On January 30, 2014, the Treasury Department issued proposed regulations under Section 752 of the Internal Revenue Code addressing partnership liabilities and under Section 707 of the Code relating to disguised sales of property.
The proposed section 752 regulations provide new guidance on classifying and allocating partnership liabilities. The proposed regulations fundamentally alter the way economic risk of loss is determined with the goal that only “commercial” guarantees will be afforded recourse treatment, and thus be allocated to the guaranteeing partner, for income tax purposes. All other guarantees – in particular “bottom dollar” guarantees – will be ignored. The proposed section 752 regulations also modify the allocation of excess nonrecourse liabilities among partners.
The proposed 752 regulations, if enacted, could significantly impact the ability of taxpayers to:
- Make tax-deferred contributions of leveraged property to partnership
- Receive tax-deferred distributions of cash from partnerships
- Maintain sufficient allocations of liabilities to avoid recapture of “negative capital accounts” associated with partnership interests
The proposed section 707 regulations address some of the deficiencies and ambiguities of existing regulations with regard to disguised sales.
These regulations are fully prospective; they will not become effective until they are finalized. Furthermore, the proposed regulations contain transition rules intended to ease the impact of the regulations on pre-existing arrangements. The Treasury Department will likely receive significant comments on the proposed regulations, and the timing or final form of any final regulations is not yet known. Partners in partnerships that are relying on allocations of recourse and nonrecourse liabilities, or that are considering entering into tax-deferred partnership transactions, should carefully review the proposed regulations and consider what actions, if any, might be taken to best position themselves in the event that final regulations similar to the proposed regulations are enacted. Partnerships that have tax protection or similar obligations to their partners should also carefully review the proposed regulations.
Classifying Liabilities as Recourse or Nonrecourse
A partnership liability is a recourse liability to the extent that a partner or related person bears the economic risk of loss for that liability. Under existing regulations, a partner bears the economic risk of loss of a liability to the extent that the partner would ultimately be required to repay the liability in the worst-case scenario, i.e., where the partnership’s assets became worthless and the liability became due and payable. Except in abusive cases, the current regulations generally take all obligations into account in determining a partner's risk of loss. In contrast, under the proposed regulations, a partner will be held to bear the economic risk of loss on a liability only if two general standards of “commercial reasonableness” are met with respect to the partner's payment obligation:
- The terms of the payment obligation satisfy all six of the factors described below (or the payment obligation is imposed by state law).
- The partner satisfies a minimum net value requirement or is an individual or decedent's estate.
Payment Obligation Factors
Under the proposed regulations, a contractual payment obligation that does not satisfy all six of the required factors below will not be recognized:
- The partner or related person guarantor must be required to maintain a commercially reasonable net worth throughout the term of the payment obligation or be subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration.
- The guarantor must be required to periodically provide the lender with commercially reasonable documentation of the guarantor’s financial condition.
- The term of the payment obligation must not end prior to the term of the partnership liability. It is not clear from the proposed regulations that any exceptions to this condition may exist, e.g., if the partner can be released from its obligation if it disposes of its interest in the partnership.
- The payment obligation must not require that either the partnership or any other obligor hold, directly or indirectly, money or liquid assets that would exceed that person’s reasonable needs.
- The guarantor must receive arm’s length consideration for assuming the payment obligation. The proposed regulations provide no guidance on what may constitute arm’s length consideration for these purposes. For example, the proposed regulations do not indicate whether it would be sufficient if the proceeds of the borrowing were distributed to the guarantor, or whether the guarantor must receive a guarantee fee or other specific consideration from the partnership or lender for entering into the guarantee.
- The payment obligation must not be a bottom-dollar or partial-dollar guarantee. As proposed in the regulations, the guarantor must be liable for up to the full amount of his or her obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied out of the partnership’s assets. Further, if a partner’s liability is limited by any indemnity or reimbursement obligation from another person, the obligation will be treated as a bottom-dollar guarantee. The only exception is for co-obligors who are jointly and severally liable and who would have qualified under the rules if they, individually, were exclusively responsible for the debt. The proposed regulations disregard a payment obligation with respect to a partnership liability that is part of a plan or arrangement to circumvent the restriction on bottom-dollar or partial-dollar guarantees.
Net Value Requirement
The proposed regulations establish a bright line rule that a guarantor’s payment obligation will only be recognized to the extent of the guarantor’s net value as of the allocation date. The proposed regulations apply a dollar for dollar requirement for all recourse payment obligations. The net value requirement is based on existing regulation section 1.752-2(k) but it applies to all partners and related persons, not just disregarded entities. However, the net value requirement does not apply to an individual or a decedent’s estate. For entities that are not disregarded for federal income tax purposes, this net value requirement will replace the existing regulations' presumption that all partners and related persons would actually satisfy their payment obligations, unless a limited anti-abuse provision applies.
Nonrecourse Liability Allocation
The proposed 752 regulations also amend the way nonrecourse liabilities are allocated. Under the new rule, which adopts a "liquidation value percentages" approach, a partner’s “share of partnership profits” must be determined based on the partners’ respective capital account balances as maintained under the partnership tax regulations as of the most recent event that could have given rise to a "book-up" of the partners' capital accounts. Partners will no longer be able to allocate nonrecourse liabilities by designating their profit shares for purposes of section 752 in the partnership agreement (as is currently permitted so long as the designation is consistent with the allocation of some significant item). The proposed regulations also eliminate the ability to allocate excess nonrecourse liabilities consistently with the manner in which related deductions are allocated. Importantly, though, partnerships would continue to be permitted to allocate excess nonrecourse liabilities in accordance with partners’ built-in gains in the partnership’s property, i.e., the “Tier 3-A Method.”
Clarifications to Disguised Sale Rules
The proposed section 707 regulations provide a number of clarifications to the disguised sale rules. In particular, the proposed regulations clarify the following:
- the ordering of the application of exceptions from the disguised sale general rule;
- the scope of the term “capital expenditures” for purposes of the reimbursement of preformation expenditures exception;
- the application of the preformation capital expenditure exception in dealing with both multiple property transfers and expenditures funded through borrowing; and
- the determination of when a reduction in liabilities is considered anticipatory under the anticipated reduction rule.
Notably, the changes to the rules regarding reimbursement of preformation expenditures clarify that the exception for such expenditures will not apply to expenditures funded through borrowings that are assumed by the partnership (to the extent the liability is allocated to another partner under the section 752 regulations). The proposed regulations also add a new qualified liability exception that applies if the liability was incurred in connection with the trade or business in which the transferred property was used, all the assets of the business are transferred to the partnership and the liability was not incurred in anticipation of the transfer. Further, the proposed regulations add additional rules regarding tiered partnerships.
Effective Date and Transition Rules
The proposed regulations on both recourse and nonrecourse liabilities generally will apply only to liabilities incurred or assumed by a partnership, and to payment obligations entered into by a partner, on or after the date of enactment of final regulations. However, under a special transition rule, for seven years following the date of enactment of final regulations, a partnership may continue to apply the existing regulations to treat an existing partner as recourse in respect of indebtedness in an amount equal to the excess of the existing partner’s recourse liabilities over the existing partner’s adjusted basis in its partnership interest, in each case immediately prior to the effective date of the final regulations, subject to certain limitations.