October 15, 2024 | By Dorian Hunt, Head of Renewables

In this, the second article of my circular cash flow series, I’m going to explore situations where a partner does business with a partnership other than in their capacity as a partner. For the first article in the series, please follow this link: https://www.linkedin.com/posts/dorian-hunt_energytransition-tax-inflationreductionact-activity-7249758003770327040-Bbv4?utm_source=share&utm_medium=member_desktop  

When a person looks into the abyss, the abyss looks back. When a partner looks at their partnership, do they see themselves staring back? I honestly can’t be sure because this is not addressed in the Code or the Regulations. However, § 707 does give us a framework to begin thinking about these questions. As mentioned in my previous article on circular cash flows, renewable energy assets often have a basis that is established in part through transactions in which cash originates at one point and then finds its destination at that same originating point. The intent of these articles is to explore the different ways these situations might be best treated for federal tax purposes. 

In the first article, I introduced Example 1, which I repeat below for reference: 

  1. Developer (“D”) begins construction on a project (the “Project”). 
  2. D and a tax equity investor (“TEI”) form tax equity partnership (“PRS”) and fund it with the cash necessary to accomplish the next step (here assume $50 each from D and TEI).  
  3. Shortly before the end of construction (but before the Project is placed in service), PRS purchases the Project from D for its fair market value of $100.   
  4. PRS places the Project in service and derives credits based on a percentage of PRS’s basis in the Project, which PRS anticipates will be its $100 purchase price. 

Now, let’s get into it. 

Section 707 

Section 707(a)(1) provides that, if a partner engages in a transaction with a partnership other than in their capacity as a member of such partnership, the transaction generally will be considered as occurring between the partnership and one who is not a partner. In other words, under this section, if a partner sells property to a partnership, the transaction is treated the same as though the partnership purchased the property from someone other than the partner.  

Let’s reintroduce Developer called D and his partnership as PRS from my previous article. In that article, I discuss how to think about D selling assets to PRS. 

At first glance § 707 may appear to answer the question of whether D’s sale of the project to PRS should be fully respected as a sale, rather than partially recharacterized as a contribution. But does it? One could argue that the provision should only apply to the extent the substance of the transaction between the partner and the partnership indicates it should be a sale on its own before the provision comes into play. 

Prior to enactment of § 707(a) in 1954, there was some question of how to treat a transaction occurring between a partner and their partnership. On the one hand, the partnership could be treated as an entity separate and apart from its partners (“entity treatment”), in which case a sale of property to a partnership by a partner would be respected as such (just as would be the case if the partnership acquired the property from an unrelated person). On the other hand, given the nature of partnerships under local law at the time, the partnership could be treated as an aggregate of its partners (“aggregate treatment”). In that case, a partner selling property to a partnership could be treated as dealing with themselves to the extent of their own interest in the partnership, but with the partnership itself with regard to the remainder. Entity treatment is PRS’s desire in our example, while aggregate treatment is similar to the possible recharacterization. So, which applies?    

The legislative history accompanying enactment of § 707(a) indicates that Congress chose entity treatment. Specifically, the Senate Report describing the rule provides: 

When a partner sells property to, or performs services for the partnership, the problem arises whether the transaction is to be treated in the same manner as though the partner were an outsider dealing with the partnership (the “entity” approach). An alternative (“aggregate” approach) is to view the partner as dealing with himself to the extent of his own interest and as dealing with the partnership with respect to the balance of the transaction. The present code fails to cover the problem and judicial decisions on the subject go in both directions. Because of its simplicity of operation, the “entity” rule has been adopted by the House and your committee.1

Clearly, then, Congress believed that it was possible for a partnership to sell property to their partnership and be treated as selling the full amount of that property – presumably even if the partner owned 99 percent of the partnership. But does that mean that a partnership’s purchase from a partner shortly after that partner contributed a portion of the purchase price to the partnership should be recharacterized as, in part, a contribution? Arguably, it should not. In some sense, every dollar used by a partnership to purchase property is in an economic sense the money of its partners. To illustrate the point, consider the following example:  

Example 2: X is a partnership in which A and B are equal partners. X has owned and operated a profitable business for several years but has never made significant distributions to its partners. Instead, X has reinvested any cash that would otherwise have been distributed in its business. In Year 10, X uses a portion of its profits to acquire land from A for $100.  Under § 707(a), A’s sale of the property should be respected as a sale in full, even though $50 of the funds used to acquire the land effectively belong to A as it represents A’s share of the undistributed X profits.

