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Final sec. 707 regulations.

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 distributions and reimbursements of preformation expenditures.(11)

* Guaranteed payments for capital

The proposed and final regulations provide that a guaranteed payment for capital that is characterized by the parties as such and that is reasonable will be presumed to be, in fact, a guaranteed payment for capital. On the other hand, a guaranteed payment for capital that is characterized by the parties as such, but is not reasonable, will be presumed not to be a guaranteed payment for capital. These presumptions can be rebutted by facts and circumstances that clearly establish the contrary. A guaranteed payment for capital is defined by Regs. Sec. 1.707-4(a)(l)(i) as a "payment to partner by a partnership that is determined without regard to partnership income and is for the use of that partner's capital." The proposed regulations provided that a reasonable payment was one that did not exceed the product of the recipient partner's unreturned capital at the beginning of the year (plus any unpaid guaranteed payment for capital payable to the partner for any prior year) and the safe harbor interest rate for that year. For this purpose, the safe harbor interest rate is 150% of the highest applicable Federal rate (AFR) in effect any time after the right to the guaranteed payment is established. Regs. Sec. 1.707-4(a)(3)(ii) modifies the determination of a reasonable payment by allowing the partner use in that calculation either the beginning of the year unreturned capital balance or a weighted average capital balance for the year. In addition, the final regulations clarify that the AFR is to take into account appropriate compounding if the payment is made more frequently than annually.

* Reasonable preferred returns

The final regulations retain the rule of the proposed regulations that a transfer of money that is reasonable (under the definition and with the modifications discussed above with respect to guaranteed payments for capital) is presumed not to be part of a disguised sale unless the facts and circumstances clearly establish to the contrary.(12)

* Operating cash flow distributions

The final regulations retain the rule of the proposed regulations that provides that transfers of money to a partner during a tax year that do not exceed the partner's interest in net operating cash flow are presumed not to be part of a disguised sale unless the facts and circumstances clearly establish otherwise.(13) A partner's interest in net operating cash flow is determined by multiplying the partnership's cash flow from operations for the year by the lesser of the partner's percentage interest in overall partnership profits for that year or the partner's percentage interest in overall partnership profits for the life of the partnership.(14) In addition, the final regulations retain the safe harbor from the proposed regulations that allows a partner, in any partnership tax year, to use the partner's smallest percentage interest in any material item of partnership income or gain that may be realized in the three-year period beginning with such tax year.(15)

In response to comments, the final regulations clarify the definition of taxable income or loss to be used as the starting point in determining net cash flow. The starting taxable income or loss figure is increased by tax-exempt interest and is decreased by capital expenditures other than from reserves or from borrowing the proceeds of which are not included on operating cash flow.(16) Operating cash flow is reduced by reserves that are established; however, there is no corresponding increased when such reserves are reduced.

There is also an unexplained difference in the treatment of reasonable guaranteed payments for capital, reasonable preferred returns and operating cash flow distributions. Guaranteed payments for capital and preferred returns are either reasonable or not. There is no provision for these payments to be considered reasonable up to the calculated amount with the excess being treated as not reasonable. In essence, this all-or-nothing approach, unless the facts and circumstances determine otherwise, could result in some surprisingly harsh results. On the other hand, an operating cash flow distribution up to the amount calculated under the guidelines of the final regulations will qualify for the presumption. Only the excess distributions will be tested under the general disguised sale rules. There does not seem to be any logical reason or any policy justification for this difference in results.

Regs. Sec. 1.704-4(c) also modifies the rule contained in the proposed regulations regarding guaranteed payments, preferred returns and operating cash flow distributions made after the end of the partnership's tax year. The proposed regulations required that such payments generally be made by the end of the tax year, but treated any such payments made during the first 75 days of the following tax year as being made on the last day of the preceding year. The final regulations now provide that if a guaranteed payment, preferred return or operating cash flow distribution qualifies for a favorable presumption, it will not lose that status if paid in a later year.

* Reimbursement of

preformation expenditures

Under the proposed regulations, a transfer of money or other property by a partnership to a partner would not be treated as part of a disguised sale if the transfer was made to reimburse the partner for certain capital expenditures incurred within one year before the contribution of property to the partnership. Regs. Sec. 1.707-4(d) extends the time period to within two years of the contribution of property to the partnership. The final regulations retain the rule contained in the proposed regulations that reimbursements of capital expenditures are excepted if they do not exceed 20% of the FMV of the contributed property. For a reimbursement that exceeds the 20% threshold, Regs. Sec. 1.707-4(d)(2)(ii) modifies the all-or-nothing rule of the proposed regulations and allows the exception up to the 20% threshold. In additions, Regs. Sec. 1.707-4(d)(2)(ii) provides an alternative rule that excepts the entire reimbursement, even the amount in excess of the 20% threshold, if the FMV of the contributed property does not exceed 120% of the contributing partner's basis in the property.

Asset Tracking Allocations

The final regulations retain, unchanged, the proposed regulations' asset tracking, or mixing bowl, example.(17) While numerous comments were submitted requesting more specific guidance concerning this type of transaction, the only guidance offered is in the preamble to the final regulations: "The example was written to illustrate the facts and circumstances test. The Service and the Treasury emphasize that the example relies on a confluence of factors and is not intended to provide bright-line guidance or to indicate whether the result might change if one or more of the enumerated factors were changed or eliminated." Many of the specific concerns surrounding this transaction have been rendered moot by the enactment of Sec. 737, discussed later.

Liability Rules

The final regulations continue to distinguish between qualified and nonqualified liabilities. The amount of consideration treated as being transferred to the "contributing" partner is a function of the type of liability transferred. Unfortunately, as with the final Sec. 752 regulations, the final disguised sale rules do not define liabilities.(18)

In general, if the partnership assumes or takes property subject to a "nonqualified" liability, the partnership is treated as transferring consideration to the partner, to the extent the amount of the liability exceeds the partner's share of that liability immediately after the partnership assumes or takes subject to the liability; see Example 1, below. In contrast, if a partnership assumes or takes property subject to a "qualified" liability of a partner, the partnership is treated as transferring consideration to the partner only to the extent the partner is otherwise treated as having sold a portion of the property. These general rules are essentially unchanged from the proposed regulations.

Example 1: A contributes $500,000 cash and B contributes an office building with an FMV of $1,000,000 and basis of $400,000, encumbered by a $500,000 nonqualified, nonrecourse liability, in the formation of partnership AB. The partnership agreement provides that all partnership items, including excess nonrecourse deductions, are allocated equally to A and B. The partnership's taking subject to the liability is treated as a transfer of $250,000 of consideration to B, i.e., the excess of the liability ($500,000) over B's share of the liability immediately after the transfer ($250,000). B is treated as having sold $250,000 of the building's FMV, which results in a gain of $150,000 ($250,000 - ($250,000/$1,000,000 X $400,000)).(19)

* Share of liability

Regs. Sec. 1.707-5(a)(2)(i) provides that in determining a partner's share of a recourse liability, the rules under the Sec. 752 regulations apply.(20) In a significant simplification from the proposed regulations, a partner's share of a nonrecourse liability is determined by using the third-tier allocation rule of Regs. Sec. 1.752-3(a)(3), i.e., the same percentage used to determine the partner's share of the excess nonrecourse liability. In addition, a special rule is provided in Regs. Sec. 1.707-5(a)(3) for plans under which a transferring partner's share of a liability is expected to be subsequently reduced and one of the principal purposes of the plan is to minimize the portion of the liability treated as part of a sale.

* Netting of liabilities - multiple

transferors

If, in pursuance of a plan, more than one partner transfers liabilities that are assumed (or taken subject to) by the partnership, each partner's share of the liabilities equals the sum of that partner's shares of the liabilities (other than the partner's qualified liabilities). Thus, in an expansion of the rule contained in the proposed regulation, non-qualified liabilities can be netted with qualified as well as nonqualified liabilities in a planned transer.

Example 2: Under a plan, G transfers asset 1 (FMV,$10,000; basis $6,000, encumbered by a $6,000 nonrecourse liability), and H transfers asset 2 (FMV, $10,000; basis $4,000, encumbered by a $7,000 recourse liability of H) to partnership GH in exchange for interests in GH. Both liabilities are nonqualified liabilities; G's and H's shares of the nonrecourse liability are $2,000 each and G's and H's shares of the recourse liability are $3,500 and $0, respectively.

