified liability" only if it was not incurred "in anticipation of" the transfer. See Treas. Reg. § 1.707-5(a)(6)(i)(B). The "in anticipation of" test is getting at much the same issue as the "but for" test, in that it is probing the factual relationship between the incurrence of the debt and the subsequent property transfer and assumption of the debt by the partnership -- and yet the IRS, for reasons unexplained, did not use a "but for" test in this instance. A simple explanation is that, unlike in the case of transfers to and from the partnership, discerning whether the incurrence of the debt is in fact related to, and should be treated as connected with, the subsequent property transfer and assumption of the debt is not such an easy task, and that the "in anticipation of" test, which more readily permits (if not requires) consideration of the purpose and intent of the parties than the "but for" test, is better suited to the job.

III. Summary of the PI Regulations

The PI Regulations follow the form of the Property Regulations and include rules similar to many of the rules in the existing regulations, with modifications. The following discussion focuses on the modifications.

General Rule. Under the PI Regulations, a transfer of money, property or other "consideration" (including the assumption of a liability) (collectively referred to in the PI Regulations as "consideration") by a partner (referred to in the PI Regulations as the "purchasing partner") to a partnership, and a transfer of consideration by the partnership to another partner (referred to in the PI Regulations as the "selling partner"), constitute a sale, in whole or in part, of the selling partner's interest in the partnership to the purchasing partner only if, based on all of the facts and circumstances, (i) the transfer of consideration by the partnership would not have been made but for the transfer of consideration to the partnership by the purchasing partner (again referred to herein as the "but for" test) , and (ii) in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations (again referred to herein as the "entrepreneurial risk" test).

As in the Property Regulations, the PI Regulations include a list of the facts and circumstances that may tend to prove the existence of a sale, many of which are identical or similar to the facts listed in the Property Regulations.19 Generally, the facts and circumstances existing on the date of the earliest of the transfers are the ones considered in determining whether a sale exists under the "but for" test.

The PI Regulations also contain a presumption that transfers made within two years of each other (without regard to the order of the transfers) are presumed to be a sale, in whole or in part, of the selling partner's interest in the partnership to the purchasing partner unless the facts and circumstances clearly establish that the transfers do not constitute a sale. Conversely, transfers more than two years apart are presumed not to be a sale of the selling partner's partnership interest unless the facts and circumstances clearly establish the that the transfers constitute a sale.

In contrast to the Property Regulations, the PI Regulations do not include any examples that contain specific analyses of the operation of the "but for" and "entrepreneurial risk" tests and the presumptions for transfers made within a two-year period and transfers made more than two years apart. Rather, the examples merely recite the order, timing, amounts and types of consideration transferred between the purchasing partner, selling partner and the partnership -- all of which occur either simultaneously or within two years of each other -- and then state flatly (seemingly as an assumption) that there are no facts that rebut the presumption of sale treatment for transfers within a two-year period, or support the application of either (i) the presumption against sale treatment for liquidating distributions or the presumptions for reasonable guaranteed payments, payments of reasonable preferred returns, operating cash flow distributions and reimbursements of preformation capital expenditures (described below) or (ii) the exception for transfers to and by service partnerships (also described below). The result is the inevitable conclusion that the transfers are treated as a sale of a portion of the selling partner's partnership interest to the purchasing partner. There is no discussion of any of the other facts and circumstances of the two transfers, such as the reasons or motivations for the transfers to and by the partnership, or whether the two transfers are even made pursuant to a single plan, understanding or agreement between the selling partner, the purchasing partner and/or the partnership.

Presumptions and Safe Harbors for Certain Partnership Transfers. The PI Regulations prescribe that rules "similar to" those provided in the Property Regulations for reasonable guaranteed payments for capital, payments of reasonable preferred returns, operating cash flow distributions and reimbursements of preformation capital expenditures apply for purposes of the PI Regulations. In addition, notwithstanding the presumption for transfers within a two-year period, a liquidating distribution of money (including marketable securities that are treated as money under Section 731(c)(1)) to the selling partner is presumed not to be a sale, in whole or in part, of the selling partner's partnership interest unless the facts and circumstances clearly establish that the transfer is part of a sale. Finally, the PI Regulations do not apply to transfers of money (again including marketable securities that are treated as money under Section 731(c)(1)) to and by a service partnership.20

Rules Relating to Liabilities. Under the PI Regulations, (i) a partnership that assumes a liability of a partner is treated as transferring consideration to the partner to the extent that the liability exceeds the partner's share of that liability immediately after the partnership assumes the liability, and (ii) a partner that assumes a partnership liability is treated as transferring consideration to the partnership to the extent that the liability exceeds the partner's share of that liability immediately before the partner assumes the liability.21 While the PI Regulations generally contain rules relating to liabilities that are similar to those contained in the Property Regulations, there is no exception in the PI Regulations for qualified liabilities of the partner or partnership. The preamble to the PI Regulations explains that the IRS and Treasury Department believed that, because a transfer to a partnership of encumbered property alone is not subject to recharacterization as a disguised sale, but rather has to be related to a transfer of consideration to another partner in order for disguised sale treatment to apply, inclusion of special rules for qualified liabilities in the PI Regulations was unnecessary.22

Finally, the PI Regulations include an anti-abuse rule which provides that, notwithstanding any other rule in the PI Regulations, an increase in a partner's share of a partnership liability may be treated as a transfer of consideration by the partner to the partnership if (i) within a short period of time after the partnership incurs or assumes a liability or another liability, one or more partners in a partnership, or related parties to a partner, in substance bears an economic risk of the liability that is disproportionate to the partner's interest in partnership profits or capital, and (ii) the transactions are undertaken pursuant to a plan that has as one of its principal purposes minimizing the extent to which the partner is treated as making a transfer of consideration to the partnership that may be treated as part of a sale under the PI Regulations. The IRS, which states that the anti-abuse rule is intended to address cases in which the rules of the PI Regulations do not adequately capture the substance of an integrated set of transactions, requests comments on this rule and examples of particular situations where application of this rule would be appropriate.23

Consequences of a Disguised Sale. To the extent that a transfer of consideration by a purchasing partner to a partnership and a transfer of consideration by the partnership to a selling partner is treated as a sale, in whole or in part, of the selling partner's interest in the partnership under the PI Regulations, the transfer is treated as a sale or exchange of that interest, in whole or in part, by the selling partner to the purchasing partner, rather than a contribution and distribution to which Sections 721 and 731, respectively, apply.24 The selling partner is treated as selling to the purchasing partner a partnership interest with a value equal to the lesser of the consideration received by the selling partner from the partnership or the consideration transferred to the partnership by the purchasing partner. A transfer that is treated as a sale or exchange is treated as a sale for all purposes of the Code, including for purposes of Sections 453, 483, 704, 708, 743, 751, 1001, 1012, and 1274.

The sale of the selling partner's partnership interest is generally considered to have taken place on the earliest of the transfers that together constitute a disguised sale of such interest, and the purchasing partner is treated as acquiring such partnership interest for all purposes of the Code on the same date.25 If the transfers are simultaneous and the consideration transferred in each transfer is the same, the partners and partnership are treated as if, on the date of sale, the purchasing partner transferred that partner's consideration directly to the selling partner in exchange for all or a portion of the selling partner's partnership interest. However, if the transfers are simultaneous but the consideration transferred in each transfer is not the same, the partners and partnership are treated as if, on the date of sale, (i) the purchasing partner transferred that partner's consideration to the partnership in exchange for the consideration to be transferred to the selling partner (which exchange itself may constitute a sale of property by the partner and/or the partnership) and then (ii) the purchasing partner transferred the consideration received from the partnership to the selling partner in exchange for all or a portion of the selling partner's interest in the partnership. If the transfers are not simultaneous, the transferor in the later transfer (either the purchasing partner or the partnership) is treated on the earlier date of sale as having delivered, in the recharacterized transactions described above, an obligation to make the later transfer (which obligation is then satisfied by the later transfer).

