disguised sales of partnership interests:...

DISGUISED SALES OF PARTNERSHIP INTERESTS:AN ANALYSIS OF THE PROPOSED REGULATIONSBy Blake D. Rubin and Andrea Macintosh Whiteway

Table of ContentsI. Introduction . . . . . . . . . . . . . . . . . . . . . . 1149II. The Problem . . . . . . . . . . . . . . . . . . . . . 1150

A. Example 1 . . . . . . . . . . . . . . . . . . . . . 1150

III. Historical Overview and Context . . . . . . . 1150A. Partnership Disguised Sales Generally . 1150B. Disguised Sales of Partnership Interests . 1152

IV. Proposed Regulations . . . . . . . . . . . . . . . 1154A. The ‘But For’ and Entrepreneurial Risk

Tests . . . . . . . . . . . . . . . . . . . . . . . . . 1154B. Facts and Circumstances

Determination . . . . . . . . . . . . . . . . . . . 1154C. Treatment of Transfers as a Sale . . . . . . 1154D. Presumptions . . . . . . . . . . . . . . . . . . . 1155E. Treatment of Liabilities . . . . . . . . . . . . 1156F. Disclosure Rules . . . . . . . . . . . . . . . . . 1157

V. Examples and Problems . . . . . . . . . . . . . 1157A. Example 2 (Simultaneous Transfers; Selling

Partner’s Consideration Less Than PurchasingPartner’s Consideration) . . . . . . . . . . . 1157

B. Example 3 (Transfer of Selling Partner’sConsideration Precedes Transfer of PurchasingPartner’s Consideration) . . . . . . . . . . . 1157

C. Example 4 (Simultaneous Transfers ofDifferent Properties) . . . . . . . . . . . . . . 1159

D. Example 5 (UPREIT Stock Buyback) . . . 1160E. Example 6 (Transfer of Encumbered

Property) . . . . . . . . . . . . . . . . . . . . . . 1161VI. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 1161

I. Introduction

On November 26, 2004, the IRS and Treasury issuedproposed regulations regarding disguised sales of part-nership interests. The proposed regulations would oper-ate to recast a wide variety of otherwise nontaxablecontribution and distribution transactions occurring be-tween partners and partnerships as taxable disguisedsales of a partnership interest. The regulations are pro-posed to be effective for transactions with respect towhich all transfers that are considered part of a sale occuron or after the date the regulations are published as finalregulations. In the authors’ view, the proposed regula-tions are seriously flawed and susceptible to legal chal-lenge.

Part II of this article illustrates the problem the pro-posed regulations are intended to address. Part III pro-vides a historical overview and context, including adiscussion of key court cases before 1984, the 1984legislative response, and the regulations dealing with the

Blake D. Rubin and Andrea Macintosh Whitewayare partners with Arnold & Porter LLP, Washington,D.C.

On November 26, 2004, the IRS and Treasury issuedproposed regulations regarding disguised sales ofpartnership interests. The authors think that proposedregulations would operate to recast a wide variety ofotherwise nontaxable contribution and distributiontransactions occurring between partners and partner-ships as taxable disguised sales of a partnershipinterest. In the authors’ view, the proposed regulationsare seriously flawed and susceptible to legal challenge.

Under the proposed regulations, according to theauthors, a taxpayer who innocently makes a capitalcontribution to a partnership in exchange for aninterest may find that because of a distribution madeto another partner in a prior year and unbeknownst tothe taxpayer, the taxpayer is treated as a partner forfederal tax purposes long before it became a partnerfor state law purposes, and long before it meets thecriteria generally required to be a partner for federaltax purposes. A taxpayer who contributes appreciatedproperty to a partnership in a transation that appearsto qualify as tax-free under section 721(a) may findthat a distribution, of which the taxpayer was un-aware, of cash or different property to another partnertransmutes the taxpayer’s transaction into a taxableexchange in a way that is inconsistent with establishedstep transaction doctrine and section 721(b), theybelieve.

The authors have never questioned the IRS’s au-thority to issue regulations governing disguised salesof partnership interests. They are hopeful that anyfinal (or reproposed) regulations in this area willaddress the problems discussed in this article.

Copyright 2005 Blake D. Rubin andAndrea Macintosh Whiteway.

All rights reserved.

TAX NOTES, May 30, 2005 1149

(C) T

ax Analysts 2005. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

disguised sales of property (after which the proposedregulations are generally patterned). Part IV summarizesthe proposed regulations, and Part V illustrates a numberof their problems through a series of examples.

II. The Problem

The problem at which the proposed regulations aredirected is illustrated by the following example.

A. Example 1

Assume that A and B are equal partners in an ‘‘old andcold’’ partnership that owns property with a fair marketvalue of $600, an adjusted basis of $200, subject tononrecourse debt of $400. Assume that under the section752 rules, the nonrecourse debt is allocated equallybetween A and B, and that each has an adjusted basis inits partnership interest of $100. A would like to sell itspartnership interest to C for its fair market value of $100,which is equal to one-half of the equity value (that is,property value in excess of debt) of the partnership’sproperty. A’s amount realized on such a sale would equal$300 (equal to A’s $100 of sales proceeds plus A’s $200share of the debt under section 752(d)). Thus, A’s gain onthe sale would be $200 (equal to A’s amount realized of$300 minus A’s adjusted basis in the interest of $100).

Suppose instead that C contributes $99 to the partner-ship, which then distributes it to A. Based on the $200equity value in the partnership, after these transactions Cwould be a 49.5 percent partner, A would be a 0.5 percentpartner, and B would be a 50 percent partner. Moreover,if the form of the transactions as a contribution by Cgoverned by section 721 and a distribution to A governedby section 731 is respected, A would recognize no gain.Rather, the $99 cash distribution would reduce A’s ad-justed basis in his interest to $1.1

Moreover, by ‘‘booking up’’ under the section 704(b)regulations, A could retain a sufficient share of non-recourse indebtedness under the section 752 regulationsto avoid recognizing any immediate gain as a result of adeemed distribution under section 752(b) that exceedsA’s adjusted basis in the partnership interest and triggersgain under section 731(a).2 Depending on the methodagreed to by the parties to make ‘‘reverse’’ section 704(c)allocations, the ‘‘book-up’’ under the section 704(b) regu-lations could also permit C to obtain the benefit of astep-up in basis in the assets of the partnership.3 Also, ifform is respected, the structure would avoid the con-structive termination of the partnership under section708(b)(1)(B) and associated restart of depreciable livesunder section 168(i)(7) that would occur in the case of an

outright sale of A’s 50 percent interest in the partnershipto C.4 All in all, that’s a pretty attractive structure if formis respected.

Most tax practitioners would likely agree that it isappropriate for the proposed regulations to treat a situ-ation like that involved in Example 1 as a disguised saleof a portion of A’s partnership interest to C. But problemsand complexity quickly result when the transfers to andfrom the partnership are separated in time or the prop-erty transferred is not cash.

III. Historical Overview and Context

A. Partnership Disguised Sales Generally1. Before 1984. Before the enactment of section 707(a)(2)in 1984, taxpayers recognized that by combining a con-tribution of property with a distribution of cash to thecontributing partner, the economic substance of a salecould be achieved without current taxation to the seller/contributing partner, provided the form of the transac-tion was respected. That was the case because, generally,contributions of property to, and distributions of prop-erty from, a partnership are not taxable to the partnershipor its partners.5 Long-standing regulations under sections721 and 731 stated that a contribution of property fol-lowed by a distribution would be taxed as a sale if thatwas the economic substance of the transaction.6 Never-theless, taxpayers enjoyed considerable success in litigat-ing disguised sale cases and a number of court decisionstreated contribution/distribution transactions that argu-ably were similar to sales as tax-free transactions.

For example, in Otey v. Commissioner7 a taxpayerformed a partnership with another party to constructFHA-financed housing on property owned by the tax-payer. The taxpayer contributed the property to thepartnership with an agreed value of $65,000, while theother party contributed no capital. However, the otherparty’s creditworthiness was essential to obtaining theconstruction loan, which was in an amount greater thanneeded for the construction. The taxpayer received adistribution from the partnership of the first $65,000 ofproceeds from the construction loan within six monthsafter the formation of the partnership and the transfer ofthe property to it. The court held that the taxpayer’scontributions of property to the partnership and thepartnership’s distribution of cash to the taxpayer weretax-free under sections 721(a) and 731(a), and did notconstitute a taxable sale by the contributing partner to thepartnership under section 707(a).2. Enactment of section 707(a)(2)(B). Congress expressedits disapproval of Otey and similar cases by enactingsection 707(a)(2)(B) as part of the Deficit Reduction Act of

1Section 733(1). Section references are to the Internal Rev-enue Code of 1986, as amended, or regulations thereunder.

