Conventional wisdom is that the U.S. income taxation of partnerships is advantageous compared to the taxation of corporations for many reasons, one of which is that it is often easier to contribute “built-in” gain property to a partnership without triggering taxation of that gain. Nevertheless, some property contributions to partnerships are treated as taxable transactions. For example, a transfer of property to a partnership, coupled with a distribution of cash or property from the partnership to the contributing partner, may be treated as though the contributor actually sold the property to the partnership in a taxable transaction.
Recently, a lesser known provision causing taxation of property contributions to partnerships has obtained more prominence. I.R.C. § 721(c) provides the Treasury Department with the authority to promulgate regulations providing for the taxation of gain realized upon the transfer of property to a partnership if that gain, when recognized, would be includible in the gross income of a foreign person.
Last August, the IRS issued Notice 2015-54, 2015-34 I.R.B. 210, in which the Treasury Department indicated that it intends to promulgate regulations providing that a U.S. person’s contribution of built-in gain property to a partnership (foreign or domestic) would generally be taxable if more than 50% of that partnership’s capital or profits interests is owned by the U.S. contributor, together with one or more foreign partners who are related (under I.R.C. §§ 267(b) or 707(b)(1)) to that U.S. contributor. See Notice 2015-54, Section 4.02. Current gain recognition would not be triggered, however, if certain requirements are satisfied, such as: (i) the partnership’s adoption of the remedial method (under Treas. Reg. § 1.704-3(d)) for allocating pre-contribution gain; (ii) the partnership’s allocation of all items of income, gain, loss and deduction from the contributed built-in gain property in the same proportion to its partners; and (iii) if the partnership is a foreign partnership, the U.S. contributor satisfies the U.S. reporting obligations in connection with that partnership, including filing the Form 8865. See id., § 4.03. In addition, certain property contributions and de minimis transactions would be excluded from the required gain recognition. See id., §§ 4.01(4), 4.02.
The potential effect of the intended regulations is illustrated through the following example. U.S. parent corporation (“US Co.”) and its wholly-owned foreign subsidiary corporation (“F Co.”) form a new domestic partnership (“US P”). US Co. contributes to US P a patent with a fair market value of $1.2 million and an adjusted basis of zero. Under the principles expressed in Notice 2015-54, US Co’s contribution of the patent to US P would generally trigger recognition of $1.2 million of taxable gain to US Co. for the tax year in which the contribution was made, unless US Co., F Co. and US P agree to satisfy all of the requirements in Notice 2015-54 for deferring recognition of that $1.2 million of gain. See id., § 4.07, Ex. 1.
Significantly, Treasury announced that the forthcoming regulations will apply to transfers occurring on or after August 6, 2015, which is the date on which Notice 2015-54 was issued. See id., § 6. In addition, within the last week or so, an IRS official speaking at an American Bar Association Tax Section Meeting defended the government’s ability to retroactively apply the regulations to transactions that occurred before the regulations were written.
The effective date, together with the IRS representative’s public statements, make clear that property contributions to partnerships that have already occurred may result in current gain recognition unless the parties comply with the requirements of Treasury Regulations that have not yet been promulgated. As a result, if you have clients who have contributed built-in gain property (including intangible assets, such as patents or goodwill) into a partnership with one or more related foreign partners since August 6, 2015, it is important for them to know that the IRS may assert that the contribution resulted in taxable gain to them in the year of the contribution, unless they satisfy certain requirements.
It is also important for these clients to know that the IRS may closely scrutinize the reported fair market value of the property that is contributed to the partnership with a related foreign partner. Notice 2015-14 makes clear that the IRS believes that some taxpayers are under-valuing the assets contributed into partnerships with a foreign partner in an effort to shift future income or gain to that foreign partner. Thus, it is important to compile persuasive substantiating evidence to support the taxpayer’s position regarding the fair market value of the contributed property in the event of an IRS challenge.