the need for a qualified debt exception under …

THE NEED FOR A QUALIFIED DEBT EXCEPTION UNDER PROPOSEDREGULATIONS DEALING WITH DISGUISED SALESBy Annie H. Jeong

Table of Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . 1555Contributions and DistributionsGenerally . . . . . . . . . . . . . . . . . . . . . . . . 1555Current Disguised Sale Regulations . . . . 1556Proposed Regulations . . . . . . . . . . . . . . . 1558Criticism of Proposed Regulations . . . . . . 1559Conclusion . . . . . . . . . . . . . . . . . . . . . . . 1560

Introduction

On November 26, 2004, the Treasury Departmentissued proposed regulations under section 7071 provid-ing rules for determining when a contribution of prop-erty to a partnership and a transfer of money or otherconsideration from a partnership to a partner should betreated as a disguised sale of a partnership interest. Whilethe proposed regulations adopt many of the principles ofthe current regulations, they do not include a ‘‘qualified

liability’’ carveout to disguised sale treatment. Rather, thepreamble to the proposed regulations suggests that theIRS and Treasury do not believe that such an exception isnecessary in light of the mechanics of the proposedregulations. Nevertheless, the IRS and Treasury haverequested comments on whether rules for qualified li-abilities similar to those under current regulations shouldbe included in the proposed regulations and whether andhow those rules should be modified to deal with particu-lar issues regarding disguised sales of partnership inter-ests. To carry out the congressional intent of section707(a)(2)(B) (under which Treasury has authority to issuerules regarding disguised sales), the general exception forqualified liabilities applicable under current regulationsto disguised sales of property by a partner to a partner-ship should apply equally to disguised sales of partner-ship interests.

Contributions and Distributions Generally

Generally, contributions of property to a partnershipin exchange for a partnership interest in the partnershipare tax-free under section 721. As a result, neither thepartnership nor the contributing partner recognizes gainor loss on the contribution, and appreciated assets can becontributed to a partnership without gain recognition byeither the contributing partner on the contribution or thepartnership on the issuance of the partnership interest.Similarly, section 731 provides that distributions from apartnership to a partner are tax-free to the distributeepartner except to the extent that the amount of moneydistributed exceeds the adjusted basis of the partner’spartnership interest. Thus, the partnership vehicle pro-vides a means by which partners can contribute propertyand receive distributions of money from a partnershipwithout recognizing gain or loss.

The general rules providing for tax-free contributionsto and distributions from a partnership drew the atten-tion of Congress, because they created the opportunityfor abusive behavior, in that taxpayers could effect a saleof property while obtaining the benefits of a tax-freetransaction. For example, assume that three individuals— A, B, and C — contribute property to AB partnership,in which A, B, and C share equally in profits and losses.A contributes property, in which he has an adjusted taxbasis of $50, with a fair market value of $100; B contrib-utes property, in which he has an adjusted tax basis of$50, with a fair market value of $250 and subject to a $150nonrecourse liability; and C contributes $100 in cash. If$50 of nonrecourse liabilities were allocated to A under

1All section references herein are to the Internal RevenueCode of 1986, as amended, or the regulations thereunder, unlessotherwise indicated.

Annie H. Jeong is an associate with Wachtell,Lipton, Rosen & Katz. She is grateful to Peter C.Canellos, David M. Einhorn, and Joshua D. Blank fortheir helpful comments and suggestions. The viewsexpressed herein are solely the author’s and shouldnot be attributed to her firm or its clients.

In this article, the author provides a brief overviewof the current partnership regulations on disguisedsales of property, particularly regarding the qualifiedliability exception, discusses the proposed regulationson disguised sales of partnership interests, and recom-mends that a qualified liability exception be includedin the final regulations on disguised sales of partner-ship interests. Without such an exception, the authorbelieves that the proposed regulations may be over-reaching and produce unintended results.

Copyright 2005 Annie H. Jeong.All rights reserved.

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Treas. reg. section 1.752-3(a)(3), A’s basis in his partner-ship interest would be increased from $50 to $100 ($50transferred basis plus $50 of nonrecourse debt allocation).Thus, immediately after his contribution, A could receivea distribution equal to $100 in cash from the partnershipwithout recognizing current gain and, in substance, effecta sale, absent any antiabuse or other rules to prevent thatresult.

Thus, in 1984, Congress enacted section 707(a)(2)(B) todeal in particular with those so-called ‘‘disguised sales.’’Section 707(a)(2)(B) grants Treasury authority to issueregulations prescribing when a transfer of money orother property (directly or indirectly) to a partnership bya partner and a related transfer of money or otherproperty (directly or indirectly) to the partner or anotherpartner by the partnership should be treated as a sale orexchange rather than as a tax-free contribution to anddistribution from the partnership.2

Before enactment of section 707(a)(2)(B), the IRS reliedprimarily on a form of the economic substance doctrinecontained in Treas. reg. section 1.731-1(c), which providesthat a transaction may not be subject to section 731 if acontribution of property to a partnership occurs and,within a short period of time, either (1) other property isdistributed (either before or after the contribution) by thepartnership to the contributing partner and the partner-ship retains the contributed property, or (2) the contrib-uted property is then distributed to another partner. Also,if the distribution were made to effect an exchange ofproperty either between partners or between the partner-ship and a partner, the transaction would be treated as anexchange of property. Congress, however, enacted section707(a)(2)(B), expressing concern that Treas. reg. section1.731-1(c)(3) did ‘‘not always prevent de facto sales ofproperty to a partnership or another partner from beingstructured as a contribution to the partnership, followed(or preceded) by a tax-free distribution from the partner-ship.’’3 While Treas. reg. section 1.731-1(c)(3) provided ameans by which the IRS could challenge disguised salesof property, Congress noted that court decisions hadchipped away at the doctrine by allowing tax-free treat-ment in cases that were economically equivalent to a saleof property to either a partnership or another partner.4

In enacting section 707(a)(2)(B), Congress cautionedTreasury against overreaching regulations that couldeffect the general rules of nonrecognition treatment un-der sections 721, 731, and 752. The legislative historystates, in part:

The Act authorizes the Treasury Department toprescribe such regulations as may be necessary orappropriate to carry out the purposes of [Section

707(a)(2)(B)]. In prescribing these regulations, Con-gress wanted Treasury to be mindful of its concernwith transactions that attempt to disguise a sale ofproperty and not with non-abusive transactionsthat accurately reflect the economic contributions ofthe partners. Similarly, Congress did not intend tochange the general rules concerning the tax treat-ment of the partners under sections 721, 731 and752 to the extent that (1) contributed property isencumbered by liabilities not in anticipation of thecontribution, [footnote omitted] or (2) contributionsto a partnership which, because of liabilities of thepartnership incurred other than in anticipation ofthe contribution, result in a deemed distributionunder section 752(b).5 (Emphasis added.)

Thus, Congress was aware that not all contributions ofproperty to a partnership followed by subsequent distri-butions should be treated as sales, particularly whencontributed property is subject to a liability that was notincurred in anticipation of the contribution or when adeemed distribution occurs as a result of the assumptionof liabilities incurred in the ordinary course.

Current Disguised Sale RegulationsCurrent regulations under section 707 provide rules

dealing with disguised sales of property to partnerships.6The current regulations provide that a transfer of prop-erty by a partner to a partnership plus a transfer ofmoney or other consideration by the partnership to thecontributing partner (including the assumption of or thetaking subject to a liability) is a sale of property, either inwhole or in part, by the contributing partner to thepartnership if, based on the facts and circumstances, thetransfer of money or other consideration by the partner-ship to the partner would not have been made ‘‘but for’’the partner’s transfer of property to the partnership, and,if the transfers are not simultaneous, the subsequenttransfer does not depend on the entrepreneurial risks ofthe partnership’s operations.7 A transfer of property to apartnership plus a transfer of money or other consider-ation to the partner that occur within a two-year period

2Section 707(a)(2)(B).3Staff of Joint Committee on Taxation, 98th Cong., 2d Sess., at

225 (Dec. 31, 1984).4Staff of JCT, 98th Cong., 2d Sess., at 226 (Dec. 31, 1984). See,

e.g., Otey v. Comm’r, 70 T.C. 312 (1978); Communications SatelliteCorp. v. U.S., 223 Ct. Cl. 253 (1980); Jupiter Corp. v. U.S., 2 Ct. Cl.58 (1983).

5Staff of JCT, 98th Cong., 2d Sess., at 231.6This article focuses primarily on the rules found in Treas.

reg. sections 1.707-3 and 1.707-5, which are hereinafter referredto as the current regulations.

7Treas. reg. section 1.707-3(b)(1). The current regulations setforth a list of facts and circumstances to be considered indetermining whether a sale occurred of a contribution anddistribution transaction, including, among others: (a) the exist-ence of a legally enforceable right of the transferor to thesubsequent transfer, (b) the existence of any legal obligation ofany person to make contributions to the partnership to allow thepartnership to transfer money or other consideration to thecontributing partner, and (c) any requirement that the partner-ship incur debt to obtain the funds necessary to allow thepartnership to make the distribution (taking into considerationwhether the partnership is able to incur that debt and whetherany person has assumed personal liability for or agreed toguarantee the debt).

COMMENTARY / SPECIAL REPORT

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are presumed to be a sale unless clearly establishedotherwise based on the facts and circumstances sur-rounding the transfer.8 There is, however, a presumptionagainst sale treatment if the transfers occur more thantwo years apart unless the facts and circumstances clearlyestablish otherwise.9

In some circumstances, the assumption of a partner’sliabilities by a partnership will be treated as a distribu-tion of property to that partner by the partnership (adeemed distribution) under the current regulations. Gen-erally, the amount of the deemed distribution depends onwhether the liabilities transferred by the contributingpartner are ‘‘qualified liabilities.’’ If the partnership as-sumes or takes property that is subject to a liability that isnot a qualified liability of the partner, the partnership willbe treated as transferring consideration to the partner inan amount equal to the liability assumed by the partner-ship over the partner’s share of the liability immediatelyafter the partnership assumes or takes the propertysubject to the liability.10

If, however, a partnership assumes or takes propertythat is subject to a qualified liability of a partner, thepartnership will be treated as transferring considerationto the contributing partner only to the extent provided inregulations.11 Generally, the partnership’s assumption of(or taking subject to) the qualified liability will not betreated as part of a sale if the transfer of property by thepartner to the partnership is not otherwise treated as partof a sale.12 But if the transfer is treated as part of a sale(independent of the assumption of or taking of theproperty subject to the qualified liability in connectionwith the transfer), the partnership’s assumption of (ortaking subject to) the qualified liability will be treated asa transfer of consideration to the partner, in a sale, in anamount equal to the lesser of the amount of considerationthat would have been treated as transferred to thepartner if the liability were not a qualified liability, or anamount equal to the qualified liability multiplied by thecontributing partner’s net equity percentage with respectto the contributed property.13

A liability that a partnership assumes or takes subjectto is treated as a ‘‘qualified liability’’ of a partner only to

the extent that the liability is incurred more than twoyears before the date on which either the partner agrees(in writing) to transfer the property or the partnertransfers the property to the partnership (whichever isearlier), provided that the liability has encumbered thetransferred property throughout the two-year period;was not incurred in anticipation of the transfer to thepartnership of the property, but rather was incurred bythe partner within the two-year period before the date onwhich the partner agrees (in writing) to transfer theproperty or on which the property is transferred to thepartnership (whichever is earlier) and has encumberedthe property since it was incurred;14 is allocable to capitalexpenditures with respect to the property under the rulesof Treas. reg. section 1.163-8T; or was incurred during theordinary course of a trade or business in which propertythat was transferred to the partnership was used or held,provided that all the assets relating to the trade orbusiness, other than those that are not material to con-tinuing the trade or business, are transferred.15 Also, ifthe liability is a recourse liability, it must not exceed thevalue of the property (less the amount of other liabilitiesthat are senior and that meet certain other requirements)transferred at the time of the transfer to constitute aqualified liability.16

When the current regulations were first proposed, theIRS and Treasury noted Congress’s concern with debtincurred in anticipation of a transfer to a partnershipwhen the partnership assumes the debt, and stated in thepreamble to the current regulations as issued in proposedform that ‘‘debt incurred more than two years before thetransfer (or a written agreement to transfer)’’ and ‘‘acqui-sition or improvement debt or trade payables related tothe transferred property’’ are ‘‘never treated as debtincurred in anticipation of the transfer.’’17

The rules for qualified liabilities provide a necessaryexception to disguised sale treatment for bona fide trans-fers of property to partnerships in which a partnershipalso assumes a liability or takes property subject to aliability. Otherwise, as the preamble to the proposedregulations suggests, any transfer to a partnership ofproperty subject to a liability could be treated as adisguised sale of property. Assuming a transfer of prop-erty is not otherwise treated as a sale, a partner is thusfree to transfer property subject to a qualified liability,and a partnership is free to assume a liability in connec-tion with a transfer of property to the partnership,without triggering the disguised sale rules. In keeping

8Treas. reg. section 1.707-3(c)(1). A partner’s share of apartnership’s liability depends on whether the liability is arecourse or nonrecourse liability. A partner’s share of a partner-ship’s recourse liability is equal to the partner’s share of theliability as determined under section 752 and the regulationsthereunder. A partner’s share of a partnership’s nonrecourseliability is determined by applying the same percentage that isused to determine a partner’s share of excess nonrecourseliability under Treas. reg. section 1.752-3(a)(3). If, however,under a plan a partner contributes or pays money to thepartnership and one or more liabilities of that partner isassumed by the partnership, the amount of liabilities thepartnership is deemed to assume is reduced by the moneytransferred, but not below zero.

9Treas. reg. section 1.707-3(d).10Treas. reg. section 1.707-5(a)(1).11Id.12Treas. reg. section 1.707-5(a)(5).13Id. A partner’s ‘‘net equity percentage’’ is defined under

Treas. reg. section 1.707-5(a)(5)(ii).

14In addition, the current regulations provide that if within atwo-year period a partner incurs a liability and either transfersproperty to a partnership or agrees (in writing) to transfer theproperty, and the partnership assumes or takes property subjectto the liability in connection with the transfer, ‘‘the liability ispresumed to be incurred in anticipation of a transfer to thepartnership, unless facts and circumstances clearly establishthat the liability was not incurred in anticipation of the trans-fer.’’ Treas. reg. section 1.707-5(a)(7)(i).

15Treas. reg. section 1.707-5(a)(6)(i).16Treas. reg. section 1.707-5(a)(6)(ii).17Notice of Proposed Rulemaking, 56 Fed. Reg. 80, 19055

(Apr. 25, 1991).



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with the congressional intent of section 707(a)(2)(B), thequalified liability exception to disguised sale treatment,in conjunction with the mechanics of the current regula-tions, adequately distinguishes between transactions that‘‘attempt to disguise a sale of property’’ from ‘‘non-abusive transactions that accurately reflect the economiccontributions of the partners.’’ In creating the qualifiedliability exception, Treasury was mindful that Congressdid not intend to change the general rules under sections721, 731, and 752 regarding contributed property subjectto liabilities that were not incurred in anticipation of thecontribution.

Proposed RegulationsLike the current regulations on disguised sales of

property to partnerships, the proposed regulations gen-erally provide that a transfer of consideration to a part-nership by an acquiring partner plus a transfer of con-sideration to a selling partner by a partnership will betreated as a sale (in whole or in part) of the sellingpartner’s partnership interest if, based on the facts andcircumstances, the partnership’s transfer of considerationwould not have been made ‘‘but for’’ the acquiringpartner’s transfer of consideration to the partnership,and, if the transfers are not simultaneous, the subsequenttransfer does not depend on the entrepreneurial risks ofthe partnership’s operations.18 If the transfers are treatedas a sale, the selling partner will be deemed to have solda partnership interest to the acquiring partner with avalue equal to the purchasing partner’s consideration orthe selling partner’s consideration (whichever is smaller).

The proposed regulations also provide a list of factsand circumstances to be considered in determiningwhether those transfers constitute a sale, including thosediscussed above regarding disguised sales of property topartnerships. Any transfers occurring within two yearsare presumed to be a sale, and transfers that occur morethan two years apart are not presumed to be a sale unlessfacts and circumstances clearly establish otherwise.19

Also, deemed transfers resulting from a section708(b)(1)(B) termination and transfers that are incident toa partnership’s formation are disregarded for purposes ofdetermining whether a disguised sale occurs.20

Unlike the current regulations, however, the proposedregulations provide that any deemed distributions ordeemed contributions resulting from reallocations ofpartnership liabilities under section 752 will not betreated as transfers of consideration for purposes of thedisguised sale rules applicable to partnership interests.21

If a partnership assumes a partner’s liability, under theproposed regulations, the partnership is treated as trans-ferring consideration to the partner in an amount equal tothe liability assumed less the partner’s share of theliability. Similarly, if a partner assumes a partnership’sliability, the partner is treated as transferring consider-ation to the partnership in an amount equal to the

liability assumed less the partner’s share of the liabilityimmediately before the partner assumed the liability. Ifmore than one partner’s liabilities are assumed by thepartnership, or if more than one partner assumes thepartnership’s liabilities, the proposed regulations providespecial rules to isolate and determine the amount ofconsideration treated as transferred with respect to eachpartner. Also, the proposed regulations provide that anyrelief from liability is included in the amount realized onthe sale of a partnership interest by the selling partner.

There is also an overriding antiabuse provision con-tained in the proposed regulations. Any increase in apartner’s share of a partnership’s liability may be rechar-acterized as a transfer of consideration to the partnershipby the partner if shortly after the partnership assumes orincurs the liability (or another liability) one or morepartners (or parties related to the partner or partners)actually bear a disproportionate amount of the economicrisk for the liability as compared to the partner’s orpartners’ profits or capital interest in the partnership, andthe transactions occur under a plan that has a principalpurpose of minimizing the extent to which the contrib-uting partner is treated as transferring consideration tothe partnership that could be treated as part of a saleunder the proposed regulations.

A partner’s share of a partnership’s liability is deter-mined in the same manner as that under the currentregulations.22 The proposed regulations, however, do notprovide an exception for qualified liabilities availableunder the current regulations. In the preamble to theproposed regulations, the IRS and Treasury reasonedthat, without the qualified liability exception under thecurrent regulations, ‘‘any transfer of property to a part-nership subject to a liability could be recharacterized as adisguised sale of property. In contrast, under the pro-posed regulations, a transfer to a partnership of encum-bered property alone would not be subject to recharac-terization as a disguised sale of a partnership interest.Rather, a transfer to a partnership of encumbered prop-erty would have to be related to a transfer of consider-ation by another partner in order for disguised saletreatment to apply.’’23

Example 9 of the proposed regulations illustrates howthe simultaneous transfers could be recast as a sale, inwhich a partnership assumes recourse liabilities of aselling partner. A and B each own a 50 percent interest inAB partnership, in which the partners share profits inproportion to their booked-up capital accounts. AB’s

18Prop. Treas. reg. section 1.707-7(b)(1).19Prop. Treas. reg. section 1.707-7(c), (d).20Prop. Treas. reg. section 1.707-7(a)(8).21Prop. Treas. reg. section 1.707-7(j).

22See supra note 7. Like the current regulations, if, under aplan, a partner contributes or pays money to the partnershipand one or more liabilities of that partner is assumed by thepartnership, the proposed regulations provide that the amountof liabilities the partnership is deemed to assume is reduced bythe money transferred, but not below zero. The proposedregulations also add an additional rule: If, under a plan, apartnership distributes or pays money to a partner who as-sumes one or more of the partnership’s liabilities, the amount ofliabilities the partner is deemed to assume is reduced by theamount of money transferred, but not below zero.

23Notice of Proposed Rulemaking, 69 Fed. Reg. 227, 68838(Nov. 26, 2004).



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assets include $100x cash and Orangeacre, which has afair market value of $860x and is encumbered by anonrecourse liability of $360x incurred in 1998. Theliability, which provides for adequate stated interest, hasan issue price of $360x, a term of 10 years, and 100percent of principal payable at maturity. C contributes$100x to AB and receives an interest in AB. That sameday, AB assumes a personal $80x recourse liability of A.As a result, A is released from all liability, and B and C areliable on the $80x recourse liability. There are no facts torebut the presumption of sale treatment, and the transfersare treated as if A sold a portion of A’s partnershipinterest to C, because the assumption of A’s liability istreated as a transfer of property to A of $80x. Thus thetransfer of C’s $100x to AB and the transfer by AB to A of$80x occur within two years. The value of the partnershipinterest sold to C is equal to $80x (that is, the lesser of theamount C transferred to AB ($100x) or the amount Areceived from AB ($80x)). Because the amount A realizeson the sale includes A’s relief from partnership debt, the$47x relief from the partnership’s $360x liability causedby the sale of a portion of A’s interest in AB to C isincluded in the amount realized by A on the sale.24 Thus,the amount realized by A on the sale of a portion of A’spartnership interest is $127x ($80x + $47x). C is treated ascontributing a capital contribution under section 721 toAB partnership equal to $20x ($100 less the $80 used toacquire a portion of A’s interest).

