Attention Partnerships: Changes
Is your dealership structured as a partnership? If so, or if you’re considering transferring property to a partnership, take note of new IRS regulations that took effect October 5, 2016.
Section 707 disguised sales
It’s common for a partner to contribute appreciated property to a partnership and for a partnership to distribute cash or appreciated property to its partners. In general, no tax is owed on either the contribution or distribution. But, in certain instances, a contribution of appreciated property by a partner followed by (or sometimes preceded by) a distribution of cash or property to that same partner will result in tax being owed.
These transactions are referred to as “disguised sales” and are addressed in Internal Revenue Code Section 707 and its regulations. They state that a taxable sale is presumed to have taken place if a partner makes a contribution, receives a cash distribution within two years, and one of several exceptions don’t apply.
The prior regulations provided one exception for debt-financed distributions. If a partnership borrowed money to finance a distribution to a partner after the partner contributed property, loan proceeds were considered part of a disguised sale only to the extent that the distribution exceeded the partner’s allocable share of the partnership liability.
The IRS believes that some partnerships have used leveraged partnership transactions to take advantage of the debt-financed distribution exception. In these scenarios, contributing partners enter into guarantees or noncommercial payment obligations with the sole purpose of achieving an allocation of the partnership liability — thus avoiding a disguised sale.
Recourse and nonrecourse liabilities
For the purposes of disguised sales, the previous regulations had separate rules for a partnership’s recourse and nonrecourse liabilities when determining a partner’s share of a partnership liability. Keep in mind that a partner bears the “economic risk of loss” (EROL) if the partnership can’t pay a recourse liability (one he or she guarantees) and that partners aren’t individually liable for nonrecourse debt.
Previous guidance stated that a partner’s share of a recourse liability consisted of the portion of the liability for which the partner bears the EROL. The new IRS regulations change the method of allocating partnership liability as it relates specifically to the disguised sale rules. All liabilities are now treated as nonrecourse liabilities (for purposes of potential disregarded sale transactions), and are allocated according to the partner’s share of profits.
Because liabilities are allocated based on a partner’s share of profits for disguised sale purposes, a partner can’t be allocated all of a loan’s liability. As a result, contributing partners can’t offset gains from the distribution of loan proceeds with 100% of a loan liability. This severely limits leveraged partnership transactions as a tax planning strategy for partners.
Consider a hypothetical dealership involving ABC Motors Inc., an S corporation that owns an unencumbered parcel of real estate (on which the dealership operates) that is worth $2 million. The property is in need of a $1 million renovation to satisfy its manufacturer’s branding requirements.
ABC Motors will contribute the $2 million property to XYZ LLC, a multimember limited liability company (LLC) taxed as a partnership that will be jointly owned by ABC Motors and an unrelated third party investor who’ll contribute the $1 million in cash needed for the renovation. The profits, losses and membership units will be owned 50-50.
After the renovations are complete — and within 24 months of the contribution of dealership property — XYZ LLC places a $1 million mortgage on the property. All of the borrowed funds are then distributed to ABC Motors to equalize the partner equity at $1 million each.
Because the distribution of cash happens within the 24-month presumption period, and the funds are allocated in a percentage greater than ABC Motors’ share of profits, the distribution is considered sales proceeds for the portion in excess of ABC Motors’ 50% profit interest. ($500,000 is the excess.) In essence, ABC Motors converted its direct ownership of real estate into cash (to an extent greater than its ownership interest in the LLC-partnership). This will result in a taxable sale transaction with $500,000 of deemed proceeds.
Although the regulations are complex, the takeaway for dealerships structured as partnerships is relatively simple: More property transactions between partners and the partnership will likely be classified as disguised sales under the new requirements. Consult your CPA about how these new regulations could affect your dealership.