Question

Information given: Sally is a 25% partner in the STUV partnership. She has a tax basis in her partnership interest of $300,000. Sally also owns some land and a small building that she would like to sell to the partnership. The property has a fair market value of $500,000. Sally purchased the building for $400,000, and after taking MACRS deductions, her tax basis in the building is $350,000.

In general, the realized gain or loss from a property transaction is measured by the fair market value of the property received less the tax basis of property given up. In this case, Sally will receive $500,000 in cash. Her tax basis in the property she is selling is $350,000. Her gain realized is $150,000. This gain is recognized for tax purposes and reported in taxable income unless you can find a Code section that excludes or defers the gain. Sally will recognize a gain if she sells the property to the partnership.

At first glance, the lawyer’s suggestion has some merit. If Sally contributes the property to the partnership in exchange for an increased interest in the partnership, Section 721 provides that no gain of loss is recognized. Her basis in her partnership interest is increased by her basis in the property contributed to $650,000 ($300,000 + $350,000). A subsequent distribution of cash to Sally will reduce her basis in the partnership by the amount of the cash distributed to $150,000 ($650,000 - $500,000). Gain is only recognized if the distribution exceeds her basis, which it does not.

It would appear that the lawyer’s suggestion will work to allow Sally to defer recognition of gain on the transaction.

You discuss this conclusion with the partner in your CPA firm. She states that the substance of both transactions it the same – a transfer of property for cash, and is skeptical that the tax law would allow the form of the transaction to be respected in this case. She also remembers from her experience something about disguised sales of property to a partnership. She asks you to check it out.

Question: Do you think the lawyer’s advice will work? How long do you have to wait? Prepare a memo explaining your reasoning in a clear concise manner citing appropriate primary authority. Your memo should include quotes from the appropriate section(s) of the Code and Income Tax Regulations

Answer 1

As per the law and the definition of transfer, capital gain will arise in case of transfer of property to the partnership firm, since the "transfer" is happening. The consideration for transfer is either the cash of $500,000 or increased interest in the partnership firm. In both the cases, the transfer is backed by consideration (something in return) which makes Sally liable to pay capital gains tax on the profit of $150,000 arising on the transfer of the property.

The disguised sale rules under Section 707(a)(2)(B) generally provide that transfers of money or other property between a partner and partnership must be treated as a taxable disguised sale of property in certain circumstances.

Section 707-3 states that:

"Except as otherwise provided in this section, if a transfer of property by a partner to a partnership and one or more transfers of money or other consideration by the partnership to that partner are described in paragraph (b)(1) of this section, the transfers are treated as a sale of property, in whole or in part, to the partnership. "

Sub-section 3 mentions - " (3) Application of disguised sale rules. If a person purports to transfer property to a partnership in a capacity as a partner, the rules of this section apply for purposes of determining whether the property was transferred in a disguised sale, even if it is determined after the application of the rules of this section that such person is not a partner. If after the application of the rules of this section to a purported transfer of property to a partnership, it is determined that no partnership exists because the property was actually sold, or it is otherwise determined that the contributed property is not owned by the partnership for tax purposes, the transferor of the property is treated as having sold the property to the person (or persons) that acquired ownership of the property for tax purposes. "

Thus, based on the above reasoning and quotations, the lawyer's advice is not fully correct in this case.