Overlap Rules. The PI Regulations address two instances in which the regulations may overlap with other rules. First, if a portion of a transfer of consideration by a partnership to a selling partner is not treated as part of a sale of the selling partner's partnership interest under the PI Regulation, but rather as a distribution to the selling partner under Section 731, and the sale is treated as occurring on the same date as the distribution, then the distribution is treated as occurring immediately after the sale. As a result, the distribution is not taken into account in determining the selling partner's basis in its partnership interest for purposes of computing gain or loss on a disguised sale of all or a portion of such interest.26 Second, the PI Regulations provide that the Property Regulations apply before the PI Regulations, and to the extent that a transfer of consideration is treated as part of a sale of property under the Property Regulations, the transfer is not taken into account for purposes of applying the PI Regulations.27 Finally, the PI Regulations provide that they do not apply to transfers incident to the formation of a partnership (although the Property Regulations may apply to such transfers), or to deemed transfers resulting from a technical termination of a partnership under Section 708(b)(1)(B). The PI Regulations do not address transfers occurring in a partnership merger or division, but the IRS requests comments on whether the regulations should contain special rules or exceptions for such transfers.28

Reporting Rules. Transfers of consideration by a partner to a partnership and of consideration by the partnership to another partner (other than transfers that are not reasonable guaranteed payments for capital, payments of reasonable preferred returns or operating cash flow distributions described in the Property Regulations) within a seven-year period -- not the two-year period prescribed under the current Property Regulations -- are generally required to be reported to the IRS on Form 8275 or on a statement attached to the transferor's tax return for the year of the transfer, if the partners treat the transfers other than as a sale for tax purposes.29 (In the same set of proposed regulations, the IRS is proposing to extend the reporting requirement in the Property Regulations for specified transfers or other events occurring within a seven-year period, rather than the two-year period currently specified in the regulations.) The preamble to the PI Regulations states that the extension of the reporting period is in response to a recommendation of the Joint Committee on Taxation arising out of its investigation of Enron that the current two-year period in the existing regulations be extended, and that a seven-year period might make it more likely that taxpayers would undertake the facts and circumstances determination for transfers occurring more than two years apart and would make it easier for the IRS to administer. The IRS requests comments on whether the disclosure requirement should be extended to a period that is more than two years, but less than seven years.30

Effective Date. The PI Regulations (including the proposed amendments to the Property Regulations) are proposed to be effective for any transaction with respect to which all transfers that are part of a sale of property or of a partnership interest occurs on or after the regulations are published as final regulations. (For transactions with respect to which all transfers that are part of a sale of an item of property occur after April 24, 1991 but before the date that the PI Regulations are published as final regulations, the Property Regulations prior to amendment apply.) In the case of transactions in which one or more of the transfers occurs prior to the date of final regulations, the determination whether the transaction is a disguised sale of a partnership interest under Section 707(a)(2)(B) is to be made on the basis of the statute and the guidance provided by the legislative history thereto.

IV. Issues Presented by the Proposed Regulations

 

A. Insufficiency of the "But For" Test

 

As described above, the PI Regulations adopt the same general framework as the Property Regulations, including the "but for" test that is found in the Property Regulations for testing whether two transfers are sufficiently "related" to support. According to the preamble to the PI Regulations, the IRS and the Treasury Department believe that "the 'but for' test of the existing regulations provides a relatively bright line rule that is easier to interpret and administer [than alternative tests] and that, in most cases, covers those transactions that should be treated as disguised sales of partnership interests." Any need for a narrower rule, the preamble suggests, is best addressed by including additional safe harbors, rather than adopting a different test.

As discussed above, in the context of the Property Regulations, there is likely to be little dispute over whether the "but for" test is satisfied, or, more importantly, that the "but for" test adequately identifies transfers that are sufficiently "related," for the simple reason that the transfers occur between the same two parties, and in most cases it will be relatively easy to determine whether the transfer from the partnership constitutes "consideration" for the transfer of property by the partner to the partnership.31 Under the Property Regulations, the more difficult question is whether the "entrepreneurial risk" test is satisfied (in the case of nonsimultaneous distributions). In the context of the PI Regulations, however, the question whether a transfer by a partner to the partnership is sufficiently "related" to a transfer by the partnership to another partner to merit treatment as a disguised sale is much more complex, for the simple reason that two nominally separate transfers are involved, each of which involves different parties and is economically "complete" without reference to the other. In this context, depending on how one views the test, the "but for" test will all too often be difficult to apply, or, even worse, seem to be clearly satisfied in circumstances where disguised sale treatment seems inappropriate.

Consider the simple example: new partner A contributes cash or property worth $100x to a partnership, and existing partner B receives a (non-liquidating) distribution of $100x in cash from the partnership. There are numerous facts and circumstances that one will need to take into account in determining whether the distribution would not have occurred "but for" the contribution, including:

  • A's purpose and intentions in making, and the partnership's purpose and intentions in receiving, the contribution;

  • B's purpose and intentions in receiving, and the partnership's purpose and intentions in making, the distribution;

  • whether A and B discussed, negotiated or reached any agreement with respect to the contribution and distribution (or indeed whether they even had any knowledge of each other's transaction); and

  • whether the partnership would have been able to make the distribution to B without the contribution by A.

 

One can conceive of many situations in which it would be easy to determine that the distribution would not have occurred "but for" the distribution (e.g., where A and B agree on the overall transaction and completion of the distribution to B is conditioned upon the making of the contribution by A), and adoption of the PI Regulations is likely to pre-empt such transactions -- which is probably a good thing. However, there will be many situations in which it will not be easy for either the IRS or the taxpayer to make this determination -- which is most definitely a bad thing, especially given that either the taxpayer or the IRS must "clearly establish" that transfers do or do not constitute a sale, depending on whether the transfers occur within a two-year period.

Furthermore, one can conceive of circumstances in which application of the "but for" test in the PI Regulations leads to the conclusion that a disguised sale has occurred, but disguised sale treatment seems inappropriate:

 

Example 2. New partner C contributes property to existing partnership AB. Within two years thereafter, partner A receives a non-liquidating distribution of cash from AB in partial redemption of A's interest in AB. Assume that C's contribution and the distribution to A are unrelated, except that under the terms of AB's existing credit facility, AB would not have been able to make the non-liquidating distribution to A in the absence of C's prior contribution to AB.

 

On these facts, there is a substantial possibility -- if not likelihood -- that application of the "but for" test in the PI Regulations would lead to the conclusion that A had made a disguised sale of a portion of its partnership interest to C, even though the distribution to A may not have even been contemplated at the time of C's contribution.32 Admittedly, the PI Regulations state that the facts and circumstances existing on the date of the earliest of the transfers are "generally" the ones considered in determining if a sale exists, and identify as a "sale" factor that the timing and amount of all or any portion of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer, so A and C may have some grounds for argument.33 However, given that both transfers occurred within a two-year period and a disguised sale of a partnership interest from A to C is presumed to exist unless A and C can adduce facts that clearly establish the contrary, it seems likely that A and C's prospects for avoiding disguised sale treatment on these facts is quite low.

The above example (and other examples discussed below) illustrate that the "but for" test is too crude a tool for identifying when two separate transfers are sufficiently "related" to support recharacterizing the two transfers as an integrated transaction involving the disguised sale of a partnership interest. In part, as the above example illustrates, it is because the test lacks any concept of proximate causation. In cases where there are multiple acts or conditions that must occur or exist in order for a subsequent transfer to occur, only one of which is the prior transfer, the "but for" test considers only the prior transfer and ignores all of the other acts or conditions, many of which should be considered relevant, if not more relevant, to the inquiry. (By analogy, if the IRS's approach in the Proposed Regulations were adopted in other contexts, in the children's rhyme about how the want of a nail led to the loss of a kingdom, the horseshoe would be hung for treason.) The "but for" test also fails to adequately discern whether two transfers are part of the same plan or arrangement, such that the intended (or even foreseeable) result of one transfer (the contribution) was to permit or facilitate the second transfer (the distribution), a fact which seems highly relevant if one is trying, in the words of the Senate Finance Committee Report, to separate "transactions that attempt to disguise a sale of property" from "non-abusive transactions that reflect the various economic contributions of the partners."

Much the same point was made in various comments that the IRS received before promulgating the PI Regulations. The New York State Bar Association suggested that, in addition to the "but for" test, the proposed regulations provide that transfers to and by a partnership constitute a disguised sale of a partnership interest only if the two transfers are "directly related."34 The ABA Tax Section suggested what it called the "double but for" test, under which a disguised sale of partnership interest would exist only where both the transfer to and the transfer by the partnership would not have been made but for the other transfer.35 The IRS and the Treasury Department rejected these comments for the following reasons:

 

[T]he IRS and the Treasury Department have concerns about the alternate tests of relatedness suggested by the commentators. Specifically, the IRS and the Treasury Department are not certain how a "directly related" test would be interpreted or applied, or whether it would be effective in narrowing the scope of the proposed rules. In addition, the IRS and the Treasury Department are concerned that certain transactions that should be treated as a disguised sale of a partnership interest would not be covered under a "double but for test." For example, assume that a prospective investor in a partnership and an existing partner who wishes to sell its partnership interest agree that upon the prospective investor's transfer to the partnership, the partnership will make a corresponding transfer to the existing partner. If the prospective investor is indifferent as to whether the existing partner retains its partnership interest, the transaction would not satisfy a "double but for test" since the transfer to the partnership was not made but for the transfer from the partnership. Nonetheless, the IRS and the Treasury Department believe that the transaction is economically indistinguishable from a sale of a partnership interest and should be treated as such. In contrast, the IRS and the Treasury Department believe that the "but for" test of the existing regulations provides a relatively bright line rule that is easier to interpret and administer and that, in most cases, covers those transactions that should be treated as disguised sales of partnership interests. The IRS and the Treasury Department thus believe that the appropriate way to narrow the scope of those rules is to provide additional safe harbors but adopt the same "but for" test included in the existing regulations.36

