19th Annual Real Estate Tax Forum - Practising Law Institute

© Practising Law InstituteTAX LAW AND ESTATE PLANNING SERIES

Tax Law and PracticeCourse Handbook Series

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19th AnnualReal Estate Tax Forum

Volume Two

Co-ChairsLeslie H. Loffman

Sanford C. PresantBlake D. Rubin

© Practising Law Institute

37

Disguised Sales of Partnership Interests: An Analysis of the Proposed Regulations

Blake D. Rubin Andrea Macintosh Whiteway

EY

Copyright 2005 Blake D. Rubin and Andrea Macintosh Whiteway. All Rights Reserved

Reprinted from the PLI Course Handbook, 18th Annual Real Estate Tax Forum (Order #144587)

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.


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Table of Contents

I. INTRODUCTION ......................................................................................... 5

II. THE PROBLEM .......................................................................................... 5

III. HISTORICAL OVERVIEW AND CONTEXT ............................................... 6A. Partnership Disguised Sales Generally ............................................ 6

1. Prior to 1984................................................................................. 62. Enactment of Code Sec. 707(a)(2)(B).......................................... 73. Regulations on Disguised Sales of Property ................................ 9

B. Disguised Sales of Partnership Interests ........................................ 111. Legislative History and Case Law .............................................. 112. IRS Rulings ................................................................................ 14

IV. PROPOSED REGULATIONS ................................................................... 15A. The “But For” and Entrepreneurial Risk Tests................................. 15B. Facts and Circumstances Determination ........................................ 15C. Treatment of Transfers as a Sale .................................................... 17D. Presumptions .................................................................................. 18

1. Transfers Made Within Two Years ............................................. 182. Other Exceptions and Presumptions.......................................... 19

E. Treatment of Liabilities .................................................................... 201. Liability Assumptions.................................................................. 202. Debt Financed Transfers of Consideration by Partnership ........ 223. Anti-Abuse Rule ......................................................................... 22

F. Disclosure Rules ............................................................................. 22

V. EXAMPLES AND PROBLEMS................................................................. 23A. Example 2 (simultaneous transfers; selling partner’s

consideration less than purchasing partner’s consideration) .......... 23B. Example 3 (transfer of selling partner’s consideration precedes

transfer of purchasing partner’s consideration)............................... 25C. Example 4 (simultaneous transfers of different properties)............. 28D. Example 5 (UPREIT stock buyback)............................................... 30E. Example 6 (transfer of encumbered property) ................................ 32

VI. CONCLUSION .......................................................................................... 33


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I. INTRODUCTION

On November 26, 2004, proposed regulations were issued regarding dis-guised sales of partnership interests. The proposed regulations wouldoperate to re-cast a wide variety of otherwise non-taxable contributionand distribution transactions occurring between partners and partnershipsas taxable disguised sales of a partnership interest. The regulations areproposed to be effective for transactions with respect to which all trans-fers that are considered part of a sale occur on or after the date the regula-tions are published as final regulations. In the authors’ view, the proposedregulations are seriously flawed and susceptible to legal challenge.

Part II of this article illustrates the problem that the proposed regula-tions are intended to address. Part III provides an historical overview andcontext, including a discussion of key court cases before 1984, the 1984legislative response, and the regulations dealing with the disguised salesof property (after which the proposed regulations are generally patterned).Part IV summarizes the proposed regulations, and Part V illustrates anumber of their problems through a series of examples.

II. THE PROBLEM

The problem at which the proposed regulations are directed is illustratedby the following example.

Example 1

Assume that A and B are equal partners in an “old and cold” partner-ship that owns property with fair market value of $600, an adjusted basisof $200, subject to nonrecourse debt of $400. Assume that under the CodeSec. 752 rules, the nonrecourse debt is allocated equally between A andB, and that each has an adjusted basis in its partnership interest of $100. Awould like to sell its partnership interest to C for its fair market value of$100, which is equal to one-half of the equity value (i.e., property value inexcess of debt) of the partnership’s property. A’s amount realized on sucha sale would equal $300 (equal to A’s $100 of sales proceeds plus A’s$200 share of the debt under Code Sec. 752(d)). Thus, A’s gain on the salewould be $200 (equal to A’s amount realized of $300 minus A’s adjustedbasis in the interest of $100).

Suppose instead that C contributes $99 to the partnership, which thendistributes it to A. Based on the $200 equity value in the partnership, afterthese transactions C would be a 49.5 percent partner, A would be a .5 per-cent partner and B would be a 50 percent partner. Moreover, if the form of


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the transactions as a contribution by C governed by Code Sec. 721 and adistribution to A governed by Code Sec. 731 is respected, A would recog-nize no gain. Rather, the $99 cash distribution would reduce A’s adjustedbasis in his interest to $1.1

Moreover, by “booking up” under the Code Sec. 704(b) regulations, Acould retain a sufficient share of nonrecourse indebtedness under theCode Sec. 752 regulations to avoid recognizing any immediate gain as aresult of a deemed distribution under Code Sec. 752(b) that exceeds A’sadjusted basis in the partnership interest and triggers gain under CodeSec. 731(a).2 Depending on the method agreed to by the parties to make“reverse” Code Sec. 704(c) allocations, the “book-up” under the CodeSec. 704(b) regulations could also permit C to obtain the benefit of a step-up in basis in the assets of the partnership.3 In addition, if form isrespected, the structure would avoid the constructive termination of thepartnership under Code Sec. 708(b)(1)(B) and associated re-start ofdepreciable lives under Code Sec. 168(i)(7) that would occur in the caseof an outright sale of A’s 50 percent interest in the partnership to C.4 All inall, a pretty attractive structure if form is respected.

Most tax practitioners would likely agree that it is appropriate for theproposed regulations to treat a situation like that involved in Example 1 asa disguised sale of a portion of A’s partnership interest to C. But problemsand complexity quickly result when the transfers to and from the partner-ship are separated in time or the property transferred is not cash.

III. HISTORICAL OVERVIEW AND CONTEXT

A. Partnership Disguised Sales Generally

1. Prior to 1984

Prior to the enactment of Code Sec. 707(a)(2) in 1984, taxpayersrecognized that by combining a contribution of property with a dis-

1. Code Sec. 733(1).2. See generally Rubin, Whiteway and Finkelstein, “Creative Planning to Control

Partnership Liability Allocations,” 62 N.Y.U. Federal Tax Institute Ch. 8(2004).

3. See generally Rubin and Whiteway, “Exploring the Outer Limits of the Section704(c) Built-in Gain Rule,” 89 Journal of Taxation Nos. 3, 4 and 5 (September,October and November, 1998).

4. See generally Wreggelsworth & Whiteway, “Partnership Terminations,” 61NYU Fed’l Tax Institute Ch. 12 (2003); Rubin and Teplinsky, “A ComprehensiveGuide to Partnership Terminations, Including the Impact of the New ProposedRegulations,” 24 Journal of Real Estate Taxation No. 2 (Winter 1997).

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tribution of cash to the contributing partner, the economic substanceof a sale could be achieved without current taxation to the seller/contributing partner, provided the form of the transaction wasrespected. This was the case because, generally, contributions ofproperty to and distributions of property from a partnership are nottaxable to the partnership or its partners.5 Longstanding regulationsunder Code Secs. 721 and 731 stated that a contribution of propertyfollowed by a distribution would be taxed as a sale if that was theeconomic substance of the transaction.6 Nevertheless, taxpayersenjoyed considerable success in litigating disguised sale cases, and anumber of court decisions treated contribution/distribution transac-tions that arguably were similar to sales as tax-free transactions.

For example, in Otey v. Commissioner,7 a taxpayer formed a part-nership with another party in order to construct FHA-financed hous-ing on property owned by the taxpayer. The taxpayer contributed theproperty to the partnership with an agreed value of $65,000, whilethe other party contributed no capital. However, the other party’scredit-worthiness was essential to obtaining the construction loan,which was in an amount greater than needed for the construction.The taxpayer received a distribution from the partnership of the first$65,000 of proceeds from the construction loan within six monthsafter the formation of the partnership and the transfer of the propertyto it. The court held that the taxpayer’s contribution of property tothe partnership and the partnership’s distribution of cash to the tax-payer were tax-free under Code Secs. 721(a) and 731(a), and did notconstitute a taxable sale by the contributing partner to the partner-ship under Code Sec. 707(a).

2. Enactment of Code Sec. 707(a)(2)(B)

Congress expressed its disapproval of Otey and similar cases byenacting Code Sec. 707(a)(2)(B) as part of the Deficit ReductionAct of 1984.8 Code Sec. 707(a)(2)(B), which was generally effectivefor property transferred after March 31, 1984,9 recharacterizes trans-actions involving the contribution of property to a partnership and

5. Code Secs. 721 and 731.6. Reg. §§1.731-1(c)(3), 1.721-1(a).7. 70 T.C. 312 (1978), aff ’d per curiam, 80-2 U.S.T.C. ¶9817 (6th Cir. 1980).8. Deficit Reduction Act of 1984, Pub. L. 98-369, sec. 73 , 98 Stat. 591-593, as

amended by sec. 1805(b), Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat.2810.

9. Id.


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the distribution of property from a partnership as one of two types ofsale or exchange transactions. The first is the sale or exchange ofproperty between a partner and a partnership. The second is the saleor exchange of a partnership interest by one partner to another part-ner. Code Sec. 707(a)(2)(B) provides in pertinent part:

Under regulations prescribed by the Secretary-

* * * *

(B) TREATMENT OF CERTAIN PROPERTY TRANSFERS. -If-

(i) there is a direct or indirect transfer of money or other property by apartner to a partnership,

(ii) there is a related direct or indirect transfer of money or other prop-erty by the partnership to such partner (or another partner), and

(iii) the transfers described in clauses (i) and (ii), when viewed together,are properly characterized as a sale or exchange of property,

such transfers shall be treated either as a transaction described in paragraph(1) [a transaction between the partnership and a partner other than in hiscapacity as a member of such partnership] or as a transaction between 2 ormore partners acting other than in their capacity as members of the partner-ship.

The legislative history states:

The [regulations under Code Secs. 721 and 731] may not always prevent defacto sales of property to a partnership or another partner from being struc-tured as a contribution to the partnership, followed (or preceded) by a tax-free distribution from the partnership. * * * Case law has permitted thisresult, despite the regulations described above, in cases which are economi-cally indistinguishable from a sale of all or part of the property. See Otey v.Commissioner, 70 T.C. 312 (1978), aff’d per curiam 80-2 USTC ¶9817, 634F.2d 1046 (1980); Communications Satellite Corp. v. United States 80-1USTC ¶9338 , 223 Ct. Cl. 253 (1980); Jupiter Corp. v. United States 83-1USTC ¶9168 , No. 83-842 (Ct. Cl. [sic] 1983).

* * Reasons for Change * *

In the case of disguised sales, the committee is concerned that taxpayershave deferred or avoided tax on sales of property (including partnershipinterests) by characterizing sales as contributions of property (includingmoney) followed (or preceded) by a related partnership distribution.Although Treasury regulations provide that the substance of the transactionshould govern, court decisions have allowed tax-free treatment in caseswhich are economically indistinguishable from sales of property to a part-nership or another partner. The committee believes that these transactions

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should be treated in a manner consistent with their underlying economicsubstance.

S. Print 98-169, Vol. I, at 225 (1984); H. Rept. 98-432, at 1218(1984).10

3. Regulations on Disguised Sales of Property

Regulations interpreting and implementing Code Sec. 707 wereproposed by the Treasury Department on April 24, 1991 and final-ized, with modifications, on September 25, 1992 (the “PropertyRegulations”). Those regulations set forth detailed rules to deter-mine whether transactions will be treated as disguised sales of prop-erty between a partner and a partnership.11

Under the Property Regulations, a partner’s transfer of propertyto a partnership and the partnership’s transfer of money or other con-sideration to the partner constitute a sale of the property, in whole orin part, by the partner to the partnership only if, based on all the factsand circumstances, “(i) the transfer of money or other considerationwould not have been made but for the transfer of property, and (ii) incases in which the transfers are not made simultaneously, the subse-quent transfer is not dependent on the entrepreneurial risks of part-nership operations.”12 Whether the distribution to the partner occursbefore or after the contribution to the partnership is immaterial.13

The facts and circumstances existing on the date of the earliesttransfer (i.e., contribution or distribution) are “generally” the rele-vant ones to be considered.14 The Property Regulations contain anonexclusive list of 10 factors that tend to prove the existence of asale. The factors are as follows: (1) that the timing and amount of asubsequent transfer are determinable with reasonable certainty at thetime of an earlier transfer; (2) that the transferor has a legallyenforceable right to the subsequent transfer; (3) that the partner’sright to receive the transfer of money or other consideration is

10. See Staff of the J. Comm. on Taxation, General Explanation of the Revenue Pro-visions of the Deficit Reduction Act of 1984, at 231-233 (J. Comm. Print); H.Rept. (Conf.) 98-861, at 861 (1984).

11. For a detailed discussion of the regulations, see Blake D. Rubin, Mark J. Silver-man and Christian M. McBurney, “Proposed Partnership Disguised Sale Regu-lations,” 52 Tax Notes 1051; Blake D. Rubin and Mark J. Silverman, “The FinalPartnership Disguised Sale Regulations Under Section 707(a)(2),” 13 Tax Man-agement Real Estate Journal No. 9 (September 1997).

12. Reg. §1.707-3(b)(1).13. Reg. §1.707-3(c)(1).14. Reg. §1.707-3(b)(2).


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secured in any manner, taking into account the period during whichit is secured; (4) that any person has made or is legally obligated tomake contributions to the partnership in order to permit the partner-ship to make the transfer of money or other consideration; (5) thatany person has loaned or has agreed to loan the partnership themoney or other consideration required to enable the partnership tomake the transfer, taking into account whether any such lendingobligation is subject to contingencies related to the results of part-nership operations; (6) that the partnership has incurred or is obli-gated to incur debt to acquire the money or other considerationnecessary to permit it to make the transfer, taking into account thelikelihood that the partnership will be able to incur that debt (consid-ering such factors as whether any person has agreed to guarantee orotherwise assume personal liability for that debt); (7) that the part-nership holds money or other liquid assets, beyond the reasonableneeds of the business, that are expected to be available to make thetransfer (taking into account the income that will be earned fromthose assets); (8) that the partnership distributions, allocations orcontrol of partnership operations is designed to effect an exchangeof the burdens and benefits of ownership of property; (9) that thetransfer of money or other consideration by the partnership to thepartner is disproportionately large in relationship to the partner’sgeneral and continuing interest in partnership profits; and (10) thatthe partner has no obligation to return or repay the money or otherconsideration to the partnership, or has such an obligation but it islikely to become due at such a distant point in the future that thepresent value of that obligation is small in relation to the amount ofmoney or other consideration transferred by the partnership to thepartner.15

Importantly, the Property Regulations provide that if within atwo-year period there is a contribution by and a distribution to apartner, the transfers are presumed to be part of a sale of the propertyto the partnership. This presumption is rebuttable only if “the factsand circumstances clearly establish that the transfers do not consti-tute a sale.”16 If the contribution by and distribution to the partnerare more than two years apart, the transfers are presumed not to be asale of the contributed property, “unless the facts and circumstancesclearly establish that the transfers constitute a sale.”17 The preamble

15. Reg. § 1.707-3(b)(2)(i)-(x).16. Reg. § 1.707-3(c).

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to the final Property Regulations clarifies that the “clearly establish”standard is intended to impose a higher evidentiary burden than themere “preponderance of the evidence” standard generally applicablein civil tax cases.18

B. Disguised Sales of Partnership Interests

1. Legislative History and Case Law

The proposed and final regulations issued under Code Sec. 707 in1991 and 1992 did not address disguised sales of partnership inter-ests. Rather, Reg. § 1.707-7, entitled “Disguised Sales of PartnershipInterests,” was “reserved” at the time those regulations were issued.At least one commentator argued that, unless and until regulationswere issued, the Internal Revenue Service (the “Service”) lacked theauthority to attack transactions as disguised sales of partnershipinterests.19 The authors disagree with that conclusion. For the rea-sons set forth below, the authors believe that, notwithstanding theabsence of regulations, the Service could successfully attack at leastclear cases as disguised sales of a partnership interest.20

First, the Deficit Reduction Act of 1984 generally provided thatCode Sec. 707(a)(2)(B) was effective with respect to property trans-ferred after March 31, 1984.21 The statutory language of Code Sec.707(a)(2)(B) is broad enough on its face to reach disguised sales ofpartnership interests.22 Second, although Code Sec. 707(a)(2)(B)states that the rules are to apply “under regulations prescribed by theSecretary,” the courts have generally concluded when faced withsimilar statutory language that the rule applies even in the absenceof regulations.23 Third, the regulations under Code Sec.

