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How To Make Easier The Transfer Of Appreciated Property To A Partnership

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Final Regulations for Transfers of Appreciated Property by US Persons to Partnerships with Related Foreign Partners under Internal Revenue Code (IRC) §721(c).

 

The regulations require recognition upon the contribution of appreciated property on gains otherwise includable in the gross income of a foreign person.  It gives the IRS the authority to override the general rule under §721(a), which states that “no gain or loss shall be recognized to a partner or any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.”

 

Exceptions to the rule allow certain taxpayers to avoid recognition of the gain.  Therefore, we will discuss the general rules before explaining these exceptions.

 

General Rules

 

A Section 721(C) Partnership

⇒ It exists when the partnership has a minimum of 80 percent joint ownership directly or indirectly between the US person and the related foreign partners.

 

A Section721(C) Property

⇒ The property transferred must have a built-in gain at the time of the contribution.  The rules exclude securities and other cash equivalents.  Also excluded are items of tangible property with a built-in gain of $20,000 or less or with an adjusted tax basis exceeding its book value.

 

Section 721(C) US Person

A US Person includes US citizens as well as US residents, domestic corporations, estates, and trusts:

⇒ Under the jurisdiction of a US court.

⇒ Controlled by one or more US Persons.

 

No domestic US Partnership qualifies as a US Person.

 

Section 721(C) Related Foreign Partner

IRC §§ 267(b) and 707(b)(2) determines the relatedness between the foreign partner and the US person.  Related foreign partners include:

⇒ Family Members.

⇒ A corporation in which the US person owns more than 50 percent of the stock.

⇒ Corporate members of the same controlled group.

⇒ A corporation and a partnership when the same person own a minimum of 50 percent of both entities.

⇒ A partnership in which an individual owns more than 50 percent.

⇒ Two partnerships in which the same person owns more than 50 percent.

 

The regulations apply IRC§26(b) and disregard the constructive ownership rules under IRC§267(c).

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The Look-Through Rule

The look-through rule applies when an upper-tier partnership with a US partner contributes 721(c) property directly to the lower-tier partnership.  IF the lower-tier partnership qualifies as a §721(c) partnership, the upper-tier partnership will recognize the entire built-in gain on the contribution.

 

EXAMPLE 1

⇒ Jenny is a US citizen. She contributes property and equipment valued at $1.2 million and an adjusted basis of $150,000 to XYZ Partners, a new domestic partnership, in exchange for a 50 percent interest.

⇒ Reinhardt is Jenny’s father. He is a German citizen and contributes $840,000 (cash) for the interest of 35 percent of the XYZ Partnership. US citizens unrelated to Jenny own the remaining 15 percent of the interest.

 

Jenny’s appreciated contribution constitutes section 721(c) property.  The partnership qualifies as a section 721(c) partnership because Jenny and Reinhardt collectively own 80 percent or more of the partnership. As a result, the non-recognition rules of IRC§721(a) do not apply.

 

AS A RESULT: Jenny must recognize a gain of $1,050,000 on the contribution.

 

EXAMPLE 2

⇒ A domestic partnership New Age Partners is owned by two partners. A foreign individual (F) holds ten percent, and an unrelated US individual (US) has a 90 percent interest. 

⇒ New Age wholly owns ABC, a domestic corporation.

⇒ During ABC’s first year of operations, it formed Second Age Partners.

⇒ Second Age Partners is a domestic partnership. It contributed section 721(c) property for a 90 percent stake in the partnership.

⇒ An unknown US person unrelated to ABC contributes cash in return for the remaining 10% interest in Second Age Partners.

 

IRC §267(c)(3) attributes stock owned by a partner to the other partners. Accordingly, following this rule, both (F) and (US) own 90 percent of Second Age Partners, which exceeds the 80 percent threshold in respect of IRC §721(c).

 

Hence, when IRC §267(c)(3) is applied, ABC is considered related to the foreign individual since 100 percent of its ownership would be attributed to the foreign individual.

 

AS A RESULT:  ABC must recognize the gain on the contribution of the property to New Age Partners. But the regulations disregard IRC §267(c)(3) in the determination of relatedness so that ABC can continue the non-recognition of the contributions of the property to New Age Partners.

 

Exceptions To Gains Recognition

⇒ DE MINIMUS EXCEPTION: When the built-in gain for all the 721(c) property contributed to a partnership in the same tax year does not exceed $1 million, gain recognition does not apply.

⇒ REMEDIAL ALLOCATION METHOD: Partnerships that adopt the Remedial Allocation Method of IRC 704(c) removes the ‘ceiling rule’ that can limit special allocations of depreciation and gain associated with appreciated property contributed to a partnership.

 

The Removal Allocation Method ensures that the contributing partner will recognize the entire built-in gain via special allocations of partnership gain OR reduced depreciation deductions associated with the contribution.

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Requirements For Remedial Allocation

Before the exception via the Remedial Allocation Method can be used to avoid immediate gain recognition on a property-by-property basis can be used, you must meet the following requirements:

⇒ SATISFY THE CONSISTENT ALLOCATION: It requires a 721(c) partnership to allocate the exact percentages of every book item attributable to the §721(c) property to the US transferor.

⇒ ACCELERATION EVENT: The US must recognize gains equal to the partial or remaining built-in gain when acceleration or partial acceleration occurs.  Acceleration events reduce (or defer) the amount of built-in gain a US transferor will typically recognize using the gain deferral method.

⇒ The taxpayer must meet extensive and detailed procedural and reporting requirements.

⇒ The US person must extend the statutory period of limitations on the assessment of tax.

⇒ The taxpayer must follow the rules for tiered partnerships under the final regulations.

 

EXAMPLE 3

⇒ Partner 1 makes a property contribution to a 721(c)partnership.

⇒ The property had an FMV of $3 million and an adjusted tax basis of $1 million.

⇒ Hence, the property had a §721(c) “built-in gain” of $2 million at the contribution date.

⇒ The partnership sells the property after two years at a tax gain of $1.5 million.

 

AS A RESULT:  IRC §704(c)requires the partnership to allocate the gain to Partner 1.  However, the default ceiling rule states that the partnership can only allocate the $1.5 million of actual gain.  Therefore, Partner 1 will never recognize the remaining $½ million built-in gain at the contribution date.

 

Suppose the partnership elected the IRC §704(c)remedial method. In that case, it must allocate the total $2 million of original built-in gain to Partner 1 and an offsetting $½ million loss to the other partners.

 

EXAMPLE 4

⇒ Partner 2 contributed of appreciated property to Partnership Two.

⇒ Partnership 2 is an IRC 721(c) partnership.

⇒ Partnership 2 elected the remedial method.

 

AS A RESULT: Partner 2 can defer the recognition of gain.

⇒ After this, Partnership 2 contributes the property to Partnership 3, which does not meet the IRC §721(c) partnership definition.

⇒ Partnership 3 did not elect the remedial method.

 

AS A RESULT:  The ceiling rule applies. If Partnership 3 sells the property, Partnership 2 will never recognize the entire gain built-in on the original contribution date.  Meanwhile, the contribution by Partnership 2 to Partnership 3 represents an acceleration event.  This results in the immediate gain recognition by Partner 1.

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