2See generally Rubin, Whiteway, and Finkelstein, ‘‘CreativePlanning to Control Partnership Liability Allocations,’’ 62N.Y.U. Federal Tax Institute ch. 8 (2004).

3See generally Rubin and Whiteway, ‘‘Exploring the OuterLimits of the Section 704(c) Built-In Gain Rule,’’ 89 Journal ofTaxation nos. 3, 4, and 5 (September, October, and November1998).

4See generally Wreggelsworth and Whiteway, ‘‘PartnershipTerminations,’’ 61 N.Y.U. Fed’l Tax Institute ch. 12 (2003); Rubinand Teplinsky, ‘‘A Comprehensive Guide to Partnership Termi-nations, Including the Impact of the New Proposed Regula-tions,’’ 24 Journal of Real Estate Taxation no. 2 (Winter 1997).

5Sections 721 and 731.6Reg. sections 1.731-1(c)(3), 1.721-1(a).770 T.C. 312 (1978), aff’d per curiam 80-2 U.S.T.C. para. 9817

(6th Cir. 1980).

COMMENTARY / SPECIAL REPORT

1150 TAX NOTES, May 30, 2005

(C) T

ax Analysts 2005. A




1984.8 Section 707(a)(2)(B), which was generally effectivefor property transferred after March 31, 1984,9 recharac-terizes transactions involving the contribution of prop-erty to a partnership and the distribution of propertyfrom a partnership as one of two types of sale orexchange transactions. The first is the sale or exchange ofproperty between a partner and a partnership. Thesecond is the sale or exchange of a partnership interest byone partner to another partner. Section 707(a)(2)(B) pro-vides in pertinent part:

Under regulations prescribed by the Secretary-* * * *(B) TREATMENT OF CERTAIN PROPERTYTRANSFERS. -If-

(i) there is a direct or indirect transfer ofmoney or other property by a partner to apartnership,(ii) there is a related direct or indirect transferof money or other property by the partner-ship to such partner (or another partner), and(iii) the transfers described in clauses (i) and(ii), when viewed together, are properly char-acterized as a sale or exchange of property,

such transfers shall be treated either as a transac-tion described in paragraph (1) [a transaction be-tween the partnership and a partner other than inhis capacity as a member of such partnership] or asa transaction between 2 or more partners actingother than in their capacity as members of thepartnership.

The legislative history states:The [regulations under sections 721 and 731] maynot always prevent de facto sales of property to apartnership or another partner from being struc-tured as a contribution to the partnership, followed(or preceded) by a tax-free distribution from thepartnership. * * * Case law has permitted this result,despite the regulations described above, in caseswhich are economically indistinguishable from asale of all or part of the property. See Otey v.Commissioner, 70 T.C. 312 (1978), aff’d per curiam 80-2USTC para. 9817, 634 F.2d 1046 (1980); Communica-tions Satellite Corp. v. United States 80-1 USTC para.9338, 223 Ct. Cl. 253 (1980); Jupiter Corp. v. UnitedStates 83-1 USTC para. 9168 , No. 83-842 (Ct. Cl.[sic] 1983).

* * Reasons for Change * *In the case of disguised sales, the committee isconcerned that taxpayers have deferred or avoidedtax on sales of property (including partnershipinterests) by characterizing sales as contributions ofproperty (including money) followed (or preceded)by a related partnership distribution. AlthoughTreasury regulations provide that the substance of

the transaction should govern, court decisions haveallowed tax-free treatment in cases which are eco-nomically indistinguishable from sales of propertyto a partnership or another partner. The committeebelieves that these transactions should be treated ina manner consistent with their underlying eco-nomic substance.

S. Print 98-169, Vol. I, at 225 (1984); H. Rept. 98-432, at1218 (1984).10

3. Regulations on disguised sales of property. Regula-tions interpreting and implementing section 707 wereproposed by the Treasury Department on April 24, 1991,and finalized, with modifications, on September 25, 1992(the Property Regulations). Those regulations set forthdetailed rules to determine whether transactions will betreated as disguised sales of property between a partnerand a partnership.11

Under the Property Regulations, a partner’s transfer ofproperty to a partnership and the partnership’s transferof money or other consideration to the partner constitutea sale of the property, in whole or in part, by the partnerto the partnership only if, based on all the facts andcircumstances, ‘‘(i) the transfer of money or other consid-eration would not have been made but for the transfer ofproperty, and (ii) in cases in which the transfers are notmade simultaneously, the subsequent transfer is notdependent on the entrepreneurial risks of partnershipoperations.’’12 Whether the distribution to the partneroccurs before or after the contribution to the partnershipis immaterial.13

The facts and circumstances existing on the date of theearliest transfer (for example, contribution or distribu-tion) are ‘‘generally’’ the relevant ones to be considered.14

The Property Regulations contain a nonexclusive list of10 factors that tend to prove the existence of a sale. Thefactors are:

(1) the timing and amount of a subsequent transferare determinable with reasonable certainty at thetime of an earlier transfer;

(2) the transferor has a legally enforceable right tothe subsequent transfer;

(3) the partner’s right to receive the transfer ofmoney or other consideration is secured in anymanner, taking into account the period duringwhich it is secured;

8Deficit Reduction Act of 1984, Pub. L. 98-369, sections 73, 98Stat. 591-593, as amended by section 1805(b), Tax Reform Act of1986, Pub. L. 99-514, 100 Stat. 2810.

9Id.

10See Staff of the Joint Committee on Taxation, GeneralExplanation of the Revenue Provisions of the Deficit Reduction Act of1984, at 231-233 (JCT Print); H. Rept. (Conf.) 98-861, at 861(1984).

11For a detailed discussion of the regulations, see Blake D.Rubin, Mark J. Silverman, and Christian M. McBurney, ‘‘TheProposed Partnership Disguised Sale Regulations,’’ Tax Notes,Aug. 26, 1991, p. 1051; Blake D. Rubin and Mark J. Silverman,‘‘The Final Partnership Disguised Sale Regulations Under Sec-tion 707(a)(2),’’ 13 Tax Management Real Estate Journal no. 9(September 1997).

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


TAX NOTES, May 30, 2005 1151

(C) T

ax Analysts 2005. A




(4) any person has made or is legally obligated tomake contributions to the partnership in order topermit the partnership to make the transfer ofmoney or other consideration;(5) any person has loaned or has agreed to loan thepartnership the money or other consideration re-quired to enable the partnership to make the trans-fer, taking into account whether any such lendingobligation is subject to contingencies related to theresults of partnership operations;(6) the partnership has incurred or is obligated toincur debt to acquire the money or other consider-ation necessary to permit it to make the transfer,taking into account the likelihood that the partner-ship will be able to incur that debt (consideringsuch factors as whether any person has agreed toguarantee or otherwise assume personal liabilityfor that debt);(7) the partnership holds money or other liquidassets, beyond the reasonable needs of the business,that are expected to be available to make thetransfer (taking into account the income that will beearned from those assets);

(8) the partnership distributions, allocations, orcontrol of partnership operations is designed toeffect an exchange of the burdens and benefits ofownership of property;

(9) the transfer of money or other consideration bythe partnership to the partner is disproportionatelylarge in relationship to the partner’s general andcontinuing interest in partnership profits; and

(10) the partner has no obligation to return orrepay the money or other consideration to thepartnership, or has such an obligation but it islikely to become due at such a distant point in thefuture that the present value of that obligation issmall in relation to the amount of money or otherconsideration transferred by the partnership to thepartner.15

Importantly, the Property Regulations provide that ifwithin a two-year period there is a contribution by and adistribution to a partner, the transfers are presumed to bepart of a sale of the property to the partnership. Thatpresumption is rebuttable only if ‘‘the facts and circum-stances clearly establish that the transfers do not consti-tute a sale.’’16 If the contribution by and distribution tothe partner are more than two years apart, the transfersare presumed not to be a sale of the contributed property,‘‘unless the facts and circumstances clearly establish thatthe transfers constitute a sale.’’17 The preamble to thefinal Property Regulations clarifies that the ‘‘clearly es-tablish’’ standard is intended to impose a higher eviden-tiary burden than the mere ‘‘preponderance of the evi-dence’’ standard generally applicable in civil tax cases.18

