Treasury regulations define a partnership liability for purposes of Sec. 752 to be a partnership obligation to the extent that the obligation (1) creates or increases the basis of partnership property, (2) gives rise to an immediate deduction in computing the partnership's taxable income, or (3) gives rise to a nondeductible expenditure not properly chargeable to capital (Regs. Sec. 1.752-1(a)(4)).
Not all partnership debt qualifies as a liability under this definition. The general purpose of Sec. 752 is to match the partnership's basis in its assets as a whole with the partners' aggregate basis in their partnership interests—in other words, to balance the inside partnership basis with the outside basis of the partners. To do this, only partnership debt that has an impact on the partnership's inside basis is a liability. All other debt is excluded from consideration.
Generally, the analysis of whether a debt is a liability under Sec. 752 is the same as that for determining whether a liability creates basis or a deduction under the general Code provisions (Sec. 1012, et seq.). This means there can be legitimate partnership debts that may or may not be treated as liabilities depending on the partnership's accounting method. This can be seen in Owen, 34 F. Supp. 2d 1071 (W.D. Tenn. 1999), in which a district court ruled that a cash-basis taxpayer could not increase his basis in real property that he sold for improvements that were paid for with promissory notes that were not paid until a following year.
Regs. Sec. 1.752-1(a)(4)(ii) defines an "obligation" as any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account under the Code. (However, see below for a discussion about whether contingent liabilities are considered obligations under the rules for allocating recourse debt among partners.) Obligations include debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps. The inclusion of contingent debt in the definition of an obligation is the result of the IRS's aggressively pursuing transactions involving claims that a partnership's assumption of a partner's contingent liabilities does not reduce the basis the partner has in his or her partnership interest.
The typical transaction involves the transfer of cash and other assets to a partnership and the assumption by the partnership of contingent business liabilities, such as potential future asbestos liabilities or health care liabilities. The partner argues that since these liabilities are contingent liabilities, their assumption by the partnership does not reduce the basis of the partner's interest in the partnership. However, the contingent liabilities would reduce the price a buyer would pay for the partnership interest on a subsequent sale. When such a sale occurs, the partner sustains a loss based on the argument that the basis of his or her partnership interest was not reduced by the transferred contingent liabilities.
In some situations, the IRS has been successful in persuading courts to apply the economic substance doctrine to void what are otherwise legitimate transactions that involve the assumption of contingent liabilities. In Coltec Industries, Inc., 454 F.3d 1340 (Fed. Cir. 2006), the Federal Circuit invoked the economic substance doctrine to disallow loss on the sale of a subsidiary's stock, where the corporation had transferred contingent asbestos liabilities to the subsidiary, claiming that the basis of the stock did not have to be reduced by the contingent liabilities. While agreeing with the taxpayer that the transaction met the technical requirements of the Code, the court disallowed the loss because there was not a nontax reason for the transaction.
The IRS also won a major victory in Jade Trading, LLC, 80 Fed. Cl. 11 (2007), where the court relied heavily on Coltec Industries in disallowing losses generated by a complex partnership transaction, because the transaction lacked economic substance. The court considered the facts that the losses were fictional, the transaction did not have a profit motive, the transaction was a tax-avoidance mechanism, the transaction had to be contained in a partnership to secure the tax benefits, and the tax benefit was disproportionate to the investment. In a similar case involving euro options, the IRS won an appeal in the Seventh Circuit in Cemco Investors, LLC, 515 F.3d 749 (7th Cir. 2008). The opinion stated that, "The IRS is free to determine assets' correct basis, under governing law, whether or not a former owner has filed a creative tax return full of fanciful numbers."
In Stobie Creek Investments, LLC, 82 Fed. Cl. 636 (Fed. Cl. 2008), aff'd, 608 F.3d 1366 (Fed. Cir. 2010), another government victory, the court was impressed with an expert's expected-rate-of-return analysis in determining that the costs and fees associated with the investment dwarfed what little profit potential the investments were capable of returning.Determining When Debt Is Bona Fide
If an advance to a partnership is bona fide debt, the transaction is treated as a loan from a third party. To have the loan be respected as third-party debt, the parties should execute a promissory note to evidence the loan in the same way a note would be executed if the loan were made to an unrelated third party. The debt instrument should have a fixed payment date and provide for adequate stated interest.
Other factors that suggest a partner/partnership loan is bona fide debt are (1) the partner's right to seek a security interest in partnership property (it may be a good idea to give the partner a secured interest in partnership property), and (2) terms that reflect commercial reasonableness—such as waiver of demand, presentation, and notice; right to attorneys' fees; and guarantee by other partners. Presumably, amounts advanced to a partnership that are not bona fide debt will be reclassified as contributions to capital.Identifying Contingent Debts
As discussed previously, regulations classify both fixed and contingent obligations as obligations when applying the definition of a liability for Sec. 752 purposes (Regs. Sec. 1.752-1(a)(4)(ii)). However, for purposes of determining if a partner is allocated a share of partnership recourse debt because he or she has an economic risk of loss, the Sec. 752 regulations specify that an obligation is disregarded if, after taking into account all facts and circumstances, the obligation is subject to contingencies making payment unlikely. In addition, if payment depends on the occurrence of a future event that is not determinable with reasonable accuracy, the obligation is disregarded until the event occurs (Regs. Sec. 1.752-2(b)(4)). In LaRue, 90 T.C. 465 (1988), the all-events test of Sec. 461 was applied in determining whether a debt was contingent. This test requires that (1) all events must have occurred to fix the fact of the liability and (2) the amount of the liability must be determinable with reasonable accuracy (Sec. 461(h)(4)).