The partnership's taking subject to the nonrecourse liability is treated as a transfer of consideration to G of only $500 ($6000 nonrecourse liability - $5,500 [$2,000, G's share of the nonrecourse liability + $3,500, G's share of the recourse liability]). The partnership's assumption of the recourse liability is considered as a transfer to H of $5,000 ($7,000 recourse liability - $2,000, H's share of both liabilities).(21)

* Qualified liabilities

A more favorable rule applies with respect to "qualified" liabilities assumed, or taken subject to, in connection with a transfer of property to a partnership. Regs. Sec. 1.707-5(a)(6) defines qualified liabilities to include (1) a liability incurred by the partner more than two years before the transfer (or more than two years before a written transfer agreement, if earlier) and that has encumbered the transferred property throughout that two-year period;(22) (2) a liability that was not incurred in anticipation of the property transfer but was with-in the two-year period described above and that has encumbered the transferred property since it was incurred; (3) a liability that is allocable, using the tracing rules of Temp. Regs. Sec. 1.163-8T, to capital expenditures with respect to the property; and (4) a liability incurred in the ordinary course of business if all assets material to continuation of the business are transferred.(23)

Regs. Sec. 1.707-5(a)(6)(ii) limits the amount of a recourse liability to the FMV of the transferred property adjusted for other specially defined senior liabilities.(24)

* Special tainting rule applicable

to qualified liabilities

The partnership's assumption of, or taking subject to, a qualified liability in connection with a transfer of property does not, in and of itself, cause disguised sale treatment. However, if a transfer of property is otherwise treated as part of a sale, all or a portion of the qualified liability must be included in the amount considered transferred.(25)

The consideration transferred is the lesser of: 1. The amount of consideration the partnership would be treated as transferring to the partner if the liability were not a qualified liability, or 2. the product of the qualified liability multiplied by the partner's net equity percentage with respect to the property.

A partner's net equity percentage is a fraction the numerator of which is the aggregate transfers of money or other consideration to the partner by the partnership (without regard to this special rule) that are treated as proceeds realized from the sale of the property. The denominator is the excess of the property's FMV over any qualified liability encumbering or property allocable to the property.(26)

Example 3: F transfers property Z (FMV, $165,000; basis, $75,000, subject to a qualified recourse liability of $75,000) to a partnership. F's share of the liability is $25,000. F receives $30,000 in money from the partnership in connection with the transfer. Without the transfer of cash to F, the partnership's assumption of the qualified liability would not be treated as part of sale. However, since the partnership transferred $30,000 to F, its assumption of the qualified liability is treated as a transfer of additional considerations to F. The additional consideration is the lesser of: 1. $50,000 (the excess of the $75,000 - F's $25,000 share), or 2. $25,000 ($75,000 X ($30,000/$90,000)). (The numerator is the amount of other consideration received, $30,000 cash; the denominator is the FMV of the property less the qualified liability ($165,000 - $75,000).)

Accordingly, F is treated as having sold $55,000 of the FMV of the property in exchange for $30,000 of cash and the partnership's assumption of $25,000 of the qualified liability. Therefore, F recognizes $30,000 gain ($55,000 amount realized - $25,000 basis [$55,000/$165,000 X $75,000]).(27)

* Debt-financed transfers

If a partner receives a "debt-financed transfer," the transfer of money or other consideration to the partner is taken into account only to the extent that the money or FMV of the other consideration transferred exceeds that partner's share of the partnership liability. A debt-financed transfer occurs when a partner transfers property to a partnership and the partnership incurs a liability of which all or a portion of the proceeds is allocable under Temp. Regs. Sec. 1.163-8T to a transfer of money or other consideration to the partner made within 90 days of the partnership's incurring the liability.(28)

The partner's allocable share of the partnership liability is the product of the partner's share of the liability multiplied by a fraction, the numerator of which is the portion of the liability allocable to the money or other property transferred and the denominator of which is the total amount of the liability.(29)