17. Reg. § 1.707-3(d).18. T.D. 8439, Sec II.C. (September 25, 1992).19. See Richard M. Lipton, “Can There Be A Disguised Sale Of Partnership Inter-

ests?,” 4 Journal of Passthrough Entities No. 1 (2001).20. See Rubin and Whiteway, “New Developments in Disguised Sales of Partner-

ship Interests,” 3 Journal of Passthrough Entities No. 6 (2000).21. Deficit Reduction Act of 1984, Pub. L. 98-369, sec. 73 , 98 Stat. 591-593.22. Deleting the language of Code Sec. 707(a)(2)(B) relating to disguised sales of

property makes this clear and leaves the following language: “If (i) there is atransfer of money or other property by a partner to a partnership,[and] (ii) thereis a related transfer of money or other property by the partnership to . . . anotherpartner, and (iii) the transfers described in clauses (i) and (ii), when viewedtogether, are properly characterized as a sale or exchange of property, suchtransfers shall be treated . . . as a transaction between 2 or more partners actingother than in their capacity as members of the partnership.”


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707(a)(2)(B) (which “reserved” with respect to disguised sales ofpartnership interests) provide that “in the case of any transactionwith respect to which one or more of the transfers occurs on orbefore April 24, 1991 [the date proposed regulations were issued],the determination of whether the transaction is a disguised sale ofproperty (including a partnership interest) under section 707(a)(2) isto be made on the basis of the statute and the guidance providedregarding that provision in the legislative history of section 73 of theTax Reform Act of 1984.”24 [Emphasis added.] The implication thatthe regulations govern the determination of whether transactionsoccurring after April 24, 1991 should be treated as a disguised saleof partnership interests is presumably inadvertent, in light of the factthat the regulations reserve those rules. Fourth, two cases that arementioned with disapproval in the legislative history of Code Sec.707(a)(2)(B) involved situations where the Service argued unsuc-cessfully that the transaction in question constituted a disguised saleof a partnership interest. A court would likely hold that these twocases were, in effect, overruled legislatively and that cases that fol-low a similar fact pattern should be decided against the taxpayer inlight of the enactment of Code Sec. 707(a)(2)(B).

The first case mentioned in the legislative history of Code Sec.707(a)(2)(B) involving a disguised sale of a partnership interest wasCommunications Satellite Corp. v. United States.25 In that case, theCourt of Claims concluded that the admission of new partners to anexisting partnership followed immediately by distributions of theircapital contributions to the existing partners did not constitute a tax-able sale of partnership interests by the existing partners. In Commu-nications Satellite, the taxpayer was a taxable corporation formedpursuant to an Act of Congress to participate in an international jointventure (“INTELSAT”) sponsored by the United Nations. INTEL-SAT was originally formed as a joint venture with 19 partners, butwas open to the admission of other partners. Each original partnermade a capital contribution based on its percentage interest in profitsand losses. Thereafter, each new partner was required to make a cap-ital contribution to the joint venture based on a formula. The effect

23. See, e.g., Pittway Corporation v. U.S., 97-1 U.S.T.C. ¶70,069 (7th Cir., 1996);see also Neumann v. Commissioner, 106 T.C. 216 (1996); Alexander v. Commis-sioner, 95 T.C. 467 (1990), aff ’d without published opinion sub nom, Stell v.Commissioner, 999 F.2d 544 (9th Cir. 1993).

24. Reg. §1.707-(9)(a)(2).25. 80-1 U.S.T.C. ¶9338 (Ct. Cl. 1980).

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of the formula was to place each new partner in essentially the sameposition with respect to capital contributions and profits distribu-tions as if it had been a partner from the beginning. The joint venturewould then distribute the amount received from the new partner tothe existing partners to reflect the reduction in their percentage inter-ests.

The Service argued that the admission payments and the distribu-tions to the taxpayer that followed together constituted the sale ofpart of the taxpayer’s partnership interest. The Court of Claims con-cluded that the payments to the taxpayers were distributions by thepartnership and not the proceeds of a sale of a partnership interest.In reaching its conclusion, the court emphasized a number of factorsnot present in typical commercial transactions, including (1) the spe-cial nature of the joint venture, (2) the lack of financial negotiationsand contracts of sale between the incoming partners and the existingpartners, (3) the existing partners had no control over the admissionof new partners, who were admitted to further the objectives of theventure, and (4) the amount of the contribution had no relationshipto the value of the incoming partners’ interests.

The second case mentioned in the legislative history of Code Sec.707(a)(2)(B) involving a disguised sale of a partnership interest wasJupiter Corp. v. United States.26 In that case, the Court of Claimsagain rejected the Service’s contention that the admission of partnersfollowed by a partial liquidation of another partner’s interest consti-tuted a taxable sale of a partnership interest. In Jupiter Corp., thetaxpayer owned a 77.5 percent general partner interest in a partner-ship and another party owned the entire remaining 22.5 percent lim-ited partner interest. Under the partnership agreement, the taxpayerwas obligated to supply all monies, in excess of the mortgage loan,needed to complete construction of a high rise building project. Pur-suant to this obligation, the taxpayer loaned the partnership approxi-mately $4,000,000, interest free, before construction of the projectwas completed. As a result of a reorganization of the partnership, agroup of new limited partners was admitted in exchange for a capitalcontribution. The initial limited partner refused to agree to theadmission if it would result in a dilution of his interest. Therefore, asa result of the admission, the taxpayer’s partnership interest wasreduced to 57.5% and the new limited partners received a 20% inter-

26. 83-1 U.S.T.C. ¶9168 (Ct. Cl. 1983).


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est in the aggregate. The capital contributions of the new limitedpartners were used to make distributions to the taxpayer and the ini-tial limited partner, and to pay off the taxpayer’s loan to the partner-ship.

The Service argued that the taxpayer had, in substance, sold a20% capital interest in the partnership to the new partners. TheCourt of Claims held that the form of the transaction as a contribu-tion and distribution should be respected, emphasizing that thetransaction was structured in accordance with legitimate businessconsiderations. The court reasoned that a direct sale between thegeneral partner and the newly admitted limited partners would nothave achieved the parties’ intent, which was for the general partnerto retain sole managerial control of the partnership and for the newlimited partners to achieve insulation from partnership liabilities.The court also stressed that a principal objective of the partnershiptax provisions was to afford the parties flexibility in allocating thetax burden of partnership transactions among themselves.

2. IRS Rulings

The Service did not have any difficulty concluding that it had theauthority to attack transactions as disguised sales of partnershipinterests, notwithstanding the lack of regulations under Code Sec.707(a)(2)(B) dealing with the issue. It so held in at least three differ-ent technical advice, field service and internal legal memos.27 Inaddition, in Notice 2001-64,28 the Service stated that it was consid-ering issuing regulations on disguised sales of partnership interestsand requested comments from the public. The Notice also reiteratedthe Service’s view that “[p]rior to the issuance of regulations, thedetermination of whether a transaction is a disguised sale of a part-nership interest under section 707(a)(2)(B) is to be made on thebasis of the statute and its legislative history.”

27. See FSA 200024001 (released June 16, 2000); TAM 200037005 (released Sep-tember 15, 2000); ILM 200250013 (released December 13, 2002). For adetailed discussion of the first two of these rulings, see Rubin and Whiteway,“New Developments in Disguised Sales of Partnership Interests,” 3 Journal ofPassthrough Entities No. 6 (2000).

28. 2001-2 C.B. 316.

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IV. PROPOSED REGULATIONS

A. The “But For” and Entrepreneurial Risk Tests

The proposed regulations issued on November 26, 2004 are gener-ally patterned after the Property Regulations with important modifica-tions. The proposed regulations provide that a transfer of money,property or other consideration (including the assumption of a liability)(“consideration”) by a partner (the “purchasing partner”) to a partner-ship and a transfer of consideration by the partnership to another part-ner (the “selling partner”) constitute a sale, in whole or in part, of theselling partner’s interest in the partnership to the purchasing partneronly if, based on all the facts and circumstances, the transfer by thepartnership would not have been made but for the transfer to the part-nership. Furthermore, in cases in which the transfers are not madesimultaneously, sale treatment will only apply if the “but for” test ismet and, in addition, the subsequent transfer is not dependent on theentrepreneurial risks of partnership operations.29

B. Facts and Circumstances Determination

The proposed regulations provide a non-exclusive list of facts andcircumstances that may tend to prove the existence of a disguised saleof a partnership interest. The facts and circumstances existing on thedate of the earliest transfer are “generally” the ones considered.30

These facts and circumstances, many of which are similar to the non-exclusive list of facts and circumstances set forth in the Property Regu-lations and discussed above, are as follows:

• That the timing and amount of all or any portion of a subsequenttransfer are determinable with reasonable certainty at the time ofan earlier transfer;

• That the person receiving the subsequent transfer has a legallyenforceable right to the transfer or that the right to receive thetransfer is secured in any manner, taking into account the periodfor which it is secured;

• That the same property (other than money, including marketablesecurities that are treated as money under Code Sec. 731(c)(1)

29. Prop. Reg. § 1.707-7(b)(1).30. Prop. Reg. § 1.707-7(b)(2).


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(“Marketable Securities”)) that is transferred to the partnership bythe purchasing partner is transferred to the selling partner;

• That partnership distributions, allocations or control of operationsare designed to effect an exchange of the benefits and burdens ofownership of transferred property (other than money or Market-able Securities), including a partnership interest;

• That the partnership holds transferred property (other than moneyor Marketable Securities) for a limited period of time, or duringthe period of time the partnership holds transferred property(other than money or Marketable Securities), the risk of gain orloss associated with the property is not significant;

• That the transfer of consideration by the partnership to the sellingpartner is disproportionately large in relationship to the sellingpartner’s general and continuing interest in partnership profits;

• That the selling partner has no obligation to return or repay theconsideration to the partnership, or has an obligation to return orrepay the consideration due at such a distant point in the futurethat the present value of that obligation is small in relation to theamount of consideration transferred by the partnership to the sell-ing partner;

• That the transfer of consideration by the purchasing partner or thetransfer of consideration to the selling partner is not made prorata31;

• That there were negotiations between the purchasing partner andthe selling partner (or between the partnership and each of thepurchasing and selling partners with each partner being aware ofthe negotiations with the other partner) concerning any transfer ofconsideration; and

• That the selling partner and purchasing partner enter into one ormore agreements, including an amendment to the partnershipagreement (other than for admitting the purchasing partner) relat-ing to the transfers.32

31. Because this factor refers to a single purchasing partner and a single sellingpartner, it is unclear what the phrase “not made pro rata” refers to. With regardto the selling partner, perhaps it is intended to mean that the selling partnerreceives a larger transfer than would be consistent with the selling partner’s“normal” share of distributions.

32. Prop. Reg. § 1.707-7(b)(2).

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C. Treatment of Transfers as a Sale

If a transfer of consideration by a purchasing partner to the partner-ship and a transfer by the partnership to the selling partner are treatedas part of a sale of a partnership interest, the transaction is treated as asale for all purposes of the Code.33 A transfer is deemed to take placeon the earlier of the date of actual transfer or the date on which thetransferor agrees in writing to make the transfer.34 Importantly, the saleis considered to take place on the date the earliest transfer takesplace.35 As will be discussed below, this rule is a source of serious mis-chief in the proposed regulations.

If the transfer of consideration by the purchasing partner and thetransfer of consideration to the selling partner are simultaneous and theconsideration transferred is the same, then the characterization isstraightforward: the partners and the partnership are treated as if, on thedate of the sale, the purchasing partner transferred that partner’s con-sideration (the “purchasing partner’s consideration”) directly to theselling partner in exchange for all or a portion of the selling partner’sinterest in the partnership. If the purchasing partner’s consideration isdifferent from the consideration transferred by the partnership to theseller (the “selling partner’s consideration”) but the transfers are simul-taneous, then the regulations construct an exchange between the pur-chasing partner and the partnership. Specifically, on the date of sale thepurchasing partner is deemed to transfer the purchasing partner’s con-sideration to the partnership in exchange for the selling partner’s con-sideration, and then the purchasing partner is deemed to transfer theselling partner’s consideration to the selling partner in exchange for theselling partner’s partnership interest.36 The deemed exchange betweenthe purchasing partner and the partnership is treated as an actualexchange for all purposes of the Code, and this deemed exchange is asecond source of considerable mischief in the proposed regulations.37

If the transfer by the purchasing partner and to the selling partnerare not simultaneous, then the deemed mechanics get even more com-plicated. If the transfer by the partnership to the selling partner occursbefore the transfer by the purchasing partner to the partnership, thepartners and the partnership are treated as if, on the date of the transfer

33. Prop. Reg. § 1.707-7(a)(2)(i).34. Prop. Reg. § 1.707-7(a)(2)(ii)(A).35. Id.36. Prop. Reg. § 1.707-7(a)(2)(ii)(B).37. Prop. Reg. § 1.707-7(a)(2)(ii)(E).


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to the selling partner, the purchasing partner transferred to the partner-ship an obligation to deliver the purchasing partner’s consideration inexchange for the selling partner’s consideration, and the purchasingpartner then transferred the selling partner’s consideration to the sellingpartner in exchange for the selling partner’s partnership interest.

If the transfer by the partnership to the selling partner occurs afterthe transfer by the purchasing partner to the partnership, the partnersand the partnership are treated as if, on the date of the transfer by thepurchasing partner, the purchasing partner transferred the purchasingpartner’s consideration to the partnership in exchange for an obligationof the partnership to deliver the selling partner’s consideration, and thepurchasing partner transferred that obligation to the selling partner inexchange for the selling partner’s partnership interest.

If the purchasing partner’s consideration and the selling partner’sconsideration are of different amounts, then the selling partner istreated as selling to the purchasing partner a partnership interest with avalue equal to the lesser of the two amounts.38 If a portion of the con-sideration transferred to a selling partner is not treated as sale proceedsbut rather as a distribution under Code Sec. 731, and the sale is treatedas occurring on the same date as the distribution, then the distributionis treated as occurring immediately following the sale.39

D. Presumptions

1. Transfers Made Within Two Years

The proposed regulations adopt a two-year presumption applica-ble to the disguised sale of partnership interests similar to the two-year presumption applicable to disguised sales of partnership prop-erty in the Property Regulations.40 Specifically, the proposed regula-tions provide that a transfer of consideration by a purchasing partnerto a partnership and a transfer of consideration by the partnership tothe selling partner that are made within two years of each other arepresumed to be a sale, unless the facts and circumstances clearlyestablish that such transfers do not constitute as sale. Like the two-year presumption contained in the Property Regulations, the pre-sumption can also be favorable to the taxpayer. Thus, if the transfersoccur more than two years apart, they are presumed not to be a sale,

38. Prop. Reg. § 1.707-7(a)(3).39. Prop. Reg. § 1.707-7(a)(5).40. See Reg. §1.707-3(c) and (d), discussed above.

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unless the facts and circumstances clearly establish that the transfersconstitute a sale.41 Although the proposed regulations do not specif-ically discuss the significance of the “clearly establish” standard, thestandard is same as that contained in the Property Regulations. Inthat context, the preamble to the final Property Regulations madeclear that the standard is intended to impose a higher evidentiaryburden than the mere “preponderance of the evidence” standard gen-erally applicable in civil tax cases.42

2. Other Exceptions and Presumptions

The proposed regulations provide that Code Sec. 707(a)(2)(B)and the proposed regulations do not apply to deemed transfersresulting from a termination of a partnership under Code Sec.708(b)(1)(B) and to transfers incident to the formation of a partner-ship.43 In addition, notwithstanding the presumption relating totransfers made within two years, a transfer of money or MarketableSecurities to a selling partner in liquidation of that partner’s entireinterest in the partnership is presumed not to be part of a disguisedsale of that interest.44 The proposed regulations also incorporate byreference the presumptions and exceptions contained in Reg.§ 1.707-4. As a result, preferred returns, guaranteed payments andoperating cash flow distributions meeting the requirements set forthin the Property Regulations will be presumed not to constitute partof a disguised sale of a partnership interest, and reimbursements ofpre-formation expenditures meeting those requirements will betreated as not part of a disguised sale of a partnership interest.45

In response to concerns that large professional service partner-ships that have frequent admissions of new partners and retirementsof old partners and could be inappropriately swept up in the newrules, the proposed regulations provide that transfers of money orMarketable Securities to and by a partnership that would bedescribed in Code Sec. 448(d)(2) if the partnership were a corpora-tion are not sales of partnership interests.46 Thus, partnerships sub-

41. Prop. Reg. § 1.707-7(c) and (d).42. T.D. 8439, Sec II.C. (September 25, 1992); text at footnote 18.43. Prop. § 1.707-7(a)(8).44. Prop. Reg. § 1.707-7(e).45. For a more detailed discussion of these rules in the context of the regulations

relating to disguised sales of property, see Blake D. Rubin, Mark J. Silvermanand Christian M. McBurney, “Proposed Partnership Disguised Sale Regula-tions,” 52 Tax Notes 1051.

