I. Introduction
The Internal Revenue Code (the “Code”) and accompanying regulations provide no explicit guidance directly addressing disguised sales of partnership interests. While the IRS issued proposed regulations under Treas. Reg. § 1.707-7 in 2004 (REG-149519-03), these regulations were withdrawn in 2009 (Announcement 2009-4, 2009-8 I.R.B. 597). In the absence of regulatory authority, determinations of whether a transaction between a partner and a partnership constitutes a sale of a partnership interest must rely on statutory language, legislative history, and case law.
Neither the Code nor legislative history clearly distinguishes between new partner admissions under § 721 and sales of partnership interests under § 741, leaving structured redemptions in a gray area. This ambiguity matters in practice because the tax consequences can differ dramatically depending on whether a transaction is respected as a redemption or recharacterized as a sale. As a result, careful structuring and documentation are critical when new capital enters a partnership in proximity to payments to exiting partners.
II. Case Law on Disguised Sales of Partnership Interests
The courts have addressed the concept of disguised sales in several landmark cases. In Communications Satellite Corp. v. United States, 625 F.2d 997 (Ct. Cl. 1980), the taxpayer contributed capital to an international joint venture and later received distributions attributable to new member contributions. The IRS argued that these distributions constituted a sale of the partnership interest by the existing partner. The Court of Claims rejected this position, holding that the transaction reflected a capital contribution by the new partners and a nontaxable distribution to the existing partner, rather than a disguised sale. The Court’s analysis focused on the transaction’s overall structure and the role of the new members’ required payments, rather than treating the distribution as sale proceeds.
Similarly, in Jupiter Corp. v. United States, 2 Cl. Ct. 58 (1983), a partnership admitted new limited partners who contributed capital and made loans to repay debts owed to an existing partner. The IRS contended that the repayments were disguised sale proceeds, whereas the partner claimed they were nontaxable distributions. The Court concluded that the transaction was a legitimate partnership reorganization and not a disguised sale.
Accordingly, both decisions are frequently relied upon in determining when distributions following a partner’s admission may properly be respected as partnership‑level transactions rather than recharacterized as disguised sales.
III. Congressional Response and Code § 707(a)(2)(B)
In response to these cases, Congress enacted § 707(a)(2)(B) to address disguised sales, noting that such transactions allow taxpayers to defer or avoid tax by structuring sales as contributions followed by related distributions. Congress delegated enforcement to the IRS through regulations, but no final regulations have ever been issued. This leaves practitioners dependent on pre-existing case law and general anti-abuse principles.
In 2004, the IRS proposed regulations under Treas. Reg. § 1.707-7, providing examples that distinguished nontaxable contributions and distributions under § 721 from taxable sales under § 741 and § 707(a)(2)(B). The proposed rules included structured redemptions, where distributions to existing partners closely followed contributions from new partners. The regulations were withdrawn in 2009 due to public feedback and complexity.
As a result, there is no regulatory authority specifically addressing redemptions under § 707, reinforcing the relevance of the facts-and-circumstances test under Treas. Reg. § 1.707-3(b)(2) in evaluating structured redemptions. Practitioners must focus on timing, payment structure, security, and retention of economic rights to assess whether a redemption is nontaxable under § 736(b) or could be treated as a disguised sale. In many transactions, these distinctions drive both deal economics and audit risk.
IV. Case Study: XYZ LLC Structured Redemption
The following case study illustrates how these principles apply in a common private-equity-style buyout structure.
Scenario: XYZ LLC is a partnership originally formed by two members, who collectively own 100% of the partnership. The partnership intends to redeem the interests of both original members through a structured, multi-year transaction.
New Capital Contribution: A newly formed Investment Company enters into a contribution agreement with an investment fund and a strategic partner (Partner X), collectively acquiring a majority interest in XYZ LLC. This contribution injects new capital into the partnership and sets the stage for the redemption of the original members.
