United States

IRS activates exception to nonrecognition on partnership contributions


Section 721(a) sets out one of the fundamental principles of partnership taxation: absent narrowly defined exceptions, no gain or loss is recognized when a person transfers property to a partnership in exchange for an interest in the partnership. However, section 721(c) allows the IRS to promulgate regulations taxing the transfer of appreciated property to a partnership if the unrealized gain would be allocated to a non-U.S. person when recognized by the partnership (such as a contribution of appreciated property to a partnership with a foreign partner). Section 721(c) has no effect without implementing regulations and has remained dormant since its enactment in 1997.

In 2015, the IRS issued Notice 2015-54, which promised regulations implementing section 721(c) and described how those regulations would function. After considering comments submitted by tax practitioners and others, the IRS issued the promised regulations in identical temporary and proposed form. The regulations adopt an approach that initially disqualifies certain transfers from nonrecognition treatment, but then provides an exception to that disqualification if the partnership adopts certain income allocation methodologies with respect to the property (the ‘gain deferral method’).

What transactions are subject to the new regulations?

The new section 721(c) regulations provide a narrow exception to the statutory nonrecognition rules. Specifically, transfers by U.S. persons to partnerships would be taxable if the following criteria are met:

  • A foreign person related1 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 percent 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

Certain transferred property is also excluded from the application of section 721(c), even if made to a partnership described above. Exempted property includes:

  • Cash equivalents
  • Securities2
  • Property with a built-in gain of less than $20,000
  • Interests in a partnership, where 90 percent of the partnership’s asset value consists of the above three types of assets

What are the consequences of a transfer subject to section 721(c)?

A transfer subject to the new section 721(c) regulations, by default, results in gain being recognized by the transferor. However, this immediate gain can be avoiding by adopting what the regulations refer to as the gain deferral method. To adopt the gain deferral method, the transferee partnership must take the following steps:

  • The partnership must use the remedial allocation method for any income or deduction items related to the contributed property
  • With certain exceptions for regulatory allocations, the partnership must allocate all book items from the property in the same manner (the ‘consistent allocation method’)
  • The transferor must immediately recognize some or all of the remaining precontribution appreciation on the occurrence of certain ‘acceleration events’
  • The partnership and the transferor must meet certain reporting requirements disclosing various items of information with respect to the contribution
  • The U.S. transferor must consent to extend the statute of limitations with respect to the transfer (various extension periods apply, but the longest is to the close of the eighth full taxable year following the contribution)

Special rules in the case of tiered partnerships (including where a partnership interest is itself the transferred property). In the case of property that would give rise to income effectively connected with a trade or business within the United States (effectively connected income (ECI), generally taxable to non-U.S. persons), the requirement to use the remedial method and the consistent allocation method does not apply, but taxpayers must meet all other requirements. Also, the ECI exception applies only if no one claims benefits under a tax treaty to reduce or exempt the income from ECI taxation.

Effective date

These regulations are generally effective to transfers that will occur or have occurred after Aug. 6, 2015 (the issue date of Notice 2015-54, which originally described the anticipated regulations). Certain (generally taxpayer friendly) provisions not described in the original notice are effective for transfers made on or after Jan. 18, 2017, but may be applied to earlier transactions by taxpayer election. While no election statement is required, electing taxpayers must elect to apply the regulations on a timely filed tax return (with extensions) or an amended return filed no later than six months after Jan. 18, 2017.

1 Within the meaning of sections 267(b) and 707(b)(1)
2 As defined by section 475(c)(2), ignoring section 475(c)(4)


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