disguised sales and other mixing bowl provisions howard e. abrams warren distinguished professor,...

Disguised Sales and Other Mixing Bowl Provisions

Howard E. AbramsWarren Distinguished Professor, USD School of Law

November 2015www.taxnerds.com

Copyright 2015 by Howard E. Abrams

Disguised Sales

Partnerships are both easy to get into and easy to get out of.

Disguised Sales


Under section 721, the contribution of property to a partnership in exchange for a partnership interest generally is tax-free.

Disguised Sales



Under section 731, the distribution of property generally is tax-free whether as a liquidating or a nonliquidating distribution.

Disguised Sales



Under section 731, the distribution of property generally is tax-free whether as a liquidating or a nonliquidating distribution.

Putting these two provisions together, a taxpayer effectively is able to exchange one asset for another through a partnership without the recognition of gain or loss.

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Disguised Sale of Property Definition – Section 707(a)(2)(B)

There must be a contribution of cash or property.

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There must be a contribution of cash or property. There must be a distribution of cash or property to

the contributing partner. Either can come first.

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There must be a contribution of cash or property. There must be a distribution of cash or property to

the contributing partner. Either can come first. The contribution and distribution, when considered

together, properly are characterized as single sale or exchange transaction.

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“Properly Characterized” – Treas. Reg. § 1.707-3(b)

Would the distribution not have been made but for the contribution?

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If the contribution and distribution are not simultaneous, was the subsequent transaction dependent on the entrepreneurial risks of the partnership venture?

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Were the contribution and distribution separated by two years or less? If so, strong presumption of a disguised sale. If not, strong presumption not a disguised sale.

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Were the contribution and distribution separated by two years or less? If so, strong presumption of a disguised sale. If not, strong presumption not a disguised sale.

Presumption can be rebutted based on the facts and circumstances (generally, those facts and circumstances existing at the time of the earliest transfer)

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“Properly Characterized” – Cont’d The regulations specify several facts that tend to establish the existence

of a disguised sale, including: The timing and amount of the subsequent transfer are reasonably

certain The transferor has a legally enforceable right to the subsequent

transfer The transferor’s right to receive the subsequent transfer is secured Any other partner has or is legally obligated to make contributions

or loans to permit the partnership to make the subsequent transfer The partnership has incurred or is obligated to incur debt to permit

the partnership to make the subsequent transfer The partnership holds money or other liquid assets, beyond the

reasonable needs of the business

Effect of Disguised Sale Treatment The transaction will be treated as a sale for all

purposes of the internal revenue code including: Installment sale provisions OID (time value of money rules) Like-kind exchange rules Depreciation Recapture rules.

Gain and loss can be recognized on a disguised sale. The contribution and distribution that are treated as

a sale are not treated as a contribution or as a distribution.

Amount of the Disguised Sale Often, the amount of the contributed cash or

property and the amount of the associated distributed property are not the same. When this occurs, the disguised sale is the smaller amount.

Example: Property with a value of $100,000 and an adjusted basis of $30,000 is contributed to a partnership, and soon thereafter the contributing partner receives a cash distribution of $40,000. If this is a disguised sale, the disguised sale equals 40% of the property (with adjusted basis of $12,000) in exchange for cash of $40,000. The remaining $60,000 of the property is treated as being contributed.

The Economics of a Disguised Sale Example: X contributes $5,000 cash to the XY

partnership and Y contributes property with fair market value of $10,000 and adjusted basis of $6,000. After the partnership is formed, $4,000 of the cash is distributed to Y. If there is no disguised sale, the books become:

X Y

CA OB CA OB

5,000 5,000 10,000 6,000 Contributions

0 0 -4,000 -4,000 Distribution

5,000 5,000 6,000 2,000 Totals

The Economics of a Disguised Sale If there is a disguised sale, then Y is taxed on the

$4,000 received less 40% of Y’s $6,000 basis, or $4,000 - $2,400, for a gain of $1,600. The contribution consists of the remaining property worth $6,000 and having a basis of $3,600.

X Y

CA OB CA OB

5,000 5,000 6,000 3,600 Contributions

5,000 5,000 6,000 2,000 From Prior Chart

Contribution of Encumbered Property If encumbered property is contributed to a

partnership and the debt is treated as shifting as a result of the contribution, the transaction will be treated as a simultaneous contribution and distribution. This will constitute a disguised sale to the extent of the debt shift unless the debt is a “qualified liability.”