Example 4:K transfers property Z to partnership KL on Apr. 9, 1993. On Sept. 13, 1993, KL incurs a recourse liability of $20,000. On Nov. 17, 1993, KL transfers $20,000 to K, and $10,000 is allocable to the $20,000 partnership liability. K's share of the recourse liability is $10,000 on Nov. 17, 1993. Since K received a debt-financed transfer, K is required to treat only $15,000 of the $20,000 transferred to K as consideration; K's allocable share of the liability used to fund $10,000 of the transfer is $5,000 [$10,000, K's share of the liability, multiplied by a fraction, the numerator of which is the amount of the liability allocable to the distribution to K, $10,000; the denominator is the total liability, $20,000].(30)

* Refinancings

The proposed regulations provided that certain partnership debt incurred to refinance other partnership debt would be treated as that other debt. Regs. Sec. 1.707-5(c) expands this refinancing rule to include both a refinancing by a partner before the transfer of property to a partnership and to a refinancing of partnership debt.

* Tiered partnerships

Regs. Sec. 1.707-5(e) provides that a liability in a lower-tier partnership retains the characterization as qualified or nonqualified that it had in the upper-tier partnership before the lower tier succeeded to such liability.

Outbound Transfers

The rules in Regs. Sec. 1.707-6, similar to those provided in Regs. Secs 1.707-3 and 1.707-5 apply in determining whether transfers of property by a partnership to a partner and one or more transfers of money or other consideration by that partner to the partnership are treated as a sale of property to that partner.

For purposes of the outbound transfer rules, the definition of qualified liability contained in Regs. Sec. 1.707-5(a)(6) is applied with the following exceptions. A qualified liability is one that is originally an obligation of the partnership and is assumed, or taken subject to, by the partner in connection with the transfer of property to the partner. In addition, if the liability was incurred more than two years before the earlier of the transfer or a written agreement to make the transfer, there is no two-year encumbrance period for the liability to be considered qualified.(31)

Disclosure

The final regulations require disclosure in two situations: (1) when certain transfers (not treated as a sale) to a partner are made within two years of a transfer of property by the partner to the partnership(32) and (2) when debt is incurred within two years of the earlier of a written agreement to transfer or of a transfer of the property that services the debt, if the debt is treated as a qualified liability.(33) Disclosure is also required in analogous disguised sale by partnership to partner situations governed by Regs. Sec. 1.707.-6.

Regs. Sec. 1.707-8 provides that disclosure is made on a completed Form 8275, Disclosure Statement, or on a statement that includes specified information and is attached to the return of the property's transferor for the tax year of the transfer. If more than one partner transfer property to a partnership under a plan, Regs. Sec. 1.707-8(c) permits disclosure by the partnership rather than by each transferor separately.

The regulations do not address the issue of penalties for failure to make the disclosure nor do they address whether a partner's position that is ultimately upheld could be subjected to penalty for failure to disclosure. It would seem that if a decision to disclose is made, care should be used to ensure that the disclosure is sufficient not only to satisfy the disguised sale rules but also to satisfy Sec. 6662 requirements.

Effective Dates

Regs. Sec. 1.707-9(a)(1) provides that the disguised sale rules apply to transactions in which all transfers that are considered part of a sale occur after Apr. 24, 1991. If at least one of the transfers occurs before Nov. 30, 1992, a partnership may apply the proposed regulations to post-Apr. 24, 1991 transfers.(34) Transfers not governed by the proposed or final regulations are governed by the statute and legislative history.

Sec. 737

Sec. 737(a) requires a partner who contributes appreciated property to a partnership and within five years receives a distribution of property from the partnership to recognize gain to the extent the FMV of the distributed property (other than money) exceeds the partner's adjusted basis in his partnership interest. The amount of gain recognized is limited to the net precontribution gain the contributing partner would recognize under Sec. 704(c)(1)(B) if all property that has been contributed by that partner to the partnership within five years of the distribution triggering Sec. 737 was distributed by the partnership to other partners. Sec. 704(c)(1)(B) provides that if property is contributed to a partnership and subsequently distributed (directly or indirectly) within five years to another partner, gain or loss will be recognized by the contributing partner in an amount equal to the gain that would have been recognized under Sec. 704(c)(1)(A) had the property been sold on the date of distribution.

Example 5: X and Y form a partnership. X contributes appreciated property A with a basis of $50 and FMV of $100. Y contributes property B with a basis and FMV of $100. Three years later, B is distributed to X. Under Sec. 737, X includes in income an amount equal to the lesser of: 1. The FMV of B when distributed less X's basis in his partnership interest, or 2. X's net precontribution gain. Immediately before the distribution, A is worth $100 and B is worth $90. X would recognize $40 of income ($90 - $50 is less than $100 - $50). On the other hand, if B was worth $125 when distributed, X would recognize $50 of income ($100 - $50 is less than $125 - $50).

Sec. 737(c) provides that any gain recognized by the contributing partner is to be reflected in basis increases in the contributing partner's partnership interest and in the partnership's basis in the contributed property. In Example 5, X's basis in his partnership interest would be increased by $40, or $50 as appropriate, and a like increase would result in the partnership's basis in property A. The increase in A's basis is the mechanism to prevent X from recognizing the same precontribution gain a second time. For example, if X recognized $40 of income, X's precontribution gain for purposes of applying Sec. 737 to a subsequent distribution would be $10 ($100 - ($50 + $40)). Without this adjustment, X could recognize the same precontribution gain more than once, a result clearly out of line with the purposes of Sec. 737.

In determining the character of gain recognized under Sec. 737, Sec. 737(a) provides that it will be the same, and in the same proportion, as the character of the net precontribution gain. Sec. 737(a) also provides that any gain recognized under Sec. 737 will be in addition to any gain recognized under Sec. 731.

The legislative history indicates that Sec. 737 will not apply on a deemed distribution under Sec. 708(b)(1)(B) but will apply to any distribution within five years of the deemed recontribution. In this case, gain under Sec. 737 will be based on the appreciation in the assets when recontributed. In Example 5, if Y were to sell his partnership interest to Z, under Sec. 708(b)(1)(B) the partnership would be treated as distributing all the assets to X and Z followed by a recontribution of the assets to the partnership. Any property distribution, not otherwise excepted, within the next five years to X or Z could cause gain recognition under Sec. 737. Sec. 737(d)(1) provides an exception for any portion of property distributed that consists of property that had been contributed by the distributee partner to the partnership. In such cases, this property is not considered in determining gain under Sec. 737 or in determining the amount of net precontribution gain. However, the exception does not apply to the extent that the property distributed consists of an interest in an entity and the value of such interest is attributable to property contributed to such entity after such interest had been contributed to the partnership. This latter provision is designed to prevent the use of an entity to avoid the application of Sec. 737.

Another potential problem with Sec. 737 arises when a partnership incorporates under Sec. 351 within five years of being formed. Assume in Example 5 that X and Y decide to incorporate by contributing all of the partnership's assets to corporation XY in exchange for all XY's stock. The partnership terminates by distributing all of the stock to X and Y. This distribution literally triggers the application of Sec. 737 and X could recognize income.

Sec. 737 applies to distributions made by a partnership on or after June 25, 1992. This effective date could cause problems for partnerships formed several years ago. If, in Example 5, X and Y formed the partnership in 1991 and planned to wait more than two years before making the property distribution to X to avoid disguised sale treatment under Sec. 707(a)(2)(B), Sec. 737 will apply if the distribution is made within five years of formation and after June 25, 1992. Would Sec. 737 apply to cause gain recognition if the partnership was formed in 1988? Since the gain under Sec. 737 is limited to the Sec. 704(c)(1)(B) amount, would this amount be zero because Sec. 704(c)(1)(B) generally applies to contributions made to the partnership after Oct. 3, 1989, even if property B was distributed after June 25, 1992? The legislative history is not clear on this point. This situation seems to warrant some transitional relief from the application of Sec. 737, but neither Sec. 737 nor the Energy Policy Act provides such relief

Conclusion

Overall, the final regulations are an improvement on the proposed regulations; yet several areas could still be enhanced: the harsh "all-or-nothing" approach applied to guaranteed payments for capital and preferred returns; the tainting of qualified liabilities; and more specific guidance pertaining to the facts and circumstances test and its application. Only time will tell whether the guidance provided by these regulations will simplify and clarify the classification of disguised sale transactions or whether the courts will be required to interpret and assess the relative importance of the facts and circumstances surrounding these transactions. The enactment of Sec. 737 to solve a relatively straightforward problem has left more questions unanswered than it appears to answer. Unless further clarification and guidance are forthcoming, this provision will be no more than a complex trap for many taxpayers.

