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July 1992

Proposed regulations for disguised sales: blame Congress not IRS. (Federal Taxation)

by Rappaport, Bernard

    Abstract- The IRS was compelled to propose new regulations in 1991 with regard to IRC Sec 707 when Congress passed new laws on the disguised sales of property to partnerships under the Tax Reform Act of 1984. Congress was concerned that the distribution of property to partnerships provides opportunities for taxpayers to avoid paying taxes. Some of the Congress-mandated additions to Sec 707 include Secs 707(a)(2)(A) and (a)(2)(B), which expands the power of the IRS to determine if transactions are bona-fide tax-free contributions and distributions to a partnership or if they are really sales characterized as contributions to evade taxes.

Otey is Not Okay

Congress was concerned that taxpayers were avoiding tax on sales of property by utilizing the tax-free contribution and distribution rules of IRC Secs. 721 and 731. Even though regulations under Secs. 707, 721, and 731 prohibit tax-free distributions when property is contributed to a partnership with the contributing partner receiving a distribution shortly thereafter, Congress felt this area was still susceptible to tax avoidance schemes. Otey v. Commissioner 70 T.C. 312 (1978) is specifically mentioned in the Committee reports as the kind of taxpayer victory in this area that Congress sought to prevent.

Otey dealt with a typical development scenario. An individual, Mr. X, with appreciated land, entered into a partnership with a developer, Mr. Y, who had good banking relationships. The partnership agreement required a preferential distribution to Mr. X when the partnership received its construction loan. Thereafter profits and losses were to be shared equally. The construction loan was entirely recourse and exceeded the preferred distribution by a substantial amount.

The partnership treated the land as a contribution to capital. It treated the preferred return as a reduction of capital, no taxable gain was reported by Mr. X. The amounts involved were as follows:

Basis of Land $ 18,750

Preferred Distribution $ 65,000

Construction Loan $870,300

The Court of Appeals in a carefully reasoned opinion ruled in the taxpayer's favor for the following reasons: * The IRS argument that this was a transaction outside the partnership (Sec. 707) did not make any sense because the only partnership asset was the land. Therefore, the partnership couldn't exist without Mr. X's capital contribution. * There was risk that the construction loan would not be obtained, therefore the preferred distribution was more like a partnership distribution than sales proceeds. * The proceeds Mr. X received were not directly from Mr. Y. In addition, Mr. X was personally liable on the loan which refuted any argument Mr. X had cashed in on Mr. Y's credit. * Mr. X would not have incurred any tax liability if he had entered into the transaction as a sole entrepreneur.

Enter the Disguised Sales Rules

Congress added Secs. 707(a)(2)(A) and (a)(2)(B), which grant the IRS broad authority to identify transactions that are structured as tax-free contributions and distributions but which are in reality disguised sales. The Committee reports reveal a concern that the Courts had opened the door in cases like Otey for tax avoidance. The factual examples cited by the Committee reports are examples of blatant disguised sales where Mr. A contributes cash and Mr. B contributes property. Mr. B then receives a distribution which is in reality a sale between Mr. A and Mr. B. The Committee reports then go on to cite Otey as an example of how case law has permitted disguised sales. They ignore the assumption of debt involved in the Otey.

Congress ... ignoring Reality?

If there is a problem with the disguised sales regulations, it can be traced back to Congress, which ignored the reality of the business world in general and the harshness of debt assumption in particular. It is true that the Committee reports called for exemptions in cases of entrepreneurial risks, borrowing through the partnership, and non-equity withdrawals. The problem with this kind of approach, as with the passive loss rules, is that legitimate business endeavors are grouped together with sham transactions.

Identifying the Transaction

Reg. Sec. 1.707-3 states that if property is transferred to a partnership and there are distributions of property to the partner, a disguised sale may exist. The next step is to determine the time lapse between contribution and distribution. If more than two years have elapsed, the burden of proof appears to be on the IRS to make the case that a sale has occurred.

If the time lapse is two years or less the burden is on the taxpayer to prove there is no sale. The regulations use a facts and circumstances test to overcome the presumption of sale.

Fact and Circumstances Test

Accountants and attorneys will be hard pressed to sort out all the information required to comply with this test. in fact, it will require an audit of their client's financial and lending activities. For example, the test includes ascertaining whether: * The transferor has a legally enforceable right to the subsequent distribution; * The right is secured; * Persons have made or are legally obligated to either contribute or loan funds to the partnership to make the distribution; * The partnership has loaned or is legally obligated to borrow funds to make the distribution; * The partnership holds funds in excess of its reasonable needs to make the distribution; and * The timing and amount of distributions are determinable within reasonable accuracy at the time the contribution is made.

Because it is a facts and circumstances rating SOP 90-9 and revising SOP 89-6 to reduce the number of sources for single audit guidance for auditors of state and local governments. Some commentators recommended that the Super SOP be combined with the planned SOP, Audits of Not-For- Profit Organizations Receiving Federal Awards, to provide one source for single audit-type engagements. Although the audit and reporting guidance in the two SOPS will be parallel, the SOPS will not be combined because of differences in the federal audit requirements applicable to not-for- profit organizations and state and local governments and because of inherent differences in the two industries. While neither SOP is intended to be a "how-to" manual, each will provide detailed and practical guidance on all aspects of a "single audit" engagement - planning, consideration of the internal control structure, substantive tests of compliance, evaluating the results of the tests of compliance, and reporting on internal control structure matters and on compliance.

The Guidance Will Be Quite Specific

Based on the comments received, practitioners seek specific guidance on materiality considerations and on required reporting (see Figure 1). Therefore, the final Super SOP will provide guidance on the various levels at which materiality decisions are to be made and on the forms of reports to be used to satisfy all the single-audit requirements. For example, guidance will be given for reporting when an uncertainty about compliance exists (i.e., where the auditor has concluded that the entity has not complied, but the auditor cannot determine the consequences of noncompliance). As a result of suggestions from commentators, an example schedule of federal financial assistance will present both cash and non- cash programs and include dollar amounts. The example schedule will be used to illustrate the application of the "50% rule" to the auditor's consideration of the internal control structure used to administer federal financial assistance programs.

Auditors will find the Super SOP practical and comprehensive in the guidance provided on single audits of state and local governments. The Super SOP is effective for audits of financial statements and of compliance with laws and regulations for fiscal years ending on or after December 31, 1992.

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