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Qualified Liabilities

“Qualified Liabilities” include: Old and cold debt (more than two years old);

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“Qualified Liabilities” include: Old and cold debt (more than two years old); Debt not incurred in anticipation of contribution;

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“Qualified Liabilities” include: Old and cold debt (more than two years old); Debt not incurred in anticipation of contribution; Debt allocable to capital improvements made to the

property under Treas. Reg. § 1.163-8T; and

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“Qualified Liabilities” include: Old and cold debt (more than two years old); Debt not incurred in anticipation of contribution; Debt allocable to capital improvements made to the

property under Treas. Reg. § 1.163-8T; and Debt incurred in the ordinary course of a trade or

business if substantially all the assets used in the trade or business are contributed to the partnership.

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How Is Debt Allocated for Purposes of the Disguised Sale Rules?

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Recourse liabilities – generally based on the portion of the debt for which the partner bears the economic risk of loss

Same as for Section 752 generally Anti-abuse rule may apply

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Recourse liabilities – generally based on the portion of the debt for which the partner bears the economic risk of loss

Same as for Section 752 generally Anti-abuse rule may apply

Nonrecourse liabilities – generally based on the partners’ shares of partnership profits

No tier 1 (minimum gain) and no tier 2 (minimum 704(c) gain) No tier 3A (excess 704(c) gain) Only use general profits interests or shares of allocation of some

significant item from the security (such as income or depeciation)

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Contribution of Encumbered Property: Example P Contributes Cash of $240,000 Q Contributes Property

Value = $160,000 Adjusted Basis = $100,000 Debt = $80,000 (nonrecourse; nonqualified)

P and Q agree to divide all profits and losses 75% to P and 25% to Q, and assume the debt is allocated in the same proportions.

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Contribution of Encumbered Property: Example Three-Quarters ($60,000) of Debt Is Shifted to P

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Contribution of Encumbered Property: Example Three-Quarters ($60,000) of Debt Is Shifted to P Disguised Sale Fraction = 60,000/160,000 (3/8)

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Contribution of Encumbered Property: Example Three-Quarters ($60,000) of Debt Is Shifted to P Disguised Sale Fraction = 60,000/160,000 (3/8) Basis Allocated to Sale = Three-Eighths of $100,000,

or $37,500

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or $37,500 Gain = $60,000 - $37,500, or $22,500

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or $37,500 Gain = $60,000 - $37,500, or $22,500 Gain Affects Inside Basis and Outside Basis

Contribution of Encumbered Property: Example SummaryTotal Sale Portion Contribution

Debt 80,000 60,000 20,000

Value 160,000 60,000 100,000

Basis 100,000 37,500 62,500

Equity 80,000 80,000

P Q

Capital Acc’t Outside Basis Capital Acc’t Outside Basis

240,000 240,000 80,000 62,500

0 60,000 0 0

240,000 300,000 80,000 62,500

Taint of a Qualified Liability

If property encumbered by a qualified liability is transferred to a partnership and the transfer is treated in part as a disguised sale because other consideration is received by the transferor, a portion of the qualified liability will be treated as consideration for the disguised sale.

Tainted Portion

The portion of the qualified liability that is tainted is the lesser of:

The portion of the liability that would be treated as consideration of the liability were not qualified; and

The total amount of the qualified liability times the transferor partner’s “net equity percentage” in the contributed property.

Net equity percentage equals the total amount treated as received in exchange for the property (ignoring the qualified liability) divided by contributor’s equity in the property.

Tainted Qualified Liability Example X contributes property with:

Value = $160,000 Adjusted basis = $40,000 Qualified Liability = $60,000 Liability Shift = $30,000 (i.e., 1/2) Cash = $20,000

But for the cash, there would be no disguised sale. If the liability were not qualified, total consideration

would equal $20,000 + $30,000.

Tainted Qualified Liability Example Tainted portion equals the lesser of:

$30,000 (the shifted portion of the liability); and Net Equity Percentage equals $20,000 (amount of cash)

divided by $100,000 (equity in the contributed property), or 20%. Since the liability equals $60,000, the net equity percentage portion equals 20% of $60,000, or $12,000.

Total consideration equals $20,000 + $12,000, or $32,000, or 1/5 of the $160,000 value of the property.

Gain equals $32,000 - $8,000, or $24,000.

Offsetting Liabilities?

Suppose a contributing partner picks up a share of an existing partnership liability. Can the partner reduce the disguised sale by the amount of partnership liabilities assumed on the contribution? That is, do we use the amount of the debt shift or the net amount of debt reduction?

Offsetting Liabilities?

Suppose a contributing partner picks up a share of an existing partnership liability. Can the partner reduce the disguised sale by the amount of partnership liabilities assumed on the contribution? That is, do we use the amount of the debt shift or the net amount of debt reduction?