(1) TD 8439 (9/25/92). (2) See Mason and Choate, "Sec. 707 Disguised Sale Regulations," 22 The Tax Adviser 551 (Sept. 1991); Choate and Mason," Sec. 707 Disguised Sale Regulations Continued," 22 The Tax Adviser 627 (Oct. 1991). (3) PL 102-486 (10/24/92). (4) Regs. Secs. 1.721-1(a) and 1.731-1(c)(3). (5) H. Rep. No. 432 (Pt. 2), 98th Cong., 2d Sess. 1218 (1984); S. Prt. No. 169 (Vol. I), 98th Cong., 2d Sess. 224-225 (1984). See also John H. Otey, Jr., 70 TC 312 (1978), aff'd per curiam, 634 F2d 1046 (6th Cir. 11980)(47 AFTR2d 81-301, 80-2 USTC [paragraph 9817); Communications Satellite Corp., 625 F2d 997 (Ct. Cl. 1980)(45 AFTR2d 80-1189, 80-1 USTC [paragraph 9338); The Jupiter Corp., & Subsidiary Cos. 2 Cl. Ct. 58 (1983)(51 AFTR2d 83-823, 83-1 USTC [paragraph 9168). (6) Regs. Sec. 1.707-3(a)(2). (7) Regs. Sec. 1.707-3(b)(2). (8) Regs. Sec. 1.707-3(c)(1). (9) Regs. Sec. 1.707-3(d). (10) Regs. Sec. 1.707-3(a)(2). (11) Regs. Sec. 1.707-4. (12) Regs. Sec. 1.707-4(a)(2). (13) Regs. Sec. 1.707-4(b)(1). (14) Regs. Sec. 1.707-4(b)(2)(i). (15) Regs. Sec. 1.707-4(b)(2)(ii). (16) Regs. Sec. 1.7007-4(b)(2)(i). (17) Regs. Sec. 1.707-3(f), Example 8. (18) For a discussion regarding the lack of this definition, see Mason and Dennis "Allocation of Partnership Liabilities," 23 The Tax Adviser 495 (Aug. 1992). (19) Adapted from Regs. Sec. 1.707-5(f), Example 1. (20) See Mason and Dennis, note 18. (21) Adapted from regs. Sec. 1.707-5(f), Example 7. (22) Prop. Regs. Sec. 1.707-5(a)(6)(i)(A) required the encumbrance to exist throughout the entire period before the transfer, not just the two-year period. (23) Prop. Regs. Sec. 1.707-5(a)(6)(i)(D) required that substantially all the assets of the trade or business be transferred. (24) The proposed regulations did not specifically limit this FMV rule to recourse liabilities. (25) This "tainting" rule was widely criticized by commentators but was left in the final regulations without discussion. (26) Regs. Sec. 1.707-5(a)(5). (27) Adapted from Regs. Sec. 1.707-5(f), Examples 5 and 6. (28) Regs. Sec. 1.707-5(b)(1). (29) Regs. Sec. 1.707-5(b)(2). (30) Adapted from Regs. Sec. 1.707-5(f), Example 10. (31) Regs. Sec. 1.707-6(b)(2)(iii). (32) Regs. Sec. 1.707-3(c)(2). (33) Regs. Sec. 1.707-5(a)(ii). (34) Notice 92-46, IRB 1992-42, 29.
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Title Annotation:disguised sales by partners
Author:Choate, Gary M.
Publication:The Tax Adviser
Date:May 1, 1993
Words:5936
Previous Article:Settling deficiencies proposed by the IRS.
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Partnership property transactions: exploring the limits of Secs. 704(c) and 707(a)(2).
Structuring guaranteed payments to avoid disguised sale treatment.
Sec. 197 antichurning implications for partnerships.
IRS requests comments on disguised-sale prop. regs.
Foreign and tax-exempt partners' tax years.
CCAs address partnership transactions.
Current developments.
Current developments.

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