IRS Code 721: Nonrecognition of Gain or Loss on Contributions

Understanding IRS Code 721 is essential for individuals involved in partnerships and limited liability companies (LLCs). This code governs the nonrecognition of gain or loss when property is contributed to a partnership, carrying significant tax implications. By deferring gains or losses, IRS Code 721 facilitates business operations and investments, playing a critical role in determining the tax treatment of contributions.

This article explores the specifics of IRS Code 721, including its requirements, nuances, and situations where exceptions may apply.

Nonrecognition Requirements

The nonrecognition of gain or loss under IRS Code 721 applies when property is exchanged solely for an interest in a partnership. This ensures the contributor receives a proportional share of profits and losses, aligning their interests with the partnership’s success. The property can be tangible, such as real estate or equipment, or intangible, such as patents and trademarks, each with unique considerations for valuation and future appreciation or depreciation.

An important principle is the continuity of interest, requiring the contributor to maintain a substantial stake in the partnership post-contribution. This rule prevents the misuse of partnerships for temporary tax deferrals. The partnership interest received must reflect the fair market value of the contributed property to ensure transparency.

Contributions of Property

Contributing property under IRS Code 721 involves various types of assets, each with distinct valuation challenges. Tangible assets, such as machinery or real estate, require assessing market value, growth potential, and any associated liabilities like mortgages. Intangible assets, like patents, demand analysis of revenue potential, market relevance, and legal protections. For instance, a patent’s value depends on its lifespan, competitive landscape, and applicability across industries.

When property with liabilities, such as a mortgage, is contributed, the partnership assumes the debt. This can lead to complex tax consequences under sections like 752, potentially resulting in a deemed distribution that affects the contributor’s basis in the partnership and may trigger taxable gain.

Contributions of Services

Contributions of services differ significantly from property under IRS Code 721. Services do not qualify for nonrecognition of gain or loss. When services are exchanged for a partnership interest, the fair market value of that interest is treated as taxable income, subject to ordinary income tax rates, which in 2024 can reach up to 37%.

This distinction is particularly relevant for service partners receiving a profits interest, which grants a share of future profits but not current capital value. Revenue Procedure 93-27 provides that receiving a profits interest for services is generally not taxable if specific conditions are met, such as the interest not being a predictable income stream, not disposed of within two years, and the partnership not being publicly traded.

For example, if a lawyer provides services to a startup in exchange for a 10% profits interest and the partnership meets the outlined conditions, the lawyer may avoid recognizing taxable income. However, this area is nuanced, and errors can lead to unexpected tax liabilities. Proper documentation and adherence to IRS rules are essential.

Partner Basis Adjustments

Partner basis adjustments are central to partnership taxation, reflecting the dynamic relationship between a partner and the partnership. A partner’s basis is determined by their contributions—whether cash, property, or services—and fluctuates based on additional contributions, distributions, and their share of income, deductions, gains, or losses. These adjustments affect the tax consequences of future distributions and the eventual sale or disposition of the partnership interest.

A partner’s basis increases with additional contributions, their share of taxable and tax-exempt income, and decreases with distributions, losses, and non-deductible expenses. Monitoring these changes is critical to avoid unexpected tax liabilities and accurately assess tax positions.

Situations That Trigger Gain Recognition

Although IRS Code 721 generally allows nonrecognition of gain or loss on property contributions, specific situations trigger gain recognition. One scenario involves contributing property with liabilities exceeding its adjusted basis. Under IRC Section 752, if the partnership assumes the liability, the excess is treated as a deemed distribution, potentially resulting in taxable gain. For instance, contributing a rental property with a $500,000 mortgage but an adjusted basis of $300,000 may result in a $200,000 taxable gain.

Another triggering event is disguised sales. If a partner contributes property and receives a disproportionate distribution—especially within two years—the IRS may recharacterize it as a sale under IRC Section 707, subjecting the partner to immediate gain recognition. For example, contributing equipment valued at $100,000 and receiving a $100,000 cash distribution shortly after could be viewed as a sale.

Additionally, gain recognition occurs if the partnership disposes of the contributed property. Under IRC Section 704(c), any built-in gain or loss at the time of contribution is allocated back to the contributing partner upon the property’s sale. For instance, contributing land with a fair market value of $1 million and an adjusted basis of $600,000 would result in the $400,000 built-in gain being recognized by the contributing partner when the land is sold. These provisions underscore the importance of careful planning to avoid unintended tax consequences.

Reporting Obligations

Accurate reporting is vital for compliance with IRS Code 721. Partnerships report property contributions on Form 1065, Schedule K-1, which allocates each partner’s share of income, deductions, and other tax items. The fair market value and adjusted basis of contributed property must be documented to ensure accurate reporting of future gain or loss.

Contributing partners must maintain detailed records, including the property’s purchase price, improvements, depreciation, and liabilities, to calculate their adjusted basis and substantiate claims during an IRS audit. For instance, a partner contributing a commercial building must retain records of acquisition costs, depreciation schedules, and mortgages to accurately report their basis and potential gain recognition.

When allocating built-in gains or losses from contributed property, partnerships must comply with Section 704(c) reporting requirements. Methods such as the traditional method, the traditional method with curative allocations, or the remedial method can be used, each with specific implications for tax reporting. Consulting tax professionals is recommended to ensure compliance and accuracy in these calculations.