No offset for debt assumed on the contribution: debt shifted away is not reduced for new share of pre-existing liabilities.

Nonsimultaneous Contributions and Distributions Strong presumption if contribution and distribution

occur within 2 years (using date of right to receive contribution if earlier).

Equally strong presumption if contribution and distribution are separated by more than 2 years.

Several Exceptions

Nonsimultaneous Contributions and Distributions Two-Year Window for Presumption. Presumption Is Rebuttable Based on Examination of

Entrepreneurial Risk. Sale Is Deemed to Occur When Contribution Is

Made Though Installment Reporting Is Possible. Must the Partner Amend If Contribution and

Distribution Are in Separate Taxable Years?

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Recomputing the Sale Price X contributes property to the P partnership with an

adjusted basis of $10,000 and value of $100,000. $100,000 in cash is distributed to X one year later,

and the contribution and distribution are treated as a disguised sale.

Implicit interest under Section 1272 must be backed-out of the sale price for the one-year deferral. If $10,000 is the proper interest component, then X has sold 90% of the property at a taxable gain of $81,000.

Complete Disguised Sale

On these facts, if there were no implicit interest, X would have made no contribution.

X would not be a partner unless treated as receiving a profits-only interest (for what?).

If X is one of two partners, disguised sale could mean no partnership is formed.

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Keeping the Other Partners Neutral• In this deferred sale example, the partnership will

be entitled to an interest deduction of $10,000. How should it be allocated?

• Had there been no disguised sale, there would be no interest deduction. To preserve the economics of the transaction, the interest deduction should be allocated entirely to the contributing partner so that the other partners are unaffected by the disguised sale.

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Deferred Sale Example

• X and Y form the XY partnership, with X contributing Blackacre with adjusted basis of $60,000 and value of $100,000. Y contributes cash of $50,000. Subsequently, the cash is distributed to X.

– Case 1: No disguised sale.– Case 2: Disguised sale, deferred interest equals $2,000,

no special allocation of interest.– Case 3: Disguised sale, deferred interest equals $2,000,

special allocation of interest.

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Case 1: No Disguised Sale

___________X___________ __________Y___________ Capital Basis Capital Basis $ 100,000 $ 60,000 $ 50,000 $ 50,000 ( 50,000) ( 50,000) 0 0 $ 50,000 $ 10,000 $ 50,000 $ 50,000

Note that capital accounts are equal, showing that each partner has contributed $50,000 to the venture.

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Cases 2 and 3: Disguised Sale• First, the numbers:

– If there is a $2,000 interest component out of the $50,000 deemed paid by the partnership, then the principal amount deemed paid equals $48,000 (48% of fair market value).

– If 48% of the property is deemed sold, then 52% (worth $52,000) is treated as contributed.

– Of the partner’s $60,000 adjusted basis in the property, 52% (or $31,200) is allocable to the contributed portion of the property and 48% (or $28,800) is allocable to the sold portion.

– The disguised sale gain thus equals $48,000 less $28,800, or $19,200.

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Case 2: Disguised Sale, No Special Allocation ___________X___________ __________Y___________

Capital Basis Capital Basis

$ 52,000 $ 31,200 $ 50,000 $ 50,000

( 1,000) ( 1,000) ( 1,000) ( 1,000)

$ 51,000 $ 30,200 $ 49,000 $ 49,000

Note that capital accounts no longer are equal, giving X a majority capital interest in the venture.

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Case 3: Disguised Sale With Special Allocation ___________X___________ __________Y___________ Capital Basis Capital Basis $ 52,000 $ 31,200 $ 50,000 $ 50,000 ( 2,000) ( 2,000) 0 0 $ 50,000 $ 29,200 $ 50,000 $ 50,000

Note that capital accounts again are equal, showing that each partner has contributed $50,000 to the venture.

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Notable Exceptions – Treas. Reg. § 1.707-4 Distributions of Operating Cash Flow.

Lesser of share of overall profits for current year and percentage of profits over life of the venture.

Safe harbor is lowest share of all material items of income over forward-looking three-year window.

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Reasonable Guaranteed Payments for Capital. Must be based on a rate that does not exceed 150%

of highest AFR.

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Reasonable Guaranteed Payments for Capital. Must be based on a rate that does not exceed 150%

of highest AFR. Reasonable Preferred Returns.

Must be based on a rate that does not exceed 150% of highest AFR

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Notable Exceptions – Cont’d Reimbursement of Preformation Capital

Expenditures. Applies to formation costs and to capital

expenditures incurred by the partner with respect to property transferred to the partnership.

