1. Partnership Leveraged Distributions: Traps Getting In and Tips Getting Out
Howard E. Abrams
Warren Distinguished Professor, USD School of Law
Todd D. Golub
Principal, National Tax, Ernst & Young, LLP
Copyright 2016 by Howard E. Abrams

2. Disguised Sales
Partnerships are both easy to get into and easy to get out of.

3. Disguised Sales
Partnerships are both easy to get into and easy to get out of.
Under section 721, the contribution of property to a partnership in exchange for a partnership interest generally is tax-free.

4. Disguised Sales
Partnerships are both easy to get into and easy to get out of.
Under section 721, the contribution of property to a partnership in exchange for a partnership interest generally is tax-free.
Under section 731, the distribution of property generally is tax-free whether as a liquidating or a nonliquidating distribution.

5. Disguised Sales
Partnerships are both easy to get into and easy to get out of.
Under section 721, the contribution of property to a partnership in exchange for a partnership interest generally is tax-free.
Under section 731, the distribution of property generally is tax-free whether as a liquidating or a nonliquidating distribution.
Putting these two provisions together, a taxpayer effectively is able to exchange one asset for another through a partnership without the recognition of gain or loss.

6. Disguised Sale of Property Definition – Section 707(a)(2)(B)
There must be a contribution of cash or property.

7. Disguised Sale of Property Definition – Section 707(a)(2)(B)
There must be a contribution of cash or property.
There must be a distribution of cash or property to the contributing partner. Either can come first.

8. Disguised Sale of Property Definition – Section 707(a)(2)(B)
There must be a contribution of cash or property.
There must be a distribution of cash or property to the contributing partner. Either can come first.
The contribution and distribution, when considered together, properly are characterized as single sale or exchange transaction.

9. “Properly Characterized” – Treas. Reg. § 1.707-3(b)
Would the distribution not have been made but for the contribution?

10. “Properly Characterized” – Treas. Reg. § 1.707-3(b)
Would the distribution not have been made but for the contribution?
If the contribution and distribution are not simultaneous, was the subsequent transaction dependent on the entrepreneurial risks of the partnership venture?

11. “Properly Characterized” – Treas. Reg. § 1.707-3(b)
Would the distribution not have been made but for the contribution?
If the contribution and distribution are not simultaneous, was the subsequent transaction dependent on the entrepreneurial risks of the partnership venture?
Were the contribution and distribution separated by two years or less? If so, strong presumption of a disguised sale. If not, strong presumption not a disguised sale.

12. “Properly Characterized” – Treas. Reg. § 1.707-3(b)
Would the distribution not have been made but for the contribution?
If the contribution and distribution are not simultaneous, was the subsequent transaction dependent on the entrepreneurial risks of the partnership venture?
Were the contribution and distribution separated by two years or less? If so, strong presumption of a disguised sale. If not, strong presumption not a disguised sale.
Presumption can be rebutted based on the facts and circumstances (generally, those facts and circumstances existing at the time of the earliest transfer)

13. “Properly Characterized” – Cont’d
The regulations specify several facts that tend to establish the existence of a disguised sale, including:
The timing and amount of the subsequent transfer are reasonably certain
The transferor has a legally enforceable right to the subsequent transfer
The transferor’s right to receive the subsequent transfer is secured
Any other partner has or is legally obligated to make contributions or loans to permit the partnership to make the subsequent transfer
The partnership has incurred or is obligated to incur debt to permit the partnership to make the subsequent transfer
The partnership holds money or other liquid assets, beyond the reasonable needs of the business

14. Effect of Disguised Sale Treatment
The transaction will be treated as a sale for all purposes of the internal revenue code including:
Installment sale provisions
OID (time value of money rules)
Like-kind exchange rules
Depreciation Recapture rules.
Gain and loss can be recognized on a disguised sale.
The contribution and distribution that are treated as a sale are not treated as a contribution or as a distribution.