B. Disguised Sales of Partnership Interests

1. Legislative history and case law. The proposed andfinal regulations issued under section 707 in 1991 and1992 did not address disguised sales of partnershipinterests. Rather, reg. section 1.707-7, entitled ‘‘DisguisedSales of Partnership Interests,’’ was ‘‘reserved’’ at thetime those regulations were issued. At least one commen-tator argued that, unless and until regulations wereissued, the IRS lacked the authority to attack transactionsas disguised sales of partnership interests.19 The authorsdisagree with that conclusion. For the reasons set forthbelow, the authors believe that, notwithstanding theabsence of regulations, the Service could successfullyattack at least clear cases as disguised sales of a partner-ship interest.20

First, the Deficit Reduction Act of 1984 generallyprovided that section 707(a)(2)(B) was effective withrespect to property transferred after March 31, 1984.21

The statutory language of section 707(a)(2)(B) is broadenough on its face to reach disguised sales of partnershipinterests.22 Second, although section 707(a)(2)(B) statesthat the rules are to apply ‘‘under regulations prescribedby the Secretary,’’ the courts have generally concludedwhen faced with similar statutory language that the ruleapplies even in the absence of regulations.23 Third, theregulations under section 707(a)(2)(B) (which ‘‘reserved’’on disguised sales of partnership interests) provide that‘‘in the case of any transaction with respect to which oneor more of the transfers occurs on or before April 24, 1991[the date proposed regulations were issued], the deter-mination of whether the transaction is a disguised sale ofproperty (including a partnership interest) under section707(a)(2) is to be made on the basis of the statute and theguidance provided regarding that provision in the legis-lative history of section 73 of the Tax Reform Act of1984.’’24 (Emphasis added.) The implication that the

15Reg. section 1.707-3(b)(2)(i)-(x).16Reg. section 1.707-3(c).17Reg. section 1.707-3(d).18T.D. 8439, Sec II.C. (Sept. 25, 1992).

19See Richard M. Lipton, ‘‘Can There Be a Disguised Sale ofPartnership Interests?’’ 4 Journal of Passthrough Entities no. 1(2001).

20See Rubin and Whiteway, ‘‘New Developments in Dis-guised Sales of Partnership Interests,’’ 3 Journal of PassthroughEntities no. 6 (2000).

21Deficit Reduction Act of 1984, Pub. L. 98-369, sections 73, 98Stat. 591-593.

22Deleting the language of section 707(a)(2)(B) relating todisguised sales of property makes that clear and leaves thefollowing language: ‘‘If (i) there is a transfer of money or otherproperty by a partner to a partnership, [and] (ii) there is arelated transfer of money or other property by the partnershipto . . . another partner, and (iii) the transfers described in clauses(i) and (ii), when viewed together, are properly characterized asa sale or exchange of property, such transfers shall betreated . . . as a transaction between 2 or more partners actingother than in their capacity as members of the partnership.’’

23See, e.g., Pittway Corp. v. U.S., 97-1 U.S.T.C. para. 70,069, Doc96-20122, 96 TNT 138-8 (7th Cir. 1996); see also Neumann v.Commissioner, 106 T.C. 216, Doc 96-10774, 96 TNT 71-7 (1996);Alexander v. Commissioner, 95 T.C. 467 (1990), aff’d withoutpublished opinion sub nom Stell v. Commissioner, 999 F.2d 544, Doc93-8640, 93 TNT 167-11 (9th Cir. 1993).

24Reg. section 1.707-(9)(a)(2).


1152 TAX NOTES, May 30, 2005

(C) T

ax Analysts 2005. A




regulations govern the determination of whether trans-actions occurring after April 24, 1991, should be treatedas a disguised sale of partnership interests is presumablyinadvertent, in light of the fact that the regulationsreserve those rules. Fourth, two cases that are mentionedwith disapproval in the legislative history of section707(a)(2)(B) involved situations in which the IRS arguedunsuccessfully that the transaction in question consti-tuted a disguised sale of a partnership interest. A courtwould likely hold that those two cases were, in effect,overruled legislatively and that cases that follow a simi-lar fact pattern should be decided against the taxpayer inlight of the enactment of section 707(a)(2)(B).

The first case mentioned in the legislative history ofsection 707(a)(2)(B) involving a disguised sale of a part-nership interest was Communications Satellite Corp. v.United States.25 In that case, the Court of Claims con-cluded that the admission of new partners to an existingpartnership followed immediately by distributions oftheir capital contributions to the existing partners did notconstitute a taxable sale of partnership interests by theexisting partners. In Communications Satellite, the tax-payer was a taxable corporation formed under an act ofCongress to participate in an international joint venture(INTELSAT) sponsored by the United Nations. INTEL-SAT was originally formed as a joint venture with 19partners, but was open to the admission of other part-ners. Each original partner made a capital contributionbased on its percentage interest in profits and losses.Thereafter, each new partner was required to make acapital contribution to the joint venture based on aformula. The effect of the formula was to place each newpartner in essentially the same position regarding capitalcontributions and profits distributions as if it had been apartner from the beginning. The joint venture would thendistribute the amount received from the new partner tothe existing partners to reflect the reduction in theirpercentage interests.

The IRS argued that the admission payments and thedistributions to the taxpayer that followed together con-stituted the sale of part of the taxpayer’s partnershipinterest. The court of claims concluded that the paymentsto the taxpayers were distributions by the partnershipand not the proceeds of a sale of a partnership interest. Inreaching its conclusion, the court emphasized a numberof factors not present in typical commercial transactions,including (1) the special nature of the joint venture, (2)the lack of financial negotiations and contracts of salebetween the incoming partners and the existing partners,(3) the existing partners had no control over the admis-sion of new partners, who were admitted to further theobjectives of the venture, and (4) the amount of thecontribution had no relationship to the value of theincoming partners’ interests.

The second case mentioned in the legislative history ofsection 707(a)(2)(B) involving a disguised sale of a part-nership interest was Jupiter Corp. v. United States.26 In thatcase the court of claims again rejected the IRS’s conten-

tion that the admission of partners followed by a partialliquidation of another partner’s interest constituted ataxable sale of a partnership interest. In Jupiter Corp., thetaxpayer owned a 77.5 percent general partner interest ina partnership and another party owned the entire re-maining 22.5 percent limited partner interest. Under thepartnership agreement, the taxpayer was obligated tosupply all monies, in excess of the mortgage loan, neededto complete construction of a high-rise building project.Under that obligation, the taxpayer loaned the partner-ship approximately $4 million, interest-free, before con-struction of the project was completed. As a result of areorganization of the partnership, a group of new limitedpartners was admitted in exchange for a capital contri-bution. The initial limited partner refused to agree to theadmission if it would result in a dilution of his interest.Therefore, as a result of the admission, the taxpayer’spartnership interest was reduced to 57.5 percent and thenew limited partners received a 20 percent interest in theaggregate. The capital contributions of the new limitedpartners were used to make distributions to the taxpayerand the initial limited partner, and to pay off the taxpay-er’s loan to the partnership.

The IRS argued that the taxpayer had, in substance,sold a 20 percent capital interest in the partnership to thenew partners. The court of claims held that the form ofthe transaction as a contribution and distribution shouldbe respected, emphasizing that the transaction was struc-tured in accordance with legitimate business consider-ations. The court reasoned that a direct sale between thegeneral partner and the newly admitted limited partnerswould not have achieved the parties’ intent, which wasfor the general partner to retain sole managerial controlof the partnership and for the new limited partners toachieve insulation from partnership liabilities. The courtalso stressed that a principal objective of the partnershiptax provisions was to afford the parties flexibility inallocating the tax burden of partnership transactionsamong themselves.

2. IRS rulings. The Service did not have any difficultyconcluding that it had the authority to attack transactionsas disguised sales of partnership interests, notwithstand-ing the lack of regulations under section 707(a)(2)(B)dealing with the issue. It so concluded in at least threedifferent technical advice, field service, and internal legalmemos.27 Also, in Notice 2001-64,28 the Service stated thatit was considering issuing regulations on disguised salesof partnership interests and requested comments fromthe public. The notice also reiterated the Service’s viewthat ‘‘[p]rior to the issuance of regulations, the determi-nation of whether a transaction is a disguised sale of a

2580-1 U.S.T.C. para. 9338 (Ct. Cl. 1980).2683-1 U.S.T.C. para. 9168 (Ct. Cl. 1983).

27See FSA 200024001, Doc 2000-16771, 2000 TNT 118-63 (re-leased June 16, 2000); TAM 200037005, Doc 2000-23895, 2000TNT 181-15 (released Sept. 15, 2000); ILM 200250013, Doc 2002-27223, 2002 TNT 241-51 (released Dec. 13, 2002). For a detaileddiscussion of the first two of those rulings, see Rubin andWhiteway, ‘‘New Developments in Disguised Sales of Partner-ship Interests,’’ 3 Journal of Passthrough Entities no. 6 (2000).