Expenditures must be incurred by the partner within the two-year period preceding the transfer.

No limit on reimbursement of formation costs. Limited to 20% of the value of the property if the

value of the property exceeds 120% of adjusted basis.

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Preformation Expenditures Problem• X owns unimproved real estate with adjusted basis of

$400,000 and fair market value of $2,000,000. X improves the property by constructing a building at a cost of $2,500,000, increasing the value of the property to $5,000,000. Can X contribute the property and get reimbursed for the construction costs?

• No! The maximum tax-free reimbursement is $1,000,000 because the value of the property exceeds 120% of its adjusted basis ($5M as compared with $2.9M).

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Preformation Expenditure Solution Construct the building with borrowed funds. Then

contribute the building subject to the debt. The debt will be a “qualified liability” because it is allocable, under the rules of Treas. Reg. § 1.163-8T, to capital improvements.

Note that there is no related party limitation, so that the debt can be borrowed from an affiliate so long as the form of the loan is respected.

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Debt-Financed Distributions (Treas. Reg. § 1.707-5(b)(1)) If a partnership incurs a liability and all or a portion of the

proceeds of the liability are allocable under Treas. Reg. § 1.163-8T to a distribution to a contributing partner made within 90 days after incurring the liability, the distribution is taken into account under the disguised sale rules only to the extent that the amount of the distribution exceeds the partner’s allocable share of the liability

This is the rule that the “leveraged partnership” structure relies on to avoid the application of the disguised sale rules

Share of Debt Limitation

If the partnership borrows $100,000 and the entire debt is allocable to partner Q, then the entire $100,000 can be distributed to Q under the debt financed distribution exception.

If the partnership borrows $100,000 and half the debt is allocable to Q, then if the entire $100,000 is distributed, Q can receive $50,000 under the debt financed distribution exception.

If the partnership borrows $100,000 and half the debt is allocable to Q, if less than half the $100,000 is distributed, only half of the distribution can be distributed to Q under the debt financed distribution exception.

Reg. §1.752-2(i)(3)

P

Sub

T

Recourse Debt

Consolidated Group

General Partner Limited Partner

Reg. §1.752-2(i)(3) Equivalence

P T

Recourse Debt

General Partner Limited Partner

LLC

P*

Reg. §1.752-2(i)(3) Equivalence

P T

Recourse Debt

Limited Partner Limited Partner

P*

Debt Guarantee

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Debt-Financed Distributions – Canal Corporation Taxpayer contributed assets to a partnership, and extracted over 95% of

its equity in the assets through a debt-financed distribution Taxpayer asserted it bore the economic risk of loss through an

indemnity for the principal amount of the debt Tax Court held that the indemnity obligation should be disregarded

under the anti-abuse rule and therefore treated the transaction as a disguised sale, based on findings that included the following:

The indemnity agreement served no commercial purpose, but only a tax purpose

The indemnitor’s net worth was substantially less than the potential amount of the indemnity obligation, and there were no restrictions on the indemnitor’s ability to further diminish its net worth

Canal Corp. Transaction

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LLC

Canal Corp.

WISCO GP

Business assets


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LLC

Canal Corp.

WISCO GP

Bank

Business assets

Loan Proceeds


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LLC

Canal Corp.

WISCO GP

Bank

Business assets

Loan Proceeds

Cash distribution


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LLC

Canal Corp.

WISCO GP

Bank

Business assets

Loan Proceeds

Cash distribution Obligation

Obligation


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LLC

Canal Corp.

WISCO GP

Bank

Indemnity

Business assets

Loan Proceeds

Cash distribution Obligation

Obligation


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LLC

Canal Corp.

WISCO GP

Bank

Indemnity

Business assets

Loan Proceeds

Cash distribution

Intercompany Note

Obligation

Obligation

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Canal Corporation – Cont’d

Does Canal Corp mean the leveraged partnership structure is dead?

Canal Corp involved a consolidated subsidiary; does the anti-abuse rule have equal application in other circumstances?

If not, what should tax advisors planning a leveraged partnership transaction think about?

Scope of the indemnity Identity of the indemnitor Indemnitor’s net worth Restrictions on indemnitor

Ordinary Course of Business Obligations Liabilities incurred by the transferor partner in the

ordinary course of business will be treated as “qualified liabilities” so long as all of the assets used in the trade or business are transferred along with the liabilities.

Note: this may raise problems when multiple cash-basis businesses are combined and receivables are held back to true up values, especially if there is inadequate working capital in the partnership.