 

Unfortunately, for the reasons discussed above, the "but for" test is unlikely to provide a "bright line" rule that is easier to interpret and administer than any alternative rule -- but even if it is, it achieves this result only by being as potentially overinclusive as the "double but for" test could be under-inclusive (at least in the IRS's view).37

Additional safe harbors don't appear to be the answer, since the flaw in the "but for" test goes to the heart of what the facts and circumstances test is trying to determine. The PI Regulations could perhaps require (by analogy to Section 355(e)) that, in addition to satisfying the "but for" test, the two transfers must be part of a "plan or arrangement" in order to be characterized as a disguised sale, or better yet, that a significant purpose of the transfer of consideration by the purchasing partner to the partnership be to permit or facilitate the transfer of consideration by the partnership to the selling partner. Either of these tests appears to be more in keeping with the command in the legislative history that the regulations apply to transactions that "attempt to disguise a sale of property" (which implies a focus on purpose or intent) and not to "non-abusive" transactions that reflect the various economic contributions of the partners.

 

B. Need for "Non-Sale Factors"

 

Given the greater complexity and nuance associated with the application of the facts and circumstances test in the context of testing for a disguised sale of a partnership interest, the PI Regulations should depart from the approach taken in the Property Regulations to list only facts and circumstances that tend to prove the existence of a disguised sale, and include a list of facts and circumstances that tend to disprove the existence of a disguised sale. For example, the absence of any negotiations, agreement or understanding, directly or indirectly, between the contributing partner and the distributee partner is a fact that most observers would treat as tending to disprove that the transactions constitute a disguised sale. As currently written, however, the PI Regulations do not expressly acknowledge or attach any weight to this fact, even under a mild "tends to disprove" formulation. Notwithstanding this omission in the PI Regulations, a court applying a "facts and circumstances" test should, and most likely would, give facts that tend to disprove the existence of a disguised sale appropriate weight. However, particularly in a case where a taxpayer is subject to the disguised sale presumption for transfers occurring within two years of each other and therefore has to "clearly establish" the absence of a disguised sale, the "thumb on the scale" approach taken by the PI Regulations in listing only facts that tend to prove the existence of a disguised sale seems both parsimonious and unjustified.

There are certainly regulatory precedents for a more balanced approach, even in circumstances where the taxpayer is working against a similar presumption. For example, in determining whether a distribution is being used principally as a "device" for the distribution of earnings and profits under Section 355(a)(1)(B), the regulations prescribe a "facts and circumstances" test, but then go on to list both specific "device factors" and specific "nondevice factors," at times describing the weight or importance to be ascribed to each factor. Examples in the regulations then discuss how the factors are to be applied in specific cases. See Treas. Reg. § 1.355-2(d).

An even better example is the regulations under Section 355(e). That section imposes corporate-level tax on certain distributions that are part of a "plan (or series of related transactions)" that included a prior or subsequent acquisition of the stock of the distributing or controlled corporation, and which contains a presumption that acquisitions occurring within two years before or after the distribution are to be treated as pursuant to a plan unless it is established that the acquisition and distribution are not pursuant to a plan or series of related transactions. Notwithstanding this presumption, the regulations under Section 355(e) prescribe a "facts and circumstances" test (in an interesting departure from the statute, without any mention of the statutory presumption), and then go on to list a series of "plan factors" and non-plan factors" to be taken into account in applying the test. See Treas. Reg. § 1.355-7T(b). Detailed examples in the regulations discuss and apply the various factors to the specific facts of the examples. See Treas. Reg. § 1.355-7T(j).38

There is no reason not to take a similar approach in the PI Regulations, notwithstanding the fact that the Property Regulations (on which the PI Regulations were based) do not contain either "non-sale" factors or detailed examples that analyze the facts that tend to prove or disprove the existence of a disguised sale. For the reasons discussed above, the IRS should seriously consider including such factors and examples39 in the final regulations.40

 

C. Contributions and Distributions of Different Property

 

Prior to the issuance of the PI Regulations, one commentator expressed the view that interpreting Section 707(a)(2)(B) to find a disguised sale of a partnership interest where one partner contributes property to a partnership and the partnership distributes different property to another partner "would not even pass the giggle test."41 Doing so requires not just collapsing the two transfers and finding a single, direct transfer between the contributing partner and the distributee partner, but rather creating additional steps (a deemed exchange of the two properties by the contributing partner and the partnership, followed by delivery of the partnership property deemed received by the contributing partner to the distributee partner in exchange for a portion of its partnership interest), something that is generally not permitted under the step- transaction and doctrines used to recharacterize multi-step transactions in accordance with their substance rather than their form.

The IRS was not persuaded, although it left the door open to further attempts at persuasion:

 

The proposed regulations do not adopt a specific favorable presumption or safe harbor for transactions involving transfers of different property. The IRS and the Treasury Department are concerned that if such a favorable presumption or safe harbor were available, a purchasing partner and selling partner could easily structure a transaction to fit within the favorable presumption or safe harbor, for example, by the purchasing partner transferring an asset that it wishes to sell to the partnership and the partnership selling the asset and transferring the sales proceeds to the selling partner. The IRS and the Treasury Department specifically request additional comments on whether a favorable presumption or safe harbor for transactions involving transfers of different property is appropriate and, if so, how any favorable presumption or safe harbor could be narrowly tailored to cover only those transactions that clearly should not be characterized as a sale of a partnership interest.42

 

For the reasons discussed below, a safe harbor for transfers involving different property, or at least a presumption against disguised sale treatment in situations involving such transfers, is clearly appropriate.

The application of the PI Regulations to transactions involving partnership divisions illustrates the illogic of the approach of the PI Regulations with respect to distributions of non-contributed property. (In the preamble to the PI Regulations, the IRS specifically requests comments on whether the PI Regulations special rules or exceptions for some or all of the transfers occurring in a partnership merger or division under Treas. Reg. § 1.708-1(c) or (d).)

Consider the following basic and, one suspects, common example:

 

Example 3. A and B are partners in Partnership AB. AB has two businesses, Business X and Business Y. In order to expand Business Y, AB enters into negotiations with C to have C contribute its Business Y assets to AB in exchange for an interest in AB. However, C has does not want to participate in Business X. In order to obtain C's agreement to contribute its Business Y assets to AB, AB agrees to dispose of Business X to A and B in connection with C's contribution to AB. AB's agreement with C does not contain any restrictions on the terms under which AB will dispose of Business X to A and B (e.g.,. whether or not the Business X will be distributed pro rata to A and B). Simultaneously with C's contribution of its Business Y assets to AB, AB contributes Business X to a new partnership (NP) and distributes NP pro rata to A and B. Assume that, after the transaction, A and B continue to own more than 50% of the capital and profits interests in AB, such that AB is the divided partnership for purposes of Treas. Reg. § 1.708-1(d)(4) and the "assets-over" form of the transaction is respected.

 

One doesn't know whether to laugh or cry at the fact that, under the PI Regulations, there is a serious risk -- some would say even a certainty -- that C's contribution of the Business Y assets to AB and AB's distribution of the NP interests to A and B would be treated as a disguised sale of partnership interests by A and B to C. 43 Because the two transfers occur simultaneously, the two transfers are presumed to be part of a sale of such partnership interests unless the facts and circumstances clearly establish that the transfers do not constitute a sale. Furthermore, the facts and circumstances clearly establish that, but for C's contribution of the Business Y assets to AB, AB would not have distributed Business X (in the form of the NP interests) to A and B.

And yet no one would seriously contend on these facts that A and B should be treated as having sold a portion of their AB partnership interests to C. A and B are merely retaining, albeit now in two different partnerships, interests in the same assets that they held before C's contribution to AB; indeed, vis-a-vis Business X, absolutely nothing has happened economically with respect to A and B's interests as a result of C's contribution to AB. However, the PI Regulations would (i) treat AB as having sold all or a portion of Business X to C in exchange for C's Business Y assets, and then (ii) treat C as having transferred Business X to A and B in exchange for an interest in AB, resulting in the recognition of gain or loss by all of the parties to the transaction. In adopting Section 707(a)(2)(B), the Senate Finance Committee warned that "Treasury should be mindful that the committee is concerned with transactions that attempt to disguise a sale of property and not with non-abusive transactions that reflect the various economic contributions of the partners."44 As currently written, the PI Regulations clearly ignore that warning.

