The IRS has issued Notice 2015-54 where the agency announced it was going to be issuing regulations under IRC §721(c) that would override the general non-recognition rules of IRC §721 in a situation where a U.S. partner transfers property to certain partnerships with foreign partners. As well, the IRS will issue related regulations under IRC §482 to grant the IRS additional authority in such situations to revise the income recognition.
Generally a taxpayer who contributes property to a partnership under IRC §721 does not recognize income on that contribution. However, under §704(c)(1)(A) the partnership must allocate items to take into account the difference between the fair value and basis at the time of contribution.
Under the regulations governing IRC §704(c) a partnership is allowed to use a reasonable method to take into account such differences. Reg. §1.704-3 defines three methods that are generally reasonable. The nature of the rules are such that under two of the three methods (the traditional method and the traditional method with curative allocations) it is possible that not the entire difference (or potentially any of the difference) will be taken into account due to the effect of the ceiling rule that limits such corrections for these methods. Described roughly, the ceiling rule requires the use of an item of income or expense actually recognized on the partnership return to make these allocations.
However, the regulations allow, but do not mandate, the use of a remedial allocation method under Reg. §1.704-3(b)(1) which allows the partnership to make remedial allocations to take into account the ceiling rule, creating offsetting allocations to other partners, even though such items do not exist on the underlying return (only the event triggering recognition exists on the return). Thus, using this method, the difference will be taken into account simply by the creation of a correcting adjustment with an offsetting allocation to other partners.
The notice indicates that the IRS has become aware that some taxpayers are entering into partnerships with related foreign partners where, by use of methods other than the remedial allocation method, the gain inherent in the property when contributed ends up being allocated to the foreign partner. They may also use valuation methods for the assets that are inconsistent with fair market value methods.
These regulations would be issued under the authority of IRC §721(c) which reads as follows:
(c) Regulations relating to certain transfers to partnerships
The Secretary may provide by regulations that subsection (a) shall not apply to gain realized on the transfer of property to a partnership if such gain, when recognized, will be includible in the gross income of a person other than a United States person.
The proposed regulations will provide that the gain nonrecognition rules of §721(a) will not apply with regard to a transfer of property covered by these regulations (referred to as §721(c) property) is transferred to a partnership meeting the requirements to be covered (referred to as a §721(c) partnership) unless the “Gain Deferral Method” described in these regulations is used for the §721(c) property.
§721(c) property is any property that has a built-in gain upon contribution except for:
- Cash equivalents
- Securities (as defined by IRC §475(c)(2) without regard to the special rule for certain receivables found in §475(c)(4))
- Tangible property with a built-in gain of no more than $20,000
A §721(c) partnership is any partnership where
- A U.S. partner contributes §721(c) property and
- After the contribution and any transactions related to the contribution, a related foreign partner and the U.S. transferor (along with any related parties) own more than 50% of the interest in capital, profits, deductions or losses
For these purposes, “related” is determined by reference to the rules under IRC §§267(b) or 707(b)(1).
The Notice describes the “Gain Deferral Method”” as follows:
- The Section 721(c) Partnership adopts the remedial allocation method described in § 1.704-3(d) for Built-in Gain with respect to all Section 721(c) Property contributed to the Section 721(c) Partnership pursuant to the same plan by a U.S. Transferor and all other U.S. Transferors that are Related Persons.
- During any taxable year in which there is remaining Built-In Gain with respect to an item of Section 721(c) Property, the Section 721(c) Partnership allocates all items of section 704(b) income, gain, loss, and deduction with respect to that Section 721(c) Property in the same proportion (for example, if income with respect to an item of Section 721(c) Property is allocated 60 percent to the U.S Transferor and 40 percent to a Related Foreign Person in a taxable year, then gain, deduction, and loss with respect to that Section 721(c) Property must also be allocated 60 percent to the U.S. Transferor and 40 percent to the Related Foreign Person).
- The reporting requirements described in section 4.06 of the notice are satisfied. The IRS intends to modify Schedule O, Transfer of Property to a Foreign Partnership, of Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships), or its instructions, for taxable years beginning in 2015 to require supplemental information for contributions of Section 721(c) Property to Section 721(c) Partnerships.
- The U.S. Transferor recognizes Built-in Gain with respect to any item of Section 721(c) property upon an Acceleration Event. An Accleration Event is defined as “any transaction that either would reduce the amount of remaining Built-in Gain that a U.S. Transferor would recognize under the Gain Deferral Method if the transaction had not occurred or could defer the recognition of the Built-in Gain.” An Acceleration Event is deemed to occur with respect to all Section 721(c) Property of a Section 721(c) Partnership for the taxable 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.”
- The Gain Deferral Method is adopted 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 earlier 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.
A transfer to a domestic corporation is a transaction to which either §§351(a) or 381(a) applies.
The IRS also plans to issue regulations that will require such partnerships to extend the statute of limitations for all items related to §721(c) property to the eighth full year following the taxable year of the contribution.
The Notice goes on to describe potential revisions in other regulations to address these transactions.
The regulations will apply to transfers occurring on or after August 6, 2015, as well transfers occurring before that date resulting from check the box elections filed on or after August 6, 2015.