Even clearly noncontingent partnership debts may not be liabilities. For example, a cash-basis partnership's accounts payable (for items that, if paid, would be currently deductible) does not qualify as a liability. Since there is no current partnership deduction (and no increase in the partnership's inside basis), there is no need to increase the partners' outside basis to be able to take the deduction (Sec. 704(d)). However, for an accrual-basis partnership, the payable has created a deduction, and if the debt was not treated as a liability providing outside basis, the partners could be prevented from receiving the current benefit of that deduction. Therefore, under the regulations, a payable is treated as a liability for an accrual-basis partnership, but not for a cash-basis partnership.Identifying Other Liabilities
Sometimes, partnership liabilities can arise in ways that are not intuitively obvious. In Rev. Rul. 95-26 and COLM Producer, Inc., 460 F. Supp. 2d 713 (N.D. Tex. 2006), the IRS concluded that a partnership's short sale of securities (i.e., the sale of borrowed securities) created a liability under Sec. 752. In the ruling, the partnership sold securities short and deposited the resulting cash with the broker to serve as collateral for the partnership's obligation to replace the borrowed securities. The liability created under the Sec. 752 rules is the amount of cash from the short sale because the basis of the partnership's assets is increased by that amount. In addition, Technical Advice Memorandum 9823002 indicated that deferred prepaid subscription income would be considered a liability and would increase the partners' bases by their share of this deferred income.Understanding When Debt Is Not Considered True Debt
Another issue in determining the amount of partnership liabilities is establishing whether the applicable debt is in fact a true debt. There are two main problem areas: (1) determining whether the debt is a true obligation of the partnership, and (2) determining whether the debt should be classified as some other type of partnership interest, such as a disguised equity interest in partnership profits or cash flow.
The question of whether there is a true partnership obligation usually arises in the context of nonrecourse debt. Numerous courts have held that where the value of the collateral securing a nonrecourse note (at the time of the note's creation) did not equal or exceed the amount of the note, the borrowers did not have sufficient incentive to treat the note as a real obligation. In this situation, repayment of the note was deemed to be contingent or optional depending on future appreciation of the asset—the supposed debt was not treated as a genuine obligation and thus was not a liability under Sec. 752 (see Tufts, 461 U.S. 300 (1983); Crane, 331 U.S. 1 (1947); Estate of Franklin, 544 F.2d 1045 (9th Cir. 1976); and Hager, 76 T.C. 759 (1981)).
Observation: When nonrecourse purchase money debt (debt incurred at the time of the purchase) exceeds a reasonable approximation of the property's fair market value, the debt is disregarded in its entirety for determining depreciation and interest deductions (Bergstrom, 37 Fed. Cl. 164 (1996); Estate of Franklin, 544 F.2d 1045 (9th Cir. 1976)).
In other situations, a question arises as to whether what is labeled debt is really debt or is in fact an equity interest in the partnership. This situation occurs primarily in sophisticated structures where outstanding partnership notes have real value but are arguably not notes at all. For example, many tax-exempt taxpayers hold notes that have some form of participating return calculated based on the success of the venture. Frequently, the return on investment is a function of the appreciation of partnership property (e.g., a shared-appreciation mortgage). This type of structure can provide the tax-exempt creditors substantially the same economic results that they would have received as partners.
However, if the tax-exempt taxpayer's investment is treated as debt instead of equity, the benefits to the parties could include (1) characterizing the tax-exempt taxpayer's return as nontaxable interest instead of unrelated business income (Sec. 512), (2) treating the debt as a liability creating tax basis for the taxable partners in their partnership interest, and (3) permitting the partnership to take cost-recovery deductions without application of certain limitations related to tax-exempt use property (Sec. 168(h)(6)).Disguised Equity Interest in Partnership Profits or Cash Flow
The issue of whether a debt is a true debt or a disguised partnership interest is a question of fact. The crucial factor in making the determination is whether the lender is participating in the enterprise as (1) an entrepreneur providing risk capital or (2) a creditor seeking a return on capital independent of the success or failure of the venture (Title Guarantee & Trust Co., 133 F.2d 990 (6th Cir. 1943); O.P.P. Holding Corp., 76 F.2d 11 (2d Cir. 1935)). The following factors are among those that have been used in determining whether a transaction created debt:
- The existence of a fixed repayment date in the not-too-distant future (Wood Preserving Corp. of Baltimore, Inc., 347 F.2d 117 (4th Cir. 1965)). This may be the single most important factor.
- The existence of adequate security for the loan through a pledge or mortgage of property with a value that exceeds the loan principal (Ambassador Apartments, Inc., 406 F.2d 288 (2d Cir. 1969)).
- The extent to which the loan is subordinated to other liabilities (P.M. Finance Corp., 302 F.2d 786 (3d Cir. 1962)).
- The extent to which the return on the loan is fixed and not dependent on profit from the enterprise (Farley Realty Corp., 279 F.2d 701 (2d Cir. 1960)).
- Whether the borrower is adequately capitalized (Fin Hay Realty Co., 398 F.2d 694 (3d Cir. 1968)).
- Whether there is a true expectation of repayment (Gibson Products Co., 637 F.2d 1041 (5th Cir. 1981)).
- The convertibility of the loan (Rev. Rul. 72-350; Hambuechen, 43 T.C. 90 (1964)).
This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 28th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian, and Linda A. Markwood, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.|