Editor: Stephen E. Aponte, CPA
When appreciated property is contributed to a partnership, the precontribution gain is accounted for under Sec. 704(c), which provides that income, gain, loss, and deduction for property contributed to the partnership by a partner are shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value (FMV) at the time of contribution. As a result, the contributing partner continues to bear the tax burden from any precontribution gain of contributed property. Sec. 704(c) addresses only contributed property with a precontribution gain. It does not address a precontribution gain associated with a liability.
The idea of a precontribution gain related to a liability may not seem logical. However, in these unique economic times, it is not only possible, it may become more prevalent in the short term. As financially distressed companies search for ways to restructure, lenders may be willing to settle their loans for less than their face value, which would result in cancellation of debt (COD) income. If this restructuring involves a new investor and the formation of a new partnership or a contribution of cash to an existing partnership, the anticipated COD income resulting from the restructuring and settled debt is effectively a precontribution gain even though it is associated with a liability instead of property. There is currently no statutory guidance that addresses a precontribution gain associated with a liability.
If property subject to a debt in excess of the property’s FMV is contributed to a newly formed partnership, Sec. 752(c) appears to help resolve this problem. Under Sec. 752(c), a liability to which property is subject will, to the extent of the FMV of such property, be considered as a liability of the property’s owner. The phrase “to the extent of the FMV of such property” seems to require that the encumbrance be fragmented. The portion not in excess of FMV apparently becomes a partnership liability for purposes of Sec. 752, while the excess, which clearly is not a Sec. 752 partnership liability due to Sec. 752(c), presumably continues to be viewed as a liability of the contributing partner.
Applying the FMV limitation of Sec. 752(c) to a partnership liability is also likely to prevent the entire liability (or at least the excess of the liability over the value of the property) from being recognized as a liability of the partnership for any tax purposes. Consequently, it appears the liability that is in excess of the property’s FMV would not be included in the amount realized by the partnership if the property is sold or as COD income if the amount of the debt in excess of FMV is forgiven. Instead, this excess would presumably be recognized by the contributing partner only, and the recognition would occur outside the partnership.
A financially distressed partnership, wishing to restructure an existing debt or perhaps obtain a new loan to replace an existing loan, may need to attract a new investor to infuse capital into the partnership. If the existing partnership contributes its assets to a new partnership subject to a liability, Sec. 752(c) may provide an effective solution. The new entity would only be able to assume a liability to the extent of the FMV of the property contributed. As a result, the new investor would presumably not be in danger of potentially having to recognize COD income related to the amount of the liability that is in excess of the assets’ FMV because this recognition would appear outside the partnership. However, receiving the lender’s consent to transfer encumbered property to a new entity may not be possible if the company is financially unstable and the lender is concerned about the collectibility of the debt. Consequently, if a financially distressed company is seeking a new investor to help restructure its existing debts, the lenders may prohibit the transfer of any encumbered property to a new entity, which means the new investor would have to be admitted to the existing partnership as opposed to a newly formed partnership.
Because of the popularity of the limited liability company (LLC), a significant number of these deficits in member capital accounts will be created through nonrecourse deductions, which refer to depreciation and other deductions that may be borne by a nonrecourse lender. The Regs. Sec. 1.704-2(e) safe harbor for the allocation of nonrecourse deductions is as follows:
- Throughout the full term of the partnership, requirements (1) and (2) of Regs. Sec. 1.704-1(b)(2)(ii)(b) are satisfied (economic effect or alternate economic effect test);
- Beginning in the first tax year in which there are nonrecourse deductions and thereafter throughout the full term of the partnership, the partnership agreement provides for allocations of nonrecourse deductions among the partners in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing nonrecourse liabilities of the partnership;
- Beginning in the partnership’s first tax year in which the partnership has nonrecourse deductions or makes a distribution of proceeds of a nonrecourse liability that are allocable to an increase in minimum gain and thereafter throughout the full term of the partnership, the partnership agreement contains a provision that complies with the requirements of Regs. Sec. 1.704-2(f) (minimum gain chargeback); and
- All other material allocations and capital account adjustments under the partnership agreement are recognized under Regs. Sec. 1.704-1(b) (without regard to whether allocations of adjusted tax basis and amount realized under Sec. 613A(c)(7)(D) are recognized under Regs. Sec. 1.704-1(b)(4)(v)).
