Partners & Partnerships
On Jan. 29, Treasury and the IRS issued comprehensive and particularly adverse proposed regulations regarding the allocation of partnership recourse and nonrecourse liabilities under Sec. 752 (REG-119305-11). These proposed regulations will apply to liabilities incurred or assumed on or after their date of final publication and are intended to address certain issues (and alleged abuses) in determining a partner's share of liabilities.
Liability allocation has significant implications for partners for both income and operating loss allocation and for determining income tax consequences when partners join or leave the partnership. In general, a partner's share of partnership debt is included as part of a partner's tax basis in the partnership interest. Losses reduce this tax basis and can be deducted only to the extent the partner has a positive tax basis in the partnership interest.
If a partner's share in liabilities is reduced, then that reduction is deemed to be a cash distribution that reduces the partner's tax basis in the partnership, and to the extent this reduction exceeds the partner's tax basis, a taxable gain could result for the partner. When a new partner joins the partnership by contributing encumbered property, the new partner may end up with a taxable gain due to the reduction in his or her liabilities.In addition, the existing partners in this partnership could end up with taxable gain if their share of the existing partnership liabilities is reduced due to the admission of the new partner.
Proposed Recourse Liability Allocation
Recourse liabilities are liabilities where a partner or a person related to a partner bears the entire economic risk of loss. Under the current Sec. 752 regulations, a partnership's recourse liability is allocated to a partner who bears the economic risk of loss under a constructive-liquidation test. The constructive-liquidation test assumes that the partnership's assets are worthless; the partnership is liquidated; all liabilities become payable; and the partner, or a person related to the partner, would be obligated to make payment on the liability, which is now due and payable.
The proposed regulations make three critical changes to the current regulations. First, requirements must be satisfied for a partner or related person's payment obligation to be recognized:
- The partner or related person is required to maintain a commercially reasonable net worth throughout the term of the payment obligation or to be subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration;
- The partner or related person is required periodically to provide commercially reasonable documentation regarding the partner's or related person's financial condition;
- The term of the payment obligation does not end prior to the term of the partnership liability;
- The payment obligation does not require that the primary obligor or any other obligor with respect to the partnership liability directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of the obligor;
- The partner or related person received arm's-length consideration for assuming the payment obligation;
- In the case of a guarantee or similar arrangement, the partner or related person is or would be liable up to the full amount of the partner's or related person's payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied; and
- In the case of an indemnity, reimbursement agreement, or similar arrangement, the partner or related person is or would be liable up to the full amount of the partner's or related person's payment obligation if, and to the extent that, any amount of the indemnitee's or other benefited party's payment obligation is satisfied.
Second, the proposed regulations would force a partner's or related person's payment obligation for a partnership liability to be reduced by any right of reimbursement from any person. Third, the proposed regulations would apply the "net value" requirement from Regs. Sec. 1.752-2(k), which currently applies only to disregarded entities, to all partners or related persons, including grantor trusts, other than individuals and decedents' estates, for payment obligations associated with liabilities that are not trade payables. It also would require an obligor subject to the net-value requirement to timely provide the partnership certain information regarding the obligor's net value that is appropriately allocable to the partnership's liabilities.
Proposed Nonrecourse Liability Allocation
A partnership liability is a nonrecourse liability if no partner or related person bears the economic risk of loss for that liability. Under Regs. Sec. 1.752-3(a), a partner's share of nonrecourse liabilities equals the sum of three tiers of allocations: (1) the amount of that partner's share of partnership minimum gain determined under Sec. 704(b); (2) the amount of any taxable gain that would be allocated to the partner under Sec. 704(c) if the partnership disposed of all property subject to nonrecourse debt for no consideration other than full satisfaction of the debt; and (3) if any nonrecourse liability balance remains (also called "excess nonrecourse liability"), the partner's share of this excess nonrecourse liability balance, based on the partner's share of the partnership's profits.
The current regulations allow the partnership agreement to specify the partner's interest in the partnership profits for purposes of allocating the excess nonrecourse liabilities, as long as the specified profit interest has substantial economic effect under Sec. 704(b) and is consistent with allocations of some other significant item of partnership income or gain (the significant-item method). Alternatively, the current regulations allow excess nonrecourse liabilities to be allocated in the same proportion as deductions attributable to those nonrecourse liabilities, as long as the deduction allocation is reasonable (the alternative method).
The proposed regulations would eliminate the significant-item and alternative methods and, in their place, introduce a liquidation-value approach. A partner's liquidation-value percentage is the ratio of the liquidation value of the partner's interest in the partnership to the aggregate liquidation value of all the partners' interests in the partnership. A partner's liquidation-value ratio must be determined upon the partnership's formation and redetermined whenever a revaluation event (as set forth in Regs. Sec. 1.704-1(b)(2)(iv)(f)(5)) occurs, regardless of whether the partnership revalues its assets.
The liquidation value of a partner's interest in a partnership is the cash amount the partner would receive with respect to the interest if, immediately after the formation of the partnership or the occurrence of a Sec. 704(b) revaluation event, the partnership sold all its assets for an amount equal to their fair market value (considering Sec. 7701(g)); satisfied all its liabilities (other than those described in Regs. Sec. 1.752-7); paid an unrelated third party to assume all of its Regs. Sec. 1.752-7 liabilities in a fully taxable transaction; and then liquidated.
Effective Date and Transition Rule
These proposed regulations will apply to liabilities incurred or assumed by a partnership on or after the date the final regulations are published. However, it is unclear how this prospective effective date would apply to preexisting guarantees or other payment obligations. The proposed regulations include a "grandfather" provision for certain partnerships that have one or more partners with negative capital accounts (the partner's share of partnership liabilities exceeds the partner's tax basis in the partnership interest). Under this provision, these transition partnerships can continue to apply the current regulations with respect to their transition partners to the extent of the transition partner's adjusted grandfathered amount for a seven-year period beginning on the date the final regulations are issued. This grandfather provision in the proposed regulations does, however, call for adjustments (to prevent any potential abuse) if there are any sales of partnership property, payment of preexisting liabilities, or any direct or indirect changes in membership of "grandfather" partners that are legal entities rather than individuals by 50% or more.
If these proposed regulations become final, they would represent a substantial change in partnership law and could cause significant problems but also create planning opportunities. This is especially true for the real estate industry, which historically has depended heavily on extensive guarantees by partners and related parties. Unexpected gains and disallowed losses will become more common because of these special rules for allocation of partnership liabilities. They will impose a heightened administrative burden on partnerships, whose agreements may have to be amended to avoid potential adverse implications.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP