Final sec. 707 regulations.

• Author: Mason, Donald J.
• Position: Disguised sales by partners

The IRS issued the final regulations(1) under Sec. 707 covering disguised sales of property between partners and partnerships on Sept. 25, 1992. The final regulations made some improvements, but overall did not make comprehensive changes to the rules as originally proposed. In previous articles, the authors have covered the details of the proposed regulations and the underlying backgound.(2) This article will analyze the final regulations and new Sec. 737, which was added as part of the Energy Policy Act of 1992.(3) The latter provision, while aimed at certain property distributions not covered under the disguised sale rules, leaves many questions unanswered and adds complexity to an area of the tax law rampant with uncertainty.

Disquised Sales - General Rules

* Statutory overview

The Deficit Reduction Act of 1984 added Sec. 707(a)(2), which grants the IRS broad regulatory authority to identify transactions that, although structured as contributions and distributions, are more properly treated as occurring between a partnership and a partner acting in a capacity other than as a member of the partnership. These provisions were in response to congressional concern that existing regulation(4) were being interpreted by the courts to allow tax-free treatment by looking at the form of transactions that, in substance, were arguably sales of property by a partner to the partnership.(5)

Sec. 707(a)(2)(B) provides that a transaction will be subject to the disguised sale rules when (1) a partner transfers, directly or indirectly, money or other property to a partnership; (2) there is a direct or indirect transfer of money or other property by the partnership to such partner; and (3) when viewed together the transfers are properly characterized as a sale or exchange of property. Sec. 707 (a)(2)(A) provides, in relevant part, that of (1) a partner transfers property to a partnership, (2) there is a related direct or indirect allocation and distribution to such partner, and (3) when (1) and (2) are viewed together,they are property characterized as occurring between a partnership and a partner acting in other than his capacity as a partner, the transfers will be treated as a sale or exchange of property. The final regulations apply to contributions and distributions described in Sec. 707(a)(2)(A) and transfers described in Sec. 707(a)(2)(B).

* Tax consequences

The proposed and final regulations have adopted an "equity withdrawal" approach in analyzing transactions as disguised sales. Under this approach, a contribution of property followed by a distribution from the partnership will not be treated as a disguised sale if the contributing partner is merely converting equity in the contributed property into an interest in partnership capital that is subject to the entrepreneurial risks of partnership operations. However, a disguised sale will be found to exist if the contributing partner is withdrawing equity in the contributed property. When a contribution and related distribution are treated as a disguised sale, the contribution and distribution will be treated as a sale or exchange between the partnership and a person acting in a capacity other than as a member of the partnership for all purpose of the Code.(6) Further, if the consideration transferred to a partner in a disguised sale is less than the fair market value (FMV) of the property transferred to the partnership, the transaction will be treated as a part sale/part contribution.

* Facts and circumstances test

The final regulations retain the facts and circumstances approach of the proposed regulations,(7) and the list of factors that may tend to prove the existence of a disguised sale. Although comments requested prioritizing the list of factors and including factors that would disprove a disguised sale, none of these suggestions were incorporated into the final regulations.

* Timing presumption

The final regulations follow the two-year presumption of the proposed regulations. Under this presumption, transfers between a partner and a partnership made within two years of each other are presumed to be a sale unless one of the exceptions pertaining to guaranteed payments for capital, reasonable preferred returns or operating cash flow distributions applies.(8) On the other hand, transfers that are more than two years apart are presumed not to be sale of the property.(9) Each of these presumptions may be rebutted only by facts and circumstances that clearly establish the contrary. The preamble to the final regulations indicates that "[t]he presumptions are intended to establish which party has the burden of going forward in litigation. In addition, the regulations require that the party against whom the presumption runs must clearly establish that the transaction is or is not a disguised sale as the case may be."

* Nonsimultaneous transfers

When a disguised sale involves nonsimultaneous transfers and the distribution occurs after the contribution, the proposed regulations treat the sale as taking place on the date the partnership is considered to be the owner of the property under general tax law principles. In this case, the partner will be treated as if he received an obligation of the partnership on the date of the sale. Various comments suggested that the final regulations should provide that, absent a contractual or legal obligation to make the subsequent transfer, the disguised sale should be deemed to occur at the time of the subsequent transfer. As stated in the preamble to the final regulations, alternatives considered were to treat the subsequent transfer as (1) a partial redemption of the partner's interest in the partnership on the later date; (2) a deemed distribution of property on the later date; or (3) a sale of some or all of the partnership interest to the other partners on the later date. The IRS believed that any of these alternatives would require complex rules and would be too intricate from an operational perspective. After consideration, the IRS determined that the approach of the proposed regulations was more consistent with disguised sale principles and the legislative directive to prevent taxpayers from deferring or avoiding tax on the sale of property. As such, the final regulations retain the rule from the proposed regulations.(10)

* Multiple property transfers

When multiple properties are transferred to a partnership, the proposed regulations prevented a partner from selectively selling high-basis property and contributing low-basis property the partnership. This result was accomplished by requiring the partner to allocate the amount realized from the disguised sale among all the properties contributed as part of a planned transaction, based on the relative FMV of each property. In response to comments, this rule requiring allocation has been deleted in the final regulations. As a result, there are no special rules in the final regulations for the allocation of amounts realized in multiple property transfers.

Certain Distributions Not Considered

Part of Disguised Sale

The proposed regulations set out certain safe harbor rules that protect the following distributions from disguised sale treatment: guaranteed payments for capital; reasonable preferred returns; operating cash flow distributions; and reimbursements of preformation expenditures. The final regulations adopt, with certain modifications, the safe harbor rules applicable to guaranteed payments and preferred returns. In addition, the final regulations liberalize the safe harbor rules applicable to operating cash flow...