October 20, 2016

Treasury Targets Tax Deferral in Leveraged Partnership Structures with New Regulations

The Treasury issued new final, temporary and proposed regulations that take aim at, and significantly reduce the effectiveness of, leveraged partnership structures intended to achieve tax deferral to the contributing partner. The new regulations supplant prior regulations in multiple ways that will materially impact several commonly used transaction structures, including the use of bottom dollar guarantees and deficit restoration obligations (DROs) to support negative capital accounts and to avoid disguised sales in connection with a contribution of property to a partnership. We expect these changes will make it more difficult, if not impossible in certain cases, to defer gain recognition in many of our clients’ transactions, including operating partnership unit deals with UPREITs and certain private equity deal structures such as freeze partnerships.

Most Impactful Changes

Guarantees, DROs and other recourse obligations to pay debt of the LLC/partnership are ignored for purposes of the disguised sale rules

In general, a contribution of property to a partnership is a tax deferred transaction unless the contributing partner receives property other than a partnership interest and that transfer of other property is sufficiently related to the contribution under the “disguised sale” rules. The assumption of a “nonqualified liability” by the partnership results in a disguised sale to the extent the debt exceeds the contributing partner’s allocable share of the debt after it is assumed by the partnership. Similarly, if the partnership incurs debt to finance a distribution to the contributing partner, a disguised sale generally results if the full amount of the debt is not allocated to the contributing partner under applicable Treasury regulations. As a result, the amount of the partnership liability “allocated” to the contributing partner for tax purposes is critical in determining whether the contributing partner recognizes gain or achieves tax deferral.

Under the old disguised sale rules, payments to the contributing partner financed with partnership debt for which the contributing partner had economic risk of loss (for example, through the partner’s guarantee of the debt) would be allocated entirely to the contributing partner, and thus could be structured to avoid gain recognition under the disguised sale rules. Under the new regulations, however, all partnership debt is treated as nonrecourse debt for purposes of the disguised sale rules, regardless of any legal obligations that a partner has to guarantee or otherwise repay the debt, with the result that the debt must be allocated in accordance with the partners’ interest in partnership profits. Consequently, contributing partners will not be able to avoid disguised sales by guaranteeing or similarly backstopping the debt assumed by the partnership or incurred by the partnership to source a distribution. Moreover, in determining a partner’s share of profits for these purposes, the parties are not permitted to use certain long-standing mechanical allocation rules and must make a determination on the facts without any further guidance from the regulations. The absence of clear rules for identifying a partner’s share of profits for disguised sale purposes will make planning and compliance difficult if not impossible outside of simple pro rata partnerships, as it is completely unclear how to apply the partners’ interest in profits standard where the partners’ interest in profits change as economic hurdles are satisfied. Finally, in no event may debt be allocated to a partner if another partner bears the economic risk of that debt; therefore, a guarantee by a partner may not attract that debt to that partner, but it will prevent any other partner from being allocated that debt for disguised sale purposes. In light of the foregoing, we expect the new rules to either drastically limit, and in some cases foreclose, the ability to achieve tax deferral in leveraged LLC/partnership transactions.[1]

The new rules apply to any transaction with respect to which all transfers occur on or after January 3, 2017.

Bottom Dollar Guarantees and DROs are no Longer Effective for General Partnership Debt Allocation Rules

Outside of the disguised sale rules, guarantees and other arrangements that cause a partner to bear the economic risk of loss with respect to partnership debt still result in the debt being allocated to the partner for purposes of determining the partner’s tax basis in its partnership interest. However, the new rules provide that “bottom dollar payment obligations” will be ignored with the result being that these bottom dollar obligations will not attract debt basis (and thus, for example, will not be effective to defer recapture of a partner’s “negative capital account”).

A bottom dollar payment obligation is defined very broadly to include any obligation of the partner to pay any portion of partnership debt (or reimburse another party for payments of that debt) unless the partner or a related person is liable for the full amount of their obligation to the extent the partnership debt is not paid. It also includes tranched debt arrangements that are structured with a view to avoiding the new rules. Any obligation, however structured (including guarantees, DROs, capital contribution obligations, etc.), is subject to the new rules.

There are four exceptions that by themselves will not cause a payment obligation to be disregarded:

  • a “vertical slice” payment obligation (i.e., where a partner is obligated to pay a fixed percentage of every dollar of partnership debt that is not paid);
  • a reimbursement right of up to 10% of the partner’s obligation; 
  • a right of proportionate contribution amongst partners to share the liability for a payment obligation where the partners have joint and several liability; and
  • a cap on a partner’s payment obligation so long as the partner is economically exposed for the capped amount if the partnership debt is not paid.

A partnership is required to disclose the use of a bottom dollar payment obligation in the year in which the obligation is entered into.

The new bottom dollar payment obligation rules apply to payment obligations entered into on or after October 5, 2016, unless the payment obligation was undertaken pursuant to a prior written agreement. Payment obligations existing on or before October 5, 2016, are not subject to the new rules. However, subject to the transition rules discussed immediately below, the foregoing rules generally will apply to payment obligations entered into prior to October 5, 2016, if the payment obligation is modified or the associated debt is modified or refinanced. Under special transition rules, a partnership may apply the prior law with respect to payment obligations entered into after October 5, 2016, to the extent of its partners’ negative capital accounts being protected by an allocation of recourse debt (as reduced by certain gain allocations) as of that date for a period of seven years. Partnerships are permitted to elect into the new rules for all pre-existing payment obligations starting with their tax year that includes October 5, 2016.

Key Takeaways for Clients

  • Clients with existing bottom dollar guarantees or DROs should work with counsel to revisit those arrangements to understand any legal obligations they may have with respect to the counterparty in light of these new regulations.
    • For example, a partnership that provided tax protection to a counterparty may be required to elect into the seven year transition rule, or a partnership may not be able to refinance nonrecourse debt that is being allocated to a tax protected partner for recourse debt with a bottom dollar guarantee from the tax protected partner. 
    • Alternatively, a beneficiary of tax protection may have exposure on its negative capital account if the tax protection did not contemplate a change in law and the counterparty wants to refinance or modify its debt.
  • Clients desiring to acquire property in tax deferred partnership transactions should expect the contributing property owner to push for the partnership to maintain nonrecourse debt during the life of any tax protection to the extent that debt can be allocated to the contributing partner under the nonrecourse debt rules.

Additional Changes to the Disguised Sale Rules

Amongst other less extensive technical changes, the new rules also provide for modifications to the exception to the disguised sale rules for the reimbursement of a contributing partner’s preformation expenditures. This important exception now applies on a property-by-property basis, and can no longer be applied to capital expenditures funded by a qualified liability. In addition, the preamble to the new rules included ominous language suggesting the Treasury plans to consider whether this exception should be repealed completely. These new rules, and all other technical changes, apply to all transactions occurring on or after October 5, 2016.

[1] The new rules also provide a small amount of relief to contributing partners by preventing gain recognition in respect of “qualified liabilities” where a de minimis amount of nonqualified liabilities are also assumed by the partnership. However, this beneficial rule is so narrow that we do not think it will have much practical application.