Section 707(a)(2)(B) Disguised Sale Rules: How LLC Members Contribute Property and Take Cash Without Triggering a Taxable Sale

A real-estate investor walks into her CPA's office in February. She contributed a warehouse worth $4 million (basis: $900,000) to a new LLC last August in exchange for a 40 percent member interest, and the LLC refinanced the property in October and distributed $2 million of the loan proceeds to her. She booked the cash as a tax-free distribution. Her CPA pulls out a calculator and tells her she may owe federal capital gains tax on roughly $2 million of the contribution — because the IRS sees the whole thing as a disguised sale, not a contribution.

This scenario is more common than most LLC members realize. The disguised sale rules under IRC Section 707(a)(2)(B) and the accompanying regulations under Treas. Reg. §§ 1.707-3 through 1.707-9 turn what look like ordinary partnership contributions and distributions into recharacterized taxable sales. The regulations are wide enough to catch real-estate joint ventures, family LLCs, leveraged partnership transactions, and even straightforward operating businesses that take in a new partner and refinance soon after.

Here is what every partner, LLC member, and tax advisor needs to know to keep the IRS from rewriting the transaction.

What the Disguised Sale Rules Actually Do

Subchapter K of the Internal Revenue Code generally treats contributions of property to a partnership in exchange for a partnership interest as tax-free under Section 721. Distributions of cash to a partner are generally tax-free under Section 731, except to the extent cash exceeds the partner's outside basis. Combined, those rules let partners shuffle property and cash among themselves without immediate tax — most of the time.

Section 707(a)(2)(B), enacted as part of the Deficit Reduction Act of 1984, exists to stop taxpayers from gaming that combination. Congress responded to a pair of cases — Otey v. Commissioner and the Communications Satellite and Jupiter Corp. line of decisions — where partners essentially sold property to their partnerships but dressed the transaction up as a contribution followed by a separate distribution.

The statute authorizes the Treasury to recharacterize the steps as a single sale or exchange when, viewed together, "the transfers are properly characterized as a sale or exchange of property." Treasury did exactly that in 1992 with the final regulations under Reg. § 1.707-3, and the framework has been refined several times since — most importantly in 2016, when leveraged partnership planning was tightened up.

When the rules apply, the consequences are sharp:

The contributing partner is treated as having sold the property to the partnership for the consideration received.
Capital gain or ordinary gain is triggered immediately on the deemed-sold portion (Section 1245 and 1250 recapture rules apply).
The partnership takes a cost basis in the recharacterized portion rather than a carryover basis.
The partner's outside basis adjusts to reflect the deemed sale rather than a tax-free contribution.

It is the worst of both worlds: the partner pays tax now, and the partnership loses the basis step-up that Section 721 would have preserved.

The Two-Step Test in Reg. § 1.707-3(b)

The regulations boil the analysis down to a two-prong test. A transfer of property to a partnership followed by a transfer of money or other consideration from the partnership to the partner is treated as a sale of property if both of the following are true based on all facts and circumstances:

But-for test. The transfer of money or other consideration would not have been made but for the transfer of property.
Entrepreneurial risk test. If the transfers are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.

The two-prong test is intentionally fact-heavy. The IRS does not need a written sales contract; circumstantial evidence is enough.

The Two-Year Presumption (and Its Mirror Image)

The most important timing rule sits in Reg. § 1.707-3(c) and (d). Two opposite presumptions apply depending on how much time separates the contribution and the distribution.

Within two years — sale is presumed. If a partner transfers property to the partnership and receives money or other consideration within two years of that transfer (before or after), the transfers are presumed to be a sale unless the facts and circumstances clearly establish otherwise. The burden is on the taxpayer to rebut.

More than two years apart — sale is presumed NOT to occur. Reg. § 1.707-3(d) flips the presumption: if the transfers happen more than two years apart, they are presumed not to be a sale unless the facts clearly establish that a sale took place. The longer the gap, the more breathing room exists to argue the partnership took on enough business risk that the two events stopped being a single integrated transaction.

The two-year window is not magic — the IRS can still attack a transaction that took longer if other facts strongly suggest a single integrated sale. But two years is the regulatory line in the sand most planners aim past when they cannot fit cleanly into one of the safe-harbor exceptions discussed below.

Mandatory Disclosure on Form 8275

If transfers occur within two years and the partner does not treat them as a sale, Reg. § 1.707-8 requires affirmative disclosure to the IRS. The disclosure is made by attaching a completed Form 8275 (or equivalent statement) to the partner's return for the year of the property transfer, identifying:

The property transferred and its fair market value
The consideration received and the timing
A clear statement that the partner takes the position the transfers are not a disguised sale

Skipping the disclosure does not by itself cause a disguised sale, but it weakens audit defense and is a frequent target of the IRS Large Business and International division's partnership compliance campaigns. Many partnership tax practitioners disclose proactively even when they are confident about the underlying position.

