Kenneth W. Gideon Chair, Section of Taxation

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1 Defending Liberty Pursuing Justice CHAIR Kenneth W. Gideon Washington, DC CHAIR-ELECT Dennis B. Drapkin Dallas, TX VICE CHAIRS Administration Sylvan Siegler Kansas City, MO Committee Operations Charles H. Egerton Orlando, FL Communications Celia Roady Washington, DC Government Relations Stuart M. Lewis Washington, DC Professional Services Robert E. McKenzie Chicago, IL Publications Jerald D. August West Palm Beach, FL SECRETARY Evelyn Brody Chicago, IL ASSISTANT SECRETARY Christine L. Agnew New York, NY COUNCIL Section Delegates to the House of Delegates Stefan F. Tucker Washington, DC Paul J. Sax San Francisco, CA Immediate Past Chair Richard A. Shaw San Diego, CA MEMBERS Ellen P. Aprill Los Angeles, CA Samuel L. Braunstein Fairfield, CT Glenn R. Carrington Washington, DC Thomas A. Jorgensen Cleveland, OH Carolyn M. Osteen Boston, MA Lloyd Leva Plaine Washington, DC Charles A. Pulaski, Jr. Phoenix, AZ Rudolph R. Ramelli New Orleans, LA N. Susan Stone Houston, TX Fred T. Witt, Jr. Phoenix, AZ Mark Yecies Washington, DC Joel D. Zychick New York, NY LIAISON FROM ABA BOARD OF GOVERNORS Bruce M. Stargatt Wilmington, DE LIAISON FROM ABA YOUNG LAWYERS DIVISION Patrick T. Schmidt Louisville, KY LIAISON FROM LAW STUDENT DIVISION Lee Rankin Lincoln, NE DIRECTOR Christine A. Brunswick Washington, DC Eric Solomon Acting Deputy Assistant Secretary (Tax Policy) Department of the Treasury 1500 Pennsylvania Avenue, NW Washington, DC Hon. Donald L. Korb Chief Counsel Internal Revenue Service 1111 Constitution Avenue, NW Washington, DC Re: Gentlemen: Section of Taxation 10th Floor th Street N.W. Washington, DC (202) FAX: (202) Comments Concerning Disguised Sales of Partnership Interests Enclosed are comments concerning disguised sales of partnership interests. These comments represent the individual views of those members who prepared them and do not represent the position of the American Bar Association or of the Section of Taxation. Sincerely, Enclosure cc: Kenneth W. Gideon Chair, Section of Taxation Michael J. Desmond, Tax Legislative Counsel (Acting), Treasury Nicholas J. DeNovio, Deputy Chief Counsel Technical, IRS Heather C. Maloy, Associate Chief Counsel (Passthroughs & Special Industries), IRS William P. O Shea, Deputy Associate Chief Counsel (Passthroughs & Special Industries), IRS Matthew Lay, Acting Attorney Advisor, Tax Legislative Counsel, Treasury Christine Ellison, Chief, Branch 3, Passthroughs & Special Industries Division, IRS

2 COMMENTS CONCERNING DISGUISED SALES OF PARTNERSHIP INTERESTS The following comments are the individual views of the members of the Section of Taxation who prepared them. The comments do not represent the position of the American Bar Association or of the Section of Taxation. These comments were prepared by individual members of the Partnerships & LLCs Committee of the Section of Taxation. Principal responsibility was exercised by Glenn Mincey and Eric Sloan. Substantive contributions were made by Patrick Browne, Phillip Gall, Steve Gorin, Steven Klig, Steven Schneider, Todd Smith, and Wayne Strasbaugh. The comments were reviewed by Jim Wreggelsworth, Committee Vice-Chair. The comments were also reviewed by Robert Schachat of the Section s Committee on Government Submissions and by Fred Witt, Supervisory Council Director. Although the members of the Section of Taxation who participated in preparing these comments have clients who would be affected by the federal income tax rules applicable to the subject matter addressed by these comments, or have advised clients on the application of such rules, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these comments. Contacts: Glenn Mincey (212) Eric Sloan (212)

