"Avoiding Unexpected Income Recognition from Partnership Disguised Sales and “Mixing Bowl” Transactions," PICPA CPA Now Blog

Mark Lubin Published in PICPA CPA Now Blog

One benefit of partnerships is relative flexibility in contributing and distributing property without incurring tax.¹ However, there are limitations on such flexibility. This blog reviews situations involving property contributions that can unexpectedly result in tax liability, particularly when a contribution is followed by a distribution of cash or other property to the contributing partner or there is a subsequent distribution of the contributed property to one or more other partners.²

Disguised Sales

Generally speaking, the federal disguised sale rules are intended to prevent taxpayers from circumventing income recognition through transactions where a partner contributes property to a partnership and receives actual or deemed distributions but the transaction economically amounts to a sale or exchange (as distinguished from situations where a partner retains an indirect stake in contributed property through a capital interest subject to entrepreneurial risk). Because there are various ways to provide a “purchasing” partner with benefits and burdens associated with property and a “selling” partner with purchase consideration, the disguised sale rules apply broadly and employ a factual analysis for determining when contributions and distributions will be treated as a disguised sale.³

Here are a few fundamental points regarding disguised sales:

• A disguised sale will generally be presumed to exist where contributions and distributions occur within two years of each other, and it will be presumed not to exist where they occur more than two years apart.⁴ Both presumptions are rebuttable based on clear factual evidence. Thus, practitioners can sometimes avoid or minimize disguised sale treatment by delaying distributions and documenting factors that support nonsale treatment. Also, practitioners should be aware that certain provisions (such as partnership merger rules) can result in deemed transfers that trigger a disguised sale.
• The assumption of a liability (or taking property subject to a liability) is generally treated as a cash payment that can subject a property contribution to disguised sale treatment.⁵ However, “qualified” liabilities (as defined in the regulations) receive relatively favorable treatment compared to other liabilities.⁶ Qualified liabilities generally include obligations incurred more than two years before a transfer or otherwise not in anticipation of the transfer, liabilities allocable to capital expenditures regarding contributed property, and certain “ordinary course” and other liabilities relating to a trade or business in which all material assets are transferred. Thus, advance planning regarding liabilities (e.g., incurring leverage in advance, structuring it to qualify for one or more exceptions, and obtaining partner guarantees where appropriate) can sometimes minimize application of the disguised sale rules.
• Regulations provide exceptions for certain guaranteed payments, preferred returns, operating cash flow distributions, reimbursements of preformation capital expenditures, and debt-financed distributions.⁷ Practitioners can often use those exceptions to avoid or minimize application of the disguised sale rules.

“Mixing Bowl” Transactions

Similar to disguised sales, “mixing bowl” transactions are subject to rules designed to prevent circumventing income recognition in certain situations where property is contributed to a partnership.⁸ These anti-mixing-bowl rules generally apply when contributed property either is distributed to one or more noncontributing partners within seven years of the contribution⁹ or has appreciated in value and the contributing partner receives a distribution of other property within seven years of the contribution.¹⁰

In the first situation, the contributing partner generally recognizes gain or loss under Section 704(c)(1)(B) to the extent it has precontribution gain or loss that was not previously recognized.¹¹ Character is generally determined as if the property had been sold at the time of the distribution.

In the second situation, the contributing partner is generally required to recognize gain under Section 737 equal to the lesser of the “excess distribution” (generally, the excess of the fair market value of the distributed property over the partner’s adjusted basis in the partnership interest) or the “net pre-contribution gain” (generally, the net gain the distributee partner would have recognized under Section 704(c)(1)(B) and Reg. Section 1.704-4 had all the property it contributed been distributed to another partner).¹²

From a planning perspective, it is important to keep track of the Section 704(c)(1)(B) and Section 737 “seven-year clock” following property contributions. Income recognition can sometimes be avoided by delaying distributions. Transactions such as partnership mergers that might involve an actual or deemed contribution that restarts the seven-year clock or otherwise trigger recognition should be avoided.

Conclusion

Practitioners should be vigilant whenever a partnership receives or has received property contributions. Through an awareness of the disguised sale and anti-mixing bowl rules and appropriate planning, partners and their advisers can often avoid or minimize unexpected tax liability under those provisions.

¹ See Internal Revenue Code (IRC) Sections 721 and 731. Corporate tax-free contributions are subject to greater restrictions, and corporate distributions are generally taxable.
² This discussion is not comprehensive, and it primarily addresses situations involving contributions of appreciated property. Other provisions not discussed in this article (including IRC Sections 721(b) and (c), 731(b)(1), 751, and 752) can also cause a contribution or distribution to result in tax liability.
³ IRC Section 707(a)(2)(B); Reg. Sections 1.707-3–5. Although this article focuses on potential disguised sales by partners, disguised sales can also apply to transfers by partnerships to partners. (See Reg. Section 1.707-6.)
⁴ Reg. Section 1.707-3(c)(2) requires IRS disclosure of certain transactions, including transfers treated as not involving a sale despite meeting the “within two years” presumption.
⁵ Gain recognition can also occur under general IRC Sections 731(a)(1) and 752(b) principles if a contributing partner is relieved (or considered to be relieved) of liabilities exceeding its basis in property contributed.
⁶ See Reg. Section 1.707-5.
⁷ Reg. Sections 1.707-4 and 1.707-5(b)(1).
⁸ Those rules are generally intended to promote the purposes of IRC Section 704(c) and policies similar to those behind the disguised sale rules.
⁹ IRC Section 704(c)(1)(B); Reg. Section 1.704-4.
¹⁰ IRC Section 737 and regulations thereunder.
¹¹ Exceptions apply to certain nonrecognition transactions and distributions to a partner of property that it previously contributed.
¹² Such recognition is in addition to any gain recognized under Section 731.

This blog originally posted on the PICPA’s CPA Now blog in June 2024.  

Mark Lubin can be reached at mark.lubin@chamberlainlaw.com or 610.772.2328.