Criticism of Proposed RegulationsIf the proposed regulations are finalized without an

exception for qualified liabilities, the regulations wouldcreate a significant trap for the unwary, particularly incircumstances in which simultaneous transfers do notoccur. While the proposed regulations provide that trans-fers that are not simultaneous will be treated as sales onlyif the subsequent transfer does not depend on the entre-preneurial risks of partnership operations, that doesnothing to ameliorate the problem when recourse debt isassumed by a partnership on the admission of a newpartner and that partner is released from liability on thedebt.

For example, assume that in year 1 two individuals, Dand E, form partnership DE for the purpose of makingwidgets, each contributing $100 to DE. F and G, twoindividuals with experience in making widgets, eachdecide to join the partnership, but only if the other alsojoins. In year 2, F joins DE by contributing land with a fairmarket value of $190 and a recourse liability of $60 whichwas incurred two years before the date on which Fagreed to transfer the property and has encumbered theproperty since that time. DE agrees to assume F’s liabilityfor the land because F would not agree to join DE unlesseither DE agreed to assume the liability (with F beingreleased from and D and E becoming ultimately liable for

the debt) or D and E each contributed an additional $30to DE. In year 3, G contributes $130 to the partnership.Absent an exception for qualified liabilities, the entiretransaction could be recast as a sale by F of a portion ofhis partnership interests to G. Before the transaction, Fwas liable for $60 of the recourse liability, and after thetransaction, F was released from the entire $60 liability.Thus, without sufficient proof to rebut the presumption,F realizes an amount equal to $60 on the purported saleof a portion of his respective partnership interest to G. Gis treated as purchasing a portion of his partnershipinterest equal to $60 and as making a contribution of $70to the partnership in exchange for a partnership interestunder section 721.

That result is unfair and highly counterintuitive. HadD, E, F, and G formed a partnership in year 1, thedisguised sale rules would not have applied to treat F asselling a portion of his partnership interest. F should notbe treated as selling, and G should not be treated asbuying, a portion of F’s partnership interest simplybecause the contributions took place in later years. More-over, F did not engage in any wrongdoing by simplyhaving a pre-existing liability on the property contrib-uted to the partnership and should not be penalizedsimply because he decided to join a venture by contrib-uting property subject to a liability.

Even after partnerships are formed, partners oftencontribute property to partnerships and admit new part-ners. A partner should not be penalized simply becausehe has only property subject to a liability not incurred inanticipation of the transaction to contribute. A presump-tion, although rebuttable, can create myriad practicalproblems that could cause unnecessary litigation andexpense. Providing an exception to disguised sale treat-ment for qualified liabilities in transactions not otherwisetreated as a sale would alleviate much of the burdenimposed by the proposed regulations as currentlydrafted. If the qualified liability exception were to haveapplied in the above example, no disguised sale treat-ment would result. Thus, an unwary partner in a part-nership who contributes encumbered property to a part-nership would be protected from that unfortunate result.

Moreover, a qualified liability exception would ad-dress Congress’s caution regarding overreaching regula-tions. It is clear from the legislative history to section707(a)(2)(B) that Congress was concerned with transac-tions in which debt assumed by the partnership wasincurred in anticipation of a contribution to a partner-ship, but did not intend to change the general nonrecog-nition provisions under sections 721, 731, and 752.25 Asnoted by the IRS and Treasury in the preamble to thecurrent regulations (as issued in proposed form), somecategories of debt, which fall within the definition ofqualified liabilities (that is, debt that is incurred morethan two years before a transfer (or an agreement inwriting to transfer), improvement or acquisition debt andtrade payables related to the property transferred) are‘‘never treated as debt incurred in anticipation of thetransfer.’’ If that debt is in fact never treated as debt24Before the sale of a portion of A’s partnership interest, A’s

share of AB’s $360x nonrecourse liability was $180x (or 50percent). After the sale, A’s share of AB’s $360 nonrecourseliability is $133x. Thus A’s share of AB’s nonrecourse liability isreduced by about $47x as a result of the sale. 25See Staff of JCT, 98th Cong., 2d Sess., at 231.



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incurred in anticipation of a transfer, and Congress wasconcerned with transactions in which debt is incurred inanticipation of a contribution to a partnership, thereappears to be no harm in including within the proposedregulations an exception for those qualified liabilities. If,however, the IRS and Treasury are wary about creatingan exception for all debt that is treated as a qualifiedliability under the current regulations, the qualified li-ability exception under the proposed regulations couldbe limited to those categories of debt specifically referredin the parenthetical above.