46. Prop. Reg. § 1.707-7(g).


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stantially all of the activities of which involve the performance ofservices in the fields of health, law, engineering, architecture,accounting actuarial science, performing arts and consulting aregenerally not subject to the new rules with respect to transfers ofmoney or Marketable Securities.47

E. Treatment of Liabilities

The proposed regulations generally provide that deemed contribu-tions to and distributions from a partnership under Code Sec. 752resulting from reallocations of partnership liabilities among partnersare not treated as transfers of consideration for purposes of the dis-guised sale rules.48 However, the amount realized by a selling partneron the sale of the selling partner’s interest in the partnership includesany liability relief that occurs in connection with the sale.49 Moreover,as discussed below, “assumptions” of partner liabilities by a partner-ship or of partnership liabilities by a partner—which occur ipso factoupon the contribution or distribution of encumbered property—cantrigger sale disguised sale treatment.

1. Liability Assumptions

The proposed regulations provide that, if a partnership assumes aliability of a partner, the partnership is treated as transferring consid-eration to the partner to the extent that the amount of the liabilityexceeds the partner’s share of the liability immediately after thepartnership assumes the liability.50 For purposes of this rule, a part-nership is treated as assuming a liability of a partner to the extentprovided in Reg. § 1.752-1(d) and (e).51 Under those rules, arecourse liability of a partner is treated as assumed by the partner-ship if the partnership becomes “personally obligated” to pay the lia-bility.52 A nonrecourse liability of a partner is treated as assumed by

47. See Code Sec. 448(d)(2)(A).48. An anti-abuse rule provides that an increase in a partner’s share of a partnership

liability may be treated as a transfer of consideration by the partner to the part-nership if within a short period after the partnership incurs the liability oranother liability, one or more partners or related parties in substance bears aneconomic risk for the liability that is disproportionate to the partner’s interest inprofits or capital and the transactions are undertaken pursuant to a plan that hasas one of its principal purposes minimizing the extent to which a partner istreated as transferring consideration to the partnership that may be treated aspart of a sale.

49. Prop. Treas. Reg. § 1.707-7(j)(1).50. Prop. Reg. § 1.707-7(j)(2). 51. Id.

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the partnership to the extent of the fair market value of property con-tributed by the partner to the partnership that is subject to the liabil-ity.53

Likewise, if a partner assumes a liability of a partnership, thepartner is treated as transferring consideration to the partnership tothe extent that the amount of the liability exceeds the partner’s shareof that liability immediately before the partner assumes the liabil-ity.54 The standard for determining whether a partner has assumed anonrecourse liability is the standard set forth in Treas. Reg. § 1.752-1(e), described above. However, the standard for determiningwhether a partner has assumed a recourse liability of the partnershipis narrower than the standard described above for determiningwhether a partnership has assume a recourse liability of a partner.More particularly, the proposed regulations require that, in order forthe partner to be treated as assuming a partnership liability, the stan-dard of Reg. § 1.704-1(b)(2)(iv)(c) must be met, which requires thatthe obligee is aware of the assumption, can directly enforce the part-ner’s obligation, and, as between the partner and the partnership, thepartner is ultimately liable.55

A partner’s share of any liability of the partnership for these pur-poses is determined as follows. A partner’s share of a recourse liabil-ity of the partnership equals the partner’s share of the liability underCode Sec. 752 and the regulations thereunder.56 A partner’s share ofa nonrecourse liability of the partnership is generally determined byapplying the same percentage used to determine the partner’s shareof the excess nonrecourse liability under Reg. § 1.752-3(a)(3).57

Unlike the Property Regulations, the proposed regulations do notprovide any special treatment for “qualified liabilities.”58

52. Reg. § 1.752-1(d)(1).53. Reg. § 1.752-1(e).54. Prop. Reg. § 1.707-7(j)(3). 55. Prop. Reg. § 1.707-1(j)(3); Reg. § 1.704-1(b)(2)(c). Compare Reg. 1.752-

1(d)(2), which employs a similar standard.56. Prop. Reg. § 1.707-7(j)(4)(i).57. Prop. Reg. § 1.707-7(j)(4)(ii). These provisions are identical to the provisions

for determining a partner’s share of recourse and nonrecourse liabilities underthe disguised sale of property regulations. See Reg. § 1.707-5(a)(2).

58. See Reg. § 1.707-5(a)(5) - (7).


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2. Debt Financed Transfers of Consideration by Partnership

The proposed regulations provide that, if a partnership incurs aliability and all or a portion of the proceeds of that liability are allo-cable under Reg. § 1.163-8T to a transfer of consideration to a part-ner made within 90 days of incurring the liability, the transfer ofconsideration to the partner is taken into account only to the extentthat the amount of consideration transferred exceeds that partner’sallocable share of the partnership liability.59

3. Anti-Abuse Rule

The proposed regulations provide that an increase in a partner’sshare of a partnership liability may be treated as a transfer of consid-eration by the partner to the partnership if within a short period oftime after the partnership incurs or assumes the liability or anotherliability, one or more partners of the partnership, or related parties toa partner, in substance bears an economic risk of loss for the liabilitythat is disproportionate to the partner’s interest in partnership profitsor capital; and the transactions are undertaken pursuant to a plan thathas as one of its principal purposes minimizing the extent to whichthe partner is treated as making a transfer of consideration to thepartnership that may be treated as part of a sale under the proposedregulations.60

F. Disclosure Rules

The proposed regulations provide that, when a partner transfersconsideration to a partnership and the partnership transfers consider-ation to another partner within a seven-year period, if the partners treatthe transfers other than as a sale for tax purposes, and the transfer ofconsideration by the partnership is not presumed to be a guaranteedpayment for capital (within the meaning of Reg. § 1.707-4(a)(1)(ii)), isnot a reasonable preferred return (within the meaning of Reg. § 1.707-4(a)(3)), and is not an operating cash flow distribution (within themeaning of Reg. § 1.707-4(b)(2)), then the transfers must be disclosedin accordance with the disclosure requirements of Reg. § 1.707-8. Dis-closure is not required, however, if the transfers fall within the excep-

59. Prop. Reg. § 1.707-7(j)(6). Compare Reg. § 1.707-5(b) in the Property Regula-tions, which contains a similar rule.

60. Prop. Reg. § 1.707-7(j)(8). These provisions are identical to the provisions fordetermining a partner’s share of recourse and nonrecourse liabilities under thedisguised sale of property regulations. See Reg. § 1.707-5(a)(2).

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tions for terminations of a partnership, formation of a partnership, ortransfers to and by service partnerships, discussed above.

The proposed regulations would also amend the disclosure require-ments under the Property Regulations to require disclosure if there is atransfer of property by a partner to a partnership, and by a partnershipto the partner, within a seven-year period instead of within a two-yearperiod, as currently provided for in Reg. § 1.707-3(c)(2) and Reg.§ 1.707-6(c).61 This extension of the period for required disclosure wasrecommended by the Joint Committee on Taxation in its report of itsinvestigation into Enron Corporation’s tax planning machinations.62

Likewise, the proposed regulations would amend Reg. §§ 1.707-5 and–6 of the Property Regulations to require disclosure if a partner trans-fers property to a partnership and the partnership assumes or takes sub-ject to the liability, or a partnership transfers property to a partner andthe partner assumes or takes subject to the liability (whether or not theliability is a qualified liability), within a seven-year period and the part-ner or partnership does not treat the transaction as a sale for tax pur-poses.

V. EXAMPLES AND PROBLEMS

The complex mechanics of the proposed regulations and the problemscreated by them are best illustrated by a series of examples.

