Editor: Mary Van Leuven, J.D., LL.M.
In 2004, the Tax Court released its decision in IPO II, 122 T.C. 295 (2004). Five years later, IPO II’s impact on the allocation of liabilities among related partners has not been fully explored. This item is intended to make the reader aware of IPO II’s potential impact on allocating partnership liabilities under Sec. 752 and, given the decision, the unique considerations that must be taken into account in reaching a desired liability allocation among related partners.
Allocation of Liabilities
Although a full discussion of the allocation of partnership liabilities is beyond the scope of this item, some background is necessary to understand the issue addressed in IPO II. In relevant part, Sec. 752 treats an increase or decrease in a partner’s share of partnership liabilities as a contribution or distribution, respectively, of money by the partner to the partnership or vice versa. Because the deemed contributions and distributions affect a partner’s basis in its partnership interests, a partner’s share of partnership liabilities is relevant in determining the amount of partnership losses the partner may include on its tax return, the amount of gain or loss recognized if the interest is sold, and the partner’s basis in property distributed by the partnership (or, if the distributed property is cash, whether the partner recognizes gain on the distribution).
The Sec. 752 regulations provide rules for determining a partner’s share of the partnership’s liabilities and make the “economic risk of loss” concept essential to the allocation of partnership liabilities. A partnership liability is recourse to the extent that one or more partners (or a related person) bear the economic risk of loss for the liability. In contrast, a liability is nonrecourse if no partner (or related person) bears the economic risk of loss for the liability. Under these rules, because members of a limited liability company (LLC) are not obligated to pay the debts of the LLC, debt incurred by an LLC is generally nonrecourse for purposes of Sec. 752, unless a member bears the economic risk of loss for such liability by contract (i.e., a guarantee) or the member (or related person) is the lender.
Regs. Sec. 1.752-2 allocates a partnership recourse liability to a partner if and to the extent the partner—or a related person—bears the economic risk of loss. Regs. Sec. 1.752-4 generally treats a person as related to a partner if, among other things, the person and the partner are:
- An individual and a corporation, and the individual owns more than 80% of the corporation’s value; or
- Two corporations that are members of the same controlled group of corporations, which generally means that the same person holds, directly or indirectly, at least 80% of the vote or value of both corporations.
If a person is related to more than one partner, the person is treated as related only to one partner—the partner with whom there is the highest percentage of related ownership. If two or more partners have the same percentage of related ownership, the liability is allocated equally among those partners (Regs. Sec. 1.752-4(a)(2)).
Example 1: A owns all the stock of X and Y Corps., which own 99% and 1%, respectively, of the interests in LLC Q. Q borrows $100 from A; neither X nor Y has a payment obligation with respect to the loan. Under the rules above, the liability is allocated equally to X and Y—$50 each—because they are equally related to A.
Note: Some tax practitioners argue that the liability in Example 1 should be allocated $99 to X and $1 to Y. In the author’s view, however, “equally” should be interpreted literally rather than as pro rata.
Notwithstanding the above, persons owning interests directly or indirectly in the same partnership generally are not treated as related when determining the economic risk of loss borne by each for the partnership’s liabilities (the related-partner exception) (Regs. Sec. 1.752-4(b) (2)(iii)). The related-partner exception is designed to prevent an allocation of partnership liabilities to one partner solely as a result of its relationship with another partner that actually bears the economic risk of loss with respect to the liability.
Example 2: Assume the same facts as in Example 1, except that A is also a member of Q. Absent the related-partner exception, X and Y could argue that they should be allocated a portion of the $100 liability under Sec. 752 because A, a person related to each of them, bears the economic risk of loss for the loan. However, the related-partner exception “turns off” X’s and Y’s relationship to A, such that all the liability is allocated to A under Sec. 752.
In IPO II, the Tax Court addressed the related-partner exception in a more complex fact pattern. In that case, an individual, Mr. Forsythe, owned all the outstanding stock of Indeck Overseas, 70% of the outstanding stock of Indeck Energy, and 63% of the outstanding stock of Indeck Power. Forsythe’s children owned the remaining 30% interest in Indeck Energy. Forsythe and Indeck Overseas owned all the interests in IPO II, an LLC classified as a partnership for federal tax purposes. IPO II borrowed cash from an unrelated third party (the IPO II debt).
Under state law, the partners in IPO II—Forsythe and Indeck Overseas—had no legal liability for the IPO II debt. However, Forsythe, Indeck Energy, and Indeck Power guaranteed the IPO II debt; Indeck Overseas did not guarantee it. IPO II allocated a portion of the IPO II debt to Indeck Overseas because Indeck Overseas was related to Indeck Energy—a nonpartner with economic risk of loss for the IPO II debt because of its co-guarantee. The IRS disagreed, asserting that the IPO II debt should be allocated entirely to Forsythe. The Tax Court agreed and held that the IPO II debt should be allocated solely to Forsythe and that none of the debt should be allocated to Indeck Overseas. In so holding, the Tax Court stated:
Indeck Overseas is only related to In-deck Energy via its “relationship” with Mr. Forsythe. . . . Pursuant to the related partner exception, this “relationship” between Indeck Overseas and Mr. Forsythe is severed for purposes of determining whether Indeck Overseas bears an economic risk of loss for any of IPO II’s recourse liability.
We conclude that Indeck Overseas and Indeck Energy are not related parties for purposes of determining whether Indeck Overseas bore any economic risk of loss with regard to IPO II’s liability . . . because: (1) Indeck Overseas is not related to Mr. Forsythe pursuant to the related partner exception; and (2) Indeck Overseas is related to Indeck Energy only through Mr. Forsythe, and that relationship is not recognized for purposes of our determination. To hold otherwise would be to allow attribution of economic risk of loss indirectly even though it cannot be attributed directly. [IPO II at 304]
The quoted language seems to indicate that the Tax Court read the related-partner exception as completely turning off the relationship between partners—both for determining whether the partners themselves are related and for determining whether a partner is related to another person or entity. Under this interpretation, if one partner’s relationship to a party at risk for the liability derives solely from that partner’s relationship to another partner, the partner will not be treated as related to the party at risk for Sec. 752 purposes.
Given the facts of the case, it is the author’s view that the Tax Court reached the correct conclusion in IPO II. A different interpretation would have allocated liability to Indeck Overseas (which bore no direct economic risk of loss for the liability) and away from Forsythe (who did have direct economic risk of loss)—the very type of allocation the related-partner exception was designed to prevent.
It is important to note, however, that the Tax Court did not limit its analysis to instances in which one partner directly bears the economic risk of loss for the liability. One could argue that the related-partner exception merely provides that partners will not be related for purposes of determining their economic risk of loss for a liability. However, when no partner directly bears the economic risk of loss for the liability, their relationship should continue to be acknowledged for purposes of determining relatedness to other entities. But the court’s analysis seems to suggest that the related-partner exception turns off a relationship between partners for all Sec. 752 purposes, even when no direct partner bears the actual economic risk of loss. To illustrate, consider the following example.
Example 3: A owns all the stock of both X and Y. Y, in turn, owns all the stock of Z. A and Y each own a 50% interest in Q, a partnership. Q borrows $100 from Z; neither A nor Y guarantees the loan.
At first blush, one might argue that A and Y are each equally related to Z, so the liability should be allocated equally to each of them. But under the Tax Court’s interpretation of the related-partner exception, A’s relationship with Y will be turned off. Because A’s relationship to Z derives solely from its relationship to Y, under the Tax Court’s interpretation of the related-partner exception, A arguably should not be treated as related to Z. Thus, the entire liability could be allocated to Y, unless the parties successfully convince a court that although A’s relationship to Y is ignored for purposes of determining whether A and Y are related, that relationship continues to exist for purposes of determining A’s relationship to Z.
Example 4: Using the same ownership fact pattern as in Example 3, assume instead that X and Y each own a 50% interest in Q. Q borrows $100 from Z. Neither X nor Y guarantees the loan.
Again, a tax practitioner’s first thought might be to allocate the liability equally between X and Y because they are both equally related to Z. However, under the Tax Court’s interpretation of the related-partner exception, X’s relationship to Y arguably should be turned off for all purposes. Thus, X may not be treated as related to Z, so the entire liability would be allocated to Y.
Note that if the parties in Example 4 expected (and wanted) the liability to be allocated equally between X and Y, that allocation could potentially be accomplished. A partnership’s liabilities are allocated based on which party ultimately bears the economic risk of loss. Absent any contractual arrangements, if Z is the lender and Q is the borrower, that person would be Z. However, the parties could shift the economic risk of loss contractually. For example, if A guarantees the liability owed to Z in Example 4—and the guarantee is respected and binding when the determination is made—A (who is equally related to both X and Y) should bear the economic risk of loss for the loan. Thus, the liability should be allocated equally between X and Y. It should be noted, however, that the taxpayer’s decision to guarantee an obligation should ultimately consider both the tax and nontax implications.
Unexpected results can also arise when an entity that was previously unrelated to a partner becomes related.
Example 5: Building on the earlier example, assume that X also owns 49% of the stock of U, a corporation unrelated to A, X, Y, and Z under the Sec. 752 definition of a related party. Now assume instead that Y and U are members in Q, which borrows $100 from X. Under the IPO II interpretation of the related-partner exception, all $100 of the liability initially is allocated to Y, as the only partner related to the lender, X. One year later, Y acquires the remaining 51% of U, and U becomes related to X and Y under the Sec. 752 definition.
If the related-partner exception did not apply, both Y and U would be equally related to X and the $100 liability would be allocated equally to Y and U. For purposes of allocating the liability among Y, Z, and U, however, the related-partner exception requires us to assume that Y is unrelated to U (i.e., Y owns no stock in U). If so, U would not be equally related to X because U is only 100% related to X because of its stock owned by Y. Thus, all the liability would be allocated to Y.
If Y has taken losses against its share of Q’s liability to X, the parties may prefer this result. For other reasons, however, the parties may want to have the liability allocated equally between Y and U. To reach that result, X could acquire the remaining 51% of U directly, causing Y and U to be equally related to X. Further, if X wanted to purchase the remaining U stock directly but still wanted all Q’s liability to X to be allocated to Y, Y could guarantee Q’s liability to X. Assuming the guarantee is respected and binding when the determination is made, Y (a partner) should bear the economic risk of loss for the loan. Thus, there would be no need to rely on a relationship between one of the partners and the lender to determine how to allocate the liability for Sec. 752 purposes; it would all be allocated to Y.
For those unfamiliar with the Sec. 752 liability allocation rules, the last two examples may seem to introduce too much selectivity. While it is true that the Tax Court’s interpretation of the related-partner exception in IPO II does appear to provide taxpayers with options in these situations, those options generally are available in virtually all situations involving the allocation of partnership liabilities. This is the most important point to remember: When related parties are involved, the Sec. 752 rules among partners can lead to some interesting (and often unexpected) allocations of partnership liabilities. When that allocation is undesirable, however, the parties involved can enter into contractual obligations to alter the allocation, subject to the contractual obligation being respected and binding when the determination is made. The key for the informed practitioner, therefore, is to identify what obligations are necessary and when those obligations need to arise to reach the desired allocation for the tax year at issue.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
© 2009 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.