3 EXECUTIVE SUMMARY 1 Section 707(a)(2)(B) 2 was added to the Code by the Deficit Reduction Act of This provision grants to the Treasury Department ( Treasury ) and the Internal Revenue Service (the IRS ) the authority to promulgate regulations concerning both disguised sales of property between partners and partnerships (the Property Regulations ) and disguised sales of partnership interests. The Property Regulations, which were promulgated in September of 1992, 4 reserved on the subject of disguised sales of partnership interests. On November 26, 2004, the IRS and Treasury issued proposed regulations on the subject of disguised sales of partnership interests (the Proposed Regulations ). 5 In an attempt to maintain consistency with the familiar rules of the Property Regulations, the IRS and Treasury drafted the Proposed Regulations to follow the form of the Property Regulations. In the preamble to the Proposed Regulations, the IRS and Treasury requested comments regarding specific issues. We appreciate the opportunity to provide comments both in response to these specific requests from the IRS and Treasury and in response to other provisions in the Proposed Regulations. We also appreciate the IRS s and Treasury s consideration of our past comments. We reiterate our suggestions from the 2004 Comments that the Proposed Regulations, when promulgated by the IRS and Treasury in final form (the Final Regulations ), should balance the legitimate interests of the government in defeating abusive tax reduction schemes with two important taxpayer concerns. First, if principles from the Property Regulations are extended directly to the Final Regulations, many legitimate business transactions (in which the parties neither contemplated nor expected a sale between the departing partner and the new partner) might be treated as disguised sales of partnership interests. Second, the government s interest in defeating abusive tax reduction schemes must be balanced against tax complexity. In addition, we reiterate our suggestion in the 2004 Comments that the Final Regulations should be more narrowly drafted than the Property Regulations. Accordingly, we suggest the Final Regulations treat a transaction as a sale only if the partner s contribution would not have been made but for the distribution to the departing partner, and the distribution to the 1 For additional and more thorough background on the history of and issues related to disguised sales of partnership interests, please see Tax Section of the American Bar Association, Comments on Disguised Sales of Partnership Interests, 2004 TAX NOTES (Apr. 2, 2004) (the 2004 Comments ). 2 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended (the Code ), and all Treas. Reg. references are to the Treasury Regulations promulgated under the Code. 3 Deficit Reduction Act of 1984, Pub. L. No , 73, 98 Stat. 494, 591, as amended by the Tax Reform Act of 1986, Pub. L , 1805(b), 100 Stat T.D. 8439, C.B. 126 (Sept. 30, 1992). Proposed regulations were published in the Federal Register in April of Fed. Reg. 19,055 (Apr. 25, 1991). 5 REG , 69 Fed. Reg. 68,838 (Nov. 26, 2004)

4 departing partner would not have been made but for new partner s contribution (a double but for test ). We recognize the government s unstated concern that economically similar transactions could have different tax consequences without the promulgation of a suitable test to identify transactions more appropriately regarded as sales. In issuing the Proposed Regulations, the IRS and Treasury have made significant progress toward accomplishing the goal of balancing the legitimate interests of the government in defeating abusive tax reduction schemes with these important taxpayer concerns. Nevertheless, as discussed in this letter, if the Proposed Regulations are finalized in their current form, many unintended and unwarranted consequences will arise. PRINCIPAL RECOMMENDATIONS 1. We recommend that the Final Regulations provide that, if (i) there is a direct or indirect transfer of money or other property by one or more partners to a partnership resulting in an increase in the partnership interest of the transferor partner(s), (ii) there is a related direct or indirect transfer of money or other property by the partnership to one or more other partners resulting in a corresponding decrease in the partnership interest(s) of the transferee partner(s), and (iii) each transfer described in clause (i) and (ii) would not have been made but for the other transfer, such transfers will be treated as a sale of a partnership interest by the transferee partner(s) to the transferor partner(s). 2. We recommend that the following two factors from the Property Regulations not be included in the Final Regulations as facts and circumstances relevant to the determination of the existence of a disguised sale of a partnership interest because such factors do not appear to be relevant with respect to sales of partnership interests: (i) the transfer of consideration by the partnership to the selling partner is disproportionately large in relationship to the selling partner s general and continuing interest in partnership profits; 6 and (ii) the selling partner has no obligation to return or repay the consideration to the partnership, or has an obligation to return or repay the consideration due at such a distant point in the future that the present value of that obligation is small in relation to the amount of consideration transferred by the partnership to the selling partner We recommend that the Final Regulations indicate that the absence of any of the listed facts and circumstances suggests that a disguised sale of a partnership interest has not occurred. 4. We recommend that the Final Regulations include a number of examples illustrating the application of the facts and circumstances set forth in the Proposed Regulations, particularly examples in which the presumption of a disguised sale of a partnership interest is rebutted. 6 7 Prop. Treas. Reg (b)(2)(vi). Prop. Treas. Reg (b)(2)(vii)

5 5. We recommend that the Final Regulations clarify the scope of the favorable presumption for transfers of money, including marketable securities that are treated as money under section 731(c)(1), to a partner in complete redemption of a partner s interest We recommend that the Final Regulations provide a safe harbor from disguised sale of partnership interest recharacterization for routine contributions to and distributions from securities partnerships, adopting the definition of a securities partnership from the section 704(c) regulations that define the term for purposes of allowing such partnerships to aggregate reverse section 704(c) allocations. 7. We recommend that the Final Regulations provide a safe harbor from disguised sale of partnership interest recharacterization for transfers to and from partnerships involved in staged closings when such transfers represent an interest charge for the delay between stages. 8. We recommend that the Final Regulations include examples demonstrating the operation of the safe harbor distributions, particularly the operation of distributions intended to constitute reimbursement of preformation expenditures. 9. We recommend that the Final Regulations provide that contributions and distributions of different property are treated as a disguised sale of a partnership interest only if (i) the property contributed by the purchasing partner is disposed of by the partnership within a short time (e.g., nine months); (ii) a distribution of property is made to the selling partner within two years of the contribution; and (iii) the distribution was made with the principal purpose of avoiding disguised sale of partnership interest treatment. 10. We recommend that the Final Regulations provide that initial allocation of partnership liabilities (in addition to subsequent reallocations) under section 752 will not be treated as part of a disguised sale of a partnership interest. 11. We recommend that the Final Regulations provide an exception from disguised sale of partnership interest treatment for the assumption of qualified liabilities. 12. We recommend that the Final Regulations provide a tracing regime in determining the consequences of a cash contribution made in close proximity to a liability incurred to fund a distribution. 13. We recommend that the Final Regulations provide that a disguised sale of a partnership interest should be treated as occurring upon the latest of the transfers by the purchasing partner to the partnership or by the partnership to the selling partner. 14. We recommend that the Final Regulations provide an exception from disguised sale of partnership interest treatment for transfers incident to partnership mergers. 8 Prop. Treas. Reg (e)

