In Notice 2015-54, the IRS indicates it will be issuing regulations under Code Section 721(c) which will provide that transfers of appreciated property to controlled partnerships that have a related foreign partner will not qualify for nonrecognition treatment unless a specific “gain deferral method” is followed.
FACTS: Code Section 721(a) provides that no gain or loss is recognized on the contribution of property to a partnership by a partner. Since 1997, Code Section 721(c) has given authority to the IRS to issue regulations that nonrecognition would be unavailable if any gain on appreciated contributed property would be included in the gross income of a foreign person when recognized. Until now, the IRS has not exercised that authority. In Notice 2015-54, the IRS has advised that regulations will be issued that will allow for gain recognition when there are foreign partners of the partnership, absent compliance with a gain deferral method safe harbor. The Notice provides significant detail on what the regulations will provide.
Many practitioners believed that no regulations would ever be issued under Section 721(c), at least as to U.S. contributors, since it requires that it operates only if any built-in gain will be eventually included in the gross income of a non-U.S. person. This would be difficult to accomplish since Section 704(c) allocates built-in gain back to the contributing partner when recognized, and thus does not allow for a shift of that gain from a U.S. contributing partner to a different foreign partner.
The IRS indicated that it thought these rules are being manipulated via misvaluations of contributed property, and they also imply that some of the allocation of gain methods under Section 704(c) may not operate to avoid all gain allocable to foreign persons (which gain allocations may result in no U.S. taxation of such gains). While such movement abroad is circumscribed as to transfers to foreign corporations under Section 367(a), ever since the repeal of Sections 1491-1494 there is no corollary limitation in regard to transfers to partnerships. Thus, the IRS felt it necessary to breathe life into Section 721(c) to protect the fisc.
The new regulations will provide that Section 721(a) nonrecognition will not apply when a U.S. Transferor contributes an item of Section 721(c) Property (or portion thereof) to a Section 721(c) Partnership, unless the Gain Deferral Method is applied with respect to the Section 721(c) Property. That’s the new rule in a nutshell, with the details being in the definitions of the capitalized terms.
A “U.S. Transferor” is any U.S. person other than a domestic partnership – thus, the regulations will apply to all U.S contributors (other than domestic partnerships). “Section 721(c) Property” is appreciated property other than cash, securities, and tangible property with appreciation not exceeding $20,000. A Section 721(c) Partnership is a domestic or foreign partnership (a) with a (direct or indirect) foreign partner that is related to a U.S. Transferor, and (b) the U.S. Transferor and related persons own 50% or more of the partnership.
If Section 721(c) applies to void nonrecognition of gain, nonrecognition is still available if the “gain recognition method” is applied. This requires (1) the partnership uses the “remedial” allocation method of Treas. Regs. Section 1.704-3(d) for built-in gain as to currently contributed property (which acts to allocate income and loss items among partners to work down the disparity between book and tax basis differences arising from contributions of appreciated property), and also as to subsequently contributed property until all built-in gains are recognized or 60 months, whichever is earlier, (2) while there is remaining built-in gain all Section 704(b) income, gain, loss and deduction with regard to that property will be allocated in the same proportions among the partners, (3) new reporting requirements are met, (4) the U.S. Transferor recognizes built-in gain upon an Acceleration Event. An “acceleration event” is any transaction that either would reduce the amount of remaining built-in gain that a U.S. Transferor would recognize under the Gain Deferral Method if the transaction had not occurred or could defer the recognition of the built-in gain (other than transfers of partnership interests to domestic corporations under Section 351 or 381), and (5) the U.S. Transferor agrees to an extended 8 year statute of limitations on these tax items.
Helpfully, a general exception to the new rules will apply if the aggregate built-in gain of Section 721(c) Property in a year is $1 million or less, if there is no Gain Deferral Method then in operation. How nice it would be for taxpayers if all new complex regulations enacted to address the few taxpayers engaged in aggressive tax planning would have reasonably generous de minimis exceptions from applicability, like these.
While the regulations are not yet out, when they do come out they will have an August 6, 2015 effective date (or earlier deemed contributions from check-the-box elections made on or after this date) for most of their provisions. This should not be a problem for taxpayers given the reasonably detailed provisions in the Notice.
The IRS indicated it will also adopt additional rules under Section 482 to address controlled transactions involving partnerships in cases where they believe that taxpayers are inappropriately shifting income to related foreign partners.
COMMENTS: There is good news and bad news for taxpayers here.
The bad news is that ANYTIME a contribution of appreciated property is made to a partnership, a review of the application of Section 721(c) will now be needed if there is a non-U.S. partner. Importantly, Section 721(c) applies whether the contribution is to a domestic or a foreign partnership. Thus all practitioners that deal with partnerships or LLCs, including those focused principally on estate planning, will need to apply these rules whenever appreciated property is contributed to the entity (although the requirement of a foreign direct or indirect partner will likely quickly eliminate most closely-held partnerships and LLCs from the rules). Since Section 721(c) is not presently on the radar of most practitioners, this is a trap for the unwary. The addition of more complexity to Subchapter K is also not a welcome event - the ballooning complexity of that Subchapter over the years is a trend that these new rules continue.
The good news is multifaceted. First, Section 721(c) will only apply in limited circumstances. There needs to be a foreign partner (but be wary of the “indirect” rule). There will need to be appreciation over $1 million. Also, the applicable U.S. Transferor and persons related to the U.S. Transferor must own more than 50% of the partnership. Second, even if Section 721(c) does apply, there is not significant downside to adopting the Gain Recognition Method as a method of avoiding gain recognition beyond administrative inconvenience.
Notice 2015-54
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