In October, the IRS issued new guidance targeting strategies that are used to exploit the tax benefits associated with partnerships and limited liability companies (LLCs) that are treated as partnerships for tax purposes. In a nutshell, under the new guidance, property transactions between partners and partnerships are more likely to be classified as disguised sales and, therefore, subject to taxes. Here’s a summary of the most important aspects of the new temporary and final regulations on disguised sales that apply to these entities.
IRS temporary regulations typically have the same authority as final regulations. As such, they are in force as of the specified effective date. However, temporary regulations may be amended before being reissued as final regulations, with a new effective date for any changes.
Contributing Appreciated Property
In general, partners who contribute appreciated property (with a fair market value that exceeds its basis) to their partnerships don’t recognize any taxable gains under federal income tax rules. But there are exceptions to this general rule.
The most common exception occurs when the partnership assumes debt that encumbers the contributed property, and the assumed debt is large enough to cause the partner’s basis in the partnership interest — his or her “outside basis” — immediately after the contribution to be negative.
In that case, a taxable gain — equal to the negative outside basis amount — is triggered. The gain increases the contributing partner’s outside basis to zero. It’s fairly uncommon for such gains to occur, because the contributing partner’s outside basis is increased by the partner’s share of all partnership liabilities, including liabilities that encumber the contributed property.
Triggering the Disguised Sale Rules
However, when the dreaded “disguised sale rules” apply, contributions of appreciated property can trigger taxable gains that contributing partners may not have anticipated. That’s mainly because the partnership’s assumption of liabilities encumbering contributed appreciated property can be treated as disguised sale proceeds.
Disguised sale gains can also be triggered when a partner contributes appreciated property and receives distributions of cash or other assets from the partnership that are deemed to be related to the property contribution. Distributions that occur within two years (before or after) of the date the property was contributed are automatically assumed to be disguised sale proceeds, unless the facts and circumstances indicate to the contrary.
From a tax perspective, the disguised sale rules are bad news for partners that contribute appreciated property to their partnerships. So, it’s important to understand these rules and avoid triggering them whenever possible. But planning around the disguised sale rules has been made more difficult thanks to final and temporary IRS regulations that were issued in October.
Important note. The disguised sale rules, including the new regulations, apply equally to LLCs that are treated as partnerships for federal tax purposes. For simplicity, this article uses the terms 1) “partnership” to refer more generally to both partnerships and LLCs that are treated as partnerships for tax purposes, and 2) “partner” to refer more generally to the owners of those entities (partners and LLC members).
Identifying Exceptions to the Disguised Sale Rules
Fortunately, partners can avoid the disguised sale rules with certain favorable exceptions that have been updated under the new IRS guidance, including:
Exception for reimbursements of preformation expenditures. Certain reimbursements by a partnership to a contributing partner for capital expenditures related to contributed property that were incurred before the contribution — so-called preformation expenditures — aren’t included in disguised sale proceeds. In other words, such reimbursements can’t trigger or increase a disguised sale gain.
The new final regulations include several taxpayer-friendly changes to the preformation expenditure exception that are effective for transfers that occur on or after October 5, 2016.
Exception for qualified liabilities. For years, IRS regulations have provided special rules for the treatment of liabilities incurred or transferred in connection with certain contributions of property to partnerships. These rules were designed to trigger taxable disguised sale gains in certain circumstances, including situations where a partner encumbers a property with debt in anticipation of contributing the property to a partnership.
The treatment of liabilities under the disguised sale rules hinges on whether they’re qualified liabilities. A qualified liability that the partnership assumes (or takes property subject to) is treated as consideration for disguised sale purposes only if the property contribution would have been treated as a disguised sale without considering the qualified liability — in other words, when the contributing partner is deemed to receive other consideration, such as cash, in exchange for the property contribution.
On the other hand, liabilities that are not qualified liabilities are always treated as consideration in determining if a property contribution and a liability assumption together constitute a disguised sale. Therefore, nonqualified liabilities that encumber appreciated property and that are assumed by a partnership can easily trigger disguised sale gains.
Distinguishing between Qualified and Nonqualified Liabilities
According to the final regulations, qualified liabilities include the following:
- Debt incurred more than two years before the property contribution.
- Debt incurred less than two years before the property contribution but not incurred in anticipation of the contribution.
- A liability the proceeds of which can be traced to capital expenditures made in connection with the contributed property (such as acquisition or improvement costs).
- A liability that was incurred in the ordinary course of the business in which property transferred to the partnership was used or held (such as trade payables), but only if all the assets related to that business are transferred (other than assets that aren’t material to the continuation of the business).
