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Sale, or Contribution-Distribution?

Assume that X and Y agree to the following: X will transfer ownership of Prop to Y, and Y will transfer cash to X.

What just happened? Obviously, X has sold Prop to Y. If the amount of cash that X receives is greater than his adjusted basis in Prop (generally, his unrecovered investment in the property), then X will realize a taxable gain.

Now assume Y is a partnership. X transfers Prop to Y in exchange for a partnership interest in Y. The exchange is not taxable to either X or Y.[i]

What if Y also transfers cash to X, whether simultaneously with the issuance of an equity interest in Y or some time later? Has X sold at least some of Prop to Y? What was the economic substance of the transaction, or should the form of the transaction be respected? What did the parties intend?

Next, consider the following scenario: X transfers Prop to Y in exchange for a partnership interest in Y; Z transfers cash to Y, also in exchange for a Y partnership interest; not long thereafter, Y distributes Prop to Z and cash to X.

Has X sold Prop to Z? Or should the X and Z transfers, on the one hand, and the Y distributions, on the other, be respected and treated as separate, unrelated events for tax purposes? Again, what was the economic substance of the transaction and the parties’ intention?

Separate Transactions

As indicated above, the contribution of property in-kind to a partnership in exchange for an equity interest therein is generally not treated as a taxable exchange.[ii]

However, the distribution of cash by a partnership to a partner may be taxable to the partner, but only to the extent the amount distributed exceeds the distributee-partner’s adjusted basis in his partnership interest.[iii]

Thus, if (i) Y’s receipt of Prop from X and its distribution of Prop to Z were treated as separate events from (ii) Z’s contribution of cash to Y and Y’s distribution of cash to X, the cash distribution to X would be taxable to X only to the extent it exceeded X’s basis for its Y partnership interest.[iv]

The Disguised Sale Rules – In General

The Code provides special rules to prevent parties from characterizing what is in fact a taxable sale or exchange of property as a contribution to a partnership followed by a distribution from the partnership that enables the contributing partner to defer or avoid tax on the transaction.

Under the so-called “disguised sale rules,” related transfers to and by a partnership that, when viewed together, are more properly characterized as a sale or exchange of property will be treated as a transaction between the partnership and one who is not a partner.[v] In some cases, it may be treated as a transaction between two partners.

Generally speaking, a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner will be treated as a sale of property by the partner to the partnership if, based on all the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of property and, in the case of non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.[vi]

The U.S. Tax Court recently considered the IRS’s application of the disguised sale rules to disallow a large ordinary loss deduction allegedly arising from a convoluted transaction that involved the transfer of distressed trade receivables (the “Receivables”) through several LLCs that purported to be partnerships.[vii]   

The Transaction

The Receivables originated with a supplier (“Supplier”) and consisted of orders for payments issued by Supplier to a real estate development and construction company (Developer), which purchased products from Supplier on credit. Supplier billed the Developer when it delivered goods to Developer in the ordinary course of business.

Developer filed for bankruptcy protection, but when it failed to satisfy certain court-imposed conditions concerning the repayment of its creditors, the court-appointed trustee recommended that the court declare Developer bankrupt. The court heeded the trustee’s recommendation, and then directed the liquidation of Developer’s assets.

The “Investment”

At that point, Investment Adviser and Tax Adviser entered the mix . . . and matters got complicated.

Pursuant to a plan hatched by these advisers (the “Transaction”), Supplier transferred the Receivables using a tiered partnership structure, as follows:

  1. First, Investment Advisor and Supplier formed LLC-1 as a tax partnership.[viii]
    a. Supplier contributed the Receivables to LLC-1 in exchange for a 99% membership interest therein.[ix]
    b. Investment Advisor owned the remaining 1% membership interest.
  2. Second, LLC-1 and LLC-2 – a limited liability company affiliated with Investment Advisor – formed LLC-3 as a tax partnership.
  3. LLC-1 contributed the majority of its Receivables to LLC-3 in exchange for a 99% membership interest, and LLC-3 acquired the remaining 1% interest.

Next, Tax Advisor solicited individual Investor, focusing on the tax benefits that Investor may realize by participating in the Transaction. Tax Advisor introduced Investor to Investment Advisor and shortly thereafter Investor entered into an investment management agreement with an affiliate of Investment Advisor.

Investor transferred $360,000 to an account at Trust Company that was to be managed by Investment Advisor for Investor’s benefit. On that same day, Investor acquired an 89.10% membership interest in LLC-3 from LLC-1 in exchange for $300,164 and another Trust Company account was opened for LLC-1, to which $300,164 was transferred.  

After Investor’s acquisition of the LLC-3 membership interest from LLC-1, LLC-3’s members were as follows: Investor with an 89.10% interest, LLC-1 with a 9.9% membership interest, and LLC-2 with a 1% interest.

LLC-3 and LLC-2 then formed LLC-4, to which LLC-3 contributed a portion of the Receivables (previously contributed by LLC-1 to LLC-3) in exchange for a 99% membership in LLC-4. LLC-2 contributed minor participation interests in two promissory notes[x] ($900 each) in exchange for a 1% interest in LLC-4. The LLC-4 operating agreement valued the LLC-3 capital contribution at $333,335 and LLC-2’s contribution at $3,376.

At about that time, Investor entered into an Advisory Services Agreement with another affiliate of Investment Advisor in exchange for a one-time fee of $59,836 (representing the balance of the $360,000 Investor initially transferred to his account at Trust Company after the payment to LLC-1 of $300,164 in exchange for an interest in LLC-3).

A few weeks later, and within the same year, LLC-4 sold all its Receivables to yet another affiliate of Investment Advisors, Financial-LLC, for $357,144.

Early the following year, Investment Advisor received a letter from Supplier requesting a withdrawal of $300,164 of its membership interest in LLC-1 and directing its payment to an account at Bank. LLC-1’s account at Trust Company, which had received a transfer of $300,164 the preceding year from Investor in exchange for part of LLC-1’s membership interest in LLC-3, had a negligible closing balance shortly after Supplier’s request.

A few months later, Investor received a tax opinion letter from Big Law Firm, which had agreed to represent Investor in reviewing the tax consequences of the Transaction in exchange for a fixed fee of $100,000. The opinion letter stated that the Transaction had the “requisite economic substance” and “business purposes” to be respected for tax purposes.

Tax Reporting

On its Form 1065, U.S. Return of Partnership Income, for the taxable year in which LLC-4 sold its Receivables, LLC-4 reported its basis for the Receivables as over $23 million[xi] and an ordinary loss of more than $22 million from the Transaction. This loss was allocated to LLC-3.

As a member of LLC-3, Investor’s share of the purported loss from the Transaction, and which he claimed as ordinary loss deductions on his own tax return, was more than $20 million.

The IRS disallowed the ordinary loss deduction that LLC-4 claimed on the Form 1065 in connection with the sale of the Receivables.

The Tax Court’s Analysis

The partnership timely petitioned the Tax Court to review the IRS’s determination.

Disguised Sale Rules

In general, a partner may contribute capital to a partnership without recognition of gain, and may receive a distribution of money from the partnership (for example, previously taxed profits) without the recognition of gain, except to the extent that the amount of money distributed does not exceed the partner’s adjusted basis for their partnership interest.[xii]

These nonrecognition rules do not apply, however, where the transaction – i.e., the partner’s contribution of property to the partnership and the distribution of money to the partner from the partnership – is found in substance to be a disguised sale of property.

A disguised sale occurs where a partner contributes property to a partnership and receives a related distribution that is, in effect, consideration for the contributed property.[xiii]

A transaction may be deemed a disguised sale if, on the basis of all the facts and circumstances, (1) the partnership’s transfer of money or other consideration to the partner would not have been made but for the partner’s transfer of property to the partnership and, (2) if the transfers were not made simultaneously, the subsequent transfer was not dependent on the entrepreneurial risks of partnership operations.[xiv]

According to the regulations promulgated under the partnership disguised sale rules, transfers between a partnership and a partner within a two-year period are presumed to be a sale of property to the partnership unless the facts and circumstances “clearly establish” otherwise.[xv]

LLC-4 contended that the Transaction was not a disguised sale. In particular, the partnership argued that the record contained no evidence of a distribution to Supplier within two years of its contribution of the Developer receivables.

The Tax Court disagreed.

The Court observed that the timeline for the Transaction was “far less than two years.” In fact, only four and one-half months separated Supplier’s contribution of the Receivables to LLC-1 and Supplier’s request to withdraw $300,164 from LLC-1.  

Moreover, the Court continued, the amount of the withdrawal requested by Supplier was the same amount Investor paid to acquire an 89.10% interest in LLC-3 from LLC-1 only days earlier. Given that LLC-1 had received a transfer of $300,164 into its Trust Company account on December 23, 2002, but had a balance in that account of only $79 the next month, the Court was satisfied that the $300,164 requested by Supplier was in fact paid from the LLC-1 account.

The above facts, the Court asserted, did not appear to be coincidental. It then added that the facts and circumstances existing on the date of the earliest transfer were generally the relevant ones to be considered in determining the presence of a sale.[xvi] The circumstances surrounding Supplier’s partial redemption of its LLC-1 interest suggested that it was a preconceived step to shift basis to Investor.

The payment to Supplier was not paid out of operational profits but rather from the proceeds of Investor’s subsequent acquisition of an interest in LLC-3 from LLC-1. The redemption and acquisition were for the same amount. Investor’s acquisition was made five days before the date on the Supplier redemption letter. The purpose of the redemption was to trigger an allocation of loss[xvii] for the benefit of Investor. The dates and the account activity of the partnerships matched to such an extent that it was clear that LLC-1 was formed solely as a conduit to execute a disguised sale of the Receivables.

LLC-4 had the burden of proving that there was no premeditated agreement that Supplier would receive any distributions. However, LLC-4 offered no alternate explanation for this account activity or posited where more than $300,000 in funds went between December 23, 2002, and January 30, 2003.

Because LLC-4 failed to counter these facts, it failed to meet its burden of proof. Therefore, the Transaction was a disguised sale.

Accordingly, the Court sustained the IRS’s disallowance of LLC-4’s claimed loss deduction to the extent that the claimed loss exceeded the transferred basis from LLC-1 (via LLC-3) in the Receivables.

Basis in Developer Receivables

A partnership’s basis for property contributed to a partnership by a partner is the same as the partner’s basis for the property at the time of the contribution.[xviii] Supplier purportedly transferred the Receivables to LLC-1 as the first step in the Transaction.

The only evidence related to basis were the above-referenced orders for payments and a spreadsheet prepared by Investment Advisor listing these. According to the Court, the documents presented did not provide enough information to determine the value of the Receivablesimmediately before Supplier contributed them to LLC-1.

Therefore, the Court could not determine the basis in the Receivables.

Validity of Partnerships

Next, the Court considered whether the various LLCs described above, through which the Transaction was effectuated, were bona fide partnerships.

A partnership exists for federal income tax purposes, the Court explained, when parties, acting in good faith and with a business purpose, intend to join together in the conduct of a trade or business and to share in the profits or losses of that trade or business. The Court further explained that, in determining whether a bona fide partnership has been formed, all relevant facts and circumstances must be considered, including “the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent.”

All the partnerships involved in this transaction were LLCs created under Delaware law. Pursuant to the so-called check-the-box regulations,[xix] an LLC with at least two members is classified as a partnership unless it elects to be classified as a corporation. The Court stated, however, that an entity’s status under the regulations does not, by itself, entitle a “partnership” to the benefits otherwise provided by the Code to bona fide partnerships.

There was no evidence, the Court stated, that Supplier and Investment Advisor, as the partners of LLC-1, came together to engage in a trade or business or investment, and to share the profits and losses therefrom. Instead, the Court continued, the purported partners were “accomplices” to the Transaction. The same was also true for LLC-4. There was no evidence that LLC-4, LLC-3, and LLC-2 were engaged in any business or investment together.

