Editor: Rick Klahsen, CPA
On October 20, 2009, a U.S. Court of Appeals upheld the decision of the Court of Federal Claims in Marriott International Resorts, L.P., No. 2009-5007 (Fed. Cir. 10/28/09), determining that an obligation to close a short sale was a Sec. 752 liability for which basis adjustment was required. This liability was included in partnership basis by the taxpayer, resulting in the acceleration of a loss. The IRS reduced the basis of the partnership interest because this obligation to complete a short sale was a Sec. 752 liability requiring basis reduction. While the facts of this case are rather specific, the decision highlights the importance of understanding how the regulations treat certain contingent liabilities. Treasury finalized Regs. Sec. 1.752-7 in 2005 (T.D. 9207), and it applies to partnership assumption of liabilities (1.752-7 liabilities) on or after June 24, 2003. These regulations were drafted to deal with the problems resulting from the son-of-boss tax shelter but have implications for many transactions that are not tax shelters.
Regs. Sec. 1.752-7 defines what constitutes a 1.752-7 liability, how these liabilities are treated when assumed by the partnership or another partner, and the impact of a later sale (or redemption) of a partnership interest by the partner that contributed the debt to the partnership. The regulations prevent duplication of losses so that the deduction related to the liability can be taken only by the partner contributing the 1.752-7 liability and not by the partnership or another person. In addition, the regulations prevent the contributing partner from accelerating losses attributable to the liability until the time of economic performance.
What Is a 1.752-7 Liability?
A 1.752-7 liability is any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account under Regs. Sec. 1.752-1(a)(4)(i), which defines a liability as an obligation that increases the basis of the obligor’s assets, gives rise to an immediate deduction to the obligor, or gives rise to an expense that is not deductible or chargeable to capital. A 1.752-7 liability is assumed by a partnership when contributed in a tax-free contribution under Sec. 721(a). Specific types of these liabilities mentioned in the regulations are debt, environmental, tort, contract, pension, short sale, and derivative financial instrument obligations.
The amount of this liability is the amount of cash that a willing assignor would pay an assignee to assume the liability in an arm’s-length transaction. A partner’s share of the partnership’s 1.752-7 liability is the amount of deduction that would be allocated to the partner for the liability if the partnership disposed of all its assets, satisfied all its liabilities (other than 1.752-7 liabilities), and paid an unrelated person to assume all the 1.752-7 liabilities in a fully taxable transaction. If the liability is assumed as a result of a Sec. 708(b)(1)(B) technical termination, it is not treated as a 1.752-7 liability unless it was part of an earlier 1.752-7 liability transfer.
Allocation of Deductions Related to Regs. Sec. 1.752-7 Liabilities
All deductions attributable to 1.752-7 liabilities are allocated in accordance with the general Sec. 704(c) principles for contributed property. Generally the deduction of the contributed built-in loss related to the liability will be allocated to the contributing partner, and any excess paid would be allocated based on the partnership agreement and the regulations. Satisfaction of the debt for less than the amount contributed would result in a ceiling rule limitation (Regs. Sec. 1.704-3). In these situations, the allocations can have differing implications due to the mechanics of the Sec. 704(c) method being used for the specific contributed asset(s).
Transfers and Liquidation of Partnership Interests
The regulations provide special rules for transfers of partnership interests by the contributing partner. In these situations, the partner’s basis is reduced to take the 1.752-7 liability into account. This prevents a loss related to the 1.752-7 liability when the contributing partner sells its interest. The later satisfaction of the 1.752-7 liability is not a partnership deduction or nondeductible expense reducing any partner’s capital account. The contributing partner can deduct this amount upon economic performance by the partnership if the partnership notifies the partner of the liability’s satisfaction. There are similar consequences when the 1.752-7 liability is transferred to another partner (rather than to the partnership itself). Only the original 1.752-7 partner (and not the successor partner) can use the deduction related to the obligation.
There are two exceptions that would exempt liabilities that would otherwise be considered a 1.752-7 liability when there is a transfer. The first is for liabilities that are assumed as part of the contribution to a partnership of a trade or business with which the liability is associated if the partnership continues the contributed trade or business. The other exception is when the remaining impact of the 1.752-7 liability is less than the lesser of 10% of the gross value of the partnership assets or $1 million.
There are similar provisions for liquidating distributions made to a contributing partner. Immediately before the distribution, the contributing partner’s basis is reduced to take the 1.752-7 liability into account. The partnership’s subsequent satisfaction of the liability does not result in a deduction to the partnership or a nondeductible expense that would decrease the remaining partners’ capital accounts. If the partnership subsequently pays the liability, the partnership may notify the contributing partner, who would then be entitled to a deduction. Any economic performance results in a deduction for the contributing partner; no deduction is allowed for the partnership. Exceptions similar to the transfer exceptions discussed above (the contribution relates to a trade or business or the de minimis exception) also apply in the case of a liquidating distribution.
This is a brief summary of the major provisions of Regs. Sec. 1.752-7, but it must be noted that these regulations are complex and introduce several new concepts. Taxpayers and practitioners must carefully analyze liabilities and other obligations that are assumed by partnerships after contribution by a partner because commitments that may not have traditionally been considered partnership liabilities can have a dramatic impact on later transactions. A partnership (or any noncontributing partner) may not be entitled to a deduction for certain obligations assumed, and partners’ basis may also be affected. Regs. Sec. 1.752-7 must be considered whenever a partnership assumes liabilities or other contingencies.
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or firstname.lastname@example.org.