282001-2 C.B. 316, Doc 2001-25708, 2001 TNT 195-9.


TAX NOTES, May 30, 2005 1153

(C) T

ax Analysts 2005. A




partnership interest under section 707(a)(2)(B) is to bemade on the basis of the statute and its legislativehistory.’’

IV. Proposed Regulations

A. The ‘But For’ and Entrepreneurial Risk TestsThe proposed regulations issued on November 26,

2004, are generally patterned after the Property Regula-tions with important modifications. The proposed regu-lations provide that a transfer of money, property, orother consideration (including the assumption of a liabil-ity) (consideration) by a partner (the purchasing partner)to a partnership and a transfer of consideration by thepartnership to another partner (the selling partner) con-stitute a sale, in whole or in part, of the selling partner’sinterest in the partnership to the purchasing partner onlyif, based on all the facts and circumstances, the transferby the partnership would not have been made but for thetransfer to the partnership. Furthermore, in cases inwhich the transfers are not made simultaneously, saletreatment will apply only if the ‘‘but for’’ test is met andalso if the subsequent transfer is not dependent on theentrepreneurial risks of partnership operations.29

B. Facts and Circumstances DeterminationThe proposed regulations provide a nonexclusive list

of facts and circumstances that may tend to prove theexistence of a disguised sale of a partnership interest. Thefacts and circumstances existing on the date of the earliesttransfer are ‘‘generally’’ the ones considered.30 Thesefacts and circumstances, many of which are similar to thenonexclusive list of facts and circumstances set forth inthe Property Regulations and discussed above, are asfollows:

• the timing and amount of all or any portion of asubsequent transfer are determinable with reason-able certainty at the time of an earlier transfer;

• the person receiving the subsequent transfer has alegally enforceable right to the transfer or the rightto receive the transfer is secured in any manner,taking into account the period for which it is se-cured;

• the same property (other than money, includingmarketable securities that are treated as moneyunder section 731(c)(1) (Marketable Securities)) thatis transferred to the partnership by the purchasingpartner is transferred to the selling partner;

• partnership distributions, allocations, or control ofoperations are designed to effect an exchange of thebenefits and burdens of ownership of transferredproperty (other than money or Marketable Securi-ties), including a partnership interest;

• the partnership holds transferred property (otherthan money or Marketable Securities) for a limitedperiod of time or, during the period of time thepartnership holds transferred property (other than

money or Marketable Securities), the risk of gain orloss associated with the property is not significant;

• the transfer of consideration by the partnership tothe selling partner is disproportionately large inrelationship to the selling partner’s general andcontinuing interest in partnership profits;

• the selling partner has no obligation to return orrepay the consideration to the partnership, or has anobligation to return or repay the consideration dueat such a distant point in the future that the presentvalue of that obligation is small in relation to theamount of consideration transferred by the partner-ship to the selling partner;

• the transfer of consideration by the purchasingpartner or the transfer of consideration to the sellingpartner is not made pro rata;31

• there were negotiations between the purchasingpartner and the selling partner (or between thepartnership and each of the purchasing and sellingpartners with each partner being aware of thenegotiations with the other partner) concerning anytransfer of consideration; and

• the selling partner and purchasing partner enterinto one or more agreements, including an amend-ment to the partnership agreement (other than foradmitting the purchasing partner) relating to thetransfers.32

C. Treatment of Transfers as a SaleIf a transfer of consideration by a purchasing partner

to the partnership and a transfer by the partnership to theselling partner are treated as part of a sale of a partner-ship interest, the transaction is treated as a sale for allpurposes of the code.33 A transfer is deemed to take placeon the earlier of the date of actual transfer or the date onwhich the transferor agrees in writing to make thetransfer.34 Importantly, the sale is considered to take placeon the date the earliest transfer takes place.35 As will bediscussed below, that rule is a source of serious mischiefin the proposed regulations.

If the transfer of consideration by the purchasingpartner and the transfer of consideration to the sellingpartner are simultaneous and the consideration trans-ferred is the same, then the characterization is straight-forward: The partners and the partnership are treated asif, on the date of the sale, the purchasing partner trans-ferred that partner’s consideration (the purchasing part-ner’s consideration) directly to the selling partner inexchange for all or a portion of the selling partner’sinterest in the partnership. If the purchasing partner’s

29Prop. reg. section 1.707-7(b)(1).30Prop. reg. section 1.707-7(b)(2).

31Because this factor refers to a single purchasing partnerand a single selling partner, it is unclear what the phrase ‘‘notmade pro rata’’ refers to. Regarding the selling partner, perhapsit is intended to mean that the selling partner receives a largertransfer than would be consistent with the selling partner’s‘‘normal’’ share of distributions.

32Prop. reg. section 1.707-7(b)(2).33Prop. reg. section 1.707-7(a)(2)(i).34Prop. reg. section 1.707-7(a)(2)(ii)(A).35Id.


1154 TAX NOTES, May 30, 2005

(C) T

ax Analysts 2005. A




consideration is different from the consideration trans-ferred by the partnership to the seller (the selling part-ner’s consideration) but the transfers are simultaneous,then the regulations construct an exchange between thepurchasing partner and the partnership. Specifically, onthe date of sale the purchasing partner is deemed totransfer the purchasing partner’s consideration to thepartnership in exchange for the selling partner’s consid-eration, and then the purchasing partner is deemed totransfer the selling partner’s consideration to the sellingpartner in exchange for the selling partner’s partnershipinterest.36 The deemed exchange between the purchasingpartner and the partnership is treated as an actualexchange for all purposes of the code, and that deemedexchange is a second source of considerable mischief inthe proposed regulations.37

If the transfer by the purchasing partner and to theselling partner are not simultaneous, then the deemedmechanics get even more complicated. If the transfer bythe partnership to the selling partner occurs before thetransfer by the purchasing partner to the partnership, thepartners and the partnership are treated as if, on the dateof the transfer to the selling partner, the purchasingpartner transferred to the partnership an obligation todeliver the purchasing partner’s consideration in ex-change for the selling partner’s consideration, and thepurchasing partner then transferred the selling partner’sconsideration to the selling partner in exchange for theselling partner’s partnership interest.

If the transfer by the partnership to the selling partneroccurs after the transfer by the purchasing partner to thepartnership, the partners and the partnership are treatedas if, on the date of the transfer by the purchasing partner,the purchasing partner transferred the purchasing part-ner’s consideration to the partnership in exchange for anobligation of the partnership to deliver the selling part-ner’s consideration, and the purchasing partner trans-ferred that obligation to the selling partner in exchangefor the selling partner’s partnership interest.

If the purchasing partner’s consideration and theselling partner’s consideration are of different amounts,the selling partner is treated as selling to the purchasingpartner a partnership interest with a value equal to thelesser of the two amounts.38 If a portion of the consider-ation transferred to a selling partner is not treated as saleproceeds but rather as a distribution under code section731, and the sale is treated as occurring on the same dateas the distribution, then the distribution is treated asoccurring immediately following the sale.39

D. Presumptions

1. Transfers made within two years. The proposed regu-lations adopt a two-year presumption applicable to thedisguised sale of partnership interests similar to thetwo-year presumption applicable to disguised sales of

partnership property in the Property Regulations.40 Spe-cifically, the proposed regulations provide that a transferof consideration by a purchasing partner to a partnershipand a transfer of consideration by the partnership to theselling partner that are made within two years of eachother are presumed to be a sale, unless the facts andcircumstances clearly establish that those transfers do notconstitute a sale. Like the two-year presumption in theProperty Regulations, the presumption can also be favor-able to the taxpayer. Thus, if the transfers occur morethan two years apart, they are presumed not to be a sale,unless the facts and circumstances clearly establish thatthe transfers constitute a sale.41 Although the proposedregulations do not specifically discuss the significance ofthe ‘‘clearly establish’’ standard, the standard is the sameas that in the Property Regulations. In that context, thepreamble to the final Property Regulations made clearthat the standard is intended to impose a higher eviden-tiary burden than the mere ‘‘preponderance of the evi-dence’’ standard generally applicable in civil tax cases.42

2. Other exceptions and presumptions. The proposedregulations provide that section 707(a)(2)(B) and theproposed regulations do not apply to deemed transfersresulting from a termination of a partnership undersection 708(b)(1)(B) and to transfers incident to the for-mation of a partnership.43 Also, notwithstanding thepresumption relating to transfers made within two years,a transfer of money or marketable securities to a sellingpartner in liquidation of that partner’s entire interest inthe partnership is presumed not to be part of a disguisedsale of that interest.44 The proposed regulations alsoincorporate by reference the presumptions and excep-tions contained in reg. section 1.707-4. As a result, pre-ferred returns, guaranteed payments, and operating cashflow distributions meeting the requirements set forth inthe Property Regulations will be presumed not to consti-tute part of a disguised sale of a partnership interest, andreimbursements of preformation expenditures meetingthose requirements will be treated as not part of adisguised sale of a partnership interest.45

In response to concerns that large professional servicepartnerships that have frequent admissions of new part-ners and retirements of old partners and could be inap-propriately swept up in the new rules, the proposedregulations provide that transfers of money or Market-able Securities to and by a partnership that would bedescribed in section 448(d)(2) if the partnership were acorporation are not sales of partnership interests.46 Thus,partnerships substantially all of the activities of whichinvolve the performance of services in the fields of

36Prop. reg. section 1.707-7(a)(2)(ii)(B).37Prop. reg. section 1.707-7(a)(2)(ii)(E).38Prop. reg. section 1.707-7(a)(3).39Prop. reg. section 1.707-7(a)(5).

