Partnership Recourse Liabilities and Disguised Sale Regulations
The IRS has released final regulations providing guidance for a partnership to allocate its liabilities among its partners.
- Treasury Decision 9876 contains final regulations concerning how partnership liabilities are allocated for disguised sale purposes.
- Treasury Decision 9877 addresses when certain obligations to restore a deficit balance in a partner’s capital account are disregarded under Section 704 of the Internal Revenue Code, when partnership liabilities are treated as recourse liabilities under Section 752, and how bottom dollar payment obligations are treated under Section 752.
If you are a partner, it is generally desirable to have liabilities allocated to you because liability allocations may permit the allocation of more losses and deductions or may release losses and deductions that have been previously disallowed. Liability allocations may also allow you to receive distributions of cash or property on a tax-deferred basis.
The allocation of partnership liabilities is governed by Section 752 and its regulations. Liabilities are split into two categories: recourse liabilities and nonrecourse liabilities. Recourse liabilities are those for which a partner, or a person related to a partner, bears the economic risk of loss (EROL). Nonrecourse liabilities are those for which no partner or related person bears the EROL.
A partner bears the EROL for a partnership liability if the partner or a related person is required to make a payment to any person within the meaning of Treas. Reg. §1.752-2. Requirements to make payments include so-called “deficit restoration obligations” (DROs), which compel a partner to restore a deficit capital account upon the liquidation of a partnership. Additionally, guarantees to satisfy a partnership liability can create an EROL to the partner executing the guarantee. Partnership liabilities for which a partner bears the EROL also generally include loans made directly by the partner, or a related person, to the partnership.
Disguised Sale Rules
IRC Section 707(a)(2)(B) provides that related transfers to and by a partnership that, when viewed together, are properly characterized as a sale or exchange of property, will be treated either as a transaction between the partnership and one who is not a partner, or between two or more partners acting other than in their capacity as partners. These transactions are considered “disguised sales.”
For example, if a partner transfers property to a partnership subject to a nonqualified liability, the partner is deemed to have received consideration equal to the portion of the liability not allocated to the partner immediately after the transaction. Accordingly, taxpayers often desire to ensure that the maximum amount of liabilities assumed by a partnership are allocated to the contributing partner to minimize the impact of a disguised sale. They often attempt to do this by structuring the transaction such that the contributing partners have EROL with respect to some portion of the partnership’s liabilities.
Temporary regulations released in October 2016 mandated that for purposes of the Section 707 disguised sale rules, a partner’s share of a partnership liability would be determined based on the partner’s share of partnership profits, even if the liability were recourse to that partner. This approach was not well-accepted by taxpayers and proposed regulations issued in June 2018, adopted in the October 9 final regulations, withdraw the temporary regulations and replace them with a more taxpayer-friendly rule permitting recourse liabilities to be allocated to the partner with the EROL.
Note: The withdrawal of the more restrictive regulations brought back the ability to more readily achieve “leveraged partnership contribution transactions,” allowing, in some cases, for a partner to contribute appreciated property and receive a tax-free distribution to the extent that the partner is properly allocated a portion of partnership debt.
The Section 707 final regulations apply to any transaction for which all transfers occur on or after October 4, 2019. A partnership and its partners may apply the Section 707 final regulations to any transaction for which all transfers occur on or after January 3, 2017, the effective date of the Section 707 temporary regulations.
With minor changes, previously-issued Section 752 temporary and proposed regulations concerning recourse liabilities and bottom-dollar guarantees have been finalized. The final regulations provide rules for whether a partner or related person has a payment obligation of a partnership liability. If the partnership does not have a commercially reasonable expectation that the partner or related person will have the ability to make the required payments under the terms of the obligation if the obligation becomes due and payable, the partner or related person is not considered to have an EROL. Consequently, the liability cannot be considered a recourse liability for purposes of Section 752. A payment obligation of a partner or related person is not recognized if the principal purpose of the arrangement is to eliminate the partner’s EROL or create the appearance of an EROL that does not otherwise exist. The regulations provide several examples of anti-abuse factors that may indicate a plan to avoid a partner’s or related person’s EROL.
