Last Summer, in Notice 2015-54, 2015-34 I.R.B. 210, the Treasury and the Internal Revenue Service announced their intention to issue regulations under Section 721(c) to ensure that, when a U.S. person transfers certain types of property to a partnership that has foreign partners related to the transferor, income or gain attributable to the property will be taken into account by the transferor either immediately or periodically. The Treasury Department and the Service further announced their intention to issue regulations under Sections 482 and 6662 applicable to controlled transactions involving partnerships to ensure the appropriate valuation of such transactions. This would extend to cost-sharing arrangements under Treas. Reg. §1.482-7.
Repeal of Sections 1491 to 1494
Repealed as part of the Taxpayer Relief Act of 1997, Sections 1491 through 1494 imposed an excise tax on certain transfers of appreciated property by a U.S. person to a foreign partnership, which generally was 35% of the amount of gain inherent in the property. Congress believed that the imposition of enhanced information reporting obligations (including Sections 6038, 6038B, and 6046A) with respect to foreign partnerships eliminated the need for imposing the draconian excise tax under Sections 1491 through 1494.
Section 704(c), as currently written, requires partnerships to allocate income, gain, loss, and deduction with respect to property contributed by a partner to the partnership so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution. Treas. Reg. §1.704-3(a)(1) acknowledges that Section 704(c) is designed to prevent the shifting of tax consequences among partners with respect to pre-contribution gain or loss. Section704(c) allocations can be made using any reasonable method consistent with that purpose, including any of the three methods described in the regulations.
One of the specified methods is the remedial allocation method, pursuant to which a partnership may eliminate distortions caused by the ‘ceiling rule‘ by making remedial allocations of income, gain, loss, or deduction to the noncontributing partners equal to the full amount of the limitation caused by the ceiling rule, and offsetting those allocations with remedial allocations of income, gain, loss, or deduction to the contributing partner.
Enter Notice 2015-34
The Service announced that the forthcoming regulations, which are due shortly, will include a de minimis rule providing that Section 721(a) will continue to apply (without regard to whether the requirements of the Gain Deferral Method are satisfied) if during the U.S. transferor's tax year (i) the sum of the built-in gain with respect to all Section 721(c) Property contributed in that year to the Section721(c) Partnership by the U.S. transferor and all other U.S. transferors that are related persons does not exceed $1 million; and (ii) the Section 721(c) Partnership is not applying the Gain Deferral Method with respect to a prior contribution of Section 721(c) Property by the U.S. transferor or another U.S. transferor that is a related person.
Need For A Remedial Rule
The regulations are anticipated to provide that Section 721(a) will not apply when a U.S. transferor contributes an item of Section 721(c) property to a Section 721(c) partnership, unless the gain deferral method described in the notice is applied regarding the Section 721(c) property. The regulations will also address the application of Section 721(c) to controlled transactions involving partnerships pertinent to the cost-sharing regulations under Treas. Reg. §1.482-7. Such regulations will provide specified methods for those controlled transactions based on methods in Treas. Reg. §1.482-7(g) adjusted for differences in the facts and circumstances between those partnerships and cost-sharing arrangements. The regulations will provide periodic adjustment rules that are based on the principles of Treas. Reg. §1.482-7(i)(6) for controlled transactions involving partnerships.
Gain Deferral Method
Contributions of Section 721(c) Property to a Section 721(c) Partnership will qualify under Section 721(a) only if the Section 721(c) Partnership applies the Gain Deferral Method. The five general requirements for applying the Gain Deferral Method are as follows. First, the Section 721(c) Partnership must adopt the remedial allocation method for built-in gain with respect to all Section 721(c) Property contributed to the Section 721(c) Partnership. Second, for any tax year in which there is remaining built-in gain with respect to an item of Section 721(c) Property, the Section 721(c) Partnership must allocate all items of Section 704(b) income, gain, loss, and deduction with respect to that Section 721(c) Property in the same proportion.
As a third point, certain reporting requirements must be satisfied. Fourth, the U.S. transferor must recognize built-in gain for any item of Section 721(c) Property upon an “Acceleration Event”, as defined. Finally, the Gain Deferral Method must be used for all Section 721(c) Property subsequently contributed to the Section 721(c) Partnership by the U.S. transferor and all other U.S. transferors that are related persons until the first to occur of: (i) the date that no built-in gain remains with respect to any Section 721(c) Property to which the Gain Deferral Method first applied; or (ii) the date that is 60 months after the date of the initial contribution of Section 721(c) Property to which the Gain Deferral Method first applied.
An Acceleration Event is deemed to occur with respect to all Section 721(c) Property of a Section 721(c) Partnership for the tax year of the Section 721(c) Partnership in which any party fails to comply with all of the requirements for applying the Gain Deferral Method.
If a Section 721(c) Partnership is a foreign partnership, a U.S. transferor (or a domestic partnership in which a U.S. transferor is a direct or indirect partner) must fulfill any reporting requirements imposed under Sections 6038, 6038B, and 6046A and the existing regulations thereunder with respect to the contribution of the Section 721(c) Property to the Section 721(c) Partnership. New information requirements will be issued with respect to Section 721(c), including application of the Gain Deferral Method and a description of any Accelerated Events.
Regulations Expected Shortly Under Section 721(c)
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