In general, when a non-controlling partner makes a transaction with his or her partnership in a non-partner capacity, any resulting gain or loss is likely be recognized, because the transaction is treated as at arm’s length and occurring with a third party. Such transactions may involve sales, loans, rental payments, services provided and other related items to or from the partnership. However, special rules apply when the transaction takes place between a partner who owns more than 50% of the partnership capital or profits (applying both direct and indirect ownership rules) and his or her partnership.
This article will explain the basics of sales or exchanges between partners and controlled partnerships under Internal revenue Code Section 707. It is not intended to constitute tax or legal advice.
Partnership taxation can involve many complex tax and legal issues, so it may be advisable to seek an experienced attorney in these matters. Failure to do proper tax planning can result in significant adverse tax consequences. Sherayzen Law Office, Ltd. can assist you in all of your tax and legal needs, and help you avoid making costly mistakes.
Disallowed Losses on Sales or Exchanges between a Partner and the Controlled Partnership
If a partner owns (directly or indirectly) more than a 50% of the capital or profits interest of the partnership, under IRS Section 707, losses from a sale or exchange between the partner and the partnership will be disallowed. However, if the partnership eventually sells the property to a third party, any gain realized on the sale may not be recognized to the extent of the disallowed loss. In other words, the disallowed loss may reduce the gain that would otherwise need to have been recognized.
If a sale or exchange takes place between an individual or entity who does not own 50% or more of the capital or profits (directly or indirectly) of a partnership, but is related to a partner, the sale or exchange is likely to be treated as occurring separately between the various partners of a partnership, and the disallowed loss will be determined accordingly. For example, assume partner A in a five-person partnership (with each partner owning 20%) also owns 100% of a corporation. If the corporation has a loss resulting from a transaction with the controlled partnership, the transaction is likely to be treated as if occurring individually between the partners, and 20% of the loss may be disallowed for the corporation (because of partner A’s ownership).
Treatment of Certain Gains Recognized on Sales or Exchanges between a Partner and the Controlled Partnership
Unless an asset is a capital asset to both the seller and purchaser, in a sale or exchange between a partner owning more than a 50% capital or profits interest (directly or indirectly) and a controlled partnership, any gain recognized is likely to be treated as ordinary income. IRS Regulation §1.707-1, transactions between partner and partnership, broadly defines non-capital assets: “[P]roperty other than a capital asset includes (but is not limited to) trade accounts receivable, inventory, stock in trade, and depreciable or real property used in the trade or business.” This can have serious unexpected tax consequences for those taxpayers who do not fully understand the applicable tax laws when making such transactions.
Additionally, if an asset is depreciable property in the hands of a transferee, any gain recognized on a sale of exchange between a partner owning more than a 50% capital or profits interest (directly or indirectly) and a controlled partnership, is also likely to be treated as ordinary income.
Tax Planning is Essential for Controlled Partnership Transactions
It is very easy to misunderstand or misapply the controlled-partnership transactions. The consequences of such actions may be dire and may lead to an unexpected jump in your tax liability (especially, if the re-classification of gain or disallowance of a loss occurs in the context of an IRS audit).
This is why it is essential to conduct comprehensive tax planning with respect to any controlled-partnership transactions. Sherayzen Law Office can help; Mr. Eugene Sherayzen, an experienced tax attorney will thoroughly analyze your partnership transactions, determine potential tax consequences and propose a comprehensive solution aimed to protect you from over-paying taxes to the IRS.