Purported Purchases of Limited Partnership Interests Were Actually Disguised Sales

The Tax Court found that the purported sale of certain  limited partnership interests and subsequent transfer of property to those partners were disguised sales under Treasury Reg. §1.707-3 in the case of Bosque Canyon Ranch, L.P., et al v. Commissioner, TC Memo 2015-130.

Reg. §1.707-3(b)(1) provides that a transfer is treated as a sale generally in the following conditions:

(b) Transfers treated as a sale --

(1) In general. A transfer of property (excluding money or an obligation to contribute money) by a partner to a partnership and a transfer of money or other consideration (including the assumption of or the taking subject to a liability) by the partnership to the partner constitute a sale of property, in whole or in part, by the partner to the partnership only if based on all the facts and circumstances--

(i) The transfer of money or other consideration would not have been made but for the transfer of property; and

(ii) In cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.

In the situation at hand the transaction is quickly summarized by the Court as follows:

Each purchaser would become a limited partner of BCR I, and the partnership would subsequently distribute to that limited partner a fee simple interest in an undeveloped five-acre parcel of property (Homesite parcel). The distribution of Homesite parcels was conditioned on BCR I granting the North American Land Trust (NALT) a conservation easement relating to 1,750 acres of BC Ranch.

The question to be answered was whether this transaction should be treated under the standard partnership distribution rules or under the disguised sale rules.  If the standard rules of IRC §731 were used, the property would exit the partnership without triggering a tax at the partnership level, with the receiving partner taking on as basis in the property the lesser of the limited partner’s basis in his/her interest in their interest or the basis of the property in the hands of the partnership if it were a standard distribution (that is, the individual continued as a partner). 

If the individual were no longer a partner after this distribution (and, although the opinion does not say so, it seems likely to be the case) then the basis of the property would simply be what the partner paid for his/her interests, adjusted only for any passthrough items prior to the distribution.

If the disguised sales rules govern instead, there would be a sale of the interest for the partnership with the partnership forced to recognize a gain on sale.  The individual receiving the lots would take on as the basis of the lot what they paid for their “interest” in this case.

Note that if the distribution was one that liquidated their interest, if the disguised sales rules did not apply the partner would get the same basis as if he/she purchased the lot directly but the partners in the partnership who received an allocation of gain (most likely the general partners) would not have any taxable income to report.

The partnership did not seriously attempt to argue that the limited partners would have made the transfer of money even if there had been no agreed upon later distribution—rather the partnership based its position on the argument that the limited partners had entrepreneurial risk since the distribution was conditioned on the easement.

The Tax Court found that the facts did not support this view.  The Court noted:

The provisions in the agreements, purporting to condition the distributions of Homesite parcels on the donations of the easements to the NALT, were inconsequential. The 2005 easement was granted on December 29, 2005, two days prior to the date on which the BCR I LP agreement was executed, and the 2007 easement was granted in September 2007, three months prior to the date the BCR II LP agreement was executed. In addition, Mr. Friedman and Randolph Addison, Jr., both testified that the partnerships would have refunded the amounts paid by the limited partners if the easements were not granted. In sum, the distributions to the limited partners were made in exchange for the limited partners’ payments and were not subject to the entrepreneurial risks of the partnerships’ operations. Accordingly, each exchange constituted a disguised sale of partnership property by BCR I or BCR II in exchange for each limited partner’s payments. See sec. 707(a)(2)(B); sec. 1.707-3(b)(1), Income Tax Regs. The property sold to each limited partner consisted of a Homesite parcel and an appurtenant right to use BC Ranch’s common areas (i.e., a one-forty-seventh interest therein). The 24 disguised sales effectuated by BCR I and the 23 disguised sales effectuated by BCR II constituted sales by the partnerships of all of their interests in BC Ranch.

The disguised sales rules are meant to block what the IRS believed were abusive transactions by treating the transaction not under the contribution and distribution rules, but rather treating them as a transaction with the partnership not made as a partner under the provisions of IRC §707(a)(1).  Attempting to “paper over” the entrepreneurial risk requirement won’t escape this treatment—especially when (as in this case) it is unlikely the supposedly “risky” event will actually occur and, even worse in this case, the plan is to refund the capital contributions if, in fact, the event doesn’t take place.