40See reg. section 1.707-3(c) and (d), discussed above.41Prop. reg. section 1.707-7(c) and (d).42T.D. 8439, section II.C. (Sept. 25, 1992); text at n.18.43Prop. reg. section 1.707-7(a)(8).44Prop. reg. section 1.707-7(e).45For a more detailed discussion of those rules in the context

of the regulations relating to disguised sales of property, seeRubin et al., supra note 11.

46Prop. reg. section 1.707-7(g).


TAX NOTES, May 30, 2005 1155

(C) T

ax Analysts 2005. A




health, law, engineering, architecture, accounting actu-arial science, performing arts, and consulting are gener-ally not subject to the new rules regarding transfers ofmoney or Marketable Securities.47

E. Treatment of LiabilitiesThe proposed regulations generally provide that

deemed contributions to and distributions from a part-nership under section 752 resulting from reallocations ofpartnership liabilities among partners are not treated astransfers of consideration for purposes of the disguisedsale rules.48 However, the amount realized by a sellingpartner on the sale of the selling partner’s interest in thepartnership includes any liability relief that occurs inconnection with the sale.49 Moreover, as discussed below,‘‘assumptions’’ of partner liabilities by a partnership or ofpartnership liabilities by a partner — which occur ipsofacto on the contribution or distribution of encumberedproperty — can trigger disguised sale treatment.1. Liability assumptions. The proposed regulations pro-vide that, if a partnership assumes a liability of a partner,the partnership is treated as transferring consideration tothe partner to the extent that the amount of the liabilityexceeds the partner’s share of the liability immediatelyafter the partnership assumes the liability.50 For purposesof that rule, a partnership is treated as assuming aliability of a partner to the extent provided in reg. section1.752-1(d) and (e).51 Under those rules, a recourse liabilityof a partner is treated as assumed by the partnership ifthe partnership becomes ‘‘personally obligated’’ to paythe liability.52 A nonrecourse liability of a partner istreated as assumed by the partnership to the extent of thefair market value of property contributed by the partnerto the partnership that is subject to the liability.53

Likewise, if a partner assumes a liability of a partner-ship, the partner is treated as transferring considerationto the partnership to the extent that the amount of theliability exceeds the partner’s share of that liability im-mediately before the partner assumes the liability.54 Thestandard for determining whether a partner has assumeda nonrecourse liability is the standard set forth in Treas.reg. section 1.752-1(e), described above. However, thestandard for determining whether a partner has assumeda recourse liability of the partnership is narrower than the

standard described above for determining whether apartnership has assumed a recourse liability of a partner.More particularly, the proposed regulations require that,for the partner to be treated as assuming a partnershipliability, the standard of reg. section 1.704-1(b)(2)(iv)(c)must be met, which requires that (1) the obligee is awareof the assumption, (2) the obligee can directly enforce thepartner’s obligation, and, (3) as between the partner andthe partnership, the partner is ultimately liable.55

A partner’s share of any liability of the partnership forthose purposes is determined as follows. A partner’sshare of a recourse liability of the partnership equals thepartner’s share of the liability under section 752 and theregulations thereunder.56 A partner’s share of a nonre-course liability of the partnership is generally determinedby applying the same percentage used to determine thepartner’s share of the excess nonrecourse liability underreg. section 1.752-3(a)(3).57

Unlike the Property Regulations, the proposed regu-lations do not provide any special treatment for ‘‘quali-fied liabilities.’’58

2. Debt financed transfers of consideration by partner-ship. The proposed regulations provide that, if a partner-ship incurs a liability and all or a portion of the proceedsof that liability are allocable under reg. section 1.163-8T toa transfer of consideration to a partner made within 90days of incurring the liability, the transfer of consider-ation to the partner is taken into account only to theextent that the amount of consideration transferred ex-ceeds that partner’s allocable share of the partnershipliability.59

3. Antiabuse rule. The proposed regulations providethat an increase in a partner’s share of a partnershipliability may be treated as a transfer of consideration bythe partner to the partnership if within a short period oftime after the partnership incurs or assumes the liabilityor another liability, one or more partners of the partner-ship, or related parties to a partner, in substance bears aneconomic risk of loss for the liability that is dispropor-tionate to the partner’s interest in partnership profits orcapital, and the transactions are undertaken under a planthat has as one of its principal purposes minimizing theextent to which the partner is treated as making a transferof consideration to the partnership that may be treated aspart of a sale under the proposed regulations.60

47See section 448(d)(2)(A).48An antiabuse rule provides that an increase in a partner’s

share of a partnership liability may be treated as a transfer ofconsideration by the partner to the partnership if within a shortperiod after the partnership incurs the liability or anotherliability, one or more partners or related parties in substancebears an economic risk for the liability that is disproportionateto the partner’s interest in profits or capital and the transactionsare undertaken under a plan that has as one of its principalpurposes minimizing the extent to which a partner is treated astransferring consideration to the partnership that may betreated as part of a sale.

49Prop. reg. section 1.707-7(j)(1).50Prop. reg. section 1.707-7(j)(2).51Id.52Reg. section 1.752-1(d)(1).53Reg. section 1.752-1(e).54Prop. reg. section 1.707-7(j)(3).

55Prop. reg. section 1.707-1(j)(3); reg. section 1.704-1(b)(2)(c).Compare reg. section 1.752-1(d)(2), which employs a similarstandard.

56Prop. reg. section 1.707-7(j)(4)(i).57Prop. reg. section 1.707-7(j)(4)(ii). Those provisions are

identical to the provisions for determining a partner’s share ofrecourse and nonrecourse liabilities under the disguised sale ofproperty regulations. See reg. section 1.707-5(a)(2).

58See reg. section 1.707-5(a)(5)-(7).59Prop. reg. section 1.707-7(j)(6). Compare reg. section 1.707-

5(b) in the Property Regulations, which contains a similar rule.60Prop. reg. section 1.707-7(j)(8). Those provisions are iden-

tical to the provisions for determining a partner’s share ofrecourse and nonrecourse liabilities under the disguised sale ofproperty regulations. See reg. section 1.707-5(a)(2).


1156 TAX NOTES, May 30, 2005

(C) T

ax Analysts 2005. A




F. Disclosure RulesThe proposed regulations provide that, when a part-

ner transfers consideration to a partnership and thepartnership transfers consideration to another partnerwithin a seven-year period, if the partners treat thetransfers other than as a sale for tax purposes, and thetransfer of consideration by the partnership (1) is notpresumed to be a guaranteed payment for capital (underreg. section 1.707-4(a)(1)(ii)), (2) is not a reasonable pre-ferred return (under reg. section 1.707-4(a)(3)), and (3) isnot an operating cash flow distribution (under reg.section 1.707-4(b)(2)), the transfers must be disclosed inaccordance with the disclosure requirements of reg. sec-tion 1.707-8. Disclosure is not required, however, if thetransfers fall within the exceptions for terminations of apartnership, formation of a partnership, or transfers toand by service partnerships, discussed above.

The proposed regulations would also amend the dis-closure requirements under the Property Regulations torequire disclosure if there is a transfer of property by apartner to a partnership, and by a partnership to thepartner, within a seven-year period instead of within atwo-year period, as provided for in reg. section 1.707-3(c)(2) and reg. section 1.707-6(c).61 That extension of theperiod for required disclosure was recommended by theJoint Committee on Taxation in its report of its investi-gation into Enron Corp.’s tax planning machinations.62

Likewise, the proposed regulations would amend reg.sections 1.707-5 and -6 of the Property Regulations torequire disclosure if a partner transfers property to apartnership and the partnership assumes or takes subjectto the liability, or a partnership transfers property to apartner and the partner assumes or takes subject to theliability (whether or not the liability is a qualified liabil-ity), within a seven-year period and the partner orpartnership does not treat the transaction as a sale for taxpurposes.

