Preface: Business tax and business tax planning require thorough analysis of all facts and special circumstances applicable to the factual tax details. Deference to appropriate tax planning expertise in all business tax scenarios is well-advised.
Disguised Sales Rules with Partnerships
Credit: Donald J. Sauder, CPA, CVA
In tax planning, one of the gravest mistakes is to automatically assume that the factual situations of a similar tax plan are applicable to your specific tax situation. It is often unique from situation to situation, and business to business. With features like qualified liabilities determination, and contingent liabilities, tax rules have specific fact-patterns applicable to what most business owners considers as one word – debt. In this article, we would like to consider two often overlooked, and ambiguous tax risks 1) disguised sales rules (DSR) in partnerships, and 2) the S-Corporation K-1 rules of stock basis.
Facts and circumstances of the tax rules applicable to disguised sales occur if a transfer of property by a partner to a partnership occur, followed with a subsequent transfer of money or other consideration by the partnership transferred back to the contributing partner. This is the tax definition of a disguised sale in whole, or in part. Applicable to facts and circumstances are following Internal Revenue Code (IRC) rules:
- The timing and amount of subsequent transfer are determinable with reasonable certainly at the time of an earlier transfer
- The transferor has a legally enforceable right to subsequent transfer
- The partners right to receive the transfer of money or other consideration is secured in any manner, considering the period during which it is secured
- That any person has made or is legally obligated to make contributions to the partnership in-order to permit the partnership to make the transfer of money or other consideration
- That any person has loaned or has agreed to loan the partnership the money or other consideration required to enable the partnership to make the transfer.
- That the partnership hold money or other liquid assets beyond the need of business to make transfers
- That the partner has no obligation to return or repay the money or other consideration to the partnership.
Consider the facts of real estate entrepreneurs Amos and Ulrich. They decide to start investing in farm land and organize a partnership coined “Farm Land Plains.” Amos transfers 50 acres in the “North Farm Property” that he owns personally to the partnership, in exchange for a 45% ownership interest. At the time of the transfer the “North Farm Property” has a fair market value of $400,000, and adjusted basis of $120,000. Immediately after the transfer of the “North Farm Property” to the partnership, Farm Land Plains distributes $300,000 cash to Amos, financed by a recourse loan. The Farm Land Plains partnership, next borrows $500,000 to purchase additional crop acreage. With the partnership cash distribution, Amos has an immediate taxable capital gain of $210,000. It is disguised sale, with tax implications, often unbeknownst to many partners.
When Ulrich takes the partnership books to the tax accountant for the annual tax filing preparation, the cash distribution is never scrutinized. In the following months, Ulrich receives an IRS tax notice with regards to the partnership. At the initial meeting the IRS auditor inquiries about the initial year filing of Form 1065, and property contributions and corresponding cash distributions. The IRS auditor asks Ulrich if he is familiar with the IRS disguised sales rules (DSR). Ulrich responds that they had a tax accountant prepare the partnership tax filing, and he is unaware of any reason they have a tax risk with an appreciated capital asset.
Now let’s consider a different factual tax scenario. Amos and Ulrich organize a partnership AU Real Estate. Amos transfers undeveloped land to AU Real Estate with the partnership intent of developing the property. The land Amos transfers and contributes to AU Real Estate holds a fair market value of $2,000,000 and tax basis of $1,000,000. The partnership agreement provides that at the completion of a triple net lease building on the new property, AU Real Estate will distribute $1,800,000 to Amos, financed from a construction loan. Should the distribution occur with-in two years of the contribution of land, the partnership has a disguised sale; and serious tax implications. These are examples of the types of tax traps that catch the unwary.
This is only a partial list of factual items relevant to disguised sales rules (DSR). Typically, the rules of general distributions from partnerships will be subject to the disguised sales rules (DSR) if the transactions meet the definition of a “sale”. Especially applicable in the context of partnership liquidations and subsequent contribution of assets to a new partnership, i.e. LLC, the disguised sales rules (DSR) are only item, that can create substantial disruptive risks in what appears to say be an easy real estate partnership tax filing.