Michael T. Donovan, Member

In Notice 2015-54, the IRS has announced its intention to issue regulations requiring the recognition of income on transfers of certain property to a partnership that has foreign partners related to the transferor. In the same notice, the IRS announced its intention to issue regulations to ensure appropriate valuation of controlled transactions involving partnerships under Section 482 of the Internal Revenue Code. The regulations described in Notice 2015-54 affect a number of partnerships and their partners. Accordingly, contemplated transactions that may be subject to the regulations should be carefully evaluated. While the issues raised by Notice 2015-54 are simple to state, they are complex in application. The purpose of this Client Alert is to make persons who may be affected aware of this development. Please contact one of the individuals listed below if you have specific questions regarding these rules.

The regulations will generally apply to transactions occurring on or after August 6, 2015. However, Notice 2015-54 cautions taxpayers that the Notice is not intended to create any inference regarding the treatment of transactions under existing law, which the IRS may be able to challenge under currently applicable rules.

It should be emphasized that proposed regulations have not been drafted and it may be some time before they are issued. Nevertheless, taxpayers contemplating a transaction described in the Notice should take into account potential application of the proposed regulations, if and when they are issued.

Background

In general, no gain or loss is recognized on the transfer of appreciated property to a partnership under Section 721(a). Prior to repeal in 1997, gain on transfers of appreciated property to foreign partnerships were subject to a 35% excise tax. When Congress repealed these rules in 1997, it preserved the IRS' authority to issue regulations reimposing gain on such transfers under Section 721(c). Under current law, Section 367 requires recognition of gain on the transfer of appreciated property to foreign corporations (subject to a number of exceptions), including special rules on the recognition of income on the transfer of intangibles to foreign corporations. These rules do not apply to transfers to foreign partnerships. Such transfers are, however, subject to reporting requirements.

In Notice 2015-54, the IRS announced that it will make two important changes to the rules governing recognition of gain on the transfer of appreciated property to partnerships:

1. First, the new rules will require the current recognition of gain on certain transfers to partnerships in which one of the partners is a foreign person who is related to the transferor.
2. Second, new rules on transactions involving controlled partnerships would be added under Section 482.

According to the Notice, the changes were prompted by the IRS' concern that certain taxpayers were attempting to contribute property to partnerships that allocate the unrealized gain or income on the contributed property to a related foreign partner that is not subject to U.S. income tax. This income and gain escaped U.S. tax entirely. The IRS was also concerned that taxpayers were valuing contributed property in a manner contrary to the Section 482 requirements, which give the IRS broad authority to reallocate gross income, credits, and deductions to properly reflect the economic reality of a controlled transaction.

Current Recognition of Gain on Transfers to Section 721(c) Partnerships

Notice 2015-54 indicates that the IRS will issue regulations dictating that gain on transfers of appreciated property to "Section 721(c) Partnerships" must be recognized "either immediately or periodically," unless certain conditions are satisfied. A Section 721(c) Partnership is any partnership, whether foreign or domestic, to which a U.S. person contributes "Section 721(c) Property," and, after the contribution and any related transactions:

(i) a foreign person who is related to the transferor, under the standards in Section 267(b) and Section 707(b), is a direct or indirect partner in the partnership; and,

(ii) the U.S. transferor and one or more related persons own more than fifty percent (50%) of the interests in partnership capital, profits, deductions or losses.

Section 721(c) Property is generally any property other than:

(i) cash equivalents;

(ii) any asset that is a security (as defined in Section 475(c)(2), with some modifications); or,

(iii) any item of tangible property with built-in gain that does not exceed $20,000.

The regulations will provide a de minimis rule under which built-in gains will not be recognized currently, if:

(i) the sum of the built-in gain with respect to all Section 721(c) Property contributed in that year to a Section 721(c) Partnership does not exceed $1 million; and,

(ii) the Section 721(c) Partnership is not applying the Gain Deferral Method (described below) with respect to a prior contribution to the partnership.

In addition, taxpayers generally will be able to defer the recognition of gain in connection with a transfer to a Section 721(c) Partnership if they satisfy the requirements specified in Notice 2015-54 (the "Gain Deferral Method"). Taxpayers who take advantage of the Gain Deferral Method to avoid current recognition of gain on transfers to a Section 721(c) Partnership would be required to recognize the gain upon the occurrence of an acceleration event. Taxpayers who take advantage of the Gain Deferral Method would also be required to extend the statute of limitations on assessment of tax with respect to all items related to the Section 721(c) Property through the close of the eighth full taxable year following the taxable year of the contribution. The regulations will also include an anti-abuse rule.

Controlled Transactions Involving Partnerships

Notice 2015-54 also states that the IRS intends to issue regulations applicable to controlled transactions involving partnerships. These regulations will be based on current Treasury Regulation Sec. 1.482-7, which provides rules applicable to cost sharing arrangements. The regulations may also impose additional documentation requirements.

Effective Dates

The regulations that the IRS intends to issue pursuant to Notice 2015-54 will generally apply to transfers occurring on or after August 6, 2015. However, the regulations will also apply to transfers that occurred prior to August 6, 2015 if they are the result of entity classification elections filed on or after August 6, 2015, and that are effective on or before August 6, 2015. New reporting requirements would apply to transfers and controlled transactions occurring on or after the date of publication of the regulations.

Analysis

The regulations announced in Notice 2015-54 have the potential to affect a number of transactions involving transfers of appreciated assets to partnerships. While the issues raised in the notice are simple to state in theory, they are complex in application. For additional information on the potential application of the regulations, please contact Michael Donovan, Tim Stewart, Rachel Hirshberg or Larry Weltman.