U.S. House and Senate Finance Committee Reconciliation Bills Modify Partnership “Disguised Sales” Provisions

On June 16, 2025, the U.S. Senate Finance Committee released draft legislative text for inclusion in the One Big Beautiful Bill Act (HR 1). Among other items, the Senate text retains a provision in a version of the bill that passed the House on May 22, 2025, that would amend Section 707(a)(2) of the Internal Revenue Code. The proposed amendment would make clear that the section, which provides for the recharacterization of certain related partner-partnership transactions as “disguised” sales or payments, is self-executing in the absence of final regulations.

I. Background

A. Pre-1984 Case Law and the Enactment of Section 707(a)(2)

Before 1984, under general tax principles, a partner’s contribution to a partnership and a partnership’s distribution to a partner were typically taxed in accordance with their form. This framework allowed transactions economically similar to sales to be structured as nontaxable contributions and distributions. In two key cases, Communications Satellite Corp. v. U.S.¹ and Jupiter Corp. v. U.S.,² courts upheld this treatment against Internal Revenue Service (IRS) challenges that the transactions were, in substance, disguised sales of partnership interests. In Communications Satellite Corp., new members were admitted to a partnership for a formulaic amount that was then distributed to existing partners. In Jupiter Corp., a new partner’s capital contribution was distributed to an existing partner whose interest was reduced. In both instances, the courts determined the transactions were to be treated for tax purposes consistent with their form as contributions and distributions, not sales.

The courts in Communications Satellite Corp. and Jupiter Corp. analyzed several factors to determine that the substance of the transactions aligned with their form. The factors considered included that the transactions were driven by legitimate business purposes or noncommercial objectives rather than tax avoidance; a direct sale was not feasible to meet the goals of the parties regarding risk and management control; there were no financial negotiations or contracts of sale between the existing and incoming partners; the price paid by the new partner was determined by a mechanical formula and had no relationship to the fair market value of the interest acquired; and the incoming partner received a newly created partnership interest with rights and preferences that did not exist prior to the transaction.

B. Congressional Response: The Enactment of Section 707(a)(2)

Congress enacted Section 707(a)(2)(B) as part of the Deficit Reduction Act of 1984. The legislative history confirms that the provision was a direct response to the Communications Satellite Corp. and Jupiter Corp. decisions. Congress apparently was concerned that taxpayers were using the contribution-and-distribution structure to defer or avoid tax on transactions that were, in substance, sales of property or partnership interests. The legislative history notes that these court decisions allowed tax-free treatment in cases “economically indistinguishable from” sales. The objective of the legislation was to authorize the Treasury Department to issue regulations that would identify and recharacterize these disguised sales, ensuring they would be “treated for tax purposes in a manner consistent with their underlying economic substance.”

II. The “Self-Executing” Debate and the Disguised Sale of Partnership Interests Guidance

The statutory text of Section 707(a)(2) currently states that its provisions apply “Under regulations prescribed by the Secretary,” which has created a longstanding debate over whether the statute could be enforced without final regulations. In 1992, the Treasury Department issued final regulations for disguised sales of property but explicitly reserved the section for disguised sales of partnership interests. Following a 2001 notice soliciting comments, Treasury and the IRS published a detailed Notice of Proposed Rulemaking on November 26, 2004, to address the issue. The proposed rules provided a comprehensive framework, including a general rule based on all facts and circumstances; a two-year presumption for determining whether transfers were related; and several safe harbors for common transactions involving service partnerships, guaranteed payments, and preferred returns.

This regulatory project was ultimately abandoned. On February 20, 2009, the IRS and Treasury formally withdrew the 2004 proposed regulations. The government announced that after reviewing comments, it would “continue to study this area and may issue guidance in the future,” although no subsequent regulations have been issued to date. Despite the withdrawal, the IRS has consistently maintained that Section 707(a)(2) is self-executing. The 2009 withdrawal notice specified that until new guidance is issued, any disguised sale determination will be based on “the statutory language, guidance provided in legislative history, and case law.”

Taxpayers, in contrast, have often relied on the plain statutory text to argue that the rules are not operative until regulations are finalized. In response, in 2001, an identical change to Section 707(a)(2) was included in a comprehensive pass-through reform discussion draft released by then-Senate Finance Committee Chairman Ron Wyden. The section-by-section summary accompanying the 2021 draft explained that the change was necessary because some taxpayers had taken the position that disguised sale transactions were not taxable as sales in the absence of final regulations. Therefore, the rationale put forth at that time was to legislatively clarify that the disguised sale rules are self-executing, thereby preventing contrary arguments based on the longstanding absence of regulatory guidance.

III. Disguised Payments for Services

The proposed statutory change would also apply to Section 707(a)(2)(A), which governs disguised payments for services. This provision is intended to prevent partnerships from structuring payments for services as tax-favored partnership allocations instead of as fees. The legislative history provided several factors to distinguish a true partnership distributive share from a disguised fee, identifying the most important factor as whether the payment is subject to “significant entrepreneurial risk.” An allocation and distribution subject to the success of the partnership’s business is characteristic of a partner’s return, whereas a payment with limited risk as to amount and timing more closely resembles a fee paid to a nonpartner service provider.

In 2015, Treasury and the IRS issued proposed regulations on disguised payments for services that closely track the 1984 legislative history. These proposed regulations — which, unlike the proposed disguised sale regulations, have not been withdrawn — elevate the “significant entrepreneurial risk” standard as the primary determinant. The proposed regulations also incorporate the secondary factors listed in the legislative history, such as whether the service provider holds a transitory partnership interest and whether the value of the partner’s continuing interest in profits is small in relation to the allocation in question.

IV. Conclusion

If enacted, this change would resolve the uncertainty regarding whether Section 707(a)(2) is self-executing. However, it would leave taxpayers with the substantial challenge of applying a facts-and-circumstances test without regulatory guidance — especially for transactions potentially recharacterized as disguised sales of partnership interests. This creates a difficult analytical environment because although the legislative history emphasizes a substance-over-form approach, the key cases Congress appears to have intended to overrule themselves applied detailed, fact-specific, substance-over-form analyses. Moreover, Treasury previously attempted to offer guidance on disguised sales of partnership interests but ultimately withdrew that guidance. Thus, absent additional guidance, taxpayers may reasonably conclude that Section 707(a)(2)(B) becoming self-executing should not alter the existing treatment of many ordinary-course partnership transactions involving proximate contributions and distributions historically not treated as disguised sales, particularly given the absence of explicit factors or mechanical tests and a legislative history that primarily targets abusive rather than legitimate economic arrangements.

Confirming through statutory amendment that Section 707(a)(2)(A) — relating to disguised payments for services — is self-executing would eliminate taxpayers’ arguments that these rules are inoperative without final regulations. While this clarification would reinforce the IRS’s position that it can directly apply principles from the 1984 legislative history to existing arrangements, its practical impact may nonetheless be limited. The IRS has consistently maintained that Section 707(a)(2)(A) is self-executing, and many taxpayers already structure compensatory partnership arrangements, such as management fee waivers in private equity funds, in alignment with principles articulated in the 2015 proposed regulations.