The final regulations and anti-abuse rules with respect to recourse liabilities apply to partnership liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after October 9, 2019.
The final regulations effectively eliminate the use of bottom-dollar guarantees. Historically, taxpayers seeking to create an EROL while minimizing potential personal exposure would enter into a so-called bottom-dollar guarantee. Under a typical bottom-dollar guarantee, the taxpayer would guarantee a portion of partnership liabilities sufficient to accomplish their planning purpose. However, the partner would only guarantee the last dollars of the loan not secured by existing collateral. This had the effect of reducing the likelihood that the partner would ever come out of pocket to cover the guarantee.
As an example, assume a partnership owns real estate valued at $50 million and takes out a $40 million loan against the property. Partner A guarantees $1 million of the $40 million debt to fund a $1 million distribution in excess of his tax basis capital account. The partnership defaults on the debt at a time when the property’s value has declined to $1 million. If Partner A’s guarantee is structured as a bottom-dollar guarantee, he is liable for no portion of the outstanding liability because Partner A is responsible for paying only the last $1 million against the loan. Since the collateral is worth at least $1 million the bottom-dollar guarantee is not effective. Partner A is not required to pay the full $1 million of his guarantee, even though the lender will have an $39 million loss.
The final regulations, consistent with the Section 752 temporary regulations, define bottom-dollar payment obligations to include any payment obligation under a guarantee or similar arrangement when the partner or related person is not liable, up to the full amount of the payment obligation in the event of non-payment by the partnership.
The final regulations expand the definition of a bottom-dollar payment obligation to include capital contribution obligations and DROs if the partner is not required to make the full amount of the partner’s capital contribution or restore the full amount of the partner’s deficit capital account.
Any bottom-dollar guarantees require disclosure on the partnership’s tax return for the tax year in which a bottom-dollar guarantee is undertaken or modified for tax years ending on or after October 5, 2016. A seven-year transition rule beginning October 5, 2016, when the temporary regulations were published, allows for use of bottom-dollar guarantees to the extent that the guarantee does not exceed the partner’s outside basis with consideration for the bottom-dollar guarantee as of October 5, 2016.
Note: Both the rules concerning recourse liabilities and bottom-dollar guarantees are aimed at determining whether a truly commercial payment obligation exists. A detailed analysis of all recourse liabilities is recommended. Although bottom-dollar guarantees were generally disregarded in previously-issued temporary regulations, avoidance of bottom-dollar guarantees is generally recommended and analysis should be done to confirm whether distributions exceeding tax basis have occurred or are likely to occur.
The Section 704(b) final regulations add rules to Treas. Reg. § 1.704-1 providing that capital contribution obligations and deficit restoration obligations (DROs) will be disregarded for Section 704(b) purposes if they are bottom-dollar guarantees and do not represent a true repayment obligation.
The Section 704(b) final regulations apply to pre-existing DROs and, as a result, pre-existing DROs may not be regarded if they do not rise to the level of a true repayment obligation.
Section 752 Anti-Abuse Rules
The final regulations include examples of factors that may indicate a plan with a principal purpose to eliminate EROL or create the appearance of EROL while lacking substance. It is important to note that the factors provided are not comprehensive, nor is the absence of any factor necessarily indicative of whether the obligation will be disregarded. The factors provided are listed below:
- The partner is not subject to commercially reasonable provisions for enforcement and collection of the obligation.
- The partner is not required to provide, either at the time the obligation is made or periodically, commercially reasonable documentation regarding the partner’s financial condition to the partnership.
- The obligation ends or could, by its terms, be terminated before the liquidation of the partner’s interest in the partnership or when the partner’s capital account is negative. An exception for this factor is provided when the transferee partner assumes the obligation.
- The terms of the obligation are not provided to all the partners in the partnership in a timely manner.
All DROs, including DROs in place prior to the finalization of these regulations, will need to be reviewed to ensure a true repayment obligation exists. While the existence of a true repayment obligation is based on the facts and circumstances surrounding that obligation, it is recommended practice to review current partnership agreements to confirm the DRO language aligns with the new rules and amend agreements as appropriate.
If you have questions regarding liability allocation among partners, please reach out to a member of our Tax Team.
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