IRS Rules Govern Disguised Sales and Allocations of Partnership Liabilities

Editor: Sally P. Schreiber, J.D.

On Oct. 4, the IRS issued final, temporary, and proposed regulations providing guidance on partnership disguised sales and allocation of liabilities.

The final regulations (T.D. 9787) address disguised sales of property by or to a partnership and allocations of excess nonrecourse liabilities to partners, which may be disguised sales.

The temporary and proposed regulations (T.D. 9788 and REG-122855-15) cover allocations of liabilities and recognition of obligations when determining if a liability is a recourse partnership liability under Sec. 752.

T.D. 9787 finalizes proposed regulations that were issued in 2014 (REG-119305-11), with some changes in response to comments. In response to a comment that the IRS’s guidance regarding a partner’s share of partnership liabilities should apply only for disguised-sale purposes, the IRS has reconsidered the rules in Prop. Regs. Sec. 1.707-5(a)(2) and, instead of finalizing that section, has issued temporary and proposed regulations that cover that issue.

Disguised Sales

Sec. 707 is intended to prevent partners from recharacterizing a sale or exchange of property as a contribution to the partnership followed by a distribution by the partnership, which could avoid or defer tax on the transaction.

There are several exceptions to this disguised-sale rule, including the debt-financed-distribution exception, which provides an exception for a distribution to the extent it is traceable to a partnership borrowing that is allocable to the partner. Other exceptions from disguised-sale treatment are found in Regs. Sec. 1.707-4, which, among other things, excludes from disguised-sale treatment payments that qualify as reasonable guaranteed payments to a partner. The regulations introduce an ordering rule for determining which payments may be excluded from disguised-sale treatment by providing that the debt-financed exemption applies first, with any remaining amounts tested under Regs. Sec. 1.707-4.

Another change in the rules is to the treatment of preformation capital expenditures under Regs. Sec. 1.707-4(d), which is amended to address three issues. First, the regulations provide how the exception for preformation capital expenditures applies in the case of multiple property transfers. In addition, the rules clarify the definition of “capital expenditures” for purposes of this exception. The regulations also provide a rule coordinating the exception for preformation capital expenditures and the rules regarding liabilities traceable to capital expenditures. To the extent a partner financed a capital expenditure with a borrowing, and economic responsibility for that borrowing has shifted to another partner, the exception for preformation capital expenditures will not apply. This rule has been broadened in the final regulations to include any qualified liability under Regs. Sec. 1.707-5(a)(6).

The regulations also clarify certain other exceptions to the disguised-sale rules, as well as how those rules apply to tiered partnerships.

The final regulations also address allocation of a partnership’s excess nonrecourse liabilities to partners for disguised-sale purposes under Sec. 752.

Allocation of Liabilities

The temporary regulations require a partner to apply the same percentage used to determine the partner’s share of excess nonrecourse liabilities under Regs. Sec. 1.752-3(a)(3) (with certain limitations