The Court explained that the “abundance of abusive tax-avoidance schemes … designed to exploit the Code’s partnership provisions requires that our scrutiny of the taxpayer’s choice to use the partnership form be especially stringent.” According to the Court, a partnership need not be respected “merely because the taxpayer can point to the existence of some business purpose or objective reality in addition to its tax-avoidance objective.” Rather, the parties’ reasons for choosing the partnership form “must, on balance, display good common sense from an economic standpoint.” Even where a partnership engages in transactions having economic substance, the parties’ choice to operate as a partnership must be for “a legitimate, profit-motivated reason,” and “the absence of a nontax business purpose is fatal.”

Anti-Abuse Rules

Finally, the Court turned to the partnership anti-abuse rules. These provide that the Code’s partnership rules[xx] and the regulations thereunder must be applied in a manner that is consistent with the intent of those rules.[xxi] A partnership satisfies the general anti-abuse rule if it meets three conditions: (1) the partnership is bona fide and each partnership transaction or series of transactions is entered into for a substantial business purpose; (2) each partnership transaction is respected under “substance over form” principles; and (3) the tax consequences to each partner must accurately reflect the partners’ economic agreement and clearly reflect each partner’s income. 

Where a partnership is formed to facilitate a transaction a principal purpose of which is to produce tax consequences inconsistent with the intent of the Code’s partnership rules, the IRS may recast the partnership transaction to achieve tax results that are intended by such rules. The IRS has broad authority to disregard the partnership so as to justify or modify the claimed tax treatment.[xxii]

Whether a partnership satisfies the anti-abuse regulation is determined on the basis of all of the facts and circumstances. The regulation provides a list of illustrative factors that may indicate a disregard for the intent of the partnership rules. According to the Court, the factors relevant to the present case included the following: (1) the present value of the aggregate federal tax liability of the partners was substantially less than if the partners had owned the partnership’s assets and conducted the partnership’s activities directly; (2) the present value of the partners’ aggregate federal tax liability was substantially less than would have been the case if the purportedly separate transactions designed to achieve the particular end result were integrated and treated as steps in a single transaction; and (3) one or more partners who were necessary to achieve the claimed tax results had a nominal interest in the partnership and were substantially protected from any risk of loss from the partnership’s activities.

Relevant to the first two factors listed above was that if Investor had purchased the assets directly from Supplier, LLC-4’s basis in the Receivables at the time of the sale that produced the losses would have been significantly lower than what was claimed. If, as the Court’s disguised sale analysis concluded, (1) Supplier’s contribution of the Receivables to LLC-1, (2) LLC-1’s contribution of the receivables to LLC-3, and (3) LLC-1’s sale of its 89.1% interest in LLC-3 to Investor were integrated into a single transaction, the result would effectively have been a direct sale of the receivables from Supplier to Investor. The tax consequence of such a sale would have been that Investor would have received a cost basis in the receivables,[xxiii] as opposed to the significantly larger basis claimed to be transferred from Supplier through LLC-1 and then to LLC-3.[xxiv] The subsequent contribution of the receivables to LLC-4 would be deemed made by Investor himself, and LLC-4’s basis would be equal to Investor’s cost basis. The subsequent sale of the Receivables by LLC-4 would, in turn, have produced significantly lower losses. The parties’ aggregate federal tax liability would, consequently, have been substantially higher.

Further, Supplier had no risk of loss because LLC-1 and LLC-4 had no activities besides the sale of tax shelters. Supplier had a nominal interest in LLC-1 and no real participation. With that, the Court concluded that the LLC-partnerships organized to participate in and effectuate the Transaction should be disregarded for violation of the partnership anti-abuse rules.


The Court was right to uphold the IRS’s disallowance of the loss claimed by LLC-4 and ultimately by Investor. When all was said and done, Investor transferred $360,000, Supplier received $300,164, and Investment Advisor was paid a fee of $59,836. Yet somehow, Investor claimed that a loss was generated, his share of which was in excess of $20 million.

