The Internal Revenue Service (IRS) has issued final, temporary and proposed regulations (Final Regulations, the Temporary Regulations and the New Proposed Regulations, respectively, and collectively, the New Regulations) that change the partnership disguised sale rules. See T.D. 9787, 81 Fed. Reg. 69,291 (Oct. 5, 2016); T.D. 9788, 81 Fed. Reg. 69,292 (Oct. 5, 2016).

The Current Regulations on Disguised Sales. Distributions of cash from a partnership to a partner are generally not taxable unless the cash distributed exceeds the partner's basis in its partnership interest. A partner generally includes its share (as determined under the relevant regulations) of a partnership's liabilities in the partner's basis. As a result, partnership liabilities can allow a partner to receive a tax-free cash distribution of the debt proceeds (or other cash), as long as the partner's basis in the partnership interest (including the partner's share of the partnership's debt) exceeds the amount distributed.

Section 707 provides rules treating the contribution of property to a partnership followed by a distribution of cash by the partnership to the contributor as a “disguised sale” for tax purposes. Under certain circumstances, §707 also treats the assumption of a liability of, or the receipt of encumbered property from, a contributing partner as a disguised sale. One significant exception to the disguised sale rules is the so-called “debt financed distribution” rule, which provides an exception for distributions financed by a partnership borrowing to the extent the partner to whom the distribution is made is allocated a share of the borrowing. As a result, a distribution of money to a partner by a partnership is not considered a disguised sale to the extent the distribution is traceable to a partnership borrowing and the amount of the distribution does not exceed the partner's allocable share of the liability incurred to fund the distribution.