What Is a Section 721(c) Partnership?

Internal Revenue Code Section 721(a) permits partners to contribute property to a partnership for an interest in that entity without recognizing an immediate gain or loss. This allows for tax-deferred transfers of assets like real estate, cash, or intellectual property, facilitating partnership formation. The contributing partner and the partnership carry over the existing tax basis of the assets, deferring tax consequences until a later date.

These non-recognition benefits, however, created opportunities for tax strategies the Internal Revenue Service (IRS) viewed as abusive. A U.S. taxpayer could contribute property with a significant built-in gain—where fair market value exceeds the tax basis—to a partnership with a foreign partner not subject to U.S. tax. This structure could allow the pre-contribution gain to be allocated to the foreign partner, moving the gain outside the U.S. tax system. To address this, regulations under Section 721(c) were established as an anti-abuse rule that overrides the non-recognition principle in certain cross-border transactions.

Identifying a Section 721(c) Partnership

A transaction creates a Section 721(c) partnership when a specific set of conditions are met. The first requirement is the presence of a U.S. transferor, defined as a “United States person” under the Internal Revenue Code. This includes U.S. citizens, resident aliens, and domestic corporations, but excludes domestic partnerships.

The transaction must involve a contribution of “Section 721(c) property,” which is any property with a built-in gain at the time of contribution. A built-in gain exists when the property’s fair market value is higher than its adjusted tax basis. A de minimis exception applies if the total built-in gain of all contributed property during the partnership’s taxable year is less than $1 million.

Another condition is the composition of the partnership after the property contribution. The partnership must include a “related foreign person” as a partner. A person is considered related to the U.S. transferor if they fall within the relationship definitions of the Internal Revenue Code, which include family members and corporations or partnerships where the transferor has a significant ownership stake. A foreign person is any person who is not a U.S. person.

The final condition is the control requirement. A Section 721(c) partnership is formed only if, after the contribution and any related transactions, the U.S. transferor and all related persons collectively own 80% or more of the interests in the partnership’s capital, profits, deductions, or losses. This control test ensures the rules target situations where a U.S. person and their affiliates can direct the partnership’s allocation of gains. If this control threshold is not met, the partnership does not fall under the Section 721(c) regulations.

Applying the Gain Deferral Method

Once a partnership is identified as a Section 721(c) partnership, the default tax treatment is the immediate recognition of the built-in gain on the contributed property. However, this immediate taxation can be avoided if the partnership and the U.S. transferor elect to apply the Gain Deferral Method. This method is a mandatory set of rules that must be followed to postpone the tax liability and ensure the pre-contribution gain is eventually taxed by the United States.

A primary requirement of the Gain Deferral Method is that the partnership must adopt the “remedial allocation method” for the contributed Section 721(c) property. This accounting method is designed to correct distortions caused by the difference between the property’s fair market value and its tax basis. It creates notional, or “remedial,” tax items of income, gain, loss, or deduction and allocates them among the partners to ensure the built-in gain is not improperly shifted away from the contributing partner.

The partnership must also apply the “consistent allocation method.” This rule requires that for each year the deferral is in place, the partnership must allocate all items of income, gain, loss, and deduction from the property to the U.S. transferor in the same percentage. This prevents altering allocation percentages to shift the tax burden to a foreign partner.

Finally, the U.S. transferor must agree to recognize any remaining built-in gain upon the occurrence of a future “acceleration event.” An acceleration event can include any failure to adhere to the Gain Deferral Method’s requirements. This commitment ensures that the deferred gain remains subject to U.S. taxation.

Required Reporting and Documentation

To maintain tax deferral under the Gain Deferral Method, the U.S. transferor must comply with annual reporting requirements. The primary vehicle for this is Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships.” The IRS uses this form to track the deferred gain and verify that all conditions are being met.

The U.S. transferor must attach a completed Form 8865 to their federal income tax return for the year of the contribution and for every subsequent year that the gain deferral is maintained. Schedule O of Form 8865, “Transfer of Property to a Foreign Partnership,” is particularly important as it requires the filer to provide detailed information about the transaction.

Specific information reported on the form includes a description of the contributed Section 721(c) property, its fair market value, and its adjusted tax basis as of the contribution date. The form also requires detailed information identifying the partnership and all of its partners. A part of the filing is an explicit statement confirming that the Gain Deferral Method is being applied.

The completed Form 8865 must be filed with the U.S. transferor’s income tax return for the correct taxable year. Failure to file this form, or filing it with incomplete or inaccurate information, is considered a failure to comply with the Gain Deferral Method and constitutes an acceleration event.

Events Triggering Gain Recognition

The deferral of gain under Section 721(c) is not permanent and can end due to specific events. These are categorized as either “acceleration events,” which trigger immediate taxation of the remaining built-in gain, or “termination events,” which end the reporting requirements without adverse tax consequences.

An acceleration event is any occurrence that forces the U.S. transferor to recognize the deferred gain. One of the most common acceleration events is a failure to comply with the requirements of the Gain Deferral Method. This includes neglecting to attach Form 8865 to the annual tax return or failing to properly apply the remedial allocation method. Other acceleration events include the partnership disposing of the Section 721(c) property where gain is not fully recognized, or if the U.S. transferor’s related foreign partner ceases to be considered “related.”

A transfer of the U.S. transferor’s interest in the partnership can also trigger gain recognition. Likewise, if the partnership transfers the contributed property to another entity in a non-recognition transaction, it may accelerate the gain. The consequence of an acceleration event is the immediate inclusion of the remaining built-in gain in the U.S. transferor’s income for that taxable year.

In contrast, a termination event ends the obligations of the Gain Deferral Method without triggering a tax liability. For example, if the partnership sells the Section 721(c) property in a fully taxable transaction and correctly allocates all the built-in gain to the U.S. transferor, the deferral is no longer needed. Another termination event is the distribution of the Section 721(c) property back to the original U.S. transferor. The requirements of the Gain Deferral Method are also terminated if the U.S. transferor recognizes the entire remaining built-in gain for any other reason.