Printer Friendly

Disguised sale final regulations.

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.


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 regulations now take into account any compounding on unpaid preferred returns or guaranteed payments that may be called for in the partnership agreement.

The calculation of operating cash flow has been refined in response to comments on tax-exempt interest and capital expenditures. The rule in the proposed regulations requiring that guaranteed payments, preferred returns and operating cash flow distributions be made within 75 days of year-end has been deleted; this allows for tests to be done on a cumulative basis. The preformation expenditures rule was expanded to include expenditures made up to two years before the contribution. Finally, the final regulations add a fifth exception, allowing the IRS to exclude other payments or transfers via guidance published in the internal Revenue Bulletin.

Treatment of liabilities

Under Prop. Regs. Sec. 1.707-5, the assumption of liabilities by a partnership is treated as proceeds in a disguised sale, to the extent that the amount of the liability exceeds the partner's share of the liability immediately after the transaction. An exception is provided for "qualified liabilities." The assumption of qualified liabilities does not, by itself, trigger sale treatment, but could be considered in the computation if the transaction was otherwise characterized as a sale.

Nonrecourse liabilities: The complex "smallest percentage" rule for determining a partner's share of nonrecourse liabilities, contained in Prop. Regs. Sec. 1.707-5(a)(2)(iii), has been dropped. The final regulations adopt the "third tier" allocation percentage from the nonrecourse liability allocation rules of Regs. Sec. 1.752-3(a)(3). This allocation is generally based on the partners' profit-sharing percentages. Two optional rules, however, allow the partnership to elect a percentage that is consistent with some other significant item of income, or in accordance allocation of nonrecourse deductions. These elections provide flexibility to partners in computing disguised sale proceeds. The first two tiers of nonrecourse debt allocation (minimum gain and Sec. 704(c) minimum gain) are ignored for this purpose.

Qualified liabilities: Liabilities incurred in the ordinary course of business are included in the definition of qualified liabilities. Prop. Regs. Sec. 1.707-5(a)(6)(D) would have required that "substantially all" the assets of that business be contributed to the partnership. The final regulations only require that the assets "material to the continuation of the trade or business" be contributed. This allows retention of nonessential assets (e.g., accounts receivable) by the transferor partner; see Regs. Sec. 1.707-5(f), Example 4.


Despite many comments, the final regulations retain the rule that a disguised sale occurs on the day the partnership becomes the owner of the property. This can cause many mechanical problems when the transfers are not simultaneous. In some cases, amended returns will be necessary.


In certain situations, if the transferor of property treats the transaction as other than a sale for tax purposes, Regs. Sec. 1.707-8 requires disclosure of this fact in the transferor's tax return. Situations requiring disclosure are:

* Transfers within two years of each other (except as noted for reasonable guaranteed payments, preferred returns, operating cash flow distributions and preformation expenditures).

* When an assumed liability was incurred within the two-year period prior to the transfer and the taxpayer is taking the position that the liability was not incurred in anticipation of the transfer.

The disclosure requirement applies only to transactions in which all transfers that are part of a sale of property occur after Sept. 30, 1992. The disclbsure requirement for nonrecourse debt, contained in the proposed regulations, has been dropped.

Effective dates

Generally, the final regulations are effective for transactions in which all transfers that are part of the sale occur after Apr. 24, 1991. However, under Notice 92-46, a partnership and its partners may elect to apply the proposed regulations instead of the final regulations to any transaction with respect to which all transfers considered part of a sale occur after Apr. 24, 1991, if at least one of the transfers considered part of the sale occurs before Nov. 30, 1992.
COPYRIGHT 1993 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Author:O'Neil, Paul A.
Publication:The Tax Adviser
Date:Nov 1, 1993
Previous Article:E&P issues/adjustments arising in connection with bankruptcy.
Next Article:Duty on royalty payments.

Related Articles
IRS issues disguised sale guidance.
Property industry hit by new Treasury regs.
Partnership property transactions: exploring the limits of Secs. 704(c) and 707(a)(2).
Final sec. 707 regulations.
Structuring guaranteed payments to avoid disguised sale treatment.
Final rules on distributions of partnership property.
Trading Up: Consumer and Environmental Regulation in a Global Economy.
Partnership mergers and divisions.
IRS requests comments on disguised-sale prop. regs.
CCAs address partnership transactions.

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters