Proposed Guidance Under Internal Revenue Code Section 707 Relating to Disguised Sales of Property¹

by Michael P. Burns²

EXECUTIVE SUMMARY

The Internal Revenue Code (the "Code") provides generally that partners are entitled to contribute property to a partnership tax free and are entitled to receive a tax-free return of previously taxed profits through distributions. This result does not apply, however, where the transaction is characterized as a disguised sale of property. Disguised sales treatment may occur when a partner contributes property to a partnership and soon thereafter receives a distribution of money or other consideration from the partnership. The Treasury Regulations (the "Regulations") provide an exception to the disguised sales rules for certain debt-financed distributions. Under these circumstances, the partner is not deemed to have received "money or other consideration" for disguised sale purposes.

The Treasury Regulations specify that a partner’s share of a recourse liability equals the portion of that liability for which the partner bears the economic risk of loss. For purposes of determining the extent to which a partner has a payment obligation (or economic risk of loss), all partners who have obligations to make payments are presumed to actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. Therefore, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation, all payment obligations allocated to the partners will increase the partner’s basis in the partnership (and therefore reduce taxes on future distributions).