Of course, even if the IRS thought that disguised sale treatment was appropriate in Example 3, such treatment could be easily avoided:

 

Example 4. Same facts as Example 3, except that instead of transferring Business X to NP, AB contributes Business Y to NP, and C contributes its Business Y assets to NP in exchange for an interest in NP.

 

On these facts, there is no basis upon which the: PI Regulations could apply. No partner transfers any property to AB; AB does not transfer any property to a partner.45 (As to NP, there are only contributions of property to NP, with no distributions by NP.)

From these examples, one could simply conclude that the PI Regulations should contain an exception for pro rata distributions to existing partners incident to a partnership division, to the extent that the involve assets that were not contributed, directly or indirectly, to the dividing partnership in connection with the transaction (what I will refer to herein as historic partnership assets). But the examples discussed above raise broader issues with respect to the wisdom of the whole approach of the PI Regulations with respect to historic partnership assets than simply the treatment of such assets in partnership divisions. For example, it should not make any difference in one's reaction to Example 3 whether the distribution to A and B is of interests in NP (such that the distribution actually qualifies as a partnership division) or consists of assets not held in partnership the distribution consists of historic partnership assets.

Neither is it clear that it should make any difference whether the distribution of historic partnership assets to existing partners is pro rata.

 

Example 5. Same facts as Example 3, except that, pursuant to an agreement between Partners A and B, AB distributes Business X solely to Partner A.

 

Even if the final PI Regulations were to contain an exception for pro rata distributions to existing partners of historic partnership assets, the fact that AB distributes Business X solely to A would make the distribution ineligible for the any exception for pro rata distributions. Again, because the distribution to A would not have occurred "but for" the contribution by C, A would be treated as having sold all or a portion of its AB partnership interest to C. Again, one can seriously question whether this result makes any sense, or is what Congress intended. As far as C is concerned, it is uninvolved in and indifferent to whether Business X is distributed to A and B on a pro rata or non-pro rata basis -- and yet, assuming that the final PI Regulations contain an exception for only pro rata distributions of historic partnership assets, C would recognize gain or loss on its contribution of its Business Y assets to AB in only the latter case. The decision whether or not to treat C as having made a disguised purchase of a partnership interest (and, perhaps more importantly to C, therefore a disguised sale of the assets it is nominally contributing) should not depend on how A and B decide to allocate AB's historic partnership interests between them, a matter which is negotiated between, and affects, only A and B. The legislative history's command that the regulations address transactions that attempt to disguise a sale of property and not "non-abusive transactions that reflect the various economic contributions of the partners" would appear to dictate that C not be treated as having made a disguised purchase of a partnership interest in these circumstances.46

What about A and B? Economically, A has disposed of a portion of its AB interest in exchange for an interest in Business X, to the extent that it receives more than its pro rata share of Business X -- but as an economic matter, this exchange is with B, the party that in effect "gave up" its interest in Business X in exchange for an increased interest in AB. This "disguised sale," if one wants to call it that, does not involve, and has nothing to do economically with, the contribution by C (although C's contribution was a catalyst for the reallocation by A and B of their respective interests in Business X and Business Y). It would seem inappropriate to use the fact of C's contribution as a basis for finding a disguised sale of a partnership interest from A to B, and, indeed, because B does not transfer any property to AB in connection with the transaction, neither Section 707(a)(2)(B) nor the PI Regulations would apply.47

As the examples above demonstrate, in most cases applying the PI Regulations to a transaction in which the property transferred by the partnership consists of historic partnership assets is illogical, and does not lead to a "proper characterization" of the transaction. The PI Regulations should therefore include at least a presumption against disguised sale treatment where the property transferred by a partner to the partnership is not the same as, or substantially similar to, the property transferred by the partnership to the other partner. The presumption could be overcome, for example, in cases, like that identified by the IRS in the preamble, where the cash or other property transferred by a partner to the partnership is used, directly or indirectly, to obtain the other property or cash transferred by the partnership to the other partner.

 

D. Exception for Transactions Incident to Partnership Formation and the Ordering Rule.

 

Transfers incident to the formation of a partnership are not subject to the PI Regulations, although the regulations caution that such transfers may be subject to the Property Regulations. Prop. Treas. Reg. § 1.707-7(a)(8).48 It is not entirely clear why this exception has been included in the PI Regulations. The cautionary reference in the PI Regulations to possible application of the Property Regulations to transfers incident to the formation of the partnership suggests that the IRS may have thought application of the latter regulations (and/or possibly other provisions of subchapter K)49 was more appropriate in such circumstances. However, application of the Property Regulations can produce tax consequences that differ from those that would result from application of the PI Regulations. and are seemingly inconsistent with the underlying "over-the-top" orientation of the PI Regulations.

This point is illustrated by the following example, in which the distributee partner avoids tax under the Property Regulations by virtue of the exception for reimbursements of preformation capital expenditures.

 

Example 6. Partners A, B and C form Partnership ABC as equal partners. Partner A contributes two assets: Asset X, which has a fair market value of 1000 and a tax basis of O, and Asset Y, which also has a fair market value of 1000 but which also has a tax basis of 1000, all of which is attributable to capital expenditures incurred by Partner A within the last two years. Partner B contributes cash in the amount of 1000. Pursuant to Partnership ABC's formation documents, Partnership ABC immediately transfers the 1000 cash contributed by Partner B to Partner A to reimburse A for the preformation capital expenditures incurred with respect to Asset Y.

 

By its terms, the PI Regulations do not apply to the transfers described in the example because such transfers were "incident to the formation" of Partnership ABC. Prop. Treas. Reg. § 1.707-7(a)(8). The contribution of assets by Partner A to Partnership ABC, and the related distribution of cash by Partnership ABC to Partner A, are subject to the Property Regulations -- but Partner A appears to escape disguised sale treatment under those regulations because the cash distribution received by Partner A from the partnership was made to reimburse Partner A for preformation capital expenditures.50

Is this the right result? One seemingly has all of the necessary ingredients for recharacterizing the transaction as a sale of an interest in Partnership ABC by Partner A to Partner B for cash -- a transfer by Partner B of cash to the partnership in exchange for a partnership interest, and a transfer of cash by the partnership to Partner A. The transfers are simultaneous, involve the same asset being contributed and distributed, and are clearly directly related under a "but for" or any other test that one might choose to use. But because the transfers occur incident to the formation of the partnership, half of what is clearly an integrated series of transfers -- Partner B's contribution of the cash -- is completely ignored, and the transaction as to Partner A is subject only to the Property Regulations. As a result, Partner A escapes tax while in substance (both economically and in reality) selling half of its partnership interest -- or, viewed another way, half of Assets X and Y51 -- to Partner B in exchange for cash.52Cf. Rev. Rul. 99-5, 1999-1 C.B. 434 (Situation 1) (purchase by unrelated party of 50% of LLC that is treated as a disregarded entity is treated as acquisition of a 50% interest in the LLC's assets, followed by a contribution to a partnership). For regulations which are supposed to identify and "properly characterize" transactions that are "in substance" disguised sales of property, this result is inexplicably exclusive.

The discussion above regarding the exception for transfers incident to formation may actually illustrate a broader issue relating to the ordering rules. Under the PI Regulations, to the extent that a transfer of consideration by a purchasing partner to a partnership or a transfer of consideration by a partnership to the selling partner may be treated as part of a sale of property under the Property Regulations, the Property Regulations apply before the PI Regulations, and to the extent the transfer is treated as part of a sale of property under the Property Regulations, such transfer is not taken into account in applying the PI Regulations. See Prop. Treas. Reg. § 1.707-7(a)(6). In the case of a transfer by a purchasing partner, applying the Property Regulations before the PI Regulations makes eminent sense. To the extent that the purchasing partner is treated as having sold assets to the partnership rather than having contributed them to the partnership under Section 721, the purchasing partner has not acquired an "interest" in the partnership, and there is therefore no reason to test whether it should be treated as having acquired an interest from another partner under the PI Regulations.

However, in the case of a transfer to a selling partner, it is by no means clear that the Property Regulations should take precedence over the PI Regulations where both potentially apply. As the discussion above illustrates, it is difficult to see any principled basis, under either the statute or the substance-over-form principles that inform the statute, for ignoring the contribution half of what may otherwise be an integrated transaction involving a related contribution by one partner and a distribution to another partner. Where both the Property Regulations and the PI Regulations can apply to a transfer to a selling partner, a more principled approach would be, rather than simply ignoring the potentially related transfer by the purchasing partner, to treat the selling partner as having sold an appropriate portion of the underlying property to the purchasing partner, followed by a contribution of that property by the purchasing partner to the partnership.53

The existence of the presumption in the Property Regulations can also result in a transaction that is perhaps more properly characterized as a sale of a partnership interest by the selling partner being instead characterized as a sale of property, with unintended and possibly inappropriate results.