V. Examples and ProblemsThe complex mechanics of the proposed regulations

and the problems created by them are best illustrated bya series of examples.

A. Example 2 (Simultaneous Transfers; SellingPartner’s Consideration Less Than PurchasingPartner’s Consideration)

Assume that A and B are equal partners in an ‘‘old andcold’’ partnership. The partnership has assets with a fairmarket value of $600. C contributes $200 to the partner-ship and the partnership simultaneously distributes $250to A in partial redemption of its interest in the partner-ship. Assume that the transfer to A would not have beenmade but for the transfer by C, so that the ‘‘but for’’ testof prop. reg. section 1.707-7(b)(1)(i) is met.

Under the proposed regulations, the partnership, A,and C are all treated as though C transferred consider-ation of $200 to A in exchange for acquiring two-thirds ofA’s partnership interest and the partnership immediatelythereafter distributed $50 to A.63 A will recognize gainbased on an amount realized of $200, plus any reductionin A’s share of partnership liabilities occurring as a resultof the deemed sale. A will be required to allocate itsadjusted basis in its partnership interest between theportion sold and the portion retained.64 The $50 consid-eration transferred to A in excess of the amount of thedeemed sale is treated as a distribution to A immediatelyfollowing the sale.65

This ordering of the deemed transactions (a $200 salefollowed by a $50 distribution) is more favorable to Athan the alternative ordering rule would be (a $50distribution followed by a $200 sale). The ordering ruleadopted by the proposed regulations enables the tax-payer to recover a larger percentage of its adjusted basisin the partnership interest against the amount realized.To illustrate, if A’s adjusted basis in the interest is $200and there are no partnership liabilities, the ordering rulein the regulations results in A recognizing $66.67 of gainon the sale and no further gain on the distribution.66 Ifinstead the $50 distribution were deemed to occur first,A’s gain on the sale would be $80.67

Assuming the partnership’s assets have value in ex-cess of adjusted basis, C will need to be certain that thepartnership makes a section 754 election to permit C toobtain the benefit of a step-up in the adjusted basis of thepartnership’s assets with respect to C.68 If the partner-ship’s assets have value below adjusted basis, that is, abuilt-in loss, a step-down in the adjusted basis of thepartnership’s assets with respect to C will be required(subject to a de minimis rule) under amendments tosection 743 enacted by the American Jobs Creation Act of2004, signed by President Bush on October 22, 2004.

B. Example 3 (Transfer of Selling Partner’sConsideration Precedes Transfer of PurchasingPartner’s Consideration)

The facts are the same as in Example 2 except that onJanuary 1, 2007, A receives a distribution of $200 from the

61Prop. reg. section 1.707-7(k).62Joint Committee on Taxation, Report of Investigation of Enron

Corporation and Related Entities Regarding Federal Tax and Com-pensation Issues, and Policy Recommendations (JCS-3-03), February2003 (hereinafter JCT Enron Report), at p. 29.

63Prop. reg. section 1.707-7(a)(3).64See Rev. Rul. 84-53, 1984-1 C.B. 159, which provides guid-

ance on how to make that allocation.65Prop. reg. section 1.707-7(a)(5).66The gain on the sale equals the amount realized of $200

minus allocated adjusted basis of $133.33 (two-thirds of totaladjusted basis). The $50 distribution does not exceed A’sremaining adjusted basis in the interest of $66.67 and does nottrigger any additional gain. Section 731(a).

67If the $50 distribution were deemed to occur first, thedistribution would reduce A’s adjusted basis in the interest to$150 and would reduce the fair market value of A’s interest to$250. The subsequent disguised sale would therefore be $200/$250 of A’s interest, and A would therefore recover $200/$250 ofA’s remaining $150 adjusted basis ($120) against the amountrealized of $200, resulting in $80 of recognized gain.

68Section 743.


TAX NOTES, May 30, 2005 1157

(C) T

ax Analysts 2005. A




partnership in partial redemption of its interest. Thereaf-ter, on November 30, 2008, C is admitted to the partner-ship in exchange for a capital contribution of $200.

Under the proposed regulations, those transfers con-stitute a disguised sale if both (1) the transfer to A wouldnot have been made but for the transfer by C, and (2) thesubsequent transfer (here, the transfer by C) was notdependent on the entrepreneurial risks of partnershipoperations.69 However, because the two transfers occurwithin two years, they are presumed to constitute adisguised sale unless the facts and circumstances ‘‘clearlyestablish’’ that they do not.70

Although the proposed regulations contain nine ex-amples, none of them illustrate the application of the‘‘but for’’ test, the determination of whether a transfer issubject to ‘‘the entrepreneurial risks of partnership op-erations,’’ or the application of the two-year presump-tion. Seven of the examples involve fact patterns in whichthe transfers are nonsimultaneous but occur within twoyears;71 the remaining two involve simultaneous trans-fers.72 None of the seven examples involving nonsimul-taneous transfers contain any facts suggesting that thetransfer to the selling partner would not have been madebut for the transfer by the purchasing partner. Nor do anyof those examples contain any facts relevant to thedetermination of whether the subsequent transfer is‘‘dependent on the entrepreneurial risks of partnershipoperations.’’ Rather, in each example, the paragraphcontaining the facts simply sets forth the dates of trans-fers. The paragraph containing the analysis then statesthat there are no facts that rebut the application of saletreatment. The reader is left with the impression thatwhenever the transfers occur within two years, saletreatment will be mandated.

As noted above, when the transfers are nonsimulta-neous, the proposed regulations require a determinationthat the subsequent transfer is not dependent on theentrepreneurial risks of partnership operations in orderfor disguised sale treatment to prevail. It is questionablewhether that test makes sense or can even be appliedwhen, as in Example 3, the subsequent transfer is by thepurchasing partner as opposed to the selling partner. IsC’s transfer to the partnership subject to the entrepre-neurial risks of partnership operations? Certainly, C’sability to make the transfer does not depend on thesuccess of the partnership’s operations in the same waythat the partnership’s ability to make a transfer might. Onthe other hand, C presumably would not agree to becomea partner unless C is satisfied with the results of partner-ship operations. The ‘‘entrepreneurial risk’’ test wasimported from the Property Regulations, under whichthe inquiry is whether the transfer from the partnership tothe partner is dependent on the entrepreneurial risks ofpartnership operations. As applied to a transfer by apartner to the partnership, it is simply inapposite.

Assuming that there are no facts and circumstancesthat ‘‘clearly establish’’ that no sale has occurred, thetransfers constitute a disguised sale and A, C, and thepartnership are treated as if the following occurred. OnJanuary 1, 2007, C is deemed to transfer a $200 non-interest-bearing promissory note to the partnership inexchange for $200 cash. Immediately thereafter, C isdeemed to purchase two-thirds of A’s partnership inter-est in exchange for $200 cash. Thereafter, on November30, 2008, C is deemed to pay $200 to the partnership insatisfaction of the note.73

Beyond the obvious gain recognition resulting to Afrom the recharacterization of the transaction as a dis-guised sale, there are a number of additional importantand problematic consequences to the parties. First, treat-ing C as receiving an interest-free loan from the partner-ship on January 1, 2007, would implicate section 7872, therules governing below market loans. Under those rules,C may be treated as paying interest on the loan to thepartnership and then receiving an offsetting transfer ofcash back from the partnership as a distribution.74 Thatwould result in C having interest expense (which mightor might not be deductible under section 163) and thepartnership having interest income (which would betaxable).

More fundamentally, treating C as acquiring the part-nership interest on January 1, 2007, means that for allfederal income tax purposes, C has been an unwittingpartner in the partnership for 23 months before the timethat C thought it was becoming a partner. Accordingly, Cwill receive an unexpected distributive share of partner-ship items of income and deduction for the 23-monthperiod. Moreover, additional ‘‘deemed transactions’’ willbe required to rationalize the federal tax consequenceswith the fact that C does not become a state law partneruntil the later date. For example, if the partnership makescash distributions to the partners between January 1,2007 (when C becomes a partner for federal tax pur-poses), and November 30, 2008 (when C becomes apartner for state law purposes), C will not receive anyshare of the distribution because C is not a partner forstate law purposes. Because C is a partner for federal taxpurposes at the time of the distribution, must we ‘‘deem’’C to receive a share of the distribution, and then totransfer it to the other partners (who actually received it),all with attendant tax consequences?

