The IRS and Treasury have recently issued final regulations (see T.D. 9891) regarding the contribution of appreciated property by U.S. persons to a partnership with foreign partners related to the contributing partner. Notably, these rules override the nonrecognition treatment generally afforded to transfers of appreciated property to a partnership, unless certain requirements are met. These final regulations are effective Jan. 17, 2020.
In 2017, the IRS and Treasury issued both proposed and temporary regulations in response to perceived abuse with respect to U.S. taxpayer arguments that, various Internal Revenue Code sections, gain associated with the transfer of appreciated property to a partnership could be allocated to related foreign partners not subject to U.S. taxation. These temporary and proposed regulations adopted an approach that initially disqualified certain transfers from nonrecognition treatment, but then provided an exception to that disqualification if the partnership adopted certain income allocation methodologies with respect to the property (the ‘gain deferral method’). The recently issued final regulations adopt, with some changes, the proposed regulations and remove the corresponding temporary regulations.
Generally, under the proposed rules, a contribution of built-in gain property by a U.S. person to a partnership with related foreign partners was taxable in the current period if:
- A foreign person related to the U.S. transferor is also a direct or indirect partner in the transferee partnership
- Together, the U.S. transferor and related person own 80% or more of the interests in partnership capital, profits, deductions OR losses
- In total, at least $1 million of built-in gain is transferred to the partnership by U.S. transferors
While the final regulations by-and-large adopt the same basic provisions described above, they have modified the definition of related person. Specifically, the final regulations preclude the application of certain constructive ownership rules with respect to certain corporate stock owned by partners in a partnership in determining whether an entity is a related person. According to the preamble to the final regulations, “This modification to the definition of related person provides relief when certain foreign individual partners of a partnership would be treated as a related person with respect to a domestic corporation by reason of section 267(c)(3) [constructive stock ownership].”
Additionally, as mentioned above, immediate gain recognition may be avoided under the final regulations if the transferee partnership takes certain measures – collectively referred to as the ‘gain deferral method.’ The final regulations generally adopt the same requirements with respect to this exception as those contained in the proposed regulations, with a few clarifications. Notably, the final regulations clarify that, for purposes of applying the ‘consistent allocation method’ (required to use the ‘gain deferral method’), upon variation of a partners interest in the partnership certain items with respect to the contributed property at issue that are allocated under the interim closing of the books method “will be treated as allocated in the same percentage for purposes of applying the consistent allocation method in a single taxable year…”.
Partnerships with U.S. persons and foreign persons as partners should make sure that they are familiar with these final regulations – particularly if there is the possibility or anticipation of a contribution of appreciated property to the partnership. While it is possible to avoid immediate gain recognition, partnerships and their partners must be vigilant in order to ensure that they recognize when such a transaction will be subject to these final rules, and take the appropriate steps to ensure they qualify for the exception to immediate gain recognition.