Debt Repayment: The proceeds from the new investors’ capital contribution are first used to repay the partnership’s outstanding mortgage debt, ensuring the partnership is debt-free before any redemption payments commence.
Redemption of Original Members: Following debt repayment, the partnership redeems the original members’ entire interests. The redemption agreement provides for:
- Redemption Schedule: Quarterly payments over multiple years, with no payments made during the first two years following the effective date of the redemption agreement.
- Contingent Final Payment: Due at the earlier of 28 quarters or a defined Triggering Event.
- Funding Source: Payments derive solely from operational cash flow, not from additional partner contributions or external financing.
- No Additional Capital Required: New or remaining partners are not required to contribute capital or loans to fund the redemption.
- Retention of Economic Rights: Original members maintain limited rights until the redemption is fully completed.
- No Change in Control: Management and operational control remain with the new investors until the redemption concludes.
This sequence—capital contribution, debt repayment, and phased redemption of original members with deferred payments—illustrates a typical structure for buyouts that balances new investor funding, debt obligations, and gradual payout to exiting partners. This setup is critical when applying the facts-and-circumstances test under Treas. Reg. § 1.707-3(b)(2) to determine whether the redemption is nontaxable under § 736(b) or could be treated as a disguised sale under § 707(a)(2)(B).
V. Applying the Facts-and-Circumstances Test
The facts-and-circumstances test under Treas. Reg. § 1.707-3(b)(2) evaluates whether a transaction constitutes a disguised sale. Applying the test to the XYZ LLC redemption:
- Timing and Certainty of Transfers: Payments are structured over multiple years and aligned with operational cash flow, rather than a fixed sale obligation.
- Legally Enforceable Right: Original members have enforceable payment rights, but the final payment is contingent on business performance and Triggering Events.
- Security: No collateral or guarantees secure payment, supporting a redemption classification.
- Obligation to Pay through Debt or Contributions: No additional partner contributions or loans are required.
- Holding of Liquid Assets for Payment: Payments come from operational cash flow, not pre-reserved funds.
- Benefit/Burden Exchange: Gradual payout and retention of certain economic rights reflect ongoing partnership involvement.
- Disproportionate Payments: Payments are not significantly disproportionate relative to remaining interests.
- No Change in Management Control or Operational Burden: Original members retain limited rights; new partners do not immediately assume control.
- No Repayment Obligation: Transaction does not create a debtor-creditor relationship.
The structured redemption is more accurately treated as a redemption under § 736(b) rather than a disguised sale under § 707(a)(2)(B). Key supporting factors include the deferred payment schedule, payments subject to entrepreneurial risk, funding solely from operational cash flow, and the absence of regulatory authority for disguised sales.
VI. Tax Consequences for Original Members
The redemption is generally treated as capital gain under § 736(b). Any portion attributable to § 751 “hot assets,” such as unrealized receivables or inventory, is treated as ordinary income.
If the original members have negative capital accounts, the outside basis is effectively reduced, which increases the total capital gain recognized upon redemption. Importantly, deferred payments, including the initial two-year deferral, do not accelerate gain recognition; gain is recognized as payments are received.
If an original member dies while still receiving § 736(b) payments, the remaining redemption payments generally receive a step-up in basis under § 1014 to fair market value at the date of death. This step-up can significantly reduce or eliminate the capital gain for the deceased partner’s heirs.
It is also important to note that repayment of the partnership’s debt using new investor capital does not trigger taxable income for the original members, as they receive no cash or property at that stage.
VII. Conclusion
In the absence of on-point regulations, structured redemptions must be analyzed under existing statutory provisions, case law, and the facts-and-circumstances framework. Properly structured transactions, such as the XYZ LLC example, can be designed to minimize IRS recharacterization risk while aligning with legitimate business and operational practices.
Questions regarding the application of disguised sale principles to partnership redemptions or ownership transitions may be directed to Sebastian Pascu, Chair of KJK’s Estate, Wealth & Succession Planning practice, at SCP@kjk.com or 216.736.7294.