15. Amount of the Disguised Sale
Often, the amount of the contributed cash or property and the amount of the associated distributed property are not the same. When this occurs, the disguised sale is the smaller amount.
Example: Property with a value of $100,000 and an adjusted basis of $30,000 is contributed to a partnership, and soon thereafter the contributing partner receives a cash distribution of $40,000. If this is a disguised sale, the disguised sale equals 40% of the property (with adjusted basis of $12,000) in exchange for cash of $40,000. The remaining $60,000 of the property is treated as being contributed.

16. The Economics of a Disguised Sale
Example: X contributes $5,000 cash to the XY partnership and Y contributes property with fair market value of $10,000 and adjusted basis of $6,000. After the partnership is formed, $4,000 of the cash is distributed to Y. If there is no disguised sale, the books become: X Y CA OB
5,000
10,000
6,000
Contributions
-4,000
Distribution
2,000
Totals

17. The Economics of a Disguised Sale
If there is a disguised sale, then Y is taxed on the $4,000 received less 40% of Y’s $6,000 basis, or $4,000 - $2,400, for a gain of $1,600. The contribution consists of the remaining property worth $6,000 and having a basis of $3,600. X Y CA OB
5,000
6,000
3,600
Contributions
2,000
From Prior Chart

18. Contribution of Encumbered Property
If encumbered property is contributed to a partnership and the debt is treated as shifting as a result of the contribution, the transaction will be treated as a simultaneous contribution and distribution. This will constitute a disguised sale to the extent of the debt shift unless the debt is a “qualified liability.”

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

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

21. Qualified Liabilities
“Qualified Liabilities” include:
Old and cold debt (more than two years old);
Debt not incurred in anticipation of contribution;
Debt allocable to capital improvements made to the property under Treas. Reg. § T; and

22. Qualified Liabilities
“Qualified Liabilities” include:
Old and cold debt (more than two years old);
Debt not incurred in anticipation of contribution;
Debt allocable to capital improvements made to the property under Treas. Reg. § T; and
Debt incurred in the ordinary course of a trade or business if substantially all the assets used in the trade or business are contributed to the partnership.

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

24. How Is Debt Allocated for Purposes of the Disguised Sale Rules?
Recourse liabilities – generally based on the portion of the debt for which the partner bears the economic risk of loss
Same as for Section 752 generally
Anti-abuse rule may apply

25. How Is Debt Allocated for Purposes of the Disguised Sale Rules?
Recourse liabilities – generally based on the portion of the debt for which the partner bears the economic risk of loss
Same as for Section 752 generally
Anti-abuse rule may apply
Nonrecourse liabilities – generally based on the partners’ shares of partnership profits
No tier 1 (minimum gain) and no tier 2 (minimum 704(c) gain)
No tier 3A (excess 704(c) gain)
Only use general profits interests or shares of allocation of some significant item from the security (such as income or depreciation)

26. Contribution of Encumbered Property: Example
P Contributes Cash of $240,000
Q Contributes Property
Value = $160,000
Adjusted Basis = $100,000
Debt = $80,000 (nonrecourse; nonqualified)
P and Q agree to divide all profits and losses 75% to P and 25% to Q, and assume the debt is allocated in the same proportions.

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

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

29. Contribution of Encumbered Property: Example
Three-Quarters ($60,000) of Debt Is Shifted to P
Disguised Sale Fraction = 60,000/160,000 (3/8)
Basis Allocated to Sale = Three-Eighths of $100,000, or $37,500

30. Contribution of Encumbered Property: Example
Three-Quarters ($60,000) of Debt Is Shifted to P
Disguised Sale Fraction = 60,000/160,000 (3/8)
Basis Allocated to Sale = Three-Eighths of $100,000, or $37,500
Gain = $60,000 - $37,500, or $22,500

31. Contribution of Encumbered Property: Example
Three-Quarters ($60,000) of Debt Is Shifted to P
Disguised Sale Fraction = 60,000/160,000 (3/8)
Basis Allocated to Sale = Three-Eighths of $100,000, or $37,500
Gain = $60,000 - $37,500, or $22,500
Gain Affects Inside Basis and Outside Basis

32. Contribution of Encumbered Property: Example Summary
Total
Sale Portion
Contribution
Debt
80,000
60,000
20,000
Value
160,000
100,000
Basis
37,500
62,500
Equity P Q
Capital Acc’t
Outside Basis
240,000
80,000
62,500
60,000
300,000

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

34. Tainted Portion
The portion of the qualified liability that is tainted is the lesser of:
The portion of the liability that would be treated as consideration of the liability were not qualified; and
The total amount of the qualified liability times the transferor partner’s “net equity percentage” in the contributed property.
Net equity percentage equals the total amount treated as received in exchange for the property (ignoring the qualified liability) divided by contributor’s equity in the property.

35. Tainted Qualified Liability Example
X contributes property with:
Value = $160,000
Adjusted basis = $40,000
Qualified Liability = $60,000
Liability Shift = $30,000 (i.e., 1/2)
Cash = $20,000
But for the cash, there would be no disguised sale.
If the liability were not qualified, total consideration would equal $20,000 + $30,000.

36. Tainted Qualified Liability Example
Tainted portion equals the lesser of:
$30,000 (the shifted portion of the liability); and
Net Equity Percentage equals $20,000 (amount of cash) divided by $100,000 (equity in the contributed property), or 20%. Since the liability equals $60,000, the net equity percentage portion equals 20% of $60,000, or $12,000.
Total consideration equals $20,000 + $12,000, or $32,000, or 1/5 of the $160,000 value of the property.
Gain equals $32,000 - $8,000, or $24,000.

37. Nonsimultaneous Contributions and Distributions
Strong presumption if contribution and distribution occur within 2 years (using date of right to receive contribution if earlier).
Equally strong presumption if contribution and distribution are separated by more than 2 years.
Several Exceptions

38. Nonsimultaneous Contributions and Distributions
Two-Year Window for Presumption.
Presumption Is Rebuttable Based on Examination of Entrepreneurial Risk.
Sale Is Deemed to Occur When Contribution Is Made Though Installment Reporting Is Possible.
Must the Partner Amend If Contribution and Distribution Are in Separate Taxable Years?

39. Recomputing the Sale Price
X contributes property to the P partnership with an adjusted basis of $10,000 and value of $100,000.
$100,000 in cash is distributed to X one year later, and the contribution and distribution are treated as a disguised sale.
Implicit interest under Section 1272 must be backed-out of the sale price for the one-year deferral. If $10,000 is the proper interest component, then X has sold 90% of the property at a taxable gain of $81,000.

40. Complete Disguised Sale
On these facts, if there were no implicit interest, X would have made no contribution.
X would not be a partner unless treated as receiving a profits-only interest (for what?).
If X is one of two partners, disguised sale could mean no partnership is formed.

41. Keeping the Other Partners Neutral
In this deferred sale example, the partnership will be entitled to an interest deduction of $10,000. How should it be allocated?
Had there been no disguised sale, there would be no interest deduction. To preserve the economics of the transaction, the interest deduction should be allocated entirely to the contributing partner so that the other partners are unaffected by the disguised sale.

42. Deferred Sale Example
X and Y form the XY partnership, with X contributing Blackacre with adjusted basis of $60,000 and value of $100,000. Y contributes cash of $50,000. Subsequently, the cash is distributed to X.
Case 1: No disguised sale.
Case 2: Disguised sale, deferred interest equals $2,000, no special allocation of interest.
Case 3: Disguised sale, deferred interest equals $2,000, special allocation of interest.

43. Case 1: No Disguised SaleX Y
Capital
Basis
$ 100,000
$ 60,000
$ 50,000
-50,000
$ 50,000
$ 10,000
Note that capital accounts are equal, showing that each partner has contributed $50,000 to the venture.

