What Is a Section 721(c) Partnership?

The tax code often allows for the non-recognition of gain when a person contributes property to a partnership. However, regulations under Internal Revenue Code Section 721(c) address situations where a U.S. taxpayer transfers appreciated property to a partnership with related foreign partners. This structure could potentially allow the gain from the property to be allocated to the foreign partners, escaping U.S. taxation.

These rules prevent the shifting of income from appreciated assets outside the U.S. tax system through contributions to partnerships. When a transaction falls under these regulations, the default outcome is immediate taxation for the U.S. person contributing the property. The rules establish a framework that either forces the recognition of this gain or imposes strict requirements to defer it.

Identifying a Section 721(c) Transaction

A transaction is subject to these regulations if it involves a U.S. transferor contributing Section 721(c) property to a Section 721(c) partnership. A U.S. transferor includes any U.S. person, such as a citizen, resident, domestic corporation, or domestic trust or estate. Notably, domestic partnerships are generally not considered U.S. transferors under these rules.

The partnership is designated a Section 721(c) partnership if a U.S. transferor and one or more related foreign persons collectively own 80 percent or more of the interests in the partnership’s capital, profits, deductions, or losses after the contribution. The partnership can be either a domestic or a foreign entity. The relationship between the U.S. partner contributing the assets and the other foreign partners who hold a significant stake in the venture is the determining factor.

Determining who qualifies as a related foreign person involves a set of attribution rules under the tax code. Relatedness can be established through direct family relationships, such as with spouses, children, grandchildren, and parents. It also extends to entities through ownership tests; for instance, a corporation is related if the U.S. transferor owns more than 50 percent of its stock.

The asset being contributed must be Section 721(c) property. This is any property that has a fair market value higher than its adjusted tax basis at the moment of contribution, meaning it has a “built-in gain.” However, there are specific exclusions, as the regulations do not apply to contributions of cash equivalents, most types of securities, or tangible property with a built-in gain of $20,000 or less.

The Default Rule of Immediate Gain Recognition

When a contribution of property meets the criteria of a Section 721(c) transaction, the default consequence is the immediate recognition of gain for the U.S. transferor. The U.S. transferor must treat the contribution as if the property were sold for its fair market value on the date of the transfer. This means the entire built-in gain is subject to U.S. tax in the year of the contribution.

This immediate taxation serves as the baseline penalty for shifting appreciated assets into a partnership with related foreign partners without taking further action. The intent is to create a strong incentive for taxpayers to either avoid these structures or to comply with the stringent requirements of the exception provided by the regulations.

The amount of gain to be recognized is calculated by subtracting the property’s adjusted tax basis from its fair market value. This forces the U.S. partner to pay tax on the appreciation that occurred while they held the asset, even though they did not receive cash from a sale.

Utilizing the Gain Deferral Method

To avoid immediate taxation, the regulations provide an exception known as the Gain Deferral Method. This is not an automatic benefit; the partnership and the U.S. transferor must proactively elect to apply it and agree to a strict set of ongoing requirements. The core of this method is designed to ensure that the built-in gain from the contributed property is eventually taxed by the United States.

A primary requirement of the Gain Deferral Method is the adoption of the “consistent allocation method.” This means the partnership must agree to allocate all income, gain, depreciation, and amortization related to the Section 721(c) property specifically to the contributing U.S. transferor. This continues until the entire built-in gain has been recognized for tax purposes, and the regulations mandate the use of the remedial allocation method to achieve this.

Beyond the allocation rules, qualifying for the Gain Deferral Method imposes several other obligations. One such condition is that the U.S. transferor must agree to extend the statute of limitations for the assessment of tax on the built-in gain.

The foreign partners who are related to the U.S. transferor must appoint a U.S. agent for the service of process, which ensures that the IRS can enforce the rules against them if necessary. The partnership must also comply with detailed annual reporting requirements, which provide the IRS with the information needed to monitor the status of the deferred gain.

Compliance and Reporting Obligations

Opting for the Gain Deferral Method requires adherence to procedural and reporting obligations, beginning in the year of the contribution and continuing annually. The U.S. transferor is responsible for filing Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, with their income tax return. This form must include a detailed statement that outlines the transaction and formally elects the Gain Deferral Method.

For every subsequent year that the gain remains deferred, the U.S. transferor must continue to file Form 8865 and provide updated information. Failure to meet these reporting requirements can result in the immediate taxation of the remaining built-in gain, along with potential penalties.

An “acceleration event” is a specific occurrence that terminates the gain deferral and requires the U.S. transferor to recognize any remaining built-in gain immediately. If an acceleration event occurs, the remaining deferred gain must be reported on the U.S. transferor’s tax return for that year. Common acceleration events include:

• The partnership selling or otherwise disposing of the Section 721(c) property.
• A transaction that reduces the U.S. transferor’s direct or indirect interest in the partnership.
• The partnership ceasing to apply the consistent allocation method.
• The related foreign partner becoming unrelated to the U.S. transferor.
• The U.S. transferor becoming a foreign person.