 

Example 7. Partners A and B form Partnership AB in Year 1. In Year 3, Partner A contributes Asset X with a fair market value and tax basis of 1000 to Partnership AB. In Year 4, Partner B contributes 1000 in cash to Partnership, AB, which immediately distributes the same amount to Partner A. Immediately prior to the distribution, Partner A's partnership interest has a fair market value of 2000 and a tax basis of 1500.

Under the PI Regulations, because the distribution of cash by Partnership AB to Partner A in Year 4 "may be treated" as a sale of Asset X by Partner A under the Property Regulations, the Property Regulations apply before the PI Regulations. Under the Property Regulations, because the distribution of cash by Partnership AB to Partner A in Year 4 occurred less then two years after the contribution of Asset X by Partner A to the partnership in Year 3, the distribution is presumed to be consideration received in exchange for the sale of Asset X by Partner A to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale.

If the distribution of cash by Partnership AB to Partner A is treated as part of a sale of Asset X under the Property Regulations, Partner A will not recognize any gain (because Asset X had a fair market value and tax basis of 1000) and the PI Regulations will not apply. If the distribution of cash by Partnership AB to Partner A is not treated as part of a sale of Asset X under the Property Regulations, the PI Regulations will apply. Assuming that, under the PI Regulations, the simultaneous contribution of cash by Partner B and the distribution of such cash to Partner A is treated as a disguised sale of one-half of Partner A's partnership interest to Partner B, Partner A will recognize 250 of gain.

E. Liability Assumptions

 

The PI Regulations treat liability assumptions generally as transactions that can give rise to transfers of consideration to or from a partnership, without any exception for "qualified liabilities" analogous to that contained in the Property Regulations. The preamble to the PI Regulations explains that the IRS believed that such an exception was considered unnecessary, given that any liability assumption treated as giving rise to a transfer of consideration by a partner to a partnership (or vice versa) would have to be related under the "but for" test to another transfer of consideration before a disguised sale of a partnership interest would be found. This approach dramatically expands the potential reach of the PI Regulations, and further illustrates the flaws of the "but for" test.

As a result of this approach, for example, the PI Regulations can result in two distributions of property by a partnership to different partners being treated as, in part, a disguised sale of a partnership interest between the partners:

 

Example 8. A and B are equal partners in Partnership AB. Partnership AB's assets include Blackacre, which has a fair market value of 200 but which is encumbered by nonrecourse mortgage debt with a principal amount of 100. The debt was incurred more than two years ago, and has encumbered Blackacre since it was incurred. A and B agree that Blackacre should be distributed to B, but B is willing to agree to the distribution only if it can remain an equal partner with A in AB. Therefore, pursuant to an agreement between A, B and Partnership AB, Partnership AB distributes 100 of excess partnership cash to A and distributes Blackacre (subject to the debt) to B. Assume that, immediately prior to the distribution, each of A and B's share of the debt was 50.

 

Under the PI Regulations, B's assumption of the nonrecourse mortgage debt with respect to Blackacre is treated as a transfer of consideration by B to the partnership in the amount of 50 (equal to the excess of the amount of the liability (100) over B's share of the liability immediately prior to the assumption (50)).54 This transfer, coupled with AB's distribution to A (which would not have occurred but for the distribution of Blackacre to B), gives rise under the PI Regulations to a disguised sale by A of a portion of its partnership interest, as follows: (i) B is treated as having assumed 50 of AB's nonrecourse mortgage debt in exchange for the transfer of 50 of cash by AB to B, and then (ii) B is treated as having delivered 50 of cash to A in exchange for a portion of A's partnership interest (with a value of 50).55 (The remainder of the transaction is treated in accordance with their form, i.e., as distributions to A and B under Section 731.)

In form and in substance, A and B are dividing up partnership assets and associated liabilities between them -- any shift in their interests in the partnership is in substance the result of this division. Treating the transaction as a sale by A of a portion of its partnership interest to B, effected through transfers of partnership assets to and between them, turns the transaction on its head. As long as the liabilities involved were not incurred in anticipation of the transaction, or for the purpose of effecting the transaction -- in other words, as long as the liabilities are "qualified liabilities" for purposes of the Property Regulations, such that the assumption of such liabilities does not by itself result in a disguised sale of property -- there is no reason to "disconnect" the liability from the property being distributed to the assuming partner and instead "connect" that liability to a separate property distribution to another partner for purposes of finding a disguised sale of a partnership interest. As the: above example illustrates, the IRS is incorrect in believing that the "but for" test is (again) up to the task of properly characterizing the transaction in these circumstances. It is therefore essential, especially if the IRS retains the "but for" test without substantial modification, that the PI Regulations include rules for "qualified liabilities" similar to those in the Property Regulations.56

 

F. Are the Reporting Rules Overbroad?

 

In concept, including a disclosure requirement in the PI Regulations appears to be appropriate, for the same reasons that led to the inclusion of disclosure requirements in the Property Regulations. One can expect, of course, that the volume of disclosure under the PI Regulations -- especially if reporting is required for all transfers occurring during a seven-year, rather than a two-year, period -- is likely to be multiples of that under the Property Regulations, particularly with respect to partnerships (like hedge funds) that regularly receive contributions and effect redemptions. As a practical matter, such partnerships are likely to have to disclose all contributions and redemptions (and possibly regular distributions, unless such distributions qualify for the exception for operating cash flow distributions). Depending on how one believes that such partnerships can satisfy the requirement in the regulations of disclosure of "[t]he facts affecting the potential tax treatment" under Section 707 of the disclosed transfers, such disclosure could be extremely burdensome (if, for example, discussion of the specific facts and circumstances of each transfer were required). Most partnerships may simply develop a single blanket set of representations (e.g., that there were no negotiations or agreements between the purchasing partner and the selling partner with respect to the transfers, and that the transfer(s) by the partnership to the selling partner(s) was not dependent on transfer(s) by the purchasing partner(s) to the partnership) that would apply to most, if not all, of the disclosed transfers, which should satisfy the disclosure requirement in the ordinary course.57

One is then left with the question whether the extension of the two-year period to seven years is necessary or appropriate. In the context of a partnership that is regularly receiving contributions and making redemptions, it doesn't make much difference, since all such contributions and redemptions will likely have to be disclosed in any event. So we are dealing with partnerships that only infrequently -- to be specific, less than every two years, but more than seven years -- either receive a contribution from or make a distribution (that does not qualify for one of the presumptions or exceptions applicable to guaranteed payments, preferred returns or operating cash flow distributions) to one or more of its partners. This is probably a limited set of partnerships, and one therefore suspects that extending the disclosure requirement to transfers occurring within a seven-year period will not substantially increase the compliance burden on taxpayers. Given that transfers more than two years apart continue to benefit from a presumption that they are not part of a disguised sale, extending the disclosure period to seven years probably will not deter taxpayers from engaging in appropriate transactions, but will have a beneficial deterrent effect on taxpayers who would otherwise engage in a disguised sale in a "stepped" transaction structured to avoid the two-year presumption and disclosure period. On balance, therefore, extension of the disclosure period appears to be appropriate, and it is difficult to come up with any principled rationale for a period longer than two years but shorter than seven years.58

V. Conclusion

IRS officials have acknowledged that the PI Regulations contain flaws (although they did not identify them) and can be improved.59 Changes to the PI Regulations along the lines discussed above, especially the modifications to the "but for" test, would go a long way towards providing a more balanced and workable set of rules. It is unclear, however, whether a detailed set of regulations in this area is required at all. Setting aside questions about whether Section 707(a)(2)(B) can apply to a disguised sale of a partnership interest in the absence of regulations, the statutory language, with its requirement that two transfers be recharacterized as a sale or exchange of property if they are "related" and if they be "properly characterized" as a sale or exchange of property, would appear to do as good a job at identifying those transfers that should be recharacterized as the any alternative test that one could develop in regulations. Moreover, since the enactment of Section 707(a)(2)(B), this does not appear to be an area which has given rise to a substantial number of disputes between taxpayers and the IRS (although this could be attributable to the difficulty of identifying potential disguised sales of partnership interests on audit). Since a Potter Stewart "I know it when I see it" approach may be as good as any in this context, in considering comments to the PI Regulations the IRS should also consider simply adopting regulations that clarify that Section 707(a)(2)(B) applies to related transfers that are properly characterized as a disguised sale of a partnership interest (to eliminate any argument that the statute does not apply to such transfers in the absence of regulations), with whatever additional rules (e.g., relating to liability assumptions and reporting rules) are believed necessary to ensure that the concept of a "transfer" is sufficiently broad and to permit the IRS to enforce the statute and regulations.

 

FOOTNOTES

 

 

1 The author gratefully acknowledges the helpful comments and insights of his colleagues William Weigel, Kathleen Ferrell and Neil Barr. Any errors are the responsibility of the author.