44. Cases 2 and 3: Disguised Sale
First, the numbers:
If there is a $2,000 interest component out of the $50,000 deemed paid by the partnership, then the principal amount deemed paid equals $48,000 (48% of fair market value).
If 48% of the property is deemed sold, then 52% (worth $52,000) is treated as contributed.
Of the partner’s $60,000 adjusted basis in the property, 52% (or $31,200) is allocable to the contributed portion of the property and 48% (or $28,800) is allocable to the sold portion.
The disguised sale gain thus equals $48,000 less $28,800, or $19,200.

45. Case 2: No Special AllocationX Y
Capital
Basis
$ 52,000
$ 31,200
$ 50,000
-1,000
$ 51,000
$ 30,200
$ 49,000
Note that capital accounts no longer are equal, with X having now having a majority interest in the partnership’s capital.

46. Case 3: With Special AllocationX Y
Capital
Basis
$ 52,000
$ 31,200
$ 50,000
-2,000
$ 50,000 $
Capital accounts again are equal. This allocation can be handled generically in the partnership agreement.

47. Notable Exceptions – Treas. Reg. § 1.707-4
Distributions of Operating Cash Flow.
Lesser of share of overall profits for current year and percentage of profits over life of the venture.
Safe harbor is lowest share of all material items of income over forward-looking three-year window.

48. Notable Exceptions – Treas. Reg. § 1.707-4
Distributions of Operating Cash Flow.
Lesser of share of overall profits for current year and percentage of profits over life of the venture.
Safe harbor is lowest share of all material items of income over forward-looking three-year window.
Reasonable Guaranteed Payments for Capital.
Must be based on a rate that does not exceed 150% of highest AFR.

49. Notable Exceptions – Treas. Reg. § 1.707-4
Distributions of Operating Cash Flow.
Lesser of share of overall profits for current year and percentage of profits over life of the venture.
Safe harbor is lowest share of all material items of income over forward-looking three-year window.
Reasonable Guaranteed Payments for Capital.
Must be based on a rate that does not exceed 150% of highest AFR.
Reasonable Preferred Returns.
Must be based on a rate that does not exceed 150% of highest AFR

50. Notable Exceptions – Cont’d
Reimbursement of Preformation Capital Expenditures.
Applies to formation costs and to capital expenditures incurred by the partner with respect to property transferred to the partnership.
Expenditures must be incurred by the partner within the two-year period preceding the transfer.
No limit on reimbursement of formation costs.
Limited to 20% of the value of the property if the value of the property exceeds 120% of adjusted basis.

51. Preformation Expenditures Problem
X owns unimproved real estate with adjusted basis of $400,000 and fair market value of $2,000,000. X improves the property by constructing a building at a cost of $2,500,000, increasing the value of the property to $5,000,000. Can X contribute the property and get reimbursed for the construction costs?
No! The maximum tax-free reimbursement is $1,000,000 because the value of the property exceeds 120% of its adjusted basis ($5M as compared with $2.9M).

52. Preformation Expenditure Solution
Construct the building with borrowed funds. Then contribute the building subject to the debt. The debt will be a “qualified liability” because it is allocable, under the rules of Treas. Reg. § T, to capital improvements.
Note that there is no related party limitation, so that the debt can be borrowed from an affiliate so long as the form of the loan is respected.

53. Debt-Financed Distributions (Treas. Reg. § 1.707-5(b)(1))
If a partnership incurs a liability and all or a portion of the proceeds of the liability are allocable under Treas. Reg. § T to a distribution to a contributing partner made within 90 days after incurring the liability, the distribution is taken into account under the disguised sale rules only to the extent that the amount of the distribution exceeds the partner’s allocable share of the liability
This is the rule that the “leveraged partnership” structure relies on to avoid the application of the disguised sale rules

54. Share of Debt Limitation
If the partnership borrows $100,000 and the entire debt is allocable to partner Q, then the entire $100,000 can be distributed to Q under the debt financed distribution exception.
If the partnership borrows $100,000 and half the debt is allocable to Q, then if the entire $100,000 is distributed, Q can receive $50,000 under the debt financed distribution exception.
If the partnership borrows $100,000 and half the debt is allocable to Q, if less than half the $100,000 is distributed, only half of the distribution can be distributed to Q under the debt financed distribution exception.

