Disguised sale final regulations.

• Author: Carman, William T.

Final regulations on the "disguised sale" provisions of Sec. 707(a)(2)(B) generally provide that a partner's contribution of property to a partnership and certain related partnership distributions may be recharacterized as a sale of the property. The final regulations replace proposed regulations that were issued Apr. 24, 1991, and change the treatment of some items. In general, the regulations are retroactively effective from Apr. 24, 1991. The final regulations also impose a tax return disclosure requirement for certain transfers occurring after Sept. 30, 1992. Failure to disclose in these, circumstances could result in negligence penalties.

Background

The contribution of property or money to a partnership is generally nontaxable under Sec. 721. Distributions of property or money are also generally nontaxable, except as provided in Sec. 731(a)(1). Sec. 707(a)(2)(B) is a substance over form" provision that provides that if a related contribution and distribution are properly characterized as a sale or exchange of property, the substance controls and the transaction is to be recharacterized as a sale for tax purposes. These rules could also result in a disguised sale of a partnership interest.

Multiple-asset transfer rule

Prop. Regs. Sec. 1.707-3 would have required a pro rata allocation of proceeds of a disguised sale among all assets transferred to a partnership. Commentators argued this rule was contrary to case law, which generally allows a partner to choose the form of a transaction by selling certain assets and contributing others to a partnership. The final regulations do not include this allocation requirement.

Exceptions to two-year presumption

Under the regulations, any distribution to a partner within two years of a contribution by that partner is presumed to be part of the sale of the property unless the facts and circumstances clearly provide otherwise. Prop. Regs. Sec. 1.707-4 provided four exceptions to this rule:

* Reasonable guaranteed payments.

* Reasonable preferred returns.

* Operating cash-flow distributions.

* Reimbursements of preformation expenditures.

The final regulations modify the determination of reasonable guaranteed payments and preferred returns. The general rule is to multiply the partner's unreturned capital at the beginning of the year by a specified percentage. The final regulations allow a partner to compute this amount based on a "weighted average capital balance" for the year. Further, the final...