Under Regs. Sec. 1.704-2(d), partnership minimum gain is the sum of the gains the partnership would realize under the Tufts principle if it disposed of all assets subject to nonrecourse liabilities solely in satisfaction of those liabilities (Tufts, 461 U.S. 300 (1983)). Regs. Sec. 1.1001-2(a)(1) provides that the amount realized on a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a consequence of the transaction. The partner’s share of minimum gain is basically the cumulative share of nonrecourse deductions plus the share of any distribution of the proceeds of nonrecourse loans. Under Regs. Sec. 1.704- 2(e), when allocating nonrecourse deductions, the concept of minimum gain replaces the charge to capital account and deficit makeup as the measure of economic reality (this is sometimes referred to as a deemed deficit restoration obligation).
If the financially distressed partnership relinquishes property in satisfaction of its debt, the resulting gain would be allocated to the members with the deficit capital accounts based on the minimum gain chargeback provisions. Under Regs. Sec. 1.704- 2(d), the amount of partnership minimum gain includes minimum gain arising from a conversion, refinancing, or other change to a debt instrument. As a result, any COD income related to that debt would also get allocated to the members with the deficit capital account balances.
Practice tip: Consequently, it is imperative that tax practitioners ensure that all the appropriate minimum gain provisions are included in the operating agreement. This will help ensure that the precontribution gain attributable to a liability that the members anticipate will be settled for less than its face value will be allocated to the existing members and not to the new investor.
The liabilities of an LLC will be nonrecourse to the members unless the members guarantee or take some other action to cause the nonrecourse liability to become recourse. However, these liabilities could still potentially be recourse to the LLC. Exculpatory liabilities are recourse to the partnership but nonrecourse to the members. If these liabilities are not secured by specific property, they may not produce minimum gain. Under Regs. Sec. 1.1001- 2(a), the amount realized on transfer of property subject to a nonrecourse liability is the tax amount of the liability, without regard to the encumbered property’s FMV. Under Regs. Sec. 1.1001-2(b), when a recourse liability is discharged by transfer of property other than cash, there is gain or loss on the property transferred to the extent of any difference between the property’s FMV and its basis, and COD income to the extent the tax amount of the liability exceeds the FMV of the property transferred.
Because an exculpatory liability is not secured by a specific asset or assets, any settlement of an exculpatory liability for less than the tax amount should produce at least some COD income pursuant to Regs. Sec. 1.1001-2(b), but not minimum gain. Accordingly, since there is no minimum gain, exculpatory liabilities will generally be allocated under a safe harbor for nonrecourse deductions or on the basis of profit shares. It would appear that the nonrecourse liability allocation of an exculpatory liability would follow the deduction and bring with it potential COD income as is the case for nonrecourse deductions and minimum gain. In addition, the safe harbor for allocations with an item of profit that has substantial economic effect should be available for COD income. However, it does not appear that the current regulations specifically address this issue.
Practice tip: Because the settlement of an exculpatory liability for less than its face value does not fall under the minimum gain chargeback provisions, it is critical that the operating agreement addresses the allocation of nonrecourse deductions attributable to these liabilities and also addresses the allocation of COD income associated with these liabilities. Failure to do so could result in some of the precontribution gain attributable to these exculpatory liabilities being allocated to the new investor.
Under Regs. Sec. 1.704-1(b)(2)(iv)(f) (3), a partnership agreement may, upon the occurrence of certain events, increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property (including intangible assets such as goodwill) on the partnership’s books. One event that can trigger a revaluation of property is the contribution of money or other property to the partnership by a new or existing member as consideration for an interest in the partnership (Regs. Sec. 1.704-1(b)(2)(iv)(f) (5)(i)).
If members with deficit capital accounts and precontribution gain attributable to liabilities elected to revalue the partnership’s property upon the admittance of a new investor, they could potentially eliminate their deficit capital accounts. Because the deficits caused by the nonrecourse deductions would no longer exist, the allocation of the exculpatory liabilities would presumably be allocated based on profit shares. Consequently, the COD income would be allocated based on profit shares as well.
It would appear that there is currently no provision that allocates exculpatory liabilities to the members who have received the benefit of nonrecourse deductions after they receive a book up in their Sec. 704(b) capital accounts. If the new investor wants to ensure that he or she does not receive an allocation of COD income resulting from any existing debt, careful and specific language should be clearly stated in the operating agreement to specifically allocate this potential COD income to the other members. The new investor should be aware that this income will increase the existing members’ Sec. 704(b) capital account, which could potentially significantly alter the economics among the members.
There is currently no statutory guidance on precontribution gains attributable to liabilities. Thorough planning should be done prior to admitting a new investor to a partnership in which the members expect to settle one or more liabilities for less than their face value. There could be significant tax and economic implications for all members that need to be addressed prior to executing a new operating agreement.
Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or firstname.lastname@example.org.