55. Reg. §1.752-2(j)(3) P T Consolidated Group Sub General Partner
Limited Partner
Recourse Debt

56. Reg. §1.752-2(j)(3) EquivalenceP* P T
LLC
General Partner
Limited Partner
Recourse Debt

57. Reg. §1.752-2(j)(3) EquivalenceP* P T
Debt Guarantee
Limited Partner
Limited Partner
Recourse Debt

58. Debt-Financed Distributions – Canal Corporation
Taxpayer contributed assets to a partnership, and extracted over 95% of its equity in the assets through a debt-financed distribution
Taxpayer asserted it bore the economic risk of loss through an indemnity for the principal amount of the debt
Tax Court held that the indemnity obligation should be disregarded under the anti-abuse rule and therefore treated the transaction as a disguised sale, based on findings that included the following:
The indemnity agreement served no commercial purpose, but only a tax purpose
The indemnitor’s net worth was substantially less than the potential amount of the indemnity obligation, and there were no restrictions on the indemnitor’s ability to further diminish its net worth

59. Canal Corp. Transaction
WISCO GP
Business assets
LLC

60. Canal Corp. Transaction
WISCO GP
Business assets
LLC
Bank
Loan Proceeds

61. Canal Corp. Transaction
WISCO GP
Business assets
LLC
Cash distribution
Bank
Loan Proceeds

62. Canal Corp. Transaction
WISCO GP
Obligation
Business assets
LLC
Cash distribution
Obligation
Bank
Loan Proceeds

63. Canal Corp. Transaction
WISCO
Indemnity GP
Obligation
Business assets
LLC
Cash distribution
Obligation
Bank
Loan Proceeds

64. Canal Corp. Transaction
Intercompany Note
WISCO
Indemnity GP
Obligation
Business assets
LLC
Cash distribution
Obligation
Bank
Loan Proceeds

65. Canal Corporation – Cont’d
Does Canal Corp mean the leveraged partnership structure is dead?
Canal Corp involved a consolidated subsidiary; does the anti-abuse rule have equal application in other circumstances?
If not, what should tax advisors planning a leveraged partnership transaction think about?
Scope of the indemnity
Identity of the indemnitor
Indemnitor’s net worth
Restrictions on indemnitor

66. Ordinary Course of Business Obligations
Liabilities incurred by the transferor partner in the ordinary course of business will be treated as “qualified liabilities” so long as all of the assets used in the trade or business are transferred along with the liabilities.
Note: this may raise problems when multiple cash- basis businesses are combined and receivables are held back to true up values, especially if there is inadequate working capital in the partnership.

67. Disclosure Rules
The taxpayer must disclose a contribution/distribution pair occurring within two years if not treated as a disguised sale unless:
The distribution is an operating cash flow return, a reasonable guaranteed payment, or a reasonable preferred return.
Note that reimbursement of preformation costs and capital improvements are not on the exceptions list. Must be disclosed.
Leveraged distributions must be disclosed.

68. Form of Disclosure
The disclosure must be made on Form 8275 and attached to the return.
A caption must identify the statement as a disclosure under section 707 along with:
The item for which the disclosure is being made;
The relevant dollar amounts; and
All relevant facts affecting potential disguised sale treatment.

69. Reverse Disguised Sales
The ABCD partnership has four equal partners, each having an outside basis of $10 and a capital account of $10. The partnership owns a nondepreciable capital asset with inside basis of $40, book value of $40, and current fair market value of $100. Each partner’s share of the unrealized appreciation is $15.

70. Reverse Disguised Sale
Suppose the partnership borrows $75, guaranteed only by D. The property, encumbered by the debt, is then distributed to D in a liquidating distribution. What are the books of the venture immediately after D’s exit?
Note: the regulations expressly provide that this is not a disguised sale.

71. Reverse Disguised SaleB C CA OB 25 10
Assets
Book Value
Adj. Basis
Value
Cash 75
Note: There is a suspended $45 inside basis adjustment but no gain recognized on the distribution.