Contributing Encumbered Assets: Partnership Disguised Sale Rules
June 05, 2017
Many of our posts this year have considered some of the unique issues that are presented by a partner’s contribution of property to a partnership, including the application of the “disguised sale” rules. Today, we will review one aspect of a recent IRS ruling involving a partnership’s assumption of liabilities in connection with a partner’s contribution of substantially all of its assets and liabilities to the partnership.
Company was a joint venture between two corporations that were engaged in Business. In addition to operating assets, Company held all of the general partner interests, and various classes of limited partner interests, in Partnership, a state law limited partnership. Partnership owned all of the membership interests in an LLC (“DRE”), which was disregarded as an entity separate from Partnership for federal income tax purposes.
Company planned to transfer cash and all of its material operating assets to Partnership (through DRE) in exchange for additional limited partner units in Partnership (the “Transfer”).
In connection with the Transfer, Partnership (through DRE) would assume certain liabilities of Company (the “Liabilities”).
All of the Liabilities were incurred more than two years before the proposed Transfer: Some were originally incurred to make distributions in connection with Company’s formation and were subsequently refinanced, and the remainder were used to acquire assets, make improvements, pay expenses, and otherwise operate Company’s business, including to refinance other liabilities incurred for the same purposes.
Company had also regularly distributed cash to its members in proportion to their ownership interests. Those cash distributions were less than Company’s earnings.
The Liabilities (and the liabilities that they refinanced) were an integral part of Company’s existing and historical capital structure.
Company represented that:
- none of the Liabilities was in default;
- the Liabilities were not incurred in anticipation of the Transfer to Partnership;
- the Transfer to Partnership was not being considered at the time the Liabilities were incurred; and
- Company would have incurred the Liabilities without regard to the Transfer to Partnership.
(Company also made other representations concerning the application of another provision of the Code – not addressed in this post – that allocates among the partners any deductions and losses attributable to partnership indebtedness.)
The Code provides that, if (i) there is a transfer of property by a partner to a partnership, (ii) there is a related transfer of money by the partnership to such partner, and (iii) these transfers, when viewed together, are properly characterized as a sale or exchange of the property, such transfers shall be treated as a transaction between a partnership and one of its partners acting other than in its capacity as member of the partnership.
Thus, where these criteria are satisfied, the transfer of money by the partnership is not treated as a distribution to a partner in respect of his partnership interest; rather, it is treated as payment for the property transferred by the partner.
This “disguised sale” is considered to take place on the date that, under general principles of tax law, the partnership is considered the owner of the property. If the transfer of money from the partnership to the partner occurs after the transfer of property to the partnership, the partner and the partnership are treated as if, on the date of the sale, the partnership transferred to the partner an obligation to transfer money to the partner.
Facts & Circumstances
The regulations promulgated under the disguised sale rules provide that a transfer of property by a partner to a partnership and a transfer of money (including the assumption of or the taking subject to a liability) by the partnership to the partner constitute a sale of property, in whole or in part, by the partner to the partnership only if, based on all the facts and circumstances, (i) the transfer of money would not have been made but for the transfer of property; and (ii) in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.
The determination of whether a transfer of property by a partner to the partnership and a transfer of money by the partnership to the partner constitute a sale, in whole or in part, is made based on all the facts and circumstances in each case. The weight to be given each of the facts and circumstances will depend on the particular case.
Among the facts and circumstances that may tend to prove the existence of a sale are the following:
(i) That the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer;
(ii) That the transferor has a legally enforceable right to the subsequent transfer;
(iii) That the partner’s right to receive the transfer of money is secured in any manner, taking into account the period during which it is secured;
(iv) That any person has made, or is legally obligated to make, contributions to the partnership in order to permit the partnership to make the transfer of money;
(v) That any person has loaned or has agreed to loan the partnership the money required to enable the partnership to make the transfer, taking into account whether any such lending obligation is subject to contingencies related to the results of partnership operations;
(vi) That a partnership has incurred or is obligated to incur debt to acquire the money necessary to permit it to make the transfer, taking into account the likelihood that the partnership will be able to incur that debt (considering such factors as whether any person has agreed to guarantee or otherwise assume personal liability for that debt);
(vii) That the partnership holds money beyond the reasonable needs of the business, that is expected to be available to make the transfer;
(viii) That partnership distributions, allocation or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property;
(ix) That the transfer of money by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and
(x) That the partner has no obligation to return or repay the money to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money transferred by the partnership to the partner.
In order to afford partners and their partnerships some “certainty,” the regulations provide that if, within a two-year period, a partner transfers property to a partnership and the partnership transfers money to the partner (without regard to the order of the transfers), the transfers are presumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale.
Conversely, if a transfer of money to a partner by a partnership and the transfer of property to the partnership by that partner are more than two years apart, the transfers are presumed not to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers constitute a sale.
The regulations further provide that if a partnership assumes or takes property subject to a “qualified liability” of a partner, and the transfer of the property by the partner to the partnership is not otherwise treated as part of a sale, the partnership’s assumption of or taking subject to the qualified liability is not treated as part of a sale.
In general, a liability is a “qualified liability” of the partner to the extent: (i) The liability (A) was incurred by the partner more than two years prior to the date the partner transfers the property to the partnership and the liability has encumbered the transferred property throughout that two-year period; or (B) was not incurred in anticipation of the transfer of the property to a partnership, but was incurred by the partner within the two-year period prior to the date the partner transfers the property to the partnership and that has encumbered the transferred property since it was incurred; or (C) is allocable to capital expenditures with respect to the property; or (D) was incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all the material assets related to that trade or business are transferred; and (ii) If the liability is a recourse liability, the amount of the liability does not exceed the fair market value of the transferred property at the time of the transfer.
If a transfer of property by a partner to a partnership is not otherwise treated as part of a sale (for example, the partnership does not also pay money to the partner in connection with the transfer), the partnership’s assumption of or taking subject to a qualified liability in connection with the transfer of property is treated as a distribution by the partnership.
By contrast, if the partnership assumes or takes property subject to a liability of the partner other than a qualified liability, the partnership is treated as transferring consideration to the partner to the extent that the amount of the liability exceeds the partner’s share of that liability immediately after the partnership assumes or takes subject to the liability.
If, within a two-year period, a partner incurs a liability (other than a liability allocable to a capital expenditure or incurred in the ordinary course of business), and transfers property to a partnership and, in connection with the transfer, the partnership assumes or takes the property subject to the liability, the liability is presumed to be incurred in anticipation of the transfer, unless the facts and circumstances establish otherwise.
The IRS Rules
After applying the foregoing rules to the Company’s facts and representations, the IRS concluded that the Liabilities assumed by Partnership (through DRE) in connection with Company’s Transfer to Partnership would constitute qualified liabilities of Company and, as such, would not be treated as consideration paid as part of a sale.
The ruling presented a fairly simple set of facts. Other situations are not as straightforward.
For example, what if the partner wanted to withdraw some equity – cash – from the property (e.g., real estate) being contributed to the partnership? The regulations provide that if a partner transfers property to a partnership, and the partnership incurs a liability, and all or a portion of the proceeds of that liability are traceable to a transfer of money from the partnership to the partner made shortly after incurring the liability, the transfer of money to the partner is taken into account as part of a sale to the extent that the amount of money transferred exceeds that partner’s allocable share of the partnership liability.
Alternatively, what if the partner incurs the liability, and withdraws equity from the property, more than two years prior to transferring the encumbered property to the partnership? What if the partnership then refinances the liability?
The regulations provide that a liability incurred within two years of a transfer of property will be presumed to be incurred in anticipation of the transfer (unless the liability was allocable to a capital expenditure or incurred in the ordinary course of business) and, thus, part of a sale – the regulations do not provide a favorable presumption for a liability incurred more than two years prior to the transfer, though such a liability may constitute a qualified liability.
However, always be mindful that, in the appropriate situation, a facts and circumstances analysis may still be applied by the IRS and, in the absence of a bona fide business reason for the indebtedness, it may be possible for the IRS to successfully characterize a portion of the refinancing as consideration for a sale.