Clearly, a person may be a partner for federal taxpurposes without being a partner for state law pur-poses.75 Nevertheless, the simple fact is that until No-vember 30, 2007, C has made no capital contribution to

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

73See prop. reg. section 1.707-7(a)(2)(ii)(C).74The regulations proposed under section 7872 in 1985 apply

that characterization in the case of an interest-free loan from acorporation to a shareholder. See prop. reg. section 1.7872-4(d).Although the proposed regulations under section 7872 dealwith only a narrow category of compensation-related belowmarket loans from partners to partnerships, the preamble to theproposed regulations states that final regulations will furtheraddress partnership transactions.

75See, e.g., Rev. Proc. 2002-22, 2002-1 C.B. 733, Doc 2002-6877,2002 TNT 54-12, in which the IRS articulated various factors that


(Footnote continued on next page.)

1158 TAX NOTES, May 30, 2005

(C) T

ax Analysts 2005. A




the partnership, has rendered no services to the partner-ship, and has no right to share in the profits, losses, orcash flows of the partnership. Under any definition ofwhat it means to be a partner for federal tax purposes, Cdoes not qualify.76

As was the case in Example 2, assuming that thepartnership’s assets have value in excess of adjustedbasis, C will need to be certain that the partnership makesa section 754 election to permit C to obtain the benefit ofa step-up in the adjusted basis of the partnership’s assets.In Example 2, however, the election will need to be ineffect for the partnership’s tax year that includes January1, 2007, when C is deemed to purchase A’s interest andbecome a partner. Because this is 23 months before Cbecame a partner for state law purposes, C may notrealize that it must request that the partnership make theelection for the earlier year. Moreover, because C wouldnot yet be a party from a state law perspective to thepartnership agreement, C may have no ability to causethe partnership to make the election.

C may not even be aware of the distribution in partialredemption of A’s interest that results in the recharacter-ization of C’s transaction as a purchase of A’s interestoccurring in an earlier year. Clearly, however, if theseregulations are finalized in their current form, C willneed to perform due diligence examining partnershipdistributions back through several years to protect itself.

In the hands of aggressive taxpayers, the ability totransfer a partnership interest from A to C with 23months retroactive effect may be exploited. For example,if C is a tax-exempt entity, transactions could be struc-tured that attempt to retroactively divert taxable incometo it. On the other hand, if the partnership generatestaxable losses and C is a taxable entity, transactions couldbe structured that attempt to retroactively transfer lossesto it outside the strictures imposed by section 706(d).

C. Example 4 (Simultaneous Transfers of DifferentProperties)77

Assume that A and B are equal partners in an ‘‘old andcold’’ partnership. The partnership owns Property 1 withan adjusted basis of $700, and a fair market value of$1,000, as well as other assets. C is admitted to thepartnership in exchange for a contribution of Property 2,which has an adjusted basis of $300 and a fair marketvalue of $1,500. The partnership simultaneously distrib-utes Property 1 to A in partial redemption of its interest inthe partnership.

Because the transfers occur within two years of oneanother, they are presumed to constitute a sale of aportion of A’s partnership interest to C. Unless the factsand circumstances ‘‘clearly establish’’ that no sale hasoccurred, the proposed regulations would treat the part-nership, A, and C as though C acquired Property 1 fromthe partnership in exchange for two-thirds of Property 2,and then C acquired A’s partnership interest in exchangefor C’s transfer of Property 1 to A.78 Accordingly, Cwould recognize gain of $800 on the deemed exchange oftwo-thirds of Property 2 for Property 1.79 Note that thisgain will be recognized even if Property 1 and Property 2are of like kind under section 1031.80 The partnershipwould recognize gain of $300 on the deemed exchange ofProperty 1 for two-thirds of Property 2.81 A wouldrecognize gain on the deemed sale of its partnershipinterest to C in exchange for Property 1.

Although the government may enjoy that gain-recognition festival, its theoretical justification seemsextremely weak and susceptible to legal challenge, par-ticularly from the perspective of C. Fundamentally, thetreatment of certain transactions as a disguised sale of apartnership interest may be seen as a statutory or regu-latory application of the step transaction doctrine.82 Thus,

it views as relevant for determining whether a state law tenancyin common relationship constitutes a partnership for federal taxpurposes.

76Section 761(b) defines a ‘‘partner’’ as a ‘‘member of apartnership,’’ which sheds little light on the issue. Section7701(a)(2) states that ‘‘the term ‘partner’ includes a member insuch a syndicate, group, pool, joint venture, or organization,’’which also sheds little light on the issue. The cases of Commis-sioner v. Tower, 327 U.S. 280 (1946), and Commissioner v. Culbert-son, 337 U.S. 733 (1949), provide general principles regarding thedetermination of whether individuals have joined together aspartners in a partnership. The primary inquiry is whether theparties had the intent to join together to operate a business andshare in its profits and losses. The inquiry is essentially factualand all relevant facts and circumstances must be examined.Furthermore, it is federal, not state, law that controls for incometax purposes, regardless of how the parties are treated understate law. See LTR 199911033, Doc 1999-10613, 1999 TNT 54-34,concluding that a limited liability company with two state lawmembers was not a partnership for federal tax purposes whenone member made no capital contribution, had no interest inprofits or losses, and had no management rights.

77This example is patterned after prop. reg. section 1.707-7(l)Example 3.

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

adjusted basis of Property 2 ($200) to the two-thirds portion ofProperty 2 exchanged for Property 1. The amount realized by Con the exchange would be $1,000, and thus C would recognize$800 of gain.

80From C’s perspective, even if Property 1 and Property 2 areof like kind within the meaning of section 1031, the exchangewould not qualify for nonrecognition treatment because Prop-erty 1 would be transferred to A immediately after the exchange.Thus, C would not hold Property 1 for investment or productiveuse in a trade or business as required by section 1031(a)(1). Evenif the exchange did qualify under section 1031, C wouldrecognize the gain on the deemed transfer of Property 1 to A inexchange for A’s partnership interest.

81If Property 1 and Property 2 are of like kind under section1031 and the other requirements of section 1031 are met, itappears that this exchange could qualify as tax-free from theperspective of the partnership.

82The step transaction doctrine is a judicially created conceptthat permits the Service to integrate various steps into a singletransaction. See Commissioner v. Clark, 489 U.S. 726, 738 (1989).Using the doctrine, the IRS can amalgamate a series of formally


(Footnote continued on next page.)

TAX NOTES, May 30, 2005 1159

(C) T

ax Analysts 2005. A




if C transfers property to a partnership and that sameproperty is transferred to partner A in partial redemptionof A’s partnership interest, a straightforward applicationof the step transaction doctrine would collapse the stepsand treat the transfer as occurring directly from C to A,with attendant purchase and sale tax consequences.

It is axiomatic, however, that the proper function ofthe step transaction doctrine is to combine existing steps,not to create new ones or reorder existing ones.83 InExample 4, the proposed regulations as applied to Cwould clearly create at least one new step. In form, Cengages in a single exchange with the partnership, trans-ferring Property 2 in exchange for a partnership interest.The proposed regulations would recharacterize this toinclude (1) a transfer of one-third of Property 2 to thepartnership in exchange for an interest in the partnershipand two-thirds of Property 2 in exchange for Property 1;and (2) the transfer of Property 1 to C in exchange for aportion of C’s partnership interest.

From C’s perspective, the form of the transactionseems perfectly consistent with its substance: C transfersProperty 2 to the partnership in exchange for an interestand, significantly, Property 2 remains in the partnership.The proposed regulations construct a taxable exchangefor C that does not in fact occur and that is inconsistent

with step transaction principles and inconsistent withsection 721(a), which would allow C to transfer Property2 to the partnership in exchange for an interest withoutrecognizing gain. If the proposed regulations are final-ized in their current form, we would not be surprised tosee them held invalid as applied to C because of theirconflict with section 721(a).

D. Example 5 (UPREIT Stock Buyback)Assume that a real estate investment trust structured

as an UPREIT84 believes that its stock, which is trading at$20 per common share, is undervalued in the market. TheREIT therefore wishes to engage in a stock buybackprogram. To effectuate this, on March 1, 2006, the oper-ating partnership makes a $20 million cash distribution tothe REIT in redemption of 1 million common operatingpartnership units held by the REIT, and the REIT thenuses the cash to buy back 1 million shares of its commonstock. Thereafter, on July 1, 2007, C contributes realproperty with an adjusted basis of $3 million and a fairmarket value of $10 million to the operating partnershipin exchange for operating partnership Units valued at $10million.

