We want to pass on an interesting potential “foot fault” involving the disguised sale rules that was raised during our live Q&A sessions at one of our virtual Tax Planning Forum® programs. A taxpayer owned a building (a §1231 asset) in a single-member LLC, which building contained substantial unrealized gain. An investor contributed funds to the single-member LLC, making it a recognized entity (i.e., a partnership), almost immediately following which a portion of the contributed funds was distributed by the deemed newly created partnership to the property-contributing partner. Post-distribution, the property-contributing partner owned more than 50% of the partnership interests. Assuming there are no exceptions to the §707(a)(2)(B) disguised sale rules, pursuant to Reg §1.707-3(b)(1) this transaction is treated as a sale of property between the property-contributing partner and the partnership.

Some simple numbers illustrate the facts producing the foot fault (which will be described shortly). Assume the contributed property has a value of $2,000,000 and the investor contributes $800,000 of cash to the LLC, which cash then is distributed by the LLC to the property-contributor. The property-contributor will be considered to have retained $800,000 of property and contributed $1,200,000 of property to the LLC, resulting in a 60% LLC interest, with the investor obtaining a 40% LLC interest in exchange for the $800,000 capital contribution. The $800,000 of retained property then is considered to be sold to the LLC under the disguised sale rules.

That the above set of facts is considered a sale of property is no surprise, but what is the foot fault? Code §707(b)(2)(A) provides that gain from the sale of property other than a §1221 capital asset between a more than 50% partner (in capital or profits) and a partnership is recharacterized as ordinary income. This ordinary income result easily could have been avoided either by (1) the property-contributor selling an $800,000 interest in the building directly to the unrelated investor, followed by the parties contributing their respective property interests to a newly formed partnership/LLC or (2) selling a 40% LLC interest to the investor for $800,000 (i.e., a deemed purchase of a 40% interest in the building followed by a deemed creation of a partnership between the original property holder and the investor). Alternatively, the LLC owner could admit a second member (e.g., a spouse) into the single-member LLC for a nominal LLC interest followed by a sale of a 40% LLC interest to the investor (coupled with a §754 election). Going this route generally is preferred, as it would isolate the depreciation deductions associated with the 40% LLC interest purchased by the investor, and §704(c) would be taken off the table.

Foot faults always are a topic of conversation at our Forum and Fundamentals programs, which are in full swing. There is one remaining in-person Tax Planning Forum® program this year (but full capacity has almost been reached), as well as a several virtual Forum and Fundamentals programs.