Section 721(c) Rules for Foreign Partner Contributions

When a U.S. person contributes property to a partnership, the transaction is often tax-free under Section 721(a) of the Internal Revenue Code, which allows for the deferral of gain. However, an exception exists to prevent U.S. taxpayers from shifting unrealized gains to foreign partners to avoid U.S. taxation. This exception is governed by regulations under Section 721(c).

The purpose of these regulations is to address transfers of appreciated property where the built-in gain could be allocated to a foreign partner not subject to U.S. tax. The rules ensure the U.S. transferor remains accountable for the tax on any pre-contribution appreciation by overriding the general nonrecognition rule unless specific requirements are met.

Determining Applicability of the Regulation

For the regulation to apply, a specific set of conditions involving the transferor, partnership, and property must be met. The first is the presence of a U.S. transferor, which is broadly defined to include U.S. citizens, resident individuals, domestic corporations, and certain trusts and estates.

The transaction must involve a “Section 721(c) partnership.” This is a partnership where a U.S. transferor and one or more related foreign persons own 80 percent or more of the interests in capital, profits, deductions, or losses immediately after the contribution.

Finally, the contribution must consist of “Section 721(c) property.” This is property with a fair market value greater than its adjusted tax basis at the time of contribution. The regulations exclude cash and certain marketable securities, focusing on assets like real estate, intellectual property, or equipment. If any of these components are missing, the transaction generally falls back under the standard nonrecognition rules.

Understanding the Gain Deferral Method

When a transaction falls under these rules, immediate taxation of the built-in gain is the default outcome. The regulations, however, provide a pathway to postpone this liability, known as the Gain Deferral Method. This method defers the recognition of gain, provided the parties agree to a set of ongoing requirements designed to ensure the gain remains within the U.S. tax base.

A central requirement is the partnership’s agreement to adopt the “remedial allocation method” for the contributed property. This method, detailed in regulations under Section 704(c), is a precise way to handle book-tax disparities by creating notional, or “remedial,” tax items of income or deduction and allocating them to the partners. This process ensures the contributing U.S. partner is eventually taxed on their full share of the pre-contribution gain.

The partnership must also agree to track the built-in gain associated with the property, as this forms the basis for applying the remedial method. Additionally, the partnership must apply the “consistent allocation method,” which works with the remedial method to prevent allocations from shifting the tax burden away from the U.S. transferor. The U.S. transferor must also commit to annual reporting for as long as the gain is deferred.

Events Triggering Gain Recognition

Opting for the Gain Deferral Method requires vigilance, as certain events can accelerate the deferred gain, making it immediately taxable to the U.S. transferor. These “acceleration events” are defined in the regulations and generally occur when the conditions for deferral are no longer being met. Understanding these triggers is important for managing tax obligations.

Failure to Comply

One of the most direct triggers is a failure to comply with the deferral requirements. If the partnership, in any year, fails to properly apply the remedial allocation method to the contributed property, the deferral is broken. The deferred gain becomes taxable to the U.S. transferor in the year of the failure.

Disposition of Property or Interest

The disposition of either the property or the partnership interest can also trigger gain recognition. If the partnership sells or otherwise disposes of the contributed property, the remaining built-in gain is recognized. Similarly, if the U.S. transferor sells or transfers their interest in the partnership, the deferral ends, as these events are considered to crystallize the gain.

Other Triggers

Other triggers involve changes in partner relationships or certain distributions. If the related foreign partner ceases to be related to the U.S. transferor, the foundational reason for the oversight is altered, which can trigger the gain. Furthermore, if the partnership makes a distribution that reduces the contributing partner’s share of the built-in gain, it can also lead to immediate taxation.

Required Information and Annual Reporting

Compliance with the Gain Deferral Method hinges on annual reporting, which is handled through Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. This form is the mechanism by which the U.S. transferor informs the IRS they are deferring gain. Proper preparation requires gathering substantial information beforehand.

The taxpayer must collect all relevant details about the transaction, including:

• The full legal name, address, and taxpayer identification number for the U.S. transferor, the partnership, and all related foreign partners.
• A detailed description of the contributed property.
• The property’s precise fair market value and adjusted tax basis on the date of contribution.
• The calculated amount of built-in gain being deferred.

This information is then reported on Form 8865. The filing must also include a formal declaration stating that the partnership has adopted and will apply the remedial allocation method as required.

The Submission Process

Once completed, Form 8865 must be attached to the U.S. transferor’s main income tax return for the year in which the contribution occurred. This could be an individual return like Form 1040 or a corporate return such as Form 1120, depending on the transferor.

This filing obligation is not a one-time event. A Form 8865 detailing the deferred gain must be filed with the U.S. transferor’s tax return for every subsequent year that the gain remains deferred. The filing deadline for the form is the same as the due date for the transferor’s income tax return, including any extensions. Missing this deadline can jeopardize the gain deferral and lead to penalties.

After submission, the form becomes part of the taxpayer’s official tax record. The U.S. transferor must retain complete copies of all submitted forms and the underlying supporting documentation. These records serve as proof of compliance and are necessary in the event of an IRS inquiry.