Can an owner contribute property to a new LLC and take back a nontaxable preferred distribution?

Instead of selling property outright and recognizing gain for income tax purposes, can a property owner contribute the property to a new limited liability company and take back a nontaxable preferred distribution? Here are the facts: Taxpayer S wants to sell a building to taxpayer B, but would like to delay paying tax on the gain realized. S asks his tax advisor whether a contribution by S of the property to a partnership with S and B as partners (with B contributing a cash equal to the fair market value of the property) followed by a distribution of cash to S will accomplish this goal. Congress and the Internal Revenue Service are aware of the possibility that a taxpayer could avoid recognizing a gain on transactions that are in essence sales of property by treating the transfer of the property as a capital contribution and the subsequent transfer of cash or other consideration as a distribution. Code Section 707 authorizes the Internal Revenue Service to recast transactions like the one described above as a sale. These are the "disguised sales rules." In making a determination whether a distribution of cash or other property to one partner following a contribution of property by the same partner, the regulations pose the fundamental question as to whether there is a purpose for the subsequent distribution other than to compensate the transferor for the surrender of the property. The determination of whether a sale has occurred rests on a facts and circumstances inquiry. The regulations contain a list of facts and circumstances that would indicate that the transfer of property should be treated as a sale, regardless of how the parties to the transaction accounted for it. One of the indicia of a sale is that the amount and timing of the subsequent partnership distribution are readily determinable at the time of the property is contributed. The fact that the transferor has a legally enforceable claim would also argue in favor of treating the transfer as a sale. The existence in the partnership agreement of provisions obligating the other partners to make cash contributions or the partnership to incur debt or other legal protections to assure that funds are available to make the required distributions are additional factors that would lead to a determination that a sale of property has taken place. On the other hand if the transferor bears some risk as to whether he will be fully compensated for his transfer of property or that he shares significantly in the risks of the partnership and future appreciation of the property would support that a valid partnership relationship exists and the transfer of property should be recognized as a contribution. If one is contemplating structuring a transaction as a contribution of property that might raise Section 707 issues, it is important that any agreement allow for a two year period to occur between the date of original contribution and any non-pro rata distribution. The regulations provide that if a partner transfer's property to a partnership and money or other consideration is received within two years, the transfer will be presumed to be a sale. Likewise, if the money or other consideration is received more than two years after the property is transferred, it is to be presumed that it is not a sale. However, the presumption that a sale has not taken place can be overridden based on the facts and circumstances. Thus even if one allows for a two-year period to elapse, care should be taken to not run afoul of the criteria set forth in the regulations for finding that a transfer should be accounted for as a sale. Of critical importance are provisions in the regulations that require full disclosure of the nature of the transaction and the amounts involved in transactions involving a transfer of property to a partnership that is not accounted for as a sale and where money or other consideration is distributed to the transferor within a two year period. If the two year waiting requirement is not met, a transaction involving the contribution of property to a partnership should be expected to undergo heavy scrutiny by the Internal Revenue Service. Sandy Klein is a partner at Shanholt Glassman Klein Kramer & Co., New York, N.Y.