Attention Partnerships and LLCs: New IRS Regs on Disguised SalesNovember 01, 2016
Under new IRS guidance, property transactions between partners and partnerships are more likely to be classified as something called “disguised sales,” which are taxable.
The IRS has been busy on the partnership front! In addition to new regulations on allocating debt to partners and LLC members released last month, the IRS also issued new guidance (early October) targeting strategies that are used to exploit the tax benefits associated with partnerships and LLCs. The changes involve classifying property transactions as “disguised sales” which are subject to taxes.
Some background info
Typically, no gain or loss is recognized when money or unencumbered property (property that is not subject to any claims by creditors) is contributed to a partnership (the non-recognition rule). However, this rule does not apply if the transaction is a sale.
Under federal income tax rules, partners who contribute appreciated property (with a fair market value- FMV- that exceeds its basis) to their partnerships don’t recognize any taxable gains....however there are some exceptions....
- When the partnership assumes debt that hurts the contributed property’s value and the assumed debt is large enough to cause the partner’s basis in the partnership interest (his/her ‘outside basis’) to be negative directly after the contribution, A taxable gain is triggered in this case.
What is a “disguised sale”?
A disguised sale of property is, generally, a contribution of property followed by a distribution of cash or other property back to the contributing partner.
- Under normal circumstances, section 721(a) of IRS code treats the contribution and distribution as unrelated events, and therefore prevents the contributing partner and the partnership from recognizing gain or loss on the contribution. In turn, section 731 usually prevents the partner and the partnership from recognizing any gain or loss on the distribution.
- If the contribution and distribution are treated as two halves of a single transaction, however, sections 721 and 731 will not apply. Instead, the transaction generally will be treated as a taxable sale or exchange between the partner and the partnership under section 1001—hence a disguised sale.
Avoiding disguised sale rules
The IRS introduced this “disguised sale rule” to prevent tax deferrals and avoidance. However, many partners contribute appreciated property to their partnerships and planning around the rules has proven very difficult and burdensome.
There are ways partners can avoid triggering the disguised sale rules, under certain exceptions including:
- Exception for reimbursements- Certain reimbursements will not trigger the disguised sale rules, like when a partnership reimburses a contributing partner for capital expenditures related to contributed property (that were incurred before the contribution)
- Exception for qualified liabilities-Liabilities incurred or transferred in connection with certain contributions of property to partnerships have special rules. If liabilities are “qualified liabilities,” they can dodge the disguised sale rules. (View #3 in this IRS publication for a complete list of all qualified liabilities.)
So, what’s new?
The temporary and final regs provide that for purposes of the disguised sale rules, all liabilities are treated as non-recourse liabilities (secured loan that is secured by a pledge of collateral, like real property, but for which the borrower is not personally liable).
When are these changes applicable?
The disguised sale rules under the final regulations will apply to transactions (for which all transfers occur) on or after October 5th, 2016.
The temporary regulations are effective Oct. 5, 2016 as well, but their provisions have various dates of applicability. The proposed regulations will be fully effective when they are published as final regulations, but partnerships may rely on them before they are finalized.
This is merely a brief overview of the changes partnerships will need to apply in their businesses. Contact our tax services team for more information.