During the preparation of this paper, a comment letter on the PI Regulations (as defined below) was submitted to the IRS. See Letter from Philip A. McCarty to the Internal Revenue Service dated January 10, 2005 (available in BNA TaxCore) (the "McCarty Letter"). Several of the points made in this paper are also made in the McCarty Letter.

2 All references to Sections are to sections of the Internal Revenue Code of 1986, as amended (the "Code").

3See Treas. Reg. § § 1.707-3, -4, -5, -6, -8 and -9.

4See Treas. Reg. § 1.707-7.

5See Prop. Reg. § 1.707-7.

6Compare Rubin & Whiteway, "New Developments in Disguised Sales of Partnership Interests," 3 J. Passthrough Entities No. 6 (2000) ("perilous" to conclude that disguised sales of partnership interests are immune from attack under Section 707(a)(2)(B) in the absence of regulations) with Lipton, "Can There Be a Disguised Sale of Partnership Interests?" 4 J. Passthrough Entities No. 1 (2001) (absence of clear statutory rule or congressional intent with respect to disguised sales of partnership interests prevents the IRS from applying Section 707(a)(2)(B) to disguised sales of partnership interests in the absence of regulations).

7Regulations under Sections 721 and 731 specifically contemplated that transactions, otherwise taking the form of contributions and distributions qualifying under Sections 721 and 731, respectively, could nonetheless be treated in appropriate circumstances as sales or exchanges of property. Treas. Reg. § 1.721-1(a) provides that

 

Section 721 shall not apply to a transaction between a partnership and a partner not acting in his capacity as a partner since the transaction is governed by section 707. Rather than contributing property to a partnership, a partner may sell property to the partnership or 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. See paragraph (c)(3) of § 1.731-1. Thus, if the transfer of property by the partner to the partnership results in the receipt by the partner of money or other consideration, including a promissory obligation fixed in amount and time for payment, the transaction will be treated as a sale or exchange under section 707 rather than a contribution under section 721.

 

Treas. Reg. § 1.731-1(c)(3) provides:

If there is a contribution of property to a partnership and within a short period:

 

(i) Before or after such contribution other property is distributed to the contributing partner and the contributed property is retained by the partnership, or

(ii) After such contribution the contributed property is distributed to another partner,

 

such distribution may not fall within the scope of section 731. Section 731 does not apply to a distribution of property, if, in fact, the distribution was made in order to effect an exchange of property between two or more of the partners or between the partnership and a partner. Such a transaction shall be treated as an exchange of property.

8 Neither case appears to be incorrectly decided, or, even if incorrectly decided, as having much in the way of precedential value. Given the unique circumstances of the partnership and the terms under which new partners were admitted in Comsat, it is doubtful that a court considering a more heavily negotiated transaction in the context of a commercial partnership involving only private parties would feel bound to reach the same result as in Comsat. In Jupiter, the differences in the partnership interest surrendered by the taxpayer and that acquired by the new investor, coupled with the uncontradicted testimony of the parties to the effect that neither would have been willing to engage in a direct sale of a partnership interest from the taxpayer to the new investor, would normally be seen as sufficient to support respecting the form of the transaction, especially in the context of subchapter K. Cf. Foxman v. Comm'r., 41 T.C. 535 (1964) ("Where the practical differences between a 'sale' and a 'liquidation' are, at most, slight, if they exist at all, and where the tax consequences to the partners can vary greatly, it is in accord with the purpose of the statutory provisions to allow the partners themselves, through arm's-length negotiations, to determine whether to take the 'sale' route or the 'liquidation' route, thereby allocating the tax burden among themselves.").

9 H.R. Rep. No. 98-432, 98th Cong., 2d Sess. 1218 (1984) ("House Report"). The Senate Finance Committee Report contains identical language. See S. Prt. No. 98-169 (Vol. 1), 98th Cong., 2d Sess. 225 (1984) ("Senate Report").

10 House Report, at 157.

11 H.R. Rep. No. 98-861, 98th Cong., 2d Sess. 861 (1984) ("Conference Report").

12 Conference Report, at 861.

13 Senate Report, at 230-31. See also R. Comm. on Tax'n, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 231-33 (1984) ("Bluebook"). The Bluebook specifically identifies two factors as indicating the existence of a disguised sale: (i) the temporal proximity of the contribution and distribution and (ii) the "apparent tax motivation" of the contributor of property in structuring the transaction as a contribution of property to the partnership (although the Bluebook goes on to caution that the existence of significant non-tax motivations for becoming a partner "is of no particular relevance" in establishing that a transaction is not a disguised sale). See Bluebook, at 232. This reference to motivation and intent echoes a significant element of the courts' analysis in Comsat and Jupiter as to whether the transactions at issue in those cases should be properly characterized as disguised sales.

14 In addition to addressing disguised sales of property by a partner to a partnership, the Property Regulations also address disguised sales of property by a partnership to a partner. See Treas. Reg. § 1.707-6(a) ("Rules similar to those provided in § 1.707-3 apply in determining whether a transfer of property by a partnership to a partner and one or more transfers of money or other consideration by that partner to the partnership are treated as a sale of property, in whole or in part, to the partner.").

15 Transfers resulting from a partnership termination under Section 708(b)(1)(B) are disregarded for purposes of the Property Regulations. See Treas. Reg. § 1.707-3(a)(4).

16 A "qualified liability" is generally any liability assumed or taken subject to by a partnership in connection with a transfer of property to the partnership by a partner to the extent that the liability (i) was incurred by the partner more than two years prior to the date that the partner transfers the property to the partnership and that has encumbered the property throughout that two-year period, (ii) was not incurred in anticipation of the transfer but was incurred within the two-year period prior to the transfer and that has encumbered the property since it was incurred, (iii) a liability that is allocable under the rules of Treas. Reg. § 1.163-8T to capital expenditures with respect to the property, or (iv) a liability that was incurred in the ordinary course of a trade or business all material assets of which are transferred to the partnership. If the liability is a recourse liability, the amount of the liability cannot exceed the fair market value of he transferred property (less the amount of senior liabilities). Treas. Reg. § 1.707-5(a)(6).

17 Form 8275 or the statement must include an identification of the items (or group of items) with respect to which disclosure is being made, the amount of such items, and "[t]he facts affecting the potential tax treatment of the item (or items) under section 707." Treas. Reg. § 1.707-8(b).

18 56 Fed. Reg. 19055, 19056 (April 25, 1991).

19New factors that are specific to disguised sales of partnership interests and are included in the PI Regulations include (1) that the same non-cash property (i.e., property other than cash or marketable securities) that is transferred to the partnership by the purchasing partner is transferred to the selling partner, (2) that the partnership holds transferred non-cash property for a limited period of time, or during the period of time the partnership holds transferred non-cash property, the risk of gain or loss with respect to the property is not significant, (3) that the transfer of consideration by the purchasing partner or the transfer of consideration to the selling partner is not made pro rata, (4) that there were negotiations between the purchasing partner and the selling partner (or between the partnership and each of them, with each partner being aware of the negotiations with the other partner) concerning any transfer of consideration, and (5) that the selling partner and the purchasing partner enter into one or more agreements, including an amendment to the partnership agreement (other than for admitting the purchasing partner) relating to the transfers. Prop. Reg. § 1.707-7(b)(2)(iii), (v), (viii), (ix), (x).

20The preamble to the PI Regulations explains that the exception takes into account that partners frequently enter and exit such partnerships and, in most cases, those transactions are factually unrelated to each other. See 69 Fed. Reg. 68838, 68841 (Nov. 26, 2004).

21See 69 Fed. Reg. 68838, 68842 (Nov. 26, 2004). The PI Regulations do provide that deemed contributions to and distributions from a partnership under Section 752 resulting from reallocations of partnership liabilities among partners are not treated as transfers of consideration, unless the transaction is otherwise treated as a sale of a partnership interest.

22The preamble does request comments on whether the PI Regulations should include special rules for qualified liabilities similar to those in the Property Regulations, and, if so, how those rules should be modified to address issues particular to disguised sales of partnership interests. See 69 Fed. Reg. 68838, 68842 (Nov. 26, 2004).

23See 69 Fed. Reg. 68838, 68842 (Nov. 26, 2004). The latter request for examples where the anti-abuse rule ought to apply suggests that the IRS itself is uncertain as to how the anti-abuse rule should apply, a disquieting thought to anyone who is looking for certainty, or at least predictability, in how the regulations will apply to a given set of facts.

24 If a portion of a transfer of consideration by a partnership to a selling partner is not treated as part of a sale of the selling partner's partnership interest under the PI Regulations, but rather as a distribution to the selling partner under Section 731, and the sale is treated as occurring on the same date as the distribution, then the distribution is treated as occurring immediately after the sale.