6 15. We recommend that the Final Regulations provide a reference to Treas. Reg (c)(6), noting that the IRS retains the authority to disregard the form of a merger transaction where it is part of a larger series of transactions that have been engaged in to avoid the principles of the Final Regulations. 16. We recommend that the Final Regulations provide an exception from disguised sale of partnership interest treatment for transfers incident to partnership divisions. 17. We recommend that the Final Regulations provide a reference to Treas. Reg (d)(6), noting that the IRS retains the authority to disregard the form of a partnership division where it is part of a larger series of transactions that have been engaged in to avoid the principles of the Final Regulations. 18. We recommend that the Final Regulations provide that disclosure of transactions is required under the Property Regulations and the Final Regulations for transfers of property made within three years. 19. We recommend that the Final Regulations provide that only the partnership should bear the reporting burden for transactions that may be considered disguised sales of partnership interests. DETAILED COMMENTS I. The General Test for a Disguised Sale of a Partnership Interest As we discussed in the 2004 Comments, Congress had a narrow focus in enacting section 707(a)(2)(B). Specifically, Congress was concerned that taxpayers had deferred or avoided tax on sales of property (including partnership interests) by characterizing sales as contributions of property (including money) followed, or preceded, by a related partnership distribution. 9 That is, Congress sought to prevent transactions in which, even though the parties did not document a transaction as a sale, the intent of the parties was in fact to engage in a sale, and the involvement of the partnership was a mere subterfuge. Stated differently, Congress sought to treat such transactions in a manner consistent with their underlying economic substance. Consistent with Congressional intent, the IRS and Treasury, in drafting the Property Regulations, determined that, when a partner transfers property to a partnership, nominally as a contribution, the partnership transfers property to the partner, nominally as a distribution, and the combined effect is to allow the transferring partner to withdraw all or a part of his or her equity in the transferred property, the transaction generally should be considered to be a sale of property to the partnership. 10 To discern the intention of the parties to engage in a 9 STAFF OF THE JOINT COMM. ON TAXATION, 98th Cong., GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, at 226 (COMM. PRINT 1984); H.R. REP. NO , at 1218 (1984) (the House Report ); S. REP. NO , at 225 (1984) (the Senate Report ). 10 See Preamble to Prop. Treas. Reg through 9 (the preamble to the proposed Property Regulations ), 56 Fed. Reg. 19,055 (Apr. 25, 1991)

7 sale, the Property Regulations ask whether there has been a transfer of property, and whether there has been a related transfer of money or other consideration that would not have been made but for the transfer of property. 11 In the 2004 Comments, we suggested that the Proposed Regulations be more narrowly drafted than rules concerning disguised sales of property, a view echoed by other commentators. 12 Moreover, the IRS and Treasury agreed that it was appropriate for the Proposed Regulations to be narrower than the Property Regulations. Nevertheless, in an apparent attempt to maintain consistency with the familiar rules of the existing Property Regulations, the IRS and Treasury drafted the Proposed Regulations to follow the form of the Property Regulations. Thus, the Proposed Regulations provide that a transfer of consideration by a partner (the purchasing partner) to a partnership and a transfer of consideration by the partnership to a different partner (the selling partner) constitute a sale of the selling partner s partnership interest only if, based on all of the facts and circumstances, the transfer by the partnership would not have been made but for the transfer to the partnership, and, in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent upon the entrepreneurial risks of partnership operations. 13 We reiterate our statements in the 2004 Comments that, although the Property Regulations certainly serve as a useful framework for the IRS and Treasury, we recommend that the Final Regulations be more narrowly drafted than the Property Regulations because (i) disguised sales of partnership interests offer limited potential for tax abuse, and (ii) the Proposed Regulations, if finalized in their current form, would impose a more substantial recharacterization upon a particular transaction than the Property Regulations currently impose. More importantly, however, we reiterate our suggestion that the Final Regulations apply to recharacterize a transaction as a disguised sale of a partnership interest only when it can be determined that the selling partner and the purchasing partner each agreed to or expected a particular result, or reached a meeting of the minds with regard to the sale and purchase of a partnership interest. To make this determination, we suggest the Final Regulations adopt a double but for test, under which a transaction would be treated as a sale only if the partner s contribution would not have been made but for the distribution to the departing partner, and the distribution to the departing partner would not have been made but for new partner s contribution. The balance of this letter discusses the Proposed Regulations and the areas with respect to which the IRS and Treasury have requested comments. Specifically, this letter discusses (i) the facts and circumstances relevant to the determination of whether a disguised sale of a partnership interest exists, (ii) presumptions and safe harbors in the Proposed Regulations and Property Regulations, (iii) rules in the Proposed Regulations relating to Treas. Reg (b)(1). See Tax Section of the New York State Bar Association, Report on Disguised Sales of Partnership Interests, 2003 TAX NOTES (Feb. 13, 2003) (the NYSBA Report ). 13 Prop. Treas. Reg (b)(1)