In Example 2, instead of holding on to its cash profits until the time until necessary to acquire the land, X could have continuously distributed profits to its partners and then – just before X’s purchase of the land – made a capital call, requesting that A and B each contribute $100 to fund the purchase; that transaction would closely resemble Example 1. Should there be a dramatic difference between two transactions that economically resemble one other quite closely? One might argue that Example 2 differs from Example 1 because, in Example 2, the $100 used to acquire the land was at the entrepreneurial risk of X’s business. But what if X had simply held the funds in a bank account, a money market account, or other investment that lacked risk? In that situation, there would be no material difference between – (i) X retaining the money and waiting for an investment to arise; and (ii) X distributing the money and waiting for reinvestment. Why then should there be an enormous tax difference between the two? 

Section 1.721-1(a) arguably supports respecting the sale of property by a partner to a partnership. By way of background, § 721 generally provides that no gain or loss is recognized by a partner on the contribution of property to a partnership in exchange for an interest therein. Similarly, § 731 generally provides that a partner will not recognize gain or loss in the case of a distribution of property by a partnership to a partner (except to the extent that any cash distributed exceeds the partner’s basis in its partnership interest). Section 1.721-1(a) provides:

Section 721 shall not apply to a transaction between a partnership and a partner not acting in their capacity as a partner since such a transaction is governed by section 707. Rather than contributing property to a partnership, a partner may sell property to the partnership or may retain the ownership of property and allow the partnership to use it. In all cases, the substance of the transaction will govern, rather than its form. See paragraph (c)(3) of § 1.731-1. Thus, if the transfer of property by the partner to the partnership results in the receipt by the partner of money or other consideration, including a promissory obligation fixed in amount and time for payment, the transaction will be treated as a sale or exchange under section 707 rather than as a contribution under section 721.

The language of the regulation clearly indicates that a partner may choose between selling or contributing property to a partnership. Although the regulation also indicates that the substance of the transaction will govern, it seems clear from the example that it was intended to prevent a partner from attempting to apply § 721 to what was clearly in substance an exchange of property for consideration other than a partnership interest. In other words, the reference to the substance of the transaction appears to be directed at preventing a partner from applying § 721’s nonrecognition treatment to a series of transactions that in substance resemble a sale – not from recharacterizing what is in form a sale as a § 721 contribution.2    

It’s Almost Halloween, So Let’s Talk About Disguised Sales

Section 1.721-1(a) preceded the enactment of the disguised sale rules of § 707(a)(2)(B). Under that section, if there is a transfer of money or other property by a partner to a partnership and a related transfer of money or other property by the partnership to the partner, and when viewed together the transfers are property characterized as a sale or exchange of property, then the transaction will be treated as a transaction described in § 707(a)(1) (which, as described above, means a transaction between the partnership and someone other than a partner). Thus, a purported   

contribution by a partner to a partnership and a related distribution of cash or other property by the partnership may be recharacterized as a sale of the property by the partner to the partnership. Effectively, the disguised sale rules are designed to ensure that the substance of the transaction governs when a partner attempts to take advantage of the nonrecognition rules of § 721 and § 731 to effect an exchange of property without recognition of gain or loss.  

Regulations issued under § 707(a)(2)(B) provide that a disguised sale has occurred only if, based on all the facts and circumstances, the partnership’s transfer of money or other consideration would not have been made “but for” the partner’s transfer of property and, if the transfers are not simultaneous, the subsequent transfer is not dependent on the “entrepreneurial risk” of the partnership’s operations.3 Section 1.707-3(b)(2) provides a non-exhaustive list of ten facts and circumstances that may tend to prove the existence of a disguised sale. Specifically, they are: 

  1. That the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer; 
  2. That the transferor has a legally enforceable right to the subsequent transfer; 
  3. That the partner’s right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured; 
  4. That any person has made or is legally obligated to make contributions to the partnership to permit the partnership to make the transfer of money or other consideration; 
  5. That any person has loaned or has agreed to loan the partnership the money or other consideration required to enable the partnership to make the transfer, taking into account whether any such lending obligation is subject to contingencies related to the results of partnership operations; 
  6. That a partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer, taking into account the likelihood that the partnership will be able to incur that debt (considering such factors as whether any person has agreed to guarantee or otherwise assume personal liability for that debt); 
  7. That the partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be available to make the transfer (taking into account the income that will be earned from those assets); 
  8. That partnership distributions, allocation, or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property; 
  9. That the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and 
  10. That the partner has no obligation to return or repay the money or other consideration to the partnership or has such an obligation, but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner. 

The weight given to each factor varies depending on the circumstances of the particular case.  