Facts and Circumstances: The IRS's Ten-Factor Checklist

Reg. § 1.707-3(b)(2) lists ten factors that "may tend to prove" a sale exists. None of them is dispositive by itself, but combinations rapidly tilt the analysis. The list includes:

The timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of the earlier transfer.
The partner has a legally enforceable right to the subsequent transfer.
The partner's right to receive the transfer is secured in any manner (escrow, third-party guarantee, lien on partnership assets).
A person has made or is legally obligated to contribute to the partnership to fund the subsequent transfer.
A person has loaned or agreed to loan the partnership the funds for the subsequent transfer.
The partnership has incurred or is obligated to incur debt to fund the subsequent transfer.
The partnership holds liquid assets disproportionate to its business needs that are expected to be used for the transfer.
Partnership distributions, allocations, or control rights are designed to effect an exchange of the burdens and benefits of property ownership.
The transfer of money is disproportionately large relative to the partner's general and continuing interest in partnership profits.
The partner has no obligation to return the money or other consideration to the partnership.

Real-estate ventures that build around items 1, 2, 5, and 6 are especially vulnerable: a contributor often signs documents the day of closing that lock in both a property transfer and a financing-funded distribution, with the amount known down to the dollar.

The Four Big Exceptions

Not every cash-out from a partnership is a disguised sale. The regulations carve out four important categories where transfers from a partnership to a contributing partner are not treated as consideration for the property.

1. Guaranteed payments for capital — Reg. § 1.707-4(a)

A reasonable guaranteed payment for the use of the partner's capital is ignored for disguised-sale purposes. Two requirements matter:

The payment must be reasonable relative to the value of the capital used.
The payment must be determined without regard to partnership income.

Payments designed as a fixed return on contributed capital — for example, a 6 percent annual preferred coupon on a $10 million contribution — are typically fine if reasonable.

2. Reasonable preferred returns — Reg. § 1.707-4(a)(2)

A "preferred return" that is paid out of partnership cash flow only when earned, but accrues and compounds in the meantime, is also outside the disguised-sale net if the rate is reasonable. The regulations measure reasonableness against a multiple of the applicable federal rate at the time of the transfer.

3. Operating cash flow distributions — Reg. § 1.707-4(b)

Routine distributions out of partnership operating cash flow are presumed not to be disguised sale consideration. The safe harbor caps the protected amount at the partner's interest in operating cash flow multiplied by the partnership's actual operating cash flow for the period. The presumption is rebuttable, but distributions that fit comfortably within the formula are generally safe.

4. Reimbursement of preformation capital expenditures — Reg. § 1.707-4(d)

This is the exception that drives most real-estate deals. If a partner spent money to acquire or improve property before contributing it, the partnership can reimburse those costs without triggering disguised sale treatment, subject to two key caps:

The reimbursement must occur within two years of the expenditure (with grandfathering for capital expenditures funded by qualified liabilities).
The reimbursement is generally limited to 20 percent of the fair market value of the contributed property — unless the partner's adjusted basis in the property at the time of the contribution is at least 80 percent of fair market value, in which case there is no cap.

A coordination rule blocks double dipping: if the preformation costs were funded with a "qualified liability" that the partnership assumes, the partner's share of the assumed liability reduces the preformation expenditure pool dollar for dollar.

The Debt-Financed Distribution Exception — the Real-Estate Workhorse

The most powerful planning rule in the disguised-sale playbook lives in Reg. § 1.707-5(b). Cash distributed to a partner that is traceable to a partnership-level borrowing is not disguised sale consideration to the extent the partner is allocated a share of the new debt under Sections 752 and 707.

The plumbing matters:

The partnership borrows new money (or refinances an existing nonqualified liability) within 90 days of the distribution.
The distribution must be traceable to the borrowing under the interest-expense rules of Reg. § 1.163-8T.
The partner's protected amount equals the partner's share of the new debt under the Section 752 allocation rules.

In a typical real-estate joint venture, the contributor of the property is often the entity that originally signed for or guaranteed the underlying mortgage. By staying on the hook for the partnership's recourse debt (or by having a sufficient share of recourse debt under bottom-dollar guarantees, which the 2016 regulations heavily limited), the contributor can be allocated enough debt to shelter a meaningful refinancing distribution.

The 2016 final regulations — and the temporary regulations issued at the same time that pulled back on bottom-dollar guarantees — significantly narrowed what counts as "recourse" liability for Section 752 purposes and curtailed the use of "leveraged partnership" structures that previously produced near-tax-free monetizations. Any plan that depends on debt-allocation magic should be modeled with current Sec. 752 regulations, not pre-2017 playbooks.