8 liabilities, (iv) application of the Proposed Regulations to partnership mergers and divisions, and (v) disclosure rules. II. Facts and Circumstances A. Facts and Circumstances Continue to Be Relevant 1. We Recommend That Certain Facts and Circumstances In the Proposed Regulations Be Reconsidered Like the Property Regulations, the Proposed Regulations provide that the determination of whether a series of transactions will constitute a sale is based upon all of the facts and circumstances surrounding a transaction. The Property Regulations include ten nonexclusive facts and circumstances that are relevant in determining whether a transaction is a disguised sale of property. 14 As discussed in the 2004 Comments, we believe that many of the facts and circumstances from the Property Regulations are also relevant in addressing disguised sales of partnership interests. Accordingly, we suggested in the 2004 Comments that the Proposed Regulations emphasize those factors that indicate an intention to minimize the entrepreneurial risk to which the departing partner s distribution is subject. Specifically, we suggested that the Proposed Regulations emphasize those facts and circumstances delineated in the Property Regulations that either determine or ensure certainty as to the amount, timing, enforceability, or source of the departing partner s distribution. Like the Property Regulations, the Proposed Regulations include a list of ten nonexclusive facts and circumstances that are intended to be relevant to the determination of the existence of a disguised sale of a partnership interest. 15 A number of new facts and circumstances are listed, but many of the facts and circumstances are adopted from the Property Regulations. We question whether the following two factors are relevant to the determination of the existence of a disguised sale of a partnership interest: (i) the transfer of consideration by the partnership to the selling partner is disproportionately large in relationship to the selling partner s general and continuing interest in partnership profits; 16 and (ii) the selling partner has no obligation to return or repay the consideration to the partnership, or has an obligation to return or repay the consideration due at such a distant point in the future that the present value of that obligation is small in relation to the amount of consideration transferred by the partnership to the selling partner. 17 The first factor, whether the transfer of consideration by the partnership to the selling partner is disproportionately large in relationship to the selling partner s general and continuing interest in partnership profits 18 should be considered in determining whether a partner Treas. Reg (b)(2). Prop. Treas. Reg (b)(2). Prop. Treas. Reg (b)(2)(vi). Prop. Treas. Reg (b)(2)(vii). Treas. Reg (b)(1)(ix)

9 engaged in a disguised sale of property to the partnership, in our view. A transaction in which a purported partner contributes property to a partnership in exchange for minimal continued participation in the entrepreneurial risks associated with such property could indeed be indicative of a disguised sale of such property, because such facts would indicate that the partner has cashed out of its equity investment in the property. Nevertheless, it is difficult to see how the relative amount of the reduction of a partner s interest in the partnership as compared to the partner s retained interest is more indicative of a sale of the partner s interest rather than a redemption of such interest. With respect to the second factor, whether the selling partner has an obligation to return or repay the consideration to the partnership, 19 it is questionable whether this factor is particularly relevant even to the determination of a disguised sale of property. That is, a partner typically does not have an obligation to return a distribution to a partnership nor does a seller of property typically have an obligation to return a transfer of consideration. Regardless of the factor s relevancy with respect to disguised sales of property, we find it particularly difficult to see how this factor is relevant to distinguish a sale of a partner s interest from a redemption of such interest. 2. We Recommend That the Final Regulations Provide Examples of Application of Facts and Circumstances With respect to analyzing the facts and circumstances of a transaction, the Proposed Regulations provide simply that the facts and circumstances existing on the date of the earliest transfer are those considered, and that the weight to be given each of the facts and circumstances will depend on the particular case. 20 We believe that the Final Regulations should include a number of examples illustrating the application of the facts and circumstances in a manner similar to the examples included in the Property Regulations that illustrate the analysis of the facts and circumstances under those regulations. 21 In addition, we recommend that the Final Regulations indicate that the absence of any of the listed facts and circumstances suggests or supports the conclusion that a disguised sale of a partnership interest has not occurred. Example 1. A and B each owns a 50-percent interest in partnership AB. AB holds property worth $8 million. On July 2, 2008, AB transfers $2 million to A. On July 14, 2009, C transfers $2 million to AB in exchange for an interest in AB. C s transfer was not contemplated by any of the parties at the time of AB s transfer to A. There were no negotiations between C and A (or between AB and either C or A) concerning any transfer of consideration Treas. Reg (b)(1)(x). Prop. Treas. Reg (b)(2). See Treas. Reg (f), Examples