Disclosure Rules

The taxpayer must disclose a contribution/distribution pair occurring within two years if not treated as a disguised sale unless:

The distribution is an operating cash flow return, a reasonable guaranteed payment, or a reasonable preferred return.

Note that reimbursement of preformation costs and capital improvements are not on the exceptions list. Must be disclosed.

Leveraged distributions must be disclosed.

Form of Disclosure

The disclosure must be made on Form 8275 and attached to the return.

A caption must identify the statement as a disclosure under section 707 along with:

The item for which the disclosure is being made; The relevant dollar amounts; and All relevant facts affecting potential disguised sale

treatment.

Taxation Under §704(c)(1)(B) If contributed property is distributed to any partner

other than the contributing partner within 7 years of the contribution, the contributing partner is taxed on the amount that would be includible under section 704(c)(1)(A) if the property had been sold for its fair market value at the time of the distribution.

704(c)(1)(B) Example

P and Q form the PQ partnership with P contributing property having an adjusted basis of $6,000 and fair market value of $10,000 while Q contributes $10,000 of cash. They agree to be equal partners. The property contributed by P is depreciable over 5 years using straight line depreciation, and after two years the property is distributed to Q when it has a value of $9,000. The distribution is not part of a disguised sale to Q.

Example (continued)

P Q

CA OB CA OB

$ 10,000 $ 6,000 $ 10,000 $ 10,000 Formation

( 1,000) ( 200) ( 1,000) ( 1,000) Year 1 Depreciation

( 1,000) ( 200) ( 1,000) ( 1,000) Year 2 Depreciation

$ 8,000 $ 5,400 $ 8,000 $ 8,000 Totals

Asset Book Value Inside Basis

Property $ 6,000 $ 3,600

Cash 10,000 10,000

Example (continued)

If the property were sold for its current fair market value of 9,000, there would be book gain of $1,000 and tax gain of $3,400. The gain that would be allocable to P under section 704(c)(1)(A) is the tax gain in excess of book gain, or $2,400.

Note: the initial built-in gain was $4,000, but $800 of that amount was eliminated each year via the allocation of depreciation.

Example (continued)

P Q

CA OB CA OB

$ 8,000 $ 5,600 $ 8,000 $ 8,000 End of Year 2

0 2,400 0 0 704(c)(1)(B)

$ 8,000 $ 8,000 $ 8,000 $ 8,000 Totals

Asset Book Value Inside Basis

Property $ 6,000 $ 6,000

Cash 10,000 10,000

Example (continued)

P Q

CA OB CA OB

$ 8,000 $ 8,000 $ 8,000 $ 8,000 After 704(c)(1)(B)

1,500 0 1,500 0 Revaluation

0 0 ( 9,000) ( 6,000) Distribution

9,500 8,000 500 2,000 Ending balances

Avoiding Section 704(c)(1)(B) Contractually lock-in contributed property for as

long as possible. Permit dispositions that are tax-free. Require that if contributed property is transferred

to a lower-tier partnership, the transferee is bound by the same rules.

Section 737

If a partner contributes appreciated property to a partnership and then exits the venture in exchange for other property, gain in the contributed property will be shifted to other partners. Section 737 speaks to this assignment of income concern.

When section 737 is triggered, it operates much like section 704(c)(1)(B):

Gain is recognized to the contributing partner. Outside basis is increased by the gain recognized. Inside basis is also increased by the gain recognized.

Section 737 Example

P and Q form the PQ partnership, with P contributing cash of $10,000 and Q contributing nondepreciable property with adjusted basis of $8,000 and fair market value of $10,000. The partnership uses $3,000 of its cash to purchase another nondepreciable asset, and when that asset is worth $9,000, it is distributed to Q in a nonliquidating distribution. At the time of the distribution, the value of the asset contributed by Q equals $12,000.

Section 737 Example (continued) Because Q receives a distribution of property within

7 years of contributing other property, section 737 is triggered. Q is taxed on the lesser of

The excess of the value of the distributed property ($9,000) over Q’s outside basis ($8,000), or $1,000.

The amount of the precontribution gain in the contributed property, assuming it was sold for current fair market value, $2,000.

Therefore, Q recognizes a gain of $1,000.

Section 737 Example (continued)

P Q

CA OB CA OB

$ 10,000 $ 10,000 $10,000 $ 8,000 Formation

0 0 0 1,000 Section 737

3,000 0 3,000 0 Mandatory Book-Up

1,000 0 1,000 0 Optional Book-Up

0 0 ( 9,000) ( 3,000) Distribution

$14,000 10,000 5,000 6,000 Totals

Assets Book Value Inside Basis

Q-Property 12,000 9,000

Cash 7,000 7,000