New treatment of disguised sales and partnership liabilities

The IRS issued proposed regulations in January dealing with disguised sales of property to or by a partnership under Sec. 707 and the treatment of partnership liabilities under Sec. 752 (REG-119305-11). According to the IRS, the proposed regulations are designed to address “deficiencies and technical ambiguities” in the current regulations.

Sec. 707 prevents partners from recharacterizing a sale or exchange of property as a contribution to the partnership followed by a distribution by the partnership, which could allow the partners to avoid or defer tax on the transaction. Instead, a partner’s transfer of property to a partnership followed by the partnership’s transfer of money or other consideration to the partner is treated as a sale of property to the partnership by the partner if, based on all the facts and circumstances, the payment of money or other consideration would not have been made but for the transfer of the property (a disguised sale). An entrepreneurial-risks test applies for nonsimultaneous transfers of property.

There are several exceptions to this disguised-sale rule, including the debt-financed-distribution exception, which provides an exception for a distribution to the extent it is traceable to a partnership borrowing that is allocable to the partner. The proposed regulations introduce an ordering rule for determining which payments may be excluded from disguised-sale treatment by providing that the debt-financed-distribution exception applies first, with any remaining amounts tested under Regs. Sec. 1.707-4.

The proposed rules also change the treatment of preformation capital expenditures under Regs. Sec. 1.707-4(d) and clarify certain other exceptions to the disguised-sale rules, as well as how those rules apply to tiered partnerships and disregarded entities.

PARTNERSHIP LIABILITIES

The Sec. 752 rules determine the treatment of partnership liabilities, including the treatment of a partner’s share of either nonrecourse or recourse liabilities. For recourse liabilities, the partner’s share is determined to be the portion for which the partner bears the risk of economic loss. A partner bears the economic risk of loss to the extent it would be obligated to pay if the partnership’s assets were worthless and the obligation became due. This rule applies even if the partnership’s assets are sufficient to pay the liability. The IRS is concerned the rule encourages arrangements whereby partners enter into “payment obligations that are not commercial” to obtain an allocation of basis in the liability. To be allocated a liability, under the proposed regulations a partner must satisfy new net-worth and other requirements that are intended to establish that the terms of the payment obligation are commercially reasonable and are not designed solely to obtain tax benefits.

The proposed regulations will generally be effective for transactions occurring after the final rules are published in the Federal Register.

For a detailed discussion of the issues in this area, see “Proposed Disguised-Sale Regs. Offer Clarification and Issues for Real Estate,” by Anthony S. Bakale, CPA, MT, and Angelina Milo, CPA, in the August 2014 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief
The Tax Adviser

Also look for articles on the following topics in the August 2014 issue of The Tax Adviser:

• Results of our annual tax software survey.
• A discussion of the deductibility of trust fiduciary fees.
• An analysis of the recent Quality Stores case on severance payments and FICA.