10 Because AB s transfer to A and C s subsequent transfer to AB occurred within two years, the transfers would be presumed under the Proposed Regulations to be a sale of a portion of A s interest in AB to C. 22 Nevertheless, the absence of any of the listed facts and circumstances suggests that a disguised sale of a partnership interest has not occurred. Moreover, if the facts and circumstances existing on the date of the earliest transfer are those considered, C s transfer to AB was not even contemplated at such time. Finally, the fact that there were no negotiations between C and A (or between AB and either C or A) concerning any transfer of consideration establishes that a disguised sale of a partnership interest has not occurred. III. Presumptions and Safe Harbors A. Transfers in Complete Redemption of a Partner s Interest As we discussed in the 2004 Comments, if a partner exchanges his entire interest for cash, the partner will recognize all of his gain (or loss) regardless of whether the partnership interest is redeemed for a cash distribution or whether the partner sells his partnership interest to another partner. (As was noted in the 2004 Comments, however, there may be different treatment under sections 734(b) and 743(b), 23 and sections 751(a) and 751(b). 24 We also note that there may be a difference under section 1(h)(6). 25 ) Therefore, a cash distribution resulting in the complete redemption of a partner s interest offers little opportunity for tax abuse. Consistent with our suggestion in the 2004 Comments, the Proposed Regulations include a favorable presumption for transfers of money, including marketable securities that are treated as money under section 731(c)(1), to a partner in complete redemption of a partner s interest. 26 Nevertheless, the favorable presumption is subject to a significant limitation. Such a transfer is presumed not to be a sale, in whole or in part, of the selling partner s interest in the partnership to the purchasing partner unless the facts and circumstances clearly establish that the transfer is part of a sale Prop. Treas. Reg (c). If the transaction is respected as a contribution and subsequent distribution, the rules of section 734(b) will apply, rather than those of section 743(b). Notably, applying the rules of section 734(b) may generally result in a less favorable result for the contributing partner than if the contributing partner had instead purchased an interest and obtained a positive basis adjustment with respect to the partnership s assets under section 743(b). 24 We note that there may be differences between sections 751(a) and (b). While we believe that the IRS and Treasury should minimize such apparent differences in formal guidance, we believe that the different treatment under sections 751(a) and (b) should not be sufficient reason to prevent an exception under the Final Regulations for transactions involving complete redemptions. It is anticipated that formal guidance with respect to section 751 is forthcoming. See Office of Tax Policy and Internal Revenue Service, Priority Guidance Plan, 2004 TNT (July 27, 2004). 25 Treas. Reg. 1.1(h)-1(b)(3)(ii) (regulations under section 1(h)(6), which would require the allocable share of section 1250 gain to be taken into account in determining unrecaptured section 1250 gain upon the sale of a partnership interest held for more than one year, do not apply to the redemption of a partnership interest). 26 Prop. Treas. Reg (e)

11 Due to the significant limitation, we question the utility of this favorable presumption. Under the Proposed Regulations, the general determination of whether a transaction is a disguised sale of a partnership interest is if, based on all of the facts and circumstances, the transfer by the partnership would not have been made but for the transfer to the partnership. The standard for rebuttal of the presumption in favor of complete redemptions of a partner s interest is explicitly greater than the general standard. That is, the facts and circumstances must clearly establish a disguised sale of a partnership interest rather than simply indicate that one exists. It is easy to see that this analysis will be fraught with uncertainty, perhaps to the point of futility. Moreover, there is no clear indication of what facts and circumstances will be most indicative of disguised sale of partnership interest treatment, or whether differing tax consequences will be considered relevant. Thus, while we believe that this presumption will be favorable to taxpayers, absent clarification, it appears that the qualifying language in this presumption may cause considerable confusion. B. Securities Partnerships and Staged Closings To promote certainty and administrative convenience, we suggested in the 2004 Comments that the IRS and Treasury provide specific protective safe harbors under the Proposed Regulations for particular commonplace transactions that should not be treated as sales of partnership interests. The Proposed Regulations include a safe harbor for transfers of money to and from a service partnership (a partnership that would be described in section 448(d)(2) if the partnership were a corporation). 27 That is, substantially all of the activities of the partnership must involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and substantially all of the interests in the partnership must be owned directly or indirectly by employees, former employees, or their successors. 28 In the preamble to the Proposed Regulations, the IRS and Treasury requested comments on whether the Proposed Regulations should include additional safe harbors, and if so, how to appropriately define those categories of partnerships. As we suggested in the 2004 Comments, we believe that another safe harbor should be provided for securities partnerships. Many securities partnerships admit new partners after the formation of the partnership and entirely or partially redeem the interests of other partners on a routine basis. Our experience is that the admission of a new partner to these partnerships typically is unrelated, as a factual matter, to the partial or complete redemption of another partner. Therefore, it seems that such contributions and distributions should not be considered to involve the sale of a partnership interest. Accordingly, we believe that the IRS and Treasury should provide a safe harbor for routine contributions to and distributions from securities partnerships. The Final Regulations could adopt the definition of a securities partnership from the section 704(c) regulations that Prop. Treas. Reg (g). See section 448(d)(2)

