No gain or loss generally is recognized on a transfer of property to a partnership in exchange for an interest in that partnership for federal income tax purposes (note that “partnership” here includes a limited liability company). Different rules, however, apply when the partnership has foreign partners that are related to the person transferring the property.
Exchanges of Property
When property is exchanged for other property, each party to the exchange generally is taxed on the difference between the fair market value of the property that the party receives over the adjusted basis of the property that the party transfers.[1] A property’s adjusted basis in most cases is the amount paid to acquire it after taking into account such factors as depreciation or amortization.[2] Thus, the transfer of property in exchange for a partnership interest generally would result in the recognition of gain or loss to the transferor and the partnership in the absence of a provision in the Internal Revenue Code preventing this result.
Contributions of Property to a Partnership
Section 721(a) is that provision. This section generally provides that no gain or loss is recognized to the partnership or its partners when there is a contribution of property in exchange for an interest in the partnership. Instead, the person contributing the property takes a basis in the partnership interest equal to the adjusted basis of the property.[3] Likewise, the partnership’s basis in the contributed property is the same as its adjusted basis in the hands of the transferor.[4] These provisions serve to preserve the built-in gain in the contributed property until the partnership sells or otherwise disposes of the property.
Partnerships are not taxed at the entity level.[5] Instead, the partners are taxed on their distributive shares of partnership income, with these shares generally being determined by the partnership agreement.[6]
Nevertheless, there are certain limitations on how a partner’s distributive share is determined. One of these limitations is found in section 704(c), which typically requires built-in gain from contributed property to be allocated to the partner that contributed the property. The purpose of section 704(c) is to prevent the shifting of built-in gain in property to other partners through partnership contributions.[7] The regulations describe three methods for making allocations under section 704(c), one of which is the “remedial allocation method.”[8]
Special Rules for Contributions of Property to Partnerships with Foreign Partners
Section 721(c) of the Internal Revenue Code also allows the Secretary of the Treasury to promulgate regulations that govern situations in which there is a transfer of property with built-in gain to a partnership if such income would be includible in the gross income of a person other than a U.S. person.
In regulations finalized in 2020, the Treasury Department did just that.[9] Apparently, the Treasury Department was concerned that certain U.S. taxpayers were claiming to be able to allocate built-in gain relating to contributed property to foreign partners in a manner that was consistent with section 704(c).[10] The section 721(c) regulations were promulgated to prevent that result.[11]
The section 721(c) regulations require a U.S. person (the “U.S. transferor”) transferring certain property with built-in gain (“721(c) property”) to a partnership that has a direct or indirect foreign partner who is related to the U.S. transferor to recognize gain on the transfer unless certain requirements are met.[12] Examples of related persons include siblings, spouses, ancestors, lineal descendants, fiduciaries and beneficiaries of trusts, certain business entities, and certain owners of business entities.[13] Foreign persons include individuals who are not U.S. citizens or residents and business entities that are not formed under the laws of the United States.[14]
This gain recognition rule doesn’t apply if : 1) the contribution is made directly to the partnership and the U.S. transferor and any related persons do not own more than 80 percent or more of the interests in partnership capital, profits, deductions, or losses; or 2) the total built-in gain of all property transferred to the partnership in the taxable year doesn’t exceed $1 million.[15]
Even if the gain recognition rule in section 721(c) applies, the partnership can still defer the immediate recognition of gain on 721(c) property under what is called the “gain deferral method.” The gain deferral method requires the following:
- Either the distributive shares of partnership gain for the section 721(c) property for all related foreign partners must be subject taxation as effectively connected with a U.S. trade or business and neither the partnership nor any related foreign partner claims a treaty-based exemption or reduced rate, or the partnership must adopt both the remedial allocation method described in the section 704(c) regulations with respect to the 721(c) property and the “consistent allocation method.”[16] The consistent allocation method is intended to prevent certain potential abuses of the remedial allocation method.[17]
- The U.S. transferor must recognize gain equal to the built-in gain with respect to the 721(c) property upon an acceleration event.[18] Generally, an acceleration event is any event that will reduce the amount of built-in gain that the U.S. transferor will recognize under the gain deferral method if the event had not occurred or could defer the recognition of the remaining built-in gain.[19] Examples include a contribution of the contributed property to another partnership or failure to comply with gain deferral method with respect to section 721(c) property.[20]
- The partnership must comply with certain procedural and reporting requirements.[21] These requirements include information regarding the 721(c) property to the IRS on the partnership’s return for the year in which the contribution of the 721(c) property takes place and annual reporting regarding the 721(c) property.[22]
- The U.S. transferor must extend the period of limitations on the assessment of tax with respect to various items connected to the 721(c) property.[23]
Final Thoughts
Navigating the rules that apply to contributions of property to partnerships with related foreign partners can be complicated. If you have any questions, we’re here to help. Contact us for a free consultation.
[1] Treas. Reg. § 1.61-2(d)(1).
[2] See I.R.C. §§ 1011, 1012, 1016.
[6] See I.R.C. §§ 701, 702, 704.
[7] Treas. Reg. § 1.704-3(a)(1).
[8] Treas. Reg. § 1.704-3(a)(1).
[9] See 85 Fed. Reg. 3833 (Jan.23, 2020); 82 Fed. Reg. 7582 (Jan. 19, 2017).
[10] 82 Fed. Reg. 7583.
[11] Id.
[12] Treas. Reg. §§ 1.721(c)-1(b)(14), 1.721(c)-2(b).
[13] See I.R.C. §§ 267(b), 707(b)(1); Treas. Reg. § 1.721(c)-1(b)(12).
[14] See I.R.C. § 7701(a)(4), (5); Treas. Reg. § 1.721(c)-1(b)(11).
[15] Treas. Reg. § 1.721(c)-2(b).
[16] Treas. Reg. § 1.721(c)-3(b)(1).
[17] See 82 Fed. Reg. 7588.
[18] Treas. Reg. § 1.721(c)-3(b)(2).
[19] Treas. Reg. § 1.721(c)-4(b).
[20] Treas. Reg. § 1.721(c)-4(b).
[21] Treas. Reg. § 1.721(c)-3(b)(3).
[22] Treas. Reg. § 1.721(c)-6(b)(1)-(4).
[23] See Treas. Reg. §§ 1.721(c)-3(b)(4), 1.721(c)-6(b)(5).