Clearly, the disguised sale rules are designed to ensure that a partner cannot avoid recognizing gain or loss on a purported contribution of property to a partnership when that contribution is accompanied by a cash payment to the partner, which is exactly what happens when D transfers the project to PRS and receives a cash payment equal to the fair market value of the project. It arguably would be a strange result to allow D to receive cash equal to the fair market value of property transferred to the partnership and avoid recognizing gain on some portion of the property.  

Based on the above, it could be argued that § 707 should prevent recharacterization of Example 1 as a part-contribution by D to PRS. Those rules appear to be designed to prevent a partner from being treated as contributing property to a partnership when that partner simultaneously receives consideration that in substance is in exchange for the property. Recharacterizing Example 1 such that D is treated as contributing a portion of the property to PRS appears to flip those principles on their head. On the other hand, the IRS could assert that § 707 cannot be relied upon to reach a different answer in the partner-to-partnership sale context than would result in the shareholder-to-corporation context. In the corporate context, the courts appear to have consistently decided that a contribution of cash by a shareholder to a corporation followed by the corporation’s use of that cash to “buy” property from the shareholder is treated for federal tax purposes as a contribution of the property purportedly sold.4 

Theoretically, there should be no difference between the treatment of a transaction between a partner and a partnership one hand and a shareholder and a corporation on the other. Thus, notwithstanding the discussion of § 707 above, it could be argued that the sale of the project in Example 1 should be recharacterized as in part a contribution of property. However, shareholders are regularly taxed on dividend distributions by corporations even if the dividends are immediately reinvested in additional stock of the distributing corporation – even if that reinvestment occurs pursuant to a prior agreement by the shareholder to reinvest the distributed funds and thus clearly is a circular cash flow. What then distinguishes the recharacterized transactions from those that are respected? 

Moreover, although it may seem odd for a different analysis to apply in the partnership and corporate contexts, it would not be the first time that is the case. Specifically, under § 707(a)(2)(B), a contribution of cash to a partnership by one partner followed by an immediate distribution of that cash to another partnership generally would be characterized as an “across the top” sale of an interest in the partnership by the partner that received the cash to the partner that provided it. In contrast, the IRS implicitly concluded that the same type of transaction would not be recharacterized as an across the top sale of stock in the corporate context if the recipient and distributee of the cash is a corporation.5 Perhaps § 707(a) – and its seeming preference for sale, rather than contribution treatment – justifies a different answer in the context of circular cash as well. 

Conclusion

In the case of a sale by D to PRS in which D expects to recognize and report a significant amount of gain, it may be hard to argue that the substance of the transactions is inconsistent with their form. D and TEI are unrelated parties that entered into the PRS partnership for business reasons and the economic positions of all the partners has changed because of the sale. TEI makes its investment in PRS to benefit from the tax credits generated by the project. Thus, TEI likely would have contributed to PRS to acquire the project even if it was not purchased from D, but rather from another party. In addition, the parties generally make a significant effort to determine the actual fair market value of the project before determining the sales price; a higher price puts more cash in the hands of D (but also results in more gain for federal tax purposes). In light of this, one could make a good argument that D’s sale to PRS should be treated as just that – a sale of property by one party to another for fair market value.  

In the next article, I’ll explore what are known as development company/operating company cross-chain sales. When we have two such silos transacting with one another, we can explore these circular cash flow concepts through a different lens. 

References

1 S. Rep. No. 1622, 83d Cong., 2d Sess. (1954).

2 This reading is consistent with § 1.731-1(c)(3) (which is referenced in § 1.721-1(a)). That section provides that a purported distribution does not fall within the scope of § 731 if the distribution was made to effect an exchange of property between the partnership and a partner or between two or more partners in the partnership.  

3 Section 1.707-3(b)(1). 

4 See, e.g., Six Seam Co. v. U.S., 524 F.2d 347, 355 (6th Cir. 1975) and Gunby v. Helvering, 122 F.2d 203, 206 (D.C. Cir. 1941). Both of these cases are cited in Jasper L. Cummings, Jr., Circular Cash Flows and the Federal Income Tax, ABA Tax Lawyer, Vol. 64, No. 3, Spring 2011. See also, PLR 200627022 (July 7, 2006) (IRS treated as a contribution of property what was, in form, a shareholder contribution of cash to a corporation that used that cash to acquire property from the shareholder). See generally, James S. Eustice, Tax Problems Arising from Transactions Between Affiliated or Controlled Corporations, 23 Tax L. Rev. 451 (1968) (referring to circular flow when shareholder contributes cash to corporation and corporation uses cash to buy asset from shareholder). 

5 See, Rev. Rul. 75-447, 1975-2 C.B. 113.