12 define the term for purposes of allowing such partnerships to aggregate reverse section 704(c) allocations. 29 We also suggested in the 2004 Comments that a safe harbor be provided for staged closings in syndicated offerings. In staged closings, a partnership receives investments from partners at different times, or in stages. In many instances, partners who invested in earlier stages will receive distributions that are funded with contributions from partners who invest in later stages. Often, the partnership requires partners who invest in later stages to include an additional amount in their contribution to represent an interest charge for the delay between the earlier stage and the later stage. That interest charge is distributed to the partners who invested in the earlier stage. Although there has been a contribution by the later stage investor and a distribution to the earlier stage investors, we recommend that this transaction not be considered a disguised sale of a partnership interest. Finally, in our experience, the parties view staged closings as purely an administrative convenience. If these transactions were treated as sales transactions, it would perhaps be possible to wait to close the offering until all investors had subscribed, but this would be done solely to avoid an adverse tax result. To avoid imposing distortions on real, economically motivated transactions where there is little potential for tax abuse, we believe that it is appropriate for the IRS and Treasury to provide a safe harbor for transfers to and from partnerships involved in staged closings when such transfers represent an interest charge for the delay between stages. To the extent that other situations arise in which the IRS and Treasury feel that a safe harbor would promote certainty and administrative convenience, the IRS and Treasury should retain the flexibility to provide additional safe harbors and favorable presumptions under the Final Regulations in public guidance similar to the manner in which the IRS and Treasury may provide safe harbors under the Property Regulations 30 and additional safe harbors under the Proposed Regulations Treas. Reg (e)(3). The regulations define a securities partnership as a partnership which is either a management company or an investment partnership, and the partnership makes all of its book allocations in proportion to the partners relative book capital accounts (except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership). A management company is a partnership registered with the Securities and Exchange Commission as a management company under the Investment Company Act of An investment partnership is a partnership that (i) holds, on the date of each capital account restatement, qualified financial assets that constitute at least 90 percent of the fair market value of the partnership's non-cash assets; and (ii) reasonably expects to make revaluations at least annually. 30 Treas. Reg (e) (providing that the IRS may provide, by guidance published in the Internal Revenue Bulletin, that certain payments or transfers to a partner are not treated as part of a disguised sale of property). 31 Prop. Treas. Reg (h)

13 C. Safe Harbors From the Property Regulations The Property Regulations provide that certain distributions will not be considered to be disguised sale proceeds. These safe harbor distributions include certain guaranteed payments, preferred returns, operating cash flow distributions, and reimbursement of preformation expenditures. 32 We note that the Proposed Regulations adopt the safe harbor distributions of the Property Regulations. 33 We believe that it would be useful for the Final Regulations to include examples demonstrating the operation of the safe harbor distributions. The operation of distributions intended to constitute guaranteed payments, preferred returns, and operating cash flow distributions appears to be reasonably clear. The operation of distributions intended to constitute reimbursements of preformation expenditures, however, is unclear, and an example depicting the operation of such distributions is particularly warranted. In addition, we reiterate our suggestion from the 2004 Comments that the Final Regulations include (and the Property Regulations should be amended to include) safe harbors for distributions that are intended to satisfy a distributee s liability for income taxes incurred as a result of an allocation of income to the distributee. 34 The preamble to the Proposed Regulations provides that the IRS and Treasury intend to address deficiencies and technical ambiguities in the Property Regulations. Although changes to the definition of operating cash flow distributions (as set forth in Treas. Reg (b)(2)(i)) are not specifically mentioned, we reiterate our suggestion that the IRS and Treasury take the opportunity to expand the definition of operating cash flow distributions to include partnership taxable income or loss resulting from sales other than in the ordinary course of the partnership s business. A transfer of money is an operating cash flow distribution if it does not exceed the partner s interest in net cash flow, defined by reference to partnership taxable income or loss in the ordinary course of the partnership s business and investment activities. 35 This definition does not provide for circumstances under which the partnership obtains distributable cash by selling a significant partnership asset. Thus, although a distribution to the partners of a partnership of cash obtained from the sale of a significant partnership asset would not seem to be appropriately treated as part of a disguised sale transaction, such distribution would not be protected under any safe harbor. Accordingly, we recommend that the IRS and Treasury expand the definition of operating cash flow distributions to include partnership taxable income or loss resulting from sales other than in the ordinary course of the partnership s business Treas. Reg Prop. Treas. Reg (f). One possible definition for such tax distributions could constitute distributions not in excess of the product of (i) the total amount of a partner s share of partnership taxable income multiplied by (ii) the maximum federal, state, and local tax rates, to the extent that such distributions exceed the total distributions provided for in Treas. Reg (b). 35 Treas. Reg (b)(2)(i)

