Long-term income streams and Wasting Value Assets


In practice, I have often seen instances where a venturer wishes to contribute a potentially valuable income stream to a corporation or a partnership in exchange for an interest in the entity. In such a case, the question becomes whether the common law assignment of income doctrine applies or, alternatively, whether the income stream should be treated as a property interest which can be contributed to either a corporation or a partnership on a tax-free basis.

Assume that X has a right to receive income over the next twenty years from the production and sale of a certain product. There is, as of the date of contribution, no income which has accrued to X as the holder of this right.[1]  The current state of the law, as summarized in the Jackel and Ellis article, is that a transfer of a right to income will most likely be treated as property and not be subject to reallocation under the assignment of income doctrine or section 482 if there is a business purpose for the transfer to the entity even if the transfer is of less than all of the income stream owned by the transferor and even if the transfer is not exclusive. Provisions such as section 704(c) will ensure, at least on the surface of things, that the income is taxed later when earned  to the party who contributed the income stream.

But here is where the potential trouble starts. The legislative history to section 704(c) (JCS-41-84, Dec. 31, 1984) strongly suggests that section 704(c) does not apply to income produced by the contributed property but applies only to basis derivative items with respect to the property, meaning sales income or depreciation deductions. What this appears to mean is that if the partnership does not sell the contributed income right but merely holds the right and collects the income, the value of the income stream will decline as the income collections are made but since the income collections are merely income on the contributed property and are not sales proceeds in the tax technical sense of things, section 704(c) will not apply.

Yes, this seems odd. Economically, the right to income is being sold because the value of the income right declines as the income is collected. But although some may not agree, the law appears clear to me. Because of this rule of law, if I may call it that, a very large dividend paid on contributed corporate stock that is not subject to section 1059 as an extraordinary dividend, or interest paid at an above-market interest rate, will also escape the net of section 704(c) as will income collections on a contributed income stream[2]. It would seem that this particular issue is ripe for a future law change.

But what if there is no “net income” to be collected because it is claimed that a section 734(b) adjustment (caused by an unrelated distribution to a partner creating capital gain to the redeemed partner under section 731(a)) attaches to the contributed income stream. Under the section 755 regulations, if the redeemed partner obtains capital gain, then the basis adjustment under section 734(b), in this case a basis step-up, can only attach to a capital asset. Is the income stream such a capital asset? It appears that the answer is yes to the extent of income that has not yet accrued.[3]

All in all, this seems like a really good deal. One can shift a long-term income stream, or strip out a large income right from a larger contributed property interest, and shift the income to partners other than the contributor of the asset. And it even seems possible to eliminate the income through a basis adjustment. We will just have to see how this all plays out.

[1] If income had accrued on this right at the time of the contribution, the assignment of income doctrine would have surely applied. See FSA 200149019, Aug. 31, 2001, Tax Notes Today, 2001 TNT 237-20 (refusing to treat as property unaccrued rights to future income and also attempting to apply section 482 to reallocate the income to the transferor). For a comprehensive overview of the issues involved in treating the assignment of an income stream to a partnership, see Monte A. Jackel and Audrey Ellis, Transfer of the Use of Property: Time for Clarification, Tax Notes Today, 2010 TNT 229-6, Nov. 29, 2010.

[2] Section 704(c)(3) is limited by its terms to items accrued as of the time of contribution.

[3] See TAM 200049009, Aug. 9, 2000, 2000 TNT 238-17, where the IRS drew the distinction between income accrued on the contract, which is not a capital asset, and property that will produce ordinary income in the future but the income has not yet accrued thereon, which is a capital asset.

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