New IRS Regs Add Fangs to Disguised Sale Rules for Leveraged Partnership Transactions

There’s a saying about our federal tax law: “if a favorable tax mechanism really works, the IRS will soon propose a regulation to stop its use.” We have yet another example of that phenomenon. In early October 2016, the Treasury Department released a package of partnership tax regulations regarding IRC § 707 “disguised sales” that essentially close out a practice that had often been utilized by wealthy taxpayers to get cash from an appreciated asset without immediate tax consequences.

Description of the Former Favorably Treated Practice

In the past, if a taxpayer had property that had significantly appreciated and the taxpayer wanted or needed cash, he or she could, of course, sell the property and pay capital gain tax due on the sale. In some instances, however, it was possible for the taxpayer to contribute the property to a partnership – such a capital contribution would not be considered a sale – and then have the partnership borrow, often using the appreciated property as collateral, and distribute the loan proceeds to the partner. The partner essentially received the same proceeds that would have been generated from an actual sale, but he or she did so without having to pay the tax.

Some years ago, the Treasury Department came up with regulations in an effort to limit the use of the partnership transaction, but it still was easy to do. The most recent final regulations effectively put an end to tax-deferred leveraged partnership transactions.

New Treasury Rules Regarding “Disguised Sales”

Under the new regs, all partnership debt is to be treated as nonrecourse for purposes of the disguised sale rules and generally requires that any such partnership debt be allocated to partners in accordance with their share of partnership profits. Even if the partner guarantees the partnership loan used to generate the cash, he or she will likely owe tax on the transaction as if there had been an actual sale.

Two-Year Presumption

Under the regulations, there is a rebuttable presumption that a sale has occurred when a partner makes a contribution to the partnership and receives a distribution of cash within two years of the contribution.

Regulations Will Have Adverse Effects Beyond “Disguised Sale” Transactions

Tax experts note that the new regulations not only curtail the use of “disguised sale” transactions; they will have an adverse impact on many other taxpayers who use partnerships to carry out their business objectives. The regs have important implications for many real estate investment trusts, private equity funds, and even for public companies. Some experts signal that the regulations may require a re-evaluation of all existing partnership structures, as well as a careful examination of existing guarantees and debt maintenance obligations. Moreover, taxpayers only have until January 3, 2017 to make the necessary adjustments to partnership capital accounts. After that date – in some small number of cases, even before – the new regulations may effectively preclude some taxpayers from engaging in debt-financed, leveraged partnership transactions.

Romano & Sumner: Skilled, Experienced Attorneys

Texas BarToday Top Ten BadgeHave you contemplated how these new Treasury Department regulations might affect your existing partnership interests and your future planning? In the face of these complex rules and regulations, it generally pays to discuss your unique situation with talented, experienced attorneys. The attorneys at Romano & Sumner, LLC have more than 20 years of combined experience providing expert legal assistance to clients in all types of taxation, wealth management, and estate planning. Cookie cutters are for bakers – not wealth management and estate planning attorneys. At Romano & Sumner, we listen to you and offer multiple alternatives that will help you maneuver through the complicated tax and legal arena. We pride ourselves upon our professionalism and client service. We keep our clients informed, returning your calls within 24 hours. We’re ready to assist you as you make the important decisions that affect your family. Call us at 281-242-0995 or complete our online contact form.

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    Romano & Sumner, PLLC

    Romano & Sumner, PLLC