14 D. Contribution and Distribution of Different Property The general rule in the Proposed Regulations and the timing presumption in Prop. Treas. Reg (c) for transfers made within two years, apply to transfers of consideration. Thus, a contribution of one property to the partnership and a distribution of different property from the partnership ( transfers of different property ) can result in disguised sale of partnership interest treatment under the Proposed Regulations; in fact, transfers of different property made within two years are presumed to result in disguised sale of partnership interest treatment. In the 2004 Comments, we recommended that transfers of different property not result in disguised sale of partnership interest treatment. 36 Although our prior comments were unheeded on this point, the preamble to the Proposed Regulations requests comments on whether a favorable presumption or safe harbor for such transactions is appropriate. 37 We feel very strongly that transfers of different property generally should not result in disguised sale of partnership interest treatment. Although we are mindful of the legitimate concern expressed in the preamble, we believe that such concern can best be addressed with a narrowly tailored antiabuse rule. Under the Proposed Regulations, when simultaneous transfers of different property result in disguised sale of partnership interest treatment, the parties and the partnership are treated as if, on the date of the sale, the purchasing partner transferred property to the partnership in exchange for the property to be transferred to the selling partner and then the purchasing partner transferred that property to the selling partner in exchange for the selling partner s interest in the partnership. 38 The Proposed Regulations include an example ( Example 3 ) that illustrates the treatment of transfers of different property: A and B each owns a 50% interest in partnership AB. AB holds Whiteacre, real property with a fair market value of $1,000x and a tax basis of $700x, along with other assets. AB has no liabilities. On January 1, 2008, C transfers Investment Property, with a fair market value of $1,500x and a tax basis of $300x, to AB. Simultaneously with that transfer, AB transfers Whiteacre to B. 39 The Proposed Regulations state that the transfers are presumed to be a disguised sale of a partnership interest (because they occur within two years) and that there are no facts to rebut the presumption. Accordingly, C is deemed to have transferred $1,000x of the Investment Property to AB in exchange for Whiteacre and then to have transferred Whiteacre to B in exchange for a portion of B s interest in AB with a value of $1,000x. 40 On the exchange of the See the 2004 Comments, p. 24. See also the NYSBA Report, at REG , 69 Fed. Reg. at 68,841. Prop. Treas. Reg (a)(2)(ii)(B). Prop. Treas. Reg (l), Ex. 3(i). Prop. Treas. Reg (l), Ex. 3(iii)

15 Investment Property for Whiteacre, C recognizes gain of $800x ($1,000x - $200x allocable basis), and AB recognizes gain of $300x ($1,000x - $700x basis). B recognizes gain or loss under section 741 based on an amount realized of $1,000x. C is also considered to have contributed to AB, in C s capacity as a partner, $500x of the Investment Property ($1,500x total value - $1,000x amount treated as consideration paid by C to AB) with an allocable basis of $100x in a transaction to which section 721 applies. Because AB is deemed to have engaged in a sale of Whiteacre and recognized gain of $300x, A will be allocated his share of such gain, even though he made no transfers and did not change his percentage interest in the partnership. The Proposed Regulations contain a list of ten non-exclusive facts and circumstances that tend to establish the existence of a sale. 41 Although Example 3 specifically states that no facts rebut the presumption of a disguised sale of a partnership interest, it appears that three of the specified facts and circumstances militate against disguised sale of partnership interest treatment: (i) the same property transferred to the partnership by the purchasing partner is not transferred to the selling partner; (ii) there were no negotiations between the purchasing partner and the selling partner (or between the partnership and each of the purchasing and selling partners with each partner being aware of the negotiations) concerning any transfer of consideration; and (iii) the selling partner and the purchasing partner did not enter into one or more agreements, including an amendment to the partnership agreement (other than for admitting the purchasing partners) relating to the transfers. 42 Are taxpayers intended to infer that these facts and circumstances are not enough to rebut the presumption that the transfers constitute a disguised sale of a partnership interest under the Proposed Regulations? If Example 3 is retained in the Final Regulations, we believe that the Final Regulations should explain why such facts and circumstances were insufficient to rebut the two-year presumption. We believe that the application of the Proposed Regulations to transfers of different property exceeds the statutory authority. Section 707(a)(2)(B) provides as follows: If (i) (ii) (iii) there is a direct or indirect transfer of money or other property by a partner to a partnership, there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property, such transfers shall be treated either as a transaction described in paragraph (1) or as a transaction between 2 or more partners acting other than in their capacity as members of the partnership Prop. Treas. Reg (b)(2). See Prop. Treas. Reg (b)(2)(iii), (ix), and (x)