A. Example 2 (simultaneous transfers; selling partner’s consideration less than purchasing partner’s consideration)

Assume that A and B are equal partners in an “old and cold” part-nership. The partnership has assets with a fair market value of $600. Ccontributes $200 to the partnership and the partnership simultaneouslydistributes $250 to A in partial redemption of its interest in the partner-ship. Assume that the transfer to A would not have been made but forthe transfer by C, so that the “but for” test of Prop. Reg. § 1.707-7(b)(1)(i) is met.

61. Prop. Reg. § 1.707-7(k).62. Joint Committee on Taxation, Report of Investigation of Enron Corporation and

Related Entities Regarding Federal Tax and Compensation Issues, and PolicyRecommendations (JCS –3-03), February 2003 (hereinafter “JCT EnronReport”), at p. 29.


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Under the proposed regulations, the partnership, A and C are alltreated as though C transferred consideration of $200 to A in exchangefor acquiring two-thirds of A’s partnership interest and the partnershipimmediately thereafter distributed $50 to A.63 A will recognize gainbased on an amount realized of $200, plus any reduction in A’s share ofpartnership liabilities occurring as a result of the deemed sale. A willbe required to allocate its adjusted basis in its partnership interestbetween the portion sold and the portion retained.64 The $50 consider-ation transferred to A in excess of the amount of the deemed sale istreated as a distribution to A immediately following the sale.65

This ordering of the deemed transactions (i.e., a $200 sale followedby a $50 distribution) is more favorable to A than the alternative order-ing rule would be (i.e., a $50 distribution followed by a $200 sale). Theordering rule adopted by the proposed regulations enables the taxpayerto recover a larger percentage of its adjusted basis in the partnershipinterest against the amount realized. To illustrate, if A’s adjusted basisin the interest is $200 and there are no partnership liabilities, the order-ing rule in the regulations results in A recognizing $66.67 of gain onthe sale and no further gain on the distribution.66 If instead the $50 dis-tribution were deemed to occur first, A’s gain on the sale would be$80.67

Assuming the partnership’s assets have value in excess of adjustedbasis, C will need to be certain that the partnership makes a Code Sec.754 election to permit C to obtain the benefit of a step-up in theadjusted basis of the partnership’s assets with respect to C. 68 If thepartnership’s assets have value below adjusted basis, i.e. a built-in loss,a step-down in the adjusted basis of the partnership’s assets withrespect to C will be required (subject to a de minimis rule) under

63. Prop. Reg. § 1.707-7(a)(3).64. See Rev. Rul. 84-53, 1984-1 C.B. 159, which provides guidance on how to make

this allocation.65. Prop. Reg. § 1.707-7(a)(5).66. The gain on the sale equals the amount realized of $200 minus allocated

adjusted basis of $133.33 (2/3 of total adjusted basis). The $50 distribution doesnot exceed A’s remaining adjusted basis in the interest of $66.67 and does nottrigger any additional gain. Code Sec. 731(a).

67. If the $50 distribution were deemed to occur first, the distribution would reduceA’s adjusted basis in the interest to $150 and would reduce the fair market valueof A’s interest to $250. The subsequent disguised sale would therefore be of$200/$250 of A’s interest, and A would therefore recover $200/$250 of A’sremaining $150 adjusted basis (i.e., $120) against the amount realized of $200,resulting in $80 of recognized gain.

68. Code Sec. 743.

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amendments to Code Sec. 743 enacted by the American Jobs CreationAct of 2004 signed by President Bush on October 22, 2004.

B. Example 3 (transfer of selling partner’s consideration precedes transfer of purchasing partner’s consideration)

The facts are the same as in Example 2 except that on January 1,2007, A receives a distribution of $200 from the partnership in partialredemption of its interest. Thereafter, on November 30, 2008, C isadmitted to the partnership in exchange for a capital contribution of$200.

Under the proposed regulations, these transfers constitute a dis-guised sale if both (1) the transfer to A would not have been made butfor the transfer by C, and (2) the subsequent transfer (here, the transferby C) was not dependent on the entrepreneurial risks of partnershipoperations.69 However, because the two transfers occur within twoyears, they are presumed to constitute a disguised sale unless the factsand circumstances “clearly establish” that they do not.70

Although the proposed regulations contain nine examples, none ofthem illustrate the application of the “but for” test, the determination ofwhether a transfer is subject to “the entrepreneurial risks of partnershipoperations,” or the application of the two-year presumption. Seven ofthe examples involve fact patterns in which the transfers are nonsimul-taneous but occur within two years;71 the remaining two involve simul-taneous transfers.72 None of the seven examples involvingnonsimultaneous transfers contain any facts suggesting that the transferto the selling partner would not have been made but for the transfer bythe purchasing partner. Nor do any of those examples contain any factsrelevant to the determination of whether the subsequent transfer is“dependent on the entrepreneurial risks of partnership operations.”Rather, in each example, the paragraph containing the facts simply setsforth the dates of transfers. The paragraph containing the analysis thenstates that there are no facts that rebut the application of sale treatment.The reader is left with the impression that whenever the transfers occurwithin two years, sale treatment will be mandated.

As noted above, when the transfers are nonsimultaneous, the pro-posed regulations require a determination that the subsequent transfer

69. Prop. Reg. § 1.707-7(b)(1).70. Prop. Reg. § 1.707-7(c).71. Prop. Reg. § 1.707-7(l) Examples 1-7.72. Prop. Reg. § 1.707-7(l) Examples 8 and 9.


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is not dependent on the entrepreneurial risks of partnership operationsin order for disguised sale treatment to prevail. It is questionablewhether this test makes sense or can even be applied where, as inExample 3, the subsequent transfer is by the purchasing partner asopposed to the selling partner. Is C’s transfer to the partnership subjectto the entrepreneurial risks of partnership operations? Certainly, C’sability to make the transfer does not depend on the success of the part-nership’s operations in the same way that the partnership’s ability tomake a transfer might. On the other hand, C presumably would notagree to become a partner unless C is satisfied with the results of part-nership operations. The “entrepreneurial risk” test was imported fromthe Property Regulations, where the inquiry is whether the transferfrom the partnership to the partner is dependent on the entrepreneurialrisks of partnership operations. As applied to a transfer by a partner tothe partnership, it is simply inapposite.

Assuming that there are no facts and circumstances that “clearlyestablish” that no sale has occurred, the transfers constitute a disguisedsale and A, C and the partnership are treated as if the followingoccurred. On January 1, 2007, C is deemed to transfer a $200 non-interest bearing promissory note to the partnership in exchange for$200 cash. Immediately thereafter, C is deemed to purchase two-thirdsof A’s partnership interest in exchange for $200 cash. Thereafter, onNovember 30, 2008, C is deemed to pay $200 to the partnership in sat-isfaction of the note. 73

Beyond the obvious gain recognition resulting to A from the rechar-acterization of the transaction as a disguised sale, there are a number ofadditional important and problematic consequences to the parties.First, treating C as receiving an interest-free loan from the partnershipon January 1, 2007 would implicate Code Sec. 7872, the rules govern-ing below market loans. Under those rules, C may be treated as payinginterest on the loan to the partnership and then receiving an offsettingtransfer of cash back from the partnership as a distribution.74 Thiswould result in C having interest expense (which might or might not be

73. See Prop. Reg. § 1.707-7(a)(2)(ii)(C).74. The regulations proposed under Code Sec. 7872 in 1985 apply this characteriza-

tion in the case of an interest-free loan from a corporation to a shareholder. SeeProp. Reg. § 1.7872-4(d). Although the proposed regulations under Code Sec.7872 deal with only a narrow category of compensation-related below marketloans from partners to partnerships, the preamble to the proposed regulationsstates that final regulations will further address partnership transactions.

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deductible under Code Sec. 163) and the partnership having interestincome (which would be taxable).

More fundamentally, treating C as acquiring the partnership intereston January 1, 2007 means that for all Federal income tax purposes, Chas been an unwitting partner in the partnership for 23 months prior tothe time that C thought it was becoming a partner. Accordingly, C willreceive an unexpected distributive share of partnership items of incomeand deduction for the 23-month period. Moreover, additional “deemedtransactions” will be required to rationalize the Federal tax conse-quences with the fact that C does not become a state law partner untilthe later date. For example, if the partnership makes cash distributionsto the partners between January 1, 2007 (when C becomes a partner forFederal tax purposes) and November 30, 2008 (when C becomes apartner for state law purposes), C will not receive any share of the dis-tribution because C is not a partner for state law purposes. Because C isa partner for Federal tax purposes at the time of the distribution, mustwe “deem” C to receive a share of the distribution, and then to transferit to the other partners (who actually received it), all with attendant taxconsequences?