Because the transfer of cash by the operating partner-ship to the REIT and the transfer of the real property tothe operating partnership occur within two years, theyare presumed to constitute a sale of a portion of theREIT’s operating partnership interest to C. Unless thefacts and circumstances ‘‘clearly establish’’ that no salehas occurred, the proposed regulations would treat theoperating partnership, the REIT, and C as follows. Cwould be deemed to receive on March 1, 2006, a paymentof $10 million from the operating partnership in ex-change for C’s agreement to transfer C’s real property tothe operating partnership on July 1, 2007. C would bedeemed immediately thereafter to transfer the $10 mil-lion to the REIT to purchase a portion of the REIT’sinterest in the operating partnership. The REIT would bedeemed to sell a portion of its interest in the operatingpartnership to C on March 1, 2006, for $10 million and toreceive a $10 million distribution from the operatingpartnership immediately thereafter. On July 1, 2007, Cwould be deemed to transfer the real property to theoperating partnership in satisfaction of the obligationthat it entered into on March 1, 2006.

From C’s perspective, the transaction apparently con-stitutes a prepaid forward contract to sell its real propertyto the operating partnership, which presumably resultsin taxable gain to C on March 1, 2006.85 Also, C is treatedas purchasing a portion of the REIT’s interest in the

separate steps and treat them as a single transaction if the stepsin substance are ‘‘integrated, interdependent, and focused to-ward a particular result.’’ Penrod v. Commissioner, 88 T.C. 1415,1428 (1987); see generally Ginsburg and Levin, Mergers, Acquisi-tions, and Buyouts, section 608 (October-November 2004).

Over the years courts have developed three different formu-lations of the doctrine. The narrowest of the versions, called the‘‘binding commitment test,’’ will step together a series oftransactions if, when the first transaction is entered into, there isa binding commitment to undertake the later steps. Commis-sioner v. Gordon, 391 U.S. 83 (1986). Under an intermediateapproach, the ‘‘mutual interdependence test,’’ transactions willbe integrated if they are so interdependent that the first wouldbe fruitless without completing later steps. Kornfeld v. Commis-sioner, 137 F.3d 1231, Doc 98-8219, 98 TNT 43-13 (10th Cir. 1998).Under the broadest of the three approaches, the ‘‘end resulttest,’’ transactions will be stepped together if they are prear-ranged parts of a single transaction that are intended to reach anultimate result. Associated Wholesale Grocers Inc. v. United States,927 F.2d 1517 (10th Cir. 1991).

83See Grove v. Commissioner, 490 F.2d 241 (2d Cir. 1973) (courtrefused to recast a shareholder’s gift of stock to charity followedby the issuer’s redemption of that stock from the charity as aredemption from the donor followed by a gift of cash to thecharity); Greene v. United States, 13 F.3d 577, Doc 94-855, 94 TNT13-9 (2d Cir. 1994) (under similar facts, court refused to recastthe transactions under either the end result test or the mutualinterdependence test); Esmark Inc. v. Commissioner, 90 T.C. 171(1988), aff’d 886 F.2d 1318 (7th Cir. 1989) (court refused to recastP corporation’s purchase of 53 percent of T corporation’s stockin a public tender offer followed by T’s redemption of suchstock in exchange for 97 percent of the stock in T’s whollyowned subsidiary (S) (a tax-free redemption under section311(d)(2)(B) of the 1954 code) as though T sold its S stock to P forcash and then used that cash to redeem 53 percent of its stockfrom the public); see also Magneson v. Commissioner, 753 F.2d 1490(9th Cir. 1985) (failing to see a more direct route to effect thetransactions, the Ninth Circuit refused to invent new steps).

84The term ‘‘UPREIT’’ is an acronym for ‘‘umbrella partner-ship real estate investment trust’’ and refers to a structure inwhich a real estate investment trust owns substantially all of itsassets through a partnership in which the REIT is the controllinggeneral partner. See generally Rubin, Whiteway, and Forrest,‘‘Doing a Deal With a REIT: The Property Owner’s Perspective,’’57 N.Y.U. Inst. on Fed’l Tax’n Ch. 15 (1999).

85Compare Rev. Rul. 2003-97, 2003-34 IRB 1, which concludedthat a so-called ‘‘variable share prepaid forward contract’’ to sellstock where the seller retained the right to ‘‘cash settle’’ thecontract did not result in immediate gain.


1160 TAX NOTES, May 30, 2005

(C) T

ax Analysts 2005. A




operating partnership for $10 million on March 1, 2006. Cthus becomes a partner in the operating partnershipbefore it expected to and receives an unexpected distribu-tive share of operating partnership income or loss. Fromthe REIT’s perspective, the transaction constitutes a tax-able sale of a portion of its interest in the operatingpartnership to C on March 1, 2006, giving rise to taxablegain to the REIT and increasing the REIT’s requirement tomake distributions under section 857(a)(1)(A)(i).

Once again, from C’s perspective, the proposed regu-lations construct a taxable exchange in a manner that isinconsistent with step transaction principles and im-pinges on the application of code section 721(a).

E. Example 6 (Transfer of Encumbered Property)Assume that D and E are equal partners in an ‘‘old and

cold’’ partnership. D and E agree that the partnershiprequires additional capitalization and that they wish tofund those requirements equally. D makes a cash capitalcontribution of $400, and E simultaneously contributesproperty that is subject to nonrecourse indebtedness of$600 with an adjusted basis of $700 and fair market valueof $1,000. Because E’s contributed property has value inexcess of the debt (that is, equity value) equal to D’s $400cash capital contribution, D and E remain equal partners.

Bizarrely, the proposed regulations find a disguisedsale of $300 of E’s interest to D on those facts. Theanalysis is as follows. On the transfer of encumberedproperty to the partnership, E is treated as receivingconsideration from the partnership to the extent that theamount of the liability ($600) exceeds E’s share of theliability immediately after the transfer.86 Thus, E isdeemed to receive $300 of consideration from the part-nership. Simultaneously, D transfers $400 cash to thepartnership. If the deemed transfer of $300 of consider-ation to E would not have occurred but for the transfer ofconsideration by D, then a disguised sale of $300 of E’sinterest from E to D has occurred.87 Moreover, the ‘‘butfor’’ test seems to be met because the deemed transfer of$300 of consideration to E would not have occurred butfor E’s contribution of encumbered property, and E’stransfer of the encumbered property would not haveoccurred but for the transfer of cash by D.

If E had contributed cash to the partnership and thepartnership assumed a liability of E, the proposed regu-lations would allow the amount of liabilities assumed bythe partnership to be reduced (but not below zero) by themoney contributed.88 However, when, as here, the part-ner contributes property other than cash subject to aliability, the proposed regulations do not allow thatnetting and thus overlook the economic reality that E istransferring property with a net equity value in excess ofthe debt of $400, causing absurd results.

VI. ConclusionThe proposed regulations would operate to recast a

wide variety of otherwise nontaxable contribution anddistribution transactions occurring between partners andpartnerships as taxable disguised sales of a partnershipinterest. In the authors’ view, they are seriously flawedand susceptible to legal challenge.

When the transfer to the selling partner precedes thetransfer by the purchasing partner, disguised sale treat-ment turns on whether the transfer to the partnership is‘‘dependent on the entrepreneurial risks of partnershipoperations,’’ which is inapposite to say the least. Ataxpayer who innocently makes a capital contribution toa partnership in exchange for an interest may find that,because of a distribution made to another partner in aprevious year and unbeknownst to the taxpayer, thetaxpayer is treated as a partner for federal tax purposeslong before it became a partner for state law purposes,and long before it meets the criteria generally required tobe a partner for federal tax purposes. In the hands ofaggressive taxpayers, the ability to retroactively become apartner before the time the taxpayer acquires any at-tributes of partner status may be exploited. A taxpayerwho contributes appreciated property to a partnership ina transaction that appears to qualify as tax-free undersection 721(a) may find that a distribution, of which thetaxpayer was unaware, of cash or different property toanother partner transmutes the taxpayer’s transactioninto a taxable exchange in a way that is inconsistent withestablished step transaction doctrine and section 721(b).Taxpayers who transfer properties encumbered by liabili-ties to a partnership will find that the proposed regula-tions lead to absurd consequences.

The authors have never questioned the Service’s au-thority to issue regulations governing disguised sales ofpartnership interests. We are hopeful that any final (orreproposed) regulations in this area will address theproblems discussed in this article.

86Prop. reg. section 1.707-6(j)(2). Under prop. reg. section1.707-6(j)(4), E’s share of the nonrecourse liability is determinedby applying the same percentage used to determine E’s share ofthe excess nonrecourse liability under reg. section 1.752-3(a)(3)(here, 50 percent).

87Prop. reg. section 1.707-6(b)(1)(i); prop. reg. section 1.707-6(a)(3). 88See prop. reg. section 1.707-6(j)(7).


TAX NOTES, May 30, 2005 1161

(C) T

ax Analysts 2005. A




disguised sales of partnership interests:...

Documents