Hidden in Plain Sight: How One Phrase in the New Tax Law Reshapes Partnership Tax Planning

Buried deep in the legislative sprawl of the One Big Beautiful Bill Act (OBBBA) is a change so subtle that most eyes would glide right over it. Section 70602 alters just a few words of existing law, replacing “under regulations prescribed by the Secretary” with “except as otherwise provided.” To most, this change is immaterial; to partnership tax practitioners, it’s anything but.

The nuance of this shift is profound. For years, the applicability of Internal Revenue Code Section 707(a)(2)—specifically 707(a)(2)(B), which addresses disguised sales between a partner and a partnership—arguably hinged on a critical qualifier – “under regulations prescribed by the Secretary.” The question presented to practitioners is whether the statute is self-executing in the absence of regulations; in other words, does that qualifier require the issuance of regulations for the statute to apply? In practice, this created a technical, though defensible, position: since Treasury never issued final regulations under certain aspects of this provision, then the disguised sale rule is not operative. Practitioners occasionally relied on this interpretive gap to sidestep the rule entirely. In fact, this type of language is so pervasive in the tax code that in 2006 the New York State Bar Association wrote a 33-page report on the various types of legislative grants of regulatory authority.

With the passage of Section 70602, that argument is dead.

The revised language—“except as otherwise provided”—isn’t just stylistic. It redefines the statutory authority. Whereas the prior language arguably could be interpreted to require the issuance of regulations, the code section now stands on its own and is self-executing with or without regulations. The old fallback—that 707(a)(2) was inoperative pending regulation—is no longer available. The statutory prohibition on disguised sales is now live and self-executing, regardless of whether Treasury has filled in the details.

Section 707(a)(2)(B) allows the IRS to recharacterize a transaction between a partner and a partnership as a sale if the facts and circumstances show that what purports to be a contribution followed by a distribution is, in substance, a sale of property. A classic example involves a partner contributing appreciated property to a partnership, only to receive a cash distribution that mirrors a purchase price.

These rules are designed to prevent taxpayers from disguising what is economically a sale as a tax-free contribution and distribution, thereby deferring or avoiding gain recognition. If the disguised sale rules apply, the transfer is taxed as a sale rather than a tax-free contribution under Section 721.

Treasury issued final regulations under Section 707(a)(2)(B) in 1992, addressing disguised sales of property between partners and partnerships. However, they reserved on the treatment of disguised sales of partnership interests. This left a perceived gap. Prior to Section 70602, some taxpayers and advisors pointed to this regulatory silence and the statute’s “under regulations prescribed” language to argue that, with respect to partnership interests, the disguised sale rule was technically not enforceable.

That position no longer holds water.

While the revised language in Section 70602 may seem innocuous amidst a bill filled with more headline-grabbing provisions, it marks a meaningful shift. It eliminates a long-standing interpretive loophole and serves as a broader signal: Congress is tightening the reins on aggressive partnership planning. This change is more than legislative housekeeping. It is the first shot across the bow in what may be a broader effort to close perceived tax loopholes exploited in the partnership context. Advisors and taxpayers should take note. Language matters—especially when it comes with a legislative mandate.