Suppose a 50% partner in a long-standing partnership owns a partnership interest having a tax basis of $150 and a value of $500, and it wants to take $100 off the table by selling a 10% partnership interest. If the partner sells such an interest, which represents 20% of its ownership interest, the partner would apply $30 of its basis against the $100 of sale proceeds, resulting in a gain of $70. However, the partner does not want to recognize gain, so it proposes that the buyer contribute the $100 to the partnership, which then is distributed by the partnership to the partner. If the contribution/distribution is respected, the “redeeming” partner would apply $100 of its $150 of basis against the distribution, and there would be no gain recognition. (Assume the buyer does not care about not receiving a §743(b) basis adjustment of $70, which it would receive in a cross-purchase transaction if a §754 election is in effect, and also ignore the §704(c) implications of a contribution/distribution transaction of this nature.)

Should the contribution/distribution transaction be respected or should it be treated as a disguised sale of a partnership interest? The current disguised sale rules of §707(a)(2) begin with the statement “[u]nder regulations prescribed by the Secretary…”. No such regulations currently exist, although Treasury did propose regulations in 2004, which were subsequently withdrawn in 2009. Some tax professionals are of the view that because of the lack of regulations, the IRS cannot challenge the contribution/distribution depiction of the above-described transaction. This email will not debate the merits of this view (which have been discussed at prior Tax Planning Forum programs), rather it will call to your attention a provision contained in both the House and Senate versions of the current proposed tax legislation. Both bills would change the statutory language from “[u]nder regulations prescribed” to “[e]xcept as provided.” This “clarification” (as so referenced in the Senate Finance Committee explanation) would apply to “property transferred after the date of enactment.” Given that this provision is contained in both versions of the proposed legislation, it likely will become law.

The above proposal would eliminate any argument that the IRS cannot recharacterize a contribution/distribution transaction as a disguised sale of a partnership interest based on the absence of regulations. Of course, at present, the IRS still does not have regulations to apply to the above-described transaction, and, until it does, the IRS would have to resort to common law principles, such as the “form over substance” doctrine. Assuming the proposed legislation is enacted, it will be a topic of discussion at our fall and winter Tax Planning Forum programs. Registration for these programs, as well as our Fundamentals of Flow-Through programs, is open. Don’t miss the opportunity to receive a discount for registration by July 31 or the opportunity to select the virtual (group internet based) or in-person (group live) program of your choice.