16 In order for sale treatment to possibly apply, the statute demands that the transfers properly be characterized as a sale or exchange of property (or partnership interests). In other words, the statute authorizes sale treatment if the parties are in the same position after the transfers as they would have been had they merely sold the property (or partnership interests). In Example 3, the parties actual transfers standing alone cannot be characterized as a sale of a partnership interest. When the partnership interest is sold, nothing happens to the partnership. As a result of the actual transfers in Example 3, partnership AB no longer owns an historic asset (Whiteacre) and acquires a new asset (Investment Property). That is not substantively the same as if B had merely sold his partnership interest to C. We do not believe that section 707(a)(2)(B) should be applied to create a series of transactions that never occurred in order to find a transaction that is a taxable sale of a partnership interest. Our view of section 707(a)(2)(B) is supported by the legislative history. None of the three cases cited in the legislative history involved transfers of different property. 43 Furthermore, in each of those cases, the government argued that the substance of what the taxpayers did in two steps could be best characterized as one event a sale. The same cannot be said of the transfers in Example 3. Our reading is supported by the balance of the Proposed Regulations and also by the Property Regulations. In all of the other examples in the Proposed Regulations, and all the examples in the Property Regulations in which a disguised sale is found, two steps are recharacterized as one sale. In Prop. Treas. Reg (l), Ex. 1, for example, the transfer of $500 to the partnership and the transfer of $500 from the partnership are characterized as one sale transaction between selling partner and purchasing partner for $500. Similarly, in Treas. Reg (f), Ex. 1, the transfer of property X to the partnership and the partnership s transfer of $3,000,000 to the same partner are characterized as one sale. Example 3 of the Proposed Regulations, in stark contrast, creates additional steps to find that a disguised sale of a partnership interest has occurred. We recommend that the application of the Proposed Regulations to transfers of different property also be rejected as a matter of policy because such application would interfere with normal, non-abusive business transactions. For instance, suppose that, in Example 3, C believes that Whiteacre is a poor long-term investment and that the costs of maintaining Whiteacre are not worthwhile. C may make a business decision that he will not join the partnership if it continues to hold Whiteacre. A and B believe that the Investment Property is a good investment and, therefore, are willing to accommodate C s wish that the partnership dispose of Whiteacre. A and B then agree that Whiteacre will be distributed to B (who will suffer appropriate dilution). We believe it is inconsistent with Congressional intent and sound tax policy to require sale treatment in such circumstances. Section 707(a)(2)(B) was added to the Code to 43 See Otey v. Commissioner, 70 T.C. 312 (1978), aff d per curiam, 634 F.2d 1046 (6th Cir. 1980); Communications Satellite Corp. v. United States, 625 F.2d 997 (Ct. Cl. 1980); Jupiter Corp. v. United States, 2 Cl. Ct. 58 (1983)

17 prevent abuses of section 721 and 731. There is no tax abuse occurring in the scenario described, because (i) the transfers are motivated by real business reasons; (ii) the parties are not trying to avoid sale treatment; (iii) there are no cash distributions (i.e., no tax-free cashing out ); (iv) the property transferred to the partnership is in substance a capital contribution to the partnership; and (v) the property transferred to the selling partner is an historic asset of the partnership that is in substance a return of capital. Yet, the taxpayers can avoid sale treatment only if they can clearly establish that the transfers do not constitute a sale which they will apparently be unable to do, because C would not have made his contribution but for the distribution to B. Another reason we recommend that the application of the Proposed Regulations to transfers of different property be rejected as a matter of policy is that the effect of the Proposed Regulations is to override substantially sections 721 and 731 without justifiable reason. 44 Overriding those sections in this context cannot be defended on the ground that the net effect of the transfers of different property involves a sale element. Every property transfer that qualifies under section 721 involves a sale element, because noncontributing partners obtain an indirect interest in the contributed property in exchange for a reduction in their proportionate share of the partnership s assets. Likewise, every property transfer that qualifies under section 731 involves a sale element, because the non-distributee partners increase their interest in the partnership in exchange for relinquishing their indirect interest in the property distributed to the distributee partner and the distributee partner increases its interest in distributed property in exchange for a smaller interest in the partnership. Nonetheless, Congress long ago determined that such transactions should not be treated as taxable events. That policy decision is fundamental to subchapter K and we advise against sweeping it aside lightly. Section 707(a)(2)(B) was not intended to sweep so broadly. While we believe that a presumption of disguised sale of partnership interest treatment is inappropriate in the case of transfers of different property, we believe that imposing sale treatment on the partnership through the deemed transaction mechanism is particularly inappropriate. In Example 3, it is difficult to discern any compelling reason under section 707(a)(2)(B) for the transfers to cause A to be taxed. A is an innocent bystander with respect to the actual transfers. If the Proposed Regulations are finalized in their current form, then, unless there is a substantial advantage to the partnership from the exchange of Whiteacre for Investment Property, A may view it in his best interest to block the transactions so as to avoid the tax ramifications. Significantly, self-help is available. For example, faced with the alternative of either doing nothing or being subject to significant taxation, AB may elect to form a new partnership with C and transfer all of its assets except Whiteacre to the new partnership. AB could then distribute Whiteacre to B and operate as an upper-tier partnership. Thus, except for creating a new entity, the parties can accomplish the same economic result and avoid disguised sale of partnership interest treatment under the Proposed Regulations. The administration of the 44 Section 731 reflects Congressional intent to limit narrowly the area in which gain or loss is recognized upon a distribution so as to remove deterrents to property being moved in and out of partnerships as business reasons dictate. See S. Rep. No. 1622, 83 rd Cong., 2 nd Sess., at 96 (1954)