Prior to the enactment of Code Sec. 707(a)(2) in 1984, taxpayers recognized that by combining a contribution of property with a distribution of cash to the contributing partner, the economic substance of a sale could be achieved without current taxation to the seller/contributing partner, provided the form of the transaction was respected. This was the case because, generally, contributions of property to and distributions of property from a partnership are not taxable to the partnership or its partners.¹ Conversely, if the seller/contributing partner received allocations of partnership taxable income under Code Sec. 704(b), the remaining partners could achieve the effect of a deduction for the purchase price of the property. Longstanding regulations under Code Secs. 721 and 731 stated that a contribution of property followed by a distribution would be taxed as a sale if that was the economic substance of the transaction.² Nevertheless, taxpayers enjoyed considerable success in litigating disguised sale cases, and a number of court decisions treated contribution/distribution transactions that arguably were similar to sales as tax-free transactions.

For example, in Otey v. Commissioner,³ a taxpayer formed a partnership with another party in order to construct FHA-financed housing on property owned by the taxpayer. The taxpayer contributed the property to the partnership with an agreed value of $65,000, while the other party contributed no capital. However, the other party’s credit worthiness was essential to obtaining the construction loan, which was in an amount greater than needed for the construction. The taxpayer received a distribution from the partnership of the first $65,000 of proceeds from the construction

loan within six months after the formation of the partnership and the transfer of the property to it. The court held that the taxpayer’s contribution of property to the partnership and the partnership’s distribution of cash to the taxpayer were tax-free under Code Secs. 721(a) and 731(a), and did not constitute a taxable sale to the partnership under Code Sec. 707(a).

Congress expressed its disapproval of Otey and similar cases by enacting Code Sec. 707(a)(2)(B) as part of the Deficit Reduction Act of 1984.⁴ Code Sec. 707(a)(2)(B), which was generally effective for property transferred after March 31, 1984,⁵ recharacterizes transactions involving the contribution of property to a partnership and the distribution of property from a partnership as one of two types of sale or exchange transactions. The first is the sale or exchange of property between a partner and a partnership. The second is the sale or exchange of a partnership interest by one partner to another partner. Code Sec. 707(a)(2)(B) provides in pertinent part:

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The legislative history states:

S. Print 98-169, Vol. I, at 225 (1984); H. Rept. 98-432, at 1218 (1984).⁶

Regulations interpreting and implementing Code Sec. 707 were proposed by the Treasury Department on April 24, 1991 and finalized, with modifications, on September 25, 1992. Those regulations set forth detailed rules to determine whether transactions will or will not be treated as disguised sales of property between a partner and a partnership.⁷

Under the regulations, a partner’s transfer of property to a partnership and the partnership’s transfer of money or other consideration to the partner constitute a sale of the property, in whole or in part, by the partner to the partnership only if, based on all the facts and circumstances, “(i) the transfer of money or other consideration would not have been made but

for the transfer of property, and (ii) in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.”⁸ Whether the distribution to the partner occurs before or after the contribution to the partnership is immaterial.⁹

The facts and circumstances existing on the date of the earliest transfer (i.e., contribution or distribution) are “generally” the relevant ones to be considered.¹⁰ The regulations contain a nonexclusive list of 10 factors that tend to prove the existence of a sale. The factors are as follows: (1) that the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer; (2) that the transferor has a legally enforceable right to the subsequent transfer; (3) that the partner’s right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured; (4) 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; (5) 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, taking into account whether any such lending obligation is subject to contingencies related to the results of partnership operations; (6) that the partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer, taking into account the likelihood that the partnership will be able to incur that debt (considering such factors as whether any person has agreed to guarantee or otherwise assume personal liability for that debt); (7) that the partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be available to make the transfer (taking into account the income that will be earned from those assets); (8) that the partnership distributions, allocations or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property; (9) that the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and (10) that the partner has no obligation to return or repay the money or other consideration to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present

value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner.¹¹

Importantly, the regulations provide that if within a two-year period there is a contribution by and a distribution to a partner, the transfers are presumed to be part of a sale of the property to the partnership. This presumption is rebuttable only if “the facts and circumstances clearly establish that the transfers do not constitute a sale.”¹² If the contribution by and distribution to the partner are more than two years apart, the transfers are presumed not to be a sale of the contributed property, “unless the facts and circumstances clearly establish that the transfers constitute a sale.”¹³ The preamble to the final regulations clarifies that the “clearly establish” standard is intended to impose a higher evidentiary burden than the mere “preponderance of the evidence” standard generally applicable in civil tax cases.¹⁴

We believe that it would be perilous to conclude that disguised sales of partnership interests are immune from attack in the absence of regulations or that the favorable cases that pre-dated Code Sec. 707(a)(2)(B) survive its enactment until regulations are issued. First, as noted above, the Deficit Reduction Act of 1984 generally provided that Code Sec. 707(a)(2)(B) was effective with respect to property transferred after March 31, 1984.¹⁵ Second, in cases where the Code provides that a particular rule is to apply

“under regulations prescribed by the Secretary,” the courts have generally concluded that the rule applies even in the absence of regulations.¹⁶ Third, the regulations under Code Sec. 707(a)(2)(B) (which “reserved” with respect to disguised sales of partnership interests) provide that “in the case of any transaction with respect to which one or more of the transfers occurs on or before April 24, 1991 [the date proposed regulations were issued], the determination of whether the transaction is a disguised sale of property (including a partnership interest) under section 707(a)(2) is to be made on the basis of the statute and the guidance provided regarding that provision in the legislative history of section 73 of the Tax Reform Act of 1984.”¹⁷ [Emphasis added.] The implication that the regulations govern the determination of whether transactions occurring after April 24, 1991 should be treated as a disguised sale of partnership interests is presumably inadvertent, in light of the fact that the regulations reserve those rules. Nevertheless, it seems likely that, when issued,¹⁸ the regulations delineating disguised sales of partnership interests will provide that transactions pre-dating the regulations are governed by the statute and legislative history. Fourth, and perhaps most significantly, two cases that are mentioned with disapproval in the legislative history of Code Sec. 707(a)(2)(B) involved situations where the Service argued unsuccessfully that the transaction in question constituted a disguised sale of a partnership interest. A court would likely hold that these two cases were, in effect, overruled legislatively and that cases that follow a similar fact pattern should be decided against the taxpayer in light of the enactment of Code Sec. 707(a)(2)(B).

The first case mentioned in the legislative history of Code Sec. 707(a)(2)(B) involving a disguised sale of a partnership interest was Communications Satellite Corp. v. United States.¹⁹ In that case, the Court of Claims concluded that the admission of new partners to an existing partnership followed immediately by distributions of their capital contributions to the existing partners did not constitute a taxable sale of partnership interests by the existing partners. In Communications Satellite,

the taxpayer was a taxable corporation formed pursuant to an Act of Congress to participate in an international joint venture (“INTELSAT”) sponsored by the United Nations. INTELSAT was originally formed as a joint venture with 19 partners, but was open to the admission of other partners. Each original partner made a capital contribution based on its percentage interest in profits and losses. Thereafter, each new partner was required to make a capital contribution to the joint venture based on a formula. The effect of the formula was to place each new partner in essentially the same position with respect to capital contributions and profits distributions as if it had been a partner from the beginning. The joint venture would then distribute the amount received from the new partner to the existing partners to reflect the reduction in their percentage interests.

The Service argued that the admission payments and the distributions to the taxpayer that followed together constituted the sale of part of the taxpayer’s partnership interest. The Court of Claims concluded that the payments to the taxpayers were distributions by the partnership and not the proceeds of a sale of a partnership interest. In reaching its conclusion, the court emphasized a number of factors not present in typical commercial transactions, including (1) the special nature of the joint venture, (2) the lack of financial negotiations and contracts of sale between the incoming partners and the existing partners, (3) the existing partners had no control over the admission of new partners, who were admitted to further the objectives of the venture, and (4) the amount of the contribution had no relationship to the value of the incoming partners’ interests.

The second case mentioned in the legislative history of Code Sec. 707(a)(2)(B) involving a disguised sale of a partnership interest was Jupiter Corp. v. United States.²⁰ In that case, the Court of Claims again rejected the Service’s contention that the admission of partners followed by a partial liquidation of another partner’s interest constituted a taxable sale of a partnership interest. In Jupiter Corp., the taxpayer owned a 77.5 percent general partner interest in a partnership and another party owned the entire remaining 22.5 percent limited partner interest. Under the partnership agreement, the taxpayer was obligated to supply all monies, in excess of the mortgage loan, needed to complete construction of a high rise building project. Pursuant to this obligation, the taxpayer loaned the partnership approximately $4,000,000, interest free, before construction of the project was completed. As a result of a reorganization of the partnership, a group of new limited partners was admitted in exchange for a

capital contribution. The initial limited partner refused to agree to the admission if it would result in a dilution of his interest. Therefore, as a result of the admission, the taxpayer’s partnership interest was reduced to 57.5% and the new limited partners received a 20% interest in the aggregate. The capital contributions of the new limited partners were used to make distributions to the taxpayer and the initial limited partner, and to pay off the taxpayer’s loan to the partnership.

The Service argued that the taxpayer had, in substance, sold a 20% capital interest in the partnership to the new partners. The Court of Claims held that the form of the transaction as a contribution and distribution should be respected, emphasizing that the transaction was structured in accordance with legitimate business considerations. The court reasoned that a direct sale between the general partner and the newly-admitted limited partners would not have achieved the parties’ intent, which was for the general partner to retain sole managerial control of the partnership and for the new limited partners to achieve insulation from partnership liabilities. The court also stressed that a principal objective of the partnership tax provisions was to afford the parties flexibility in allocating the tax burden of partnership transactions among themselves.