25For purposes of the PI Regulations, a transfer is treated as occurring on the date of the actual transfer, or, if earlier, on the date that the transferor agrees in writing to make the transfer. Prop. Reg. § 1.707-7(a)(2)(ii)(A). The PI Regulations do not draw any distinction between unconditional written agreements and agreements that are subject to material conditions.

26As long as the partner's remaining basis in its partnership interest (after taking into account the disguised sale) exceeds the basis of the property that it is treated as receiving under Section 731, this rule will generally produce a more favorable result to the selling partner than would a rule which treated the distribution as occurring immediately before the sale. (Conversely, this rule may produce a less favorable result for the partnership (and the other partners) if treating the distribution as occurring before the disguised sale would give rise to a positive basis adjustment, under Section 734(b), to partnership property that is subsequently treated as transferred by the partnership to the purchasing partner as part of the disguised sale.)

27 The preamble states that the IRS viewed this ordering rule as appropriate because, in some cases, the tax consequences of a disguised sale of property may be simpler than the tax consequences of a disguised sale of a partnership interest (e.g., by avoiding a technical termination under Section 708(b)(1)(B) or basis adjustments under Section 743(b)). See 69 Fed. Reg. 68838, 68843 (Nov. 26th, 2004).

28See 69 Fed. Reg. 68838, 68843 (Nov. 26, 2004).

29Disclosure is not required if one of the exceptions for transfers incident to partnership formation, transfers resulting from a technical termination of a partnership under Section 708(b)(1)(B), or transfers to or by service partnerships applies to either of the transfers.

30See 69 Fed. Reg. 68838, 68843 (Nov. 26, 2004).

31 In the case of a new partner, everything that the partner receives from the partnership is in consideration for the contribution made by the partner (assuming that the partner is not separately providing services to or transacting with the partnership). Admittedly, in the case of an existing partner, identifying the incremental distributions that the partner receives from the partnership in consideration for the contribution of additional property can be somewhat more complex. See Treas. Reg. § 1.707-3(f), Example 4.

32 In the example, it is possible that the facts could support an argument that the distribution to A was dependent on the entrepreneurial risks of partnership operations, and therefore that the "entrepreneurial risk" test, which applies in the context of nonsimultaneous transfers, would not be met. The facts may not always support such an argument, however, as in the case where the partnership is not subject to significant entrepreneurial risk, and/or where the amount of the subsequent distribution is fixed (e.g., where A is exercising a fixed price put option with respect to a portion of its partnership interest).

33 It still is difficult to see how these facts would rebut the conclusion that the distribution would not have occurred "but for" the contribution, given the facts in the example. What these arguments really show is the insufficiency of the "but for" test in establishing the existence of a relationship between the two transfers that is viewed as sufficient to support disguised sale treatment.

34See New York State Bar Association Tax Section, Report on Disguised Sales of Partnership Interests Responding to Notice 2001-64 (2003) (reprinted in LEXIS, Tax Notes Today (March 6, 2003) (2003 TNT 44-15 2003 TNT 44-15: IRS Tax Correspondence)).

35See ABA Section of Taxation, Comments Concerning Disguised Sales of Partnership Interests (2004) (reprinted in LEXIS, Tax Notes Today (April 5, 2004) (2004 TNT 65-73 2004 TNT 65-73: Public Comments on Regulations)).

36See 69 Fed. Reg. 68838, 68840 (Nov. 26, 2004).

37 It is arguable whether the example posed in the preamble to illustrate the under-inclusiveness of the "double but for" test is persuasive. The example does not indicate, for example, whether the existing partner will receive the assets contributed by the prospective investor or historic partnership assets. For the reasons discussed below, there is a strong argument to be made that a transfer of historic partnership assets should generally not be treated as part of a disguised sale. In addition, if the prospective investor is indifferent as to whether a distribution is made to the existing partner -- i.e., it is willing and intends to make a contribution to the partnership without regard to whether any distribution is made to the existing partner -- finding a disguised sale of a partnership interest to the prospective investor does not seem to be a "proper characterization" of the transaction, notwithstanding that it may be "economically indistinguishable" from a sale. ("Economically indistinguishable" cannot be the test, since every non-pro rata partnership distribution is economically indistinguishable from a pro rata distribution followed by a sale of a partnership interest by the distributee partner to the other partner(s) -- so there has to be something more to support proper characterization of the transfers as a sale.)

38See also Treas. Reg. § 1.881-3(b) (determination of whether the participation of an intermediate entity in a financing arrangement is pursuant to a "tax avoidance plan" is to be based on "all relevant evidence"; regulations list a series of factors that are among the facts and circumstances to be taken into account in the determination).

39 Even Treas. Reg. § 1.701-2 (the partnership anti-abuse rule), which lists only factors that indicate that a partnership was formed or availed of with a principal purpose of reducing taxes in a manner inconsistent with the intent of subchapter K, contains examples which discuss and analyze facts which support not applying the rule.

40 Examples of "non-sale" factors would include (i) that the subsequent transfer was not contemplated or intended at the time of the earlier transfer, (ii) that the property transferred by the purchasing partner to the partnership is different from the property transferred by the partnership to the selling partner, (iii) the absence of any negotiations or agreement between the purchasing partner and the selling partner (or between the partnership and each of them, with each partner being aware of the negotiations with the other partner).

41 Lipton, supra.

42See 69 Fed. Reg. 68838, 68841 (Nov. 26, 2004).

43 Whether A, B and C laugh or cry will likely depend in substantial part on whether A and B realize a gain or loss on the recharacterized transaction. For example, if (i) A and B have a built-in loss on Business X and comparatively little (or no) built-in gain in Business Y (or vice versa, such that they have an overall built-in loss on their partnership interests), and (ii) C is indifferent to sale treatment (because it does not have any built-in gain in the assets it is contributing, or because it is not subject to U.S. tax), A and B may welcome the ability to avoid Section 731 nonrecognition treatment with respect to the distribution of Business X and instead recognize some or all of their built-in loss with respect to Business X or their partnership interests under the PI Regulations (assuming that they can avoid the loss disallowance rules of Section 707(b)(1)). The over inclusiveness of the "but for" rule and the "thumb on the scale" effect of the presumption will not always work to the detriment of taxpayers.

The same opportunity presents itself to contributing partners. If a partnership is making a non-liquidating distribution (or a non-cash liquidating distribution) to a partner that is indifferent to disguised sale treatment, other partners can try to trigger losses by contributing built-in loss property to the partnership and taking advantage of the presumption that transfers within two years of each other are presumed to be disguised sales of partnership interests. Assuming that the IRS cannot "clearly establish" that the distribution would not have occurred but for the contributions (depending on the facts, the contributing partners may be able to argue that the contributions were required in order for the partnership to maintain a certain critical mass, or to prevent the distribution from triggering defaults under the partnership's credit facilities), the contributing partners will avoid nonrecognition under Section 721 with respect to the built-in loss property and be able to recognize their built-in losses (again, assuming that they can avoid the loss disallowance rules of Section 707(b)(1)).

44 Senate Report, at 230.

45 Note that, even if AB were to distribute the NP interests to A and B -- which would leave the parties in the exact same legal and economic position as in Example 3, except that the position of AB and NP would be reversed -- the PI Regulations by their terms still would not apply. AB would have made a transfer to A and B, but there would be no corresponding transfer to AB.

46 It is again possible to avoid even the potential application of the PI Regulations in the context of a transaction like that in Example 5. AB, instead of distributing Business X to A, could contribute Business Y to a new partnership (NP), to which C would also contribute its Business Y assets. AB would then liquidate, distributing Business X and a portion of the NP interests to A, and the remainder of the NP interests to B. Because no partner would contribute any property to AB in connection with the transaction, the PI Regulations would not apply. In theory, the IRS could contend that NP should be treated as a continuation, or "alter ego" of AB under Treas. Reg. § 1.701-2, but for the reasons discussed in text it is difficult to see how the use of NP is inconsistent with the intent of subchapter K. (The case for treating NP as a continuation or alter ego of AB becomes even more difficult if AB remains in existence and is treated as the continuing "divided" partnership under Treas. Reg. § 1.708-1(d).)

47 To find such a disguised sale, one would have to treat AB as having distributed Business X pro rata to A and B, and then treat B as having transferred its interest in Business X to A in exchange for a portion of A's interest in AB. There is no basis in the Code or in case law for such treatment. See Foxman v. Comm'r, 41 T.C. 535 (1964).

It should also be noted that this recharacterization treats A has having received only a portion of Business X in consideration for a sale of its partnership interest; A would receive its pro rata share of Business X as a distribution under Section 731. Even if A is considered to have engaged in the disguised sale with new partner C rather than with existing partner B, the same logic applies: the distribution of Business X to A, to the extent of A's pro rata share of Business should be respected in accordance with its form, and treated as a distribution under Section 731. Cf. Section 731(c)(3)(B) (an a distribution of marketable, securities, amount treated as "money" is reduced to the extent of partner's distributive share of built-in gain in the distributed securities); Section 751(b)(1)(A) (distribution of "hot" assets treated as a sale or exchange of property only to the extent the distribution is "in exchange" for all or a part of the partner's interest in other partnership property).

