In October 2016, the IRS issued a suite of final, temporary and proposed regulations that tighten the disguised sale rules for contributions of appreciated property to partnerships.
One of the most significant changes made by the new rules effectively eliminates the ability of partners to defer gain on contributed property by taking advantage of leveraged partnership transactions. These rules apply to partnerships as well as to limited liability companies (LLCs), which are taxed as partnerships.
Disguised sales unmasked
Ordinarily, a partner doesn’t recognize gain when he or she contributes property to a partnership. In addition, distributions from a partnership to a partner are generally tax-free to the extent of the partner’s basis in his or her partnership interest. The disguised sale rules are designed to prevent partners from avoiding current taxation of what essentially is a sale of appreciated property by characterizing it as a contribution followed by an unrelated distribution.
The rules are complex. But in a nutshell, they treat a contribution and distribution as a single, taxable sale if 1) the partnership wouldn’t have made the distribution but for the contribution, and 2) the transfers aren’t simultaneous. In this case, the subsequent transfer isn’t subject to the “entrepreneurial risks” of partnership operations.
Generally, absent evidence to the contrary, contributions and distributions within two years of each other are presumed to be disguised sales.
Exception for leveraged partnerships
There are several exceptions to the disguised sale rules, most notably the debt-financed distribution exception. Under this exception, if the partnership distributes borrowed funds to a partner who contributes property, the transaction is treated as a disguised sale only to the extent the distribution exceeds the partner’s allocable share of that debt.
Prior to the new rules, a partner could use a leveraged partnership transaction to tap his or her equity in contributed property without triggering current taxation. To accomplish this, the partner would guarantee the partnership’s debt, rendering it recourse debt as to the partner, which is fully allocable to him or her. The new rules essentially eliminate the benefits of leveraged partnership transactions by providing that, for disguised sale purposes, such debt must be treated as nonrecourse, which is generally allocable among the partners according to their respective shares of the partnership’s profits.
Here’s an example that illustrates the impact of the new rules. Ron forms a partnership with several other partners, contributing property with a fair market value of $2 million and an adjusted basis of $400,000. The contribution doesn’t trigger taxable gain, and Ron’s adjusted basis in his partnership interest is $400,000. Two months later, the partnership borrows $1.6 million and distributes the funds to Ron, who has personally guaranteed the loan. Because the debt is recourse with respect to Ron, the entire amount is allocable to him, increasing his adjusted basis to $2 million. Ordinarily, this transaction would be treated as a disguised sale, resulting in a $1.6 million gain to Ron. Under the old rules, however, the debt-financed distribution exception would apply, allowing Ron to avoid current taxation. (Keep in mind, however, that the distribution reduces Ron’s basis to $400,000, so the tax is deferred rather than eliminated.)
Under the new rules, Ron’s guarantee is disregarded for disguised sale purposes, so the debt is treated as nonrecourse. Thus, Ron’s $1.6 million distribution is taxable to the extent it exceeds his $400,000 adjusted basis plus his allocable share (based on his percentage of partnership profits) of the debt.
Assess the impact
Partnerships should evaluate the impact of the new rules on their tax planning strategies. In addition to limiting the value of leveraged partnerships, the rules make several other changes to the disguised sale rules and modify the way partnership liabilities are allocated outside the disguised sale context.