Perhaps worse still, reputable professionals concocted the Transaction, opined that it had economic substance and business purpose, and collected handsome fees for their involvement.

The obvious lesson here, for both taxpayers and their advisers, is that it is not enough that a transaction falls within the literal words of a particular statutory or regulatory provision in order to achieve a desired tax result. The transaction must also be consistent with the intent of those provisions.

When the particular facts and circumstances indicate, as they did in the case discussed above, that a transaction does not have economic substance or a bona fide business purpose, the IRS may properly disregard a purported partnership, treat a purported partner as a non-partner, reallocate a partnership’s items of income, gain, loss, deduction, or credit, or otherwise adjust or modify the claimed tax treatment to ensure that the outcome is consistent with the statutory and regulatory intent.  

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Instead, the recognition of any gain realized on the exchange is deferred. To preserve the gain inherent in Prop – for recognition on a later, taxable disposition of the interest or Prop – X takes his partnership interest in Y with the basis X had in Prop; likewise, Y takes Prop with that same basis. IRC Sec. 722 and Sec. 723

[ii] IRC Sec. 721.

[iii] IRC Sec. 731(a).

[iv] Yes, there are other disguised sale rules that may be implicated here. IRC Sec. 704(c)(1)(B), for example, provides if any appreciated property contributed is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 7 years of being contributed, the contributing partner shall be treated as recognizing gain from the sale of such property in an amount equal to the gain which would otherwise have been allocated to such partner under IRC Sec. 704(c) if the property had been sold at its fair market value at the time of the distribution. See also IRC Sec. 737.  

[v] Depending upon the size of the transferor’s partnership interest and the nature of the property transferred, the gain realized may be treated as ordinary income for tax purposes, while any loss realized may be disallowed. IRC Sec. 707(b).

[vi] Reg. Sec. 1.707-3. If the transfer of money from the partnership to the partner occurs after the transfer of property to the partnership, the partner and the partnership are treated as if, on the date of the sale, the partnership transferred to the partner an obligation to transfer money to the partner.

[vii] Piccirc, LLC V. Comm’r, T.C. Memo. 2024-50 April 22, 2024.  

[viii] A business entity that is not a per se corporation, that has at least two members, and that has not elected to be treated as a corporation for tax purposes. Reg. 301.7701-3.

[ix] Supplier had received a legal opinion, related to the validity and enforceability of its assignment of the Developer receivables to LLC-1, which represented that Supplier had the necessary authority to perform its obligations.

[x] RSK Investments, LLC and Wester Gailes Capital Management, LLC issued the notes.

[xi] Presumably derived from Supplier’s basis for the Receivables it initially contributed to LLC-1.

[xii] IRC Sec. 721 and Sec. 731.

[xiii] IRC Sec. 707(a)(2)(B); Reg. Sec. 1.707-3.

[xiv] Reg. Sec. 1.707-3(b)(1).

[xv] Reg. Sec. 1.707-3(c)(1).

[xvi] Reg. Sec. 1.707-3(b)(2).

[xvii] Under IRC Sec. 704(c).

[xviii] IRC Sec. 724.

[xix] Under Reg. Sec. 301.7701-3(b)(1).

[xx] Subchapter K of the Code.

[xxi] Reg. Sec. 1.701-2.

[xxii] Interestingly, LLC-4 contended that it was in compliance with the Code and that the Court should not have addressed judicial anti-abuse doctrines such as economic substance, sham transaction, business purpose, and step transaction. The IRS disagreed with this argument. The Court responded that it did not need to address the arguments associated with these doctrines because it concluded that the transaction was a disguised sale, and the partnerships were shams. An analysis similar to that discussed above would be used for an analysis under these doctrines. The Court added that any discussion of these doctrines would not have changed the Court’s conclusion that IRS’s determination was correct.

[xxiii] Under IRC Sec. 1012.

[xxiv] Under IRC Sec. 721.