48 The PI Regulations specifically provide that neither Section 707(a)(2)(B) nor the PI Regulations apply to transfers incident to the formation of the partnership. The reference to Section 707(a)(2)(B) is unnecessary and potentially pernicious (or at least confusing), insofar as such transfers may nonetheless be subject to the Property Regulations, which are issued in part under the authority of Section 707(a)(2)(B). A better approach would be to mirror the approach taken in Treas. Reg. § 1.707-3(a)(4), which states that transfers resulting from a termination of a partnership under Section 708(a)(1)(B) are "disregarded." in applying the Property Regulations.

49 For example, Section 704(c)(1)(B) would apply if a partnership were to distribute, within seven years after contribution, property contributed by one partner on formation of the partnership to a different partner. Note, however, that Section 704(c)(1)(B) would require the recognition of gain or loss only by the contributing partner, not by the distributee partner, whereas the PI Regulations would require gain or loss recognition by both partners if the original transfer did not occur pursuant to formation of the partnership and the two transfers were treated as giving rise to a disguised sale of a partnership interest.

50See Treas. Reg. § 1.707-4(d), which provides that a transfer of consideration by a partnership to a partner is not treated as part of a sale of property by the partner to the partnership under the Property Regulations to the extent that the transfer to the partner by the partnership "is made to reimburse the partner for, and does not exceed the amount of, capital expenditures" that (i) are incurred within the two-year period preceding the transfer by the partner to the partnership, and (ii) are incurred by the partner with respect to, among other things, property contributed to the partnership by the partner, but only to the extent that the reimbursed capital expenditures do not exceed 20% of the fair market value of such property at the time of contribution (unless the fair market value of the contributed property does not exceed 120% of the partner's adjusted basis in the contributed property at the time of the contribution, in which case the 20% limitation does not apply).

Note that while the headings in the Property Regulations and the PI Regulations, as well as the preambles to both sets of regulations, all refer to this exception as applying to "preformation" capital expenditures, by its terms the exception is not limited to capital expenditures that are incurred prior to formation of the partnership, but rather only to capital expenditures that are incurred with respect to property prior to its contribution to the partnership. In keeping with convention, this paper will nonetheless refer to the exception as applying to preformation capital expenditures, although it is important to remember that the exception is equally applicable to post-formation contributions of property.

A number of questions, all of which are beyond the scope of this paper, can be asked about the interpretation and application of this taxpayer-friendly provision. Under what circumstances is a distribution considered to be "made to reimburse" a partner for capital expenditures incurred with respect to the contributed property? What is the meaning of the term "capital expenditures" -- would it apply, for example, to expenditures that are capitalized into the basis of inventory? Do the limitations on the amount that can be reimbursed apply on a property-by-property basis, or do all property that is contributed in a single transaction or series of related transactions by the relevant partner have to be aggregated? In the preamble to the PI Regulations, the IRS acknowledges that it is aware of certain "deficiencies" and "technical ambiguities" in these rules and their interaction with the rules for qualified liabilities, and requests comments on these provisions.

51I am assuming that, if the transaction were treated as a sale by Partner A of assets to Partner B for cash, followed by a contribution of the purchased assets by Partner B to the partnership, there is at least a substantial risk that Partners A and B would not be able to "cherry pick" Partner A's high-basis assets for sale to Partner B, while leaving Partner A to contribute its low-basis assets. Cf. Rev. Rul. 68-55, 1968-1 C.B. 140 (in determining amount of gain recognized under Section 351(b) where multiple assets are transferred to a corporation in exchange for stock and cash, each asset is considered transferred for a pro rata portion of the stock and cash).

As an aside, one could take the view that the transaction should more properly be characterized as a sale of assets by Partner A to Partner B rather than a sale of a partnership interest, and therefore that the PI Regulations as drafted would not apply. If so, the better approach would seem to be to broaden the PI Regulations to cover such a disguised sale of assets rather than to permit the transaction to escape the regulations entirely. There is little question but that Section 707(a)(2)(B) is drafted broadly enough to authorize regulations that would capture such transactions. See Section 707(a)(2)(B) (permitting treatment of transfers as "a transaction between 2 or more partners acting other than in their capacity as members of the partnership").

52It should be noted that, even if the transaction in Example 6 were subject to the PI Regulations rather than the Property Regulations, the PI Regulations as currently drafted would offer Partner A at least some hope of avoiding tax. Under the PI Regulations, "rules similar to those provided in § 1.707-4 [which includes the exception for reimbursements of pre-formation capital expenditures] apply to determine the extent to which a transfer to a selling partner is treated as part of a sale of the selling partner's interest in the partnership to the purchasing partner." Prop. Treas. Reg. § 1.707-7(f).

With respect to reimbursements of pre-formation capital expenditures, whatever the justification for this exception in the context of the Property Regulations, the wisdom of including this exception in the PI Regulations is debatable. No similar "reimbursement" or "basis recapture" rule would apply if Partner A sold a partnership interest to Partner B (or if Partner A sold an undivided interest in its assets to Partner B, unless the parties were permitted to "cherry pick" high basis assets, and even then one can't "cherry pick" an asset's basis separate from its built-in gain). However, in a transaction that otherwise bears all of the hallmarks of a disguised sale, the PI Regulations would seem to permit Partner A to treat the distribution made by Partnership ABC in reimbursement of Partner A's preformation capital expenditures as not being part of a sale of its partnership interest to Partner B.

53Whether or not the identity of the party to whom the selling partner is selling the property -- the partnership or the other partner -- makes a difference will depend on the facts. If, for example, the final PI Regulations omit any exception for reimbursements of preformation capital expenditures in the case of a disguised sale property to another partner, only a sale to the latter would potentially qualify for the exception, which can have consequences for both the selling and other partners.

54Note that, because the nonrecourse mortgage: debt with respect to Blackacre is a "qualified liability" of the partnership under Treas. Reg. §§ 1.707-6(b) and 1.707-5(a)(6), B's assumption of the debt does not give rise to a disguised sale of Blackacre to B under the Property Regulations. As a result, even though the overlap rules provide that the Property Regulations apply before the PI Regulations, the PI Regulations still apply -- albeit without any similar exception for qualified liabilities.

55The tax consequences to the parties would be even more bizarre if AB had distributed 100 of AB property to A rather than cash. In that case, B would have been treated as having assumed 50 of AB's nourecourse mortgage debt in exchange for 50 of AB property, resulting in the recognition of gain or loss by AB with respect to such property.

56 Indeed, one could even consider an exception from the PI Regulations for all partner assumptions of liabilities, qualified or not, by a partner that occur in connection with partnership distributions of property to that partner, at least to the extent that the amount of "excess" liabilities assumed (i.e., the amount of the assumed liability in excess of the partner's share of such liabilities immediately before the distribution) exceeds the value of the property distributed to the partner. If the liability is a "qualified liability," the assumption of such liability by the partner will not be treated as part of a disguised sale of property by the partnership to the partner (unless the transaction is otherwise treated as a disguised sale), and the same should be true for purposes of determining whether there is a disguised sale of a partnership interest. If the liability is not a "qualified liability," the assumption of the liability will be treated as a transfer of consideration, to the extent described in Treas. Reg. § 1.707-5(a), to the partner in a disguised sale of property by the partnership to the partner, and, under the overlap rules, such transfer will again be ignored for purposes of applying the PI Regulations.

57Although the proposed regulations require that disclosure be made by any person who makes a transfer required to be disclosed, the regulations permit the persons otherwise required to disclose to designate by written agreement a single person to make the disclosure. Prop. Reg. §1.707-8(c). One would expect most partnership agreements to contain language authorizing the partnership to make the required disclosure on behalf of itself and its partners.

58The selection of seven years as the appropriate period for disclosure can be supported by analogy to Section 704(c)(1)(B) (contributing partner recognizes 704(c) built-in gain or loss with respect to contributed property if the property is distributed to another partner within 7 years after contribution).

59See Stratton, "IRS Officials Clarify Disguised Partnership Sales Regs," Tax Notes Today (Jan 11, 2005) (available on LEXIS, 2005 TNT 7-2 2005 TNT 7-2: News Stories).

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Mollerus, Michael
  • Institutional Authors
    Davis, Polk & Wardwell
  • Cross-Reference
    For REG-149519-03, see Doc 2004-22588 [PDF] or 2004 TNT 228-

    3 2004 TNT 228-3: IRS Proposed Regulations.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-4297
  • Tax Analysts Electronic Citation
    2005 TNT 42-60
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