How the Mixing Bowl Rules Affect Partnership Taxation

Partnerships offer a flexible structure for combining assets and business operations. This flexibility, however, historically allowed for transactions that closely resembled sales of property but avoided immediate taxation. To address this, Congress enacted specific anti-abuse provisions commonly known as the “mixing bowl” rules. These rules are designed to prevent partners from using a partnership to indefinitely defer taxes on what is effectively a sale or exchange of property.

The issue the mixing bowl rules target is the “disguised sale.” In a typical scenario, one partner would contribute an appreciated asset, like real estate, to a partnership. Soon after, another partner would contribute cash, and the partnership would then distribute that cash to the first partner. While structured as a contribution and a distribution, the economic reality is a sale of the real estate. The mixing bowl rules prevent this by setting timeframes and conditions to recharacterize and tax these transactions appropriately.

The Contributed Property Rule

The first component of the mixing bowl provisions is the contributed property rule, governed by Internal Revenue Code Section 704. This rule applies when property with a “built-in gain” is distributed to a partner other than the one who contributed it. A built-in gain is the excess of a property’s fair market value over the contributing partner’s adjusted tax basis at the time of contribution. The rule is triggered if the partnership distributes this property to a different partner within seven years of the contribution.

When this rule is triggered, the original contributing partner must recognize the built-in gain. The amount of gain is what would have been allocated to that partner if the partnership had sold the property for its fair market value at the time of the distribution. This prevents partners from using the partnership to shift the tax burden of pre-contribution appreciation to someone else.

For example, a partner contributes land to a partnership with a fair market value of $500,000 and an adjusted basis of $100,000, creating a $400,000 built-in gain. Four years later, the partnership distributes this land to another partner. Under the contributed property rule, the original partner must recognize the $400,000 built-in gain in the year of the distribution.

The character of this recognized gain, whether capital gain or ordinary income, is determined as if the partnership had sold the property to the distributee partner.

The Property Distribution Rule

A parallel provision, the property distribution rule, is governed by Internal Revenue Code Section 737. This rule applies when a partner who contributed property with a built-in gain receives a distribution of different property from the partnership. This provision is triggered if the distribution occurs within seven years of the original property contribution.

Under this rule, the contributing partner recognizes gain equal to the lesser of two amounts. The first is the partner’s “net precontribution gain,” which is the total built-in gain on all property that partner contributed within the last seven years. The second is the “excess distribution,” calculated as the fair market value of the distributed property over the partner’s adjusted basis in their partnership interest. The partner recognizes the smaller of these two figures.

For example, a partner contributes property with a $100,000 built-in gain and has a $50,000 basis in their partnership interest. Three years later, the partnership distributes a different asset with a fair market value of $80,000 to that same partner. The excess distribution is $30,000 ($80,000 value minus $50,000 basis), and the net precontribution gain is $100,000. The partner must recognize a $30,000 gain, as it is the lesser amount.

This rule prevents a partner from “cashing out” their built-in gain tax-free by contributing an appreciated asset and then receiving a distribution of other valuable property.

Key Exceptions to the Mixing Bowl Rules

The mixing bowl rules have several exceptions for situations that are not disguised sales. A primary exception under both rules occurs when a partnership distributes property back to the original contributing partner. Since the partner is receiving their own property back, no tax is triggered.

Certain partnership liquidations can also be exempt. If a partnership liquidates as part of a complete termination, the mixing bowl rules may not apply if specific conditions are met. For instance, a partner receiving an interest in the originally contributed property during the liquidation can negate the rule’s application.

Transactions where a partnership incorporates are also an exception. When a partnership transfers its assets to a corporation in a tax-free incorporation, the event is not treated as a distribution that triggers the mixing bowl provisions. This allows partnerships to change their legal form without creating an inadvertent taxable event.

Basis Adjustments and Character of Gain

When gain is recognized under the mixing bowl rules, adjustments must be made to the tax basis of the assets involved to prevent the same gain from being taxed again. The process involves changes to the partner’s basis in their partnership interest (“outside basis”) and the partnership’s basis in its assets (“inside basis”).

The contributing partner who recognizes gain increases their outside basis by the amount of gain recognized, reflecting that the partner has already been taxed on that appreciation. The partnership also increases its inside basis in the property that was the source of the gain. Under the contributed property rule, the partnership increases its basis in the contributed property just before the distribution. Under the property distribution rule, the partnership increases its basis in the property the partner originally contributed.

The character of the recognized gain is also a consideration, as it determines whether the gain is taxed as ordinary income or capital gain. The rules dictate that the gain’s character is determined by the character of the contributed property in the hands of the contributing partner.

For instance, if a developer contributes property that was inventory (ordinary income property), any recognized gain will be ordinary income. If an investor contributes a capital asset like stock, the recognized gain will be a capital gain. This ensures a partner cannot use the partnership to convert ordinary income into a capital gain.