Clearly, a person may be a partner for Federal tax purposes withoutbeing a partner for state law purposes.75 Nevertheless, the simple fact isthat until November 30, 2007, C has made no capital contribution tothe partnership, has rendered no services to the partnership, and has noright to share in the profits, losses or cash flows of the partnership.Under any definition of what it means to be a partner for Federal taxpurposes, C does not qualify.76

As was the case in Example 2, assuming that the partnership’sassets have value in excess of adjusted basis, C will need to be certainthat the partnership makes a Code Sec. 754 election to permit C toobtain the benefit of a step-up in the adjusted basis of the partnership’sassets. In Example 2, however, the election will need to be in effect forthe partnership’s tax year that includes January 1, 2007, when C isdeemed to purchase A’s interest and become a partner. Because this is23 months before C became a partner for state law purposes, C may notrealize that it must request that the partnership make the election forthe earlier year. Moreover, because C would not yet be a party from a

75. See, e.g., Rev. Proc. 2002-22, 2002-1 C.B. 733, in which the IRS articulated var-ious factors that it views as relevant for determining whether a state law tenancyin common relationship constitutes a partnership for Federal tax purposes.


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state law perspective to the partnership agreement, C may have no abil-ity to cause the partnership to make the election.

C may not even be aware of the distribution in partial redemption ofA’s interest that results in the recharacterization of C’s transaction as apurchase of A’s interest occurring in an earlier year. Clearly, however,if these regulations are finalized in their current form, C will need toperform due diligence examining partnership distributions backthrough several years to protect itself.

In the hands of aggressive taxpayers, the ability to transfer a part-nership interest from A to C with 23 months retroactive effect may beexploited. For example, if C is a tax-exempt entity, transactions couldbe structured that attempt to retroactively divert taxable income to it.On the other side of the coin, if the partnership generates taxable lossesand C is a taxable entity, transactions could be structured that attemptto retroactively transfer losses to it outside the strictures imposed byCode Sec. 706(d).

C. Example 4 (simultaneous transfers of different properties)77

Assume that A and B are equal partners in an “old and cold” part-nership. The partnership owns Property 1 with an adjusted basis of$700, and a fair market value of $1,000, as well as other assets. C isadmitted to the partnership in exchange for a contribution of Property2, which has an adjusted basis of $300 and a fair market value of$1,500. The partnership simultaneously distributes Property 1 to A inpartial redemption of its interest in the partnership.

76. Code Sec. 761(b) defines a “partner” as a “member of a partnership,” whichsheds little light on the issue. Code Sec. 7701(a)(2) states that “the term ‘part-ner’ includes a member in such a syndicate, group, pool, joint venture, or orga-nization,” which also sheds little light on the issue. The cases of Commissionerv. Tower, 327 U.S. 280 (1946) and Commissioner v. Culbertson, 337 U.S. 733(1949), provide general principles regarding the determination of whether indi-viduals have joined together as partners in a partnership. The primary inquiry iswhether the parties had the intent to join together to operate a business andshare in its profits and losses. The inquiry is essentially factual and all relevantfacts and circumstances must be examined. Furthermore, it is federal, not state,law that controls for income tax purposes, regardless of how the parties aretreated under state law. See PLR 199911033, holding that a limited liabilitycompany with two state law members was not a partnership for Federal tax pur-poses where one member made no capital contribution, had no interest in profitsor losses and had no management rights.

77. This example is patterned after Prop. Reg. § 1.707-7(l) Example 3.

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Because the transfers occur within two years of one another, theyare presumed to constitute a sale of a portion of A’s partnership interestto C. Unless the facts and circumstances “clearly establish” that no salehas occurred, the proposed regulations would treat the partnership, Aand C as though C acquired Property 1 from the partnership inexchange for two-thirds of Property 2, and then C acquired A’s partner-ship interest in exchange for C’s transfer of Property 1 to A.78 Accord-ingly, C would recognize gain of $800 on the deemed exchange of two-thirds of Property 2 for Property 1.79 Note that this gain will be recog-nized even if Property 1 and Property 2 are of like kind within themeaning of Code Sec. 1031.80 The partnership would recognize gain of$300 on the deemed exchange of Property 1 for two-thirds of Property2.81 A would recognize gain on the deemed sale of its partnership inter-est to C in exchange for Property 1.

Although the government may enjoy this gain-recognition festival,its theoretical justification seems extremely weak and susceptible tolegal challenge, particularly from the perspective of C. Fundamentally,the treatment of certain transactions as a disguised sale of a partnershipinterest may be seen as a statutory or regulatory application of the step-transaction doctrine.82 Thus, if C transfers property to a partnership andthat same property is transferred to partner A in partial redemption ofA’s partnership interest, a straightforward application of the step-trans-action would collapse the steps and treat the transfer as occurringdirectly from C to A, with attendant purchase and sale tax conse-quences.

It is axiomatic, however, that the proper function of the step-trans-action doctrine is to combine existing steps, not to create new ones orreorder existing ones.83 In Example 4, the proposed regulations as

78. Prop. Reg. §§ 1.707-7(a)(2)(ii)(B) and 1.707-7(a)(3).79. C would be permitted to allocate two-thirds of the $300 adjusted basis of Prop-

erty 2 ($200) to the two-thirds portion of Property 2 exchanged for Property 1.The amount realized by C on the exchange would be $1,000, and thus C wouldrecognize $800 of gain.

80. From C’s perspective, even if Property 1 and Property 2 are of like kind withinthe meaning of Code Sec. 1031, the exchange would not qualify for nonrecogni-tion treatment because Property 1 would be transferred to A immediately afterthe exchange. Thus, C would not hold Property 1 for investment or productiveuse in a trade or business as required by Code Sec. 1031(a)(1). Even if theexchange did qualify under Code Sec. 1031, C would recognize the gain on thedeemed transfer of Property 1 to A in exchange for A’s partnership interest.

81. If Property 1 and Property 2 are of like kind within the meaning of Code Sec.1031 and the other requirements of Code Sec. 1031 are met, it appears that thisexchange could qualify as tax-free from the perspective of the partnership.


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applied to C would clearly create at least one new step. In form, Cengages in a single exchange with the partnership, transferring Prop-erty 2 in exchange for a partnership interest. The proposed regulationswould recharacterize this to include (1) a transfer of one-third of Prop-erty 2 to the partnership in exchange for an interest in the partnershipand two-thirds of Property 2 in exchange for Property 1; and (2) thetransfer of Property 1 to C in exchange for a portion of C’s partnershipinterest.

From C’s perspective, the form of the transaction seems perfectlyconsistent with its substance: C transfers Property 2 to the partnershipin exchange for an interest, and, significantly, Property 2 remains in thepartnership. The proposed regulations construct a taxable exchange forC that does not in fact occur and that is inconsistent with step-transac-tion principles and inconsistent with Code Sec. 721(a), which wouldallow C to transfer Property 2 to the partnership in exchange for aninterest without recognizing gain. If the proposed regulations are final-ized in their current form, we would not be surprised to see them heldinvalid as applied to C because of their conflict with Code Sec. 721(a).

D. Example 5 (UPREIT stock buyback)

Assume that a real estate investment trust structured as anUPREIT84 believes that its stock, which is trading at $20 per commonshare, is undervalued in the market. The REIT therefore wishes toengage in a stock buyback program. To effectuate this, on March 1,

82. The step-transaction doctrine is a judicially created concept that permits theService to integrate various steps into a single transaction. See Commissioner v.Clark, 489 U.S. 726, 738 (1989). Using this doctrine, the Service can amalgam-ate a series of formally separate steps and treat them as a single transaction ifthe steps in substance are “integrated, interdependent, and focused toward a par-ticular result.” Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987); see gener-ally, Ginsburg & Levin, Mergers, Acquisitions, and Buyouts, § 608 (October-November 2004). Over the years courts have developed three different formulations of the doc-trine. The narrowest of the versions, called the “binding commitment test,” willstep together a series of transactions if, when the first transaction is entered into,there is a binding commitment to undertake the later steps. Commissioner v.Gordon, 391 U.S. 83 (1986). Under an intermediate approach, the “mutualinterdependence test,” transactions will be integrated if they are so interdepen-dent that the first would be fruitless without completing later steps. Kornfeld v.Commissioner, 137 F.3d 1231 (10th Cir. 1998). Under the broadest of the threeapproaches, the “end result test,” transactions will be stepped together if theyare pre-arranged parts of a single transaction that are intended to reach an ulti-mate result. Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517(10th Cir. 1991).

