Section 721 of the Internal Revenue Code Explained
Understand the tax deferral on property contributed to a partnership and the long-term consequences for your tax basis and the allocation of future gains.
When businesses form, participants often contribute assets like machinery, real estate, or intellectual property, not just cash. Transferring an asset that has increased in value to a new business creates a potential tax event. For example, if a partner contributes real estate that has appreciated, a question arises whether that gain is taxed immediately. Understanding the tax implications of these non-cash contributions is necessary for structuring a new business correctly from the start.
The Core Principle of Tax-Free Contributions
Internal Revenue Code Section 721 provides that when a partner contributes property to a partnership for an interest in that partnership, no gain or loss is recognized by the partner or the partnership. This provision allows businesses to form without being hindered by a tax bill at creation, encouraging the pooling of assets. This rule functions as a tax deferral, not a permanent forgiveness of the tax liability.
For example, a partner who contributes land with a tax basis of $50,000 that is worth $200,000 at contribution has a $150,000 “built-in gain.” The partner does not have to report this gain on their personal tax return in the year of contribution. The tax on this gain is postponed until a later date, such as when the partnership sells the asset or when the partner sells their interest in the partnership. The recognition of the economic gain is simply delayed, allowing the new venture to be capitalized with needed assets.
Defining a Qualifying Property Contribution
For the tax-free rule to apply, the item transferred must qualify as “property.” The term is interpreted broadly and includes tangible assets like cash, machinery, and real estate, as well as intangible assets like patents and copyrights.
The most significant exclusion from this category is the contribution of services. When an individual receives a partnership interest in exchange for performing services, or for the promise of future services, the transaction does not qualify for tax-free treatment. Instead, the value of the partnership interest is treated as taxable compensation.
The service partner must recognize ordinary income equal to the fair market value of the partnership interest they receive. This income is subject to regular income and potentially self-employment taxes. The timing of this income recognition depends on whether the interest is subject to a substantial risk of forfeiture.
Key Exceptions to Tax-Free Treatment
Even when qualifying property is contributed, some situations can make the transaction taxable. One exception involves contributions to a partnership that would be treated as an “investment company.” This rule prevents taxpayers from using a partnership to diversify an investment portfolio without recognizing gains. This occurs if over 80% of the partnership’s assets are held for investment and are readily marketable stocks or securities.
For example, if a person contributes appreciated stock in one company to a partnership holding various stocks from other partners, the contribution is a taxable exchange. The contributing partner must recognize the built-in gain on the securities transferred, as if they had sold them and contributed the cash.
Another exception is the “disguised sale” rule under Internal Revenue Code Section 707. This provision prevents partners from disguising a sale of property as a tax-free contribution. If a partner contributes property and soon after receives a cash distribution from the partnership, the event may be recharacterized as a sale, requiring the partner to recognize gain or loss.
Calculating Partner and Partnership Basis
A tax-free contribution establishes a tax attribute known as basis. Two separate basis calculations are required: the partner’s basis in their partnership interest (“outside basis”) and the partnership’s basis in the contributed asset (“inside basis”). These figures are for determining gain or loss on future sales and for calculating deductions like depreciation.
A partner’s outside basis starts with the adjusted basis of the property they contributed. For example, a partner contributing equipment with an adjusted basis of $30,000 has an initial outside basis of $30,000. This figure increases with additional contributions and the partner’s share of income and decreases with distributions and the partner’s share of losses.
The partnership’s inside basis in the contributed asset is the same as the contributing partner’s adjusted basis in the property at the time of contribution. When a partner contributes property subject to a liability, like a building with a mortgage, the partner’s outside basis is decreased by the amount of liability allocated to the other partners. Conversely, a partner’s outside basis increases by their share of any new partnership debt.
For instance, assume a partner contributes property with a $100,000 basis and a $40,000 mortgage to a 50/50 partnership. The partner’s initial basis of $100,000 is reduced by the $20,000 of the mortgage allocated to the other partner ($40,000 mortgage relief less the partner’s own $20,000 share of the liability). This results in an outside basis of $80,000 for the contributing partner.
Tax Consequences on a Future Sale of Assets
The tax deferral from the initial contribution is addressed when the partnership sells the asset. Rules under Internal Revenue Code Section 704 ensure that the tax for any “built-in” gain at the time of contribution is allocated back to the contributing partner. This prevents pre-contribution appreciation from being shifted to other partners.
Revisiting the example of the partner who contributed land with a $50,000 basis when it was worth $200,000, the partnership holds the land with an inside basis of $50,000. If the partnership later sells the land for $220,000, it recognizes a total tax gain of $170,000 ($220,000 sale price minus $50,000 basis).
The first $150,000 of this gain, representing the pre-contribution appreciation, must be allocated to the contributing partner. The remaining $20,000 of gain, which is appreciation that occurred after the contribution, is allocated among all partners according to their profit-sharing ratios. This special allocation ensures the original deferral is properly reconciled.