- For transactions where all transfers occur on or after October 5, 2016, a liability that wasn’t incurred in anticipation of the transfer of the property to a partnership, but that was incurred in connection with a trade or business in which property transferred to the partnership was used or held but only if all the assets related to that trade or business are transferred other than assets that are not material to a continuation of the trade or business.
Debts (other than acquisition debt, improvement debt and trade payables) incurred within two years of the property contribution are presumed to have been incurred in anticipation of the property contribution unless the facts and circumstances clearly indicate otherwise.
If property subject to liabilities that aren’t qualified liabilities is contributed to a partnership, the liabilities are treated as disguised sale consideration to the extent that the contributing partner is relieved of the liability.
Here’s an example of how the disguised sale rules can work under the final regulations, which apply to transactions for which all transfers occur on or after October 5, 2016.
Example 1: Partnership’s Assumption of Nonrecourse Liability Encumbering Transferred Property
Partners A and B form the AB Partnership (a 50/50 deal) to rent office space. Partner A transfers $500,000 in cash to the partnership. Partner B transfers an office building with a fair market value (FMV) of $1 million and an adjusted basis of $400,000.
The office is also encumbered by a $500,000 nonrecourse liability that the partnership assumes. Partner B incurred the liability 12 months earlier to finance the acquisition of other property. No facts rebut the presumption that the liability was incurred in anticipation of transferring the property to the partnership. The partnership agreement provides that all partnership items are allocated equally between Partners A and B.
The $500,000 nonrecourse liability isn’t a qualified liability. Under IRS regulations, Partner B must be allocated 50% of the liability ($250,000) for disguised sale purposes.
Therefore, the partnership’s assumption of the liability is treated as a transfer of $250,000 of disguised sale consideration to Partner B. That’s the amount by which the $500,000 liability exceeds Partner B’s $250,000 share of the liability under the disguised sale rules immediately after the partnership’s assumption of the liability.
In summary, Partner B is treated as having sold $250,000 of the FMV of the office building to the partnership in exchange for the partnership’s assumption of a $250,000 liability. Therefore, Partner B must recognize a disguised sale gain of $150,000. The gain is calculated by taking $250,000 of disguised sale proceeds and subtracting the basis of $100,000 for the part of the property that is deemed to be sold in the disguised sale ($250,000/$1,000,000 x $400,000).
Partner A is unaffected by the disguised sale rules.
Discouraging Contributions of Leveraged Assets to Partnerships and LLCs
For disguised sale purposes only, a new temporary IRS regulation forces partnerships to determine a partner’s percentage share of any liabilities assumed by a partnership when encumbered property is contributed to the partnership — whether the liability is recourse or nonrecourse and whether it’s guaranteed by the contributing partner — using the contributing partner’s percentage share of partnership profits. A partner’s percentage shares of partnership profits must be determined based on all facts and circumstances at the time of the property contribution.
Important note: The new rule can result in adverse tax consequences for taxpayers that contribute leveraged assets to partnerships, as illustrated by the following example.
Example 2: Partnership’s Assumption of Recourse Liability Encumbering Transferred Property
Partner C transfers Property Y to a partnership in which Partner C has a 50% interest in partnership profits. Property Y has a FMV of $10 million, and it’s subject to an $8 million liability that Partner C incurred and guaranteed immediately before transferring the property. Partner C used the $8 million of debt proceeds to finance other expenditures unrelated to the partnership.
Upon the transfer of the property, the partnership assumed the $8 million liability, which is a recourse debt. Under federal tax law, the entire $8 million liability is allocated to Partner C for purposes of determining his basis in his partnership interest (outside basis), because he guaranteed the debt.
Under the facts in this example, however, the $8 million liability is not a qualified liability for disguised sale purposes. Therefore, the partnership’s assumption of the liability results in a deemed transfer of consideration to Partner C in connection with his transfer of Property Y to the partnership. Even though Partner C is allocated the entire amount of the $8 million liability for outside basis purposes, he’s allocated only 50% of the liability ($4 million) for disguised sale purposes. This is pursuant to the rule stating that his share of the liability for disguised sale purposes equals his 50% interest in partnership profits.
In summary, Partner C is deemed to receive disguised sale proceeds of $4 million upon transferring Property Y to the partnership. That amount equals the excess of the $8 million liability assumed by the partnership over Partner C’s share of the liability for disguised sale purposes ($4 million). This is the outcome even though Partner C remains personally liable for the entire $8 million liability because he guaranteed it.
This example illustrates only one of many unfavorable changes included in the new temporary IRS regulation. Be especially cautious when contributing leveraged assets to partnerships for any transfers that occur on or after January 2, 2017. The tax results under the disguised sale rules can be surprisingly unfavorable.
Finding Additional Information
This is only a brief summary of the new temporary and final disguised sale regulations. Consult your tax professional for full details on how the new rules might affect your partnership (or LLC) and its partners (or members).