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2006 the Operating Partnership makes a $20 million cash distributionto the REIT in redemption of one million common Operating Partner-ship Units held by the REIT, and the REIT then uses the cash to buyback one million shares of its common stock. Thereafter, on July 1,2007, C contributes real property with an adjusted basis of $3,000,000and a fair market value of $10,000,000 to the Operating Partnership inexchange for Operating Partnership Units valued at $10,000,000.

Because the transfer of cash by the Operating Partnership to theREIT and the transfer of the real property to the Operating Partnershipoccur within two years, they are presumed to constitute a sale of a por-tion of the REIT’s Operating Partnership interest to C. Unless the factsand circumstances “clearly establish” that no sale has occurred, theproposed regulations would treat the Operating Partnership, the REITand C as follows. C would be deemed to receive on March 1, 2006 apayment of $10,000,000 from the Operating Partnership in exchangefor C’s agreement to transfer C’s real property to the Operating Partner-ship on July 1, 2007. C would be deemed immediately thereafter totransfer the $10,000,000 to the REIT to purchase a portion of theREIT’s interest in the Operating Partnership. The REIT would bedeemed to sell a portion of its interest in the Operating Partnership to Con March 1, 2006 for $10,000,000 and to receive a $10,000,000 distri-bution from the Operating Partnership immediately thereafter. OnJuly 1, 2007, C would be deemed to transfer the real property to the

83. See Grove v. Commissioner, 490 F.2d 241 (2d Cir. 1973) (court refused to recasta shareholder’s gift of stock to charity followed by the issuer’s redemption ofthat stock from the charity as a redemption from the donor followed by a gift ofcash to the charity); Greene v. United States, 13 F.3d 577 (2d Cir. 1994) (undersimilar facts, court refused to recast the transactions under either the end resulttest or the mutual interdependence test); Esmark, Inc. v. Commissioner, 90 T.C.171 (1988), aff ’d, 886 F.2d 1318 (7th Cir. 1989) (court refused to recast P corpo-ration’s purchase of 53% of T corporation’s stock in a public tender offer fol-lowed by T’s redemption of such stock in exchange for 97% of the stock in T’swholly owned subsidiary (“S”) (a tax-free redemption under section311(d)(2)(B) of the 1954 code) as though T sold its S stock to P for cash andthen used that cash to redeem 53% of its stock from the public); see also Mag-neson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985) (failing to see a moredirect route to effect the transactions, the Ninth Circuit refused to invent newsteps).

84. The term “UPREIT” is an acronym for “umbrella partnership real estate invest-ment trust” and refers to a structure in which a real estate investment trust(“REIT”) owns substantially all of its assets through a partnership in which theREIT is the controlling general partner. See generally, Rubin, Whiteway andForrest, “Doing a Deal with a REIT: The Property Owner's Perspective,” 57N.Y.U. Inst. on Fed’l Tax’n Ch. 15 (1999).


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Operating Partnership in satisfaction of the obligation that it enteredinto on March 1, 2006.

From C’s perspective, the transaction apparently constitutes a pre-paid forward contract to sell its real property to the Operating Partner-ship, which presumably results in taxable gain to C on March 1,2006.85 In addition, C is treated as purchasing a portion of the REIT’sinterest in the Operating Partnership for $10,000,000 on March 1,2006. C thus becomes a partner in the Operating Partnership before itexpected to and receives an unexpected distributive share of OperatingPartnership income or loss. From the REIT’s perspective, the transac-tion constitutes a taxable sale of a portion of its interest in the Operat-ing Partnership to C on March 1, 2006, giving rise to taxable gain to theREIT and increasing the REIT’s requirement to make distributions pur-suant to Code Sec. 857(a)(1)(A)(i).

Once again, from C’s perspective, the proposed regulations con-struct a taxable exchange in a manner that is inconsistent with step-transaction principles and impinges on the application of Code Sec.721(a).

E. Example 6 (transfer of encumbered property)

Assume that D and E are equal partners in an “old and cold” part-nership. D and E agree that the partnership requires additional capitali-zation and that they wish to fund those requirements equally. D makesa cash capital contribution of $400, and E simultaneously contributesproperty that is subject to nonrecourse indebtedness of $600 with anadjusted basis of $700 and fair market value of $1,000. Because E’scontributed property has value in excess of the debt (i.e., equity value)equal to D’s $400 cash capital contribution, D and E remain equal part-ners.

Bizarrely, the proposed regulations find a disguised sale of $300 ofE’s interest to D on these facts. The analysis is as follows. Upon thetransfer of encumbered property to the partnership, E is treated asreceiving consideration from the partnership to the extent that theamount of the liability ($600) exceeds E’s share of the liability imme-diately after the transfer.86 Thus, E is deemed to receive $300 of con-sideration from the partnership. Simultaneously, D transfers $400 cash

85. Compare Rev. Rul. 2003-5, 2003-2 C.B. 254, which held that a so-called “vari-able share prepaid forward contract” to sell stock where the seller retained theright to “cash settle” the contract did not result in immediate gain.

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to the partnership. If the deemed transfer of $300 of consideration to Ewould not have occurred but for the transfer of consideration by D,then a disguised sale of $300 of E’s interest from E to D has occurred.87

Moreover, the “but for” test seems to be met because the deemed trans-fer of $300 of consideration to E would not have occurred but for E’scontribution of encumbered property, and E’s transfer of the encum-bered property would not have occurred but for the transfer of cash byD.

If E had contributed cash to the partnership and the partnershipassumed a liability of E, the proposed regulations would allow theamount of liabilities assumed by the partnership to be reduced (but notbelow zero) by the money contributed.88 However, where, as here, thepartner contributes property other than cash subject to a liability, theproposed regulations do not allow such netting and thus overlook theeconomic reality that E is transferring property with a net equity valuein excess of the debt of $400, causing absurd results.

VI. CONCLUSION

The proposed regulations would operate to re-cast a wide variety of other-wise non-taxable contribution and distribution transactions occurringbetween partners and partnerships as taxable disguised sales of a partner-ship interest. In the authors’ view, they are seriously flawed and suscepti-ble to legal challenge.

Where the transfer to the selling partner precedes the transfer by thepurchasing partner, disguised sale treatment turns on whether the transferto the partnership is “dependent on the entrepreneurial risks of partnershipoperations,” which is inapposite to say the least. A taxpayer who inno-cently makes a capital contribution to a partnership in exchange for aninterest may find that because of a distribution made to another partner ina prior year and unbeknownst to the taxpayer, the taxpayer is treated as apartner for Federal tax purposes long before it became a partner for statelaw purposes, and long before it meets the criteria generally required to bea partner for Federal tax purposes. In the hands of aggressive taxpayers,the ability to retroactively become a partner prior to the time the taxpayer

86. Prop. Reg. § 1.707-6(j)(2). Under Prop. Reg. § 1.707-6(j)(4), E’s share of thenonrecourse liability is determined by applying the same percentage used todetermine the E’s share of the excess nonrecourse liability under Reg. § 1.752-3(a)(3) (here, 50 percent).

87. Prop. Reg. § 1.707-6(b)(1)(i); Prop. Reg. § 1.707-6(a)(3).88. See Prop. Reg. § 1.707-6(j)(7).


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acquires any attributes of partner status may be exploited. A taxpayer whocontributes appreciated property to a partnership in a transaction thatappears to qualify as tax-free under Code Sec. 721(a) may find that a dis-tribution, of which the taxpayer was unaware, of cash or different prop-erty to another partner transmutes the taxpayer’s transaction into a taxableexchange in a way that is inconsistent with established step-transactiondoctrine and Code Sec. 721(b). Taxpayers who transfer properties encum-bered by liabilities to a partnership will find that the proposed regulationslead to absurd consequences.

The authors have never questioned the Service’s authority to issue reg-ulations governing disguised sales of partnership interests. We are hopefulthat any final (or re-proposed) regulations in this area will address theproblems discussed in this article.

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19th Annual Real Estate Tax Forum - Practising Law Institute

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