It may be that the IRS and Treasury were concernedwith transactions in which a partnership assumes apartner’s stand-alone debt that is unrelated to the prop-erty contributed to the partnership, and example 9 of theproposed regulations reflects such a situation. Indeed,such an assumption of stand-alone debt may be equiva-lent to a distribution of cash or other property to thepartner that in many instances should trigger the pre-sumption for disguised sale treatment to prevent abusivetransactions. A qualified liability, however, appears toinclude only liabilities that are inherently related tocontributed property. If, however, the IRS and Treasuryare concerned that a qualified liability could includestand-alone liabilities, a solution to prevent disguisedsales that occur as a result of the assumption by apartnership of a partner’s stand-alone liability could be todefine ‘‘qualified liability’’ specifically to include onlyliabilities that are related or attached to the propertycontributed to the partnership.

The IRS and Treasury may also have considered that aqualified liability exception was unnecessary because ofthe rule under the proposed regulations that deemeddistributions and contributions resulting from realloca-tion of partnership liabilities are not treated as transfersof consideration for purposes of the disguised sale rules.While that rule may protect against disguised sale treat-ment for the reallocation of pre-existing partnershipliabilities, it does not appear to protect a partner whocontributes property subject to a nonrecourse liabilitythat is assumed by the partnership. The exception forreallocations of liabilities refers only to partnership li-abilities that are reallocated among the partners and notto partners’ liabilities that are assumed by the partner-ship. In other words, the exception appears to deal withreallocations only under section 752(a) and not section752(b). Thus, a partner could be treated as receiving atransfer of money or other consideration from the part-nership if the partnership agrees to assume propertysubject to a liability.

While a partnership’s assumption of a partner’s re-course liability could create potential for abuse, it isunclear what is being protected when a partnershipassumes a partner’s nonrecourse liability. Mortgages onreal property are not uncommon, and a partner shouldnot be subject to a presumption of disguised sale treat-ment simply because the partner joined an existingpartnership by contributing property subject to a nonre-

course liability and within two years before or after thatpartner’s admission, another person contributed prop-erty to the partnership. If the partner is not ultimatelyliable on the liability regardless of whether the liabilitywas assumed by the partnership, it is unclear how thepartner economically benefits when the partnership re-ceives the property subject to the liability. And, when thenonrecourse liability falls within the definition of aqualified liability, the application of disguised sale rulesto partnership interests without a qualified liability ex-ception seem even less defensible.

Finally, the antiabuse provisions available under theproposed regulations provide sufficient grounds for theIRS to challenge transactions the IRS believes are offen-sive. Thus, regardless of whether liabilities transferred bya partner to a partnership fall within the definition ofqualified liabilities the overriding antiabuse provisioncontained in proposed Treas. reg. section 1.707-7(j)(8)could recharacterize an increase in any partner’s share ofa partnership’s liabilities as a transfer of consideration bya partner to the partnership. If the IRS and Treasury areconcerned about transfers of liabilities by a partner to apartnership, the antiabuse provision could provide that apartner’s relief from liabilities may be recharacterized asa transfer of consideration by the partnership to thepartner if requirements similar to those contained underthe antiabuse provisions under the proposed regulationsare met.

Conclusion

Without an exception for qualified liabilities, the pro-posed regulations do not distinguish between ‘‘non-abusive transactions that accurately reflect the economiccontributions of the partners’’ from those that ‘‘attempt todisguise a sale of property.’’ Congress had no intention ofchanging the tax treatment of partners under sections721, 731, and 752 when property subject to a liability thatwas not incurred in anticipation of the contribution iscontributed to a partnership. If Treasury thought itappropriate to except qualified liabilities from the dis-guised sale treatment for property, the same exceptionshould also apply to disguised sale treatment for part-nership interests. Without an exception for qualifiedliabilities, the proposed regulations are overreaching andproduce unjust results.

A qualified liability exception similar to that under thecurrent regulations would ameliorate much of that bur-den. Thus, a partner who contributes property subject toa liability incurred in a trade or business that meets thedefinition of a qualified liability would generally notneed to be concerned that his contribution could berecharacterized as a sale of a partnership interest when asubsequent partner is admitted, unless the entire trans-action was abusive. However, any liabilities that are notqualified liabilities could still fall within the general ruleand thus be subject to scrutiny by the IRS.



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