Qualified Liabilities — Old Debt vs. New Debt

Reg. § 1.707-5(a)(6) sorts partnership debt into two buckets: qualified liabilities and everything else. Qualified liabilities — broadly, debt incurred more than two years before the contribution, or debt incurred in the ordinary course of operating the contributed property — are treated more leniently. Their assumption by the partnership generally does not count as disguised sale consideration except to the extent the partner is relieved of debt the partner would not have been relieved of in the absence of the contribution.

Non-qualified liabilities — typically debt incurred shortly before the contribution to fund cash to the contributor — are treated as direct disguised-sale consideration to the extent the partner is relieved of the debt. This is where many "borrow and contribute" schemes break down.

A Worked Example — Putting It All Together

Imagine an LLC member, Anna, who owns an apartment building:

Fair market value: $10 million
Adjusted tax basis: $2 million
Existing acquisition mortgage (incurred five years ago, qualified liability): $6 million
Preformation capital improvements paid out of pocket in the last 18 months: $400,000

Anna contributes the property (subject to the mortgage) to a new LLC. She is allocated a 50 percent share of the partnership's debt under Section 752. The partnership refinances and pulls out an extra $1.5 million 60 days after the contribution, distributing the $1.5 million to Anna and giving her a $400,000 cash reimbursement out of equity.

Walking through the rules:

Assumption of $6 million qualified liability — outside the disguised-sale net under Reg. § 1.707-5(a)(5), because the debt is "old and cold."
$400,000 preformation reimbursement — protected if it does not exceed 20 percent of FMV ($2 million) and the costs are documented (they easily fit).
$1.5 million refinancing distribution — protected under the debt-financed distribution exception to the extent of Anna's Section 752 share of the new debt (50 percent of $1.5 million = $750,000). The remaining $750,000 is disguised sale consideration.

Anna recognizes gain proportional to the deemed-sold portion. Allocating basis pro rata, the deemed sold fraction is $750,000 ÷ $10 million = 7.5 percent of the property. Her gain equals $750,000 minus 7.5 percent of $2 million basis = $600,000 of taxable gain in the year of contribution.

She also files Form 8275 disclosing the position that the remaining transfers are not a disguised sale, because they happened within two years. If she had simply assumed the rules did not apply, she would face a $600,000 understatement plus penalties and interest if audited.

Common Mistakes That Trigger a Disguised Sale

Tax advisors who specialize in partnership transactions see the same patterns repeatedly:

Refinancing too quickly after contribution without modeling Section 752 allocations under the current regulations.
Treating preformation reimbursements as automatic without checking the 20-percent cap or the qualified-liability coordination rule.
Using bottom-dollar guarantees to inflate a partner's recourse debt share post-2016. The temporary regulations sharply limited this technique.
Documenting the contribution and the distribution in the same closing binder with cross-referenced exhibits — exhibit A for the IRS auditor that the transfers are integrated.
Skipping Form 8275 disclosure when within the two-year window.
Forgetting that the rules cover all "consideration," not just cash. Assumption of a contributor's personal liabilities, marketable securities, in-kind distributions of partnership property, and even certain partnership interests can all count.

Recordkeeping Discipline Beats Audit Surprise

Most disguised-sale exposure comes from poor recordkeeping rather than aggressive planning. Auditors look for:

Closing-date statements showing simultaneous transfers
Loan commitments dated before the contribution
Side letters guaranteeing a specific distribution amount
Capital account ledgers that move in lockstep with property transfers
Operating agreements with mandatory distribution clauses tied to the contribution

A clean paper trail — board minutes that show the partnership's independent decision to refinance, contemporaneous appraisals that support the FMV, capital improvement invoices for preformation expenditures, and accounting books that allocate Section 752 liability shares correctly — is the single best defense if the IRS comes asking.

Keep Your Partnership's Books Audit-Ready From Day One

Disguised-sale exposure is one of the clearest examples of why partnership and LLC books need to be airtight. Tracking partner contributions, capital accounts, debt allocations, preformation expenditure reimbursements, and the exact dates of every transfer in a system that auditors can follow is no longer optional — it is the difference between a clean 1065 and a recharacterized sale.

Beancount.io gives you plain-text accounting that is transparent, version-controlled, and AI-ready. Every contribution, distribution, and basis adjustment is recorded in human-readable text, which means your CPA can review every entry without exporting from a black-box system. Get started for free and see why partnerships, real-estate joint ventures, and finance professionals are switching to plain-text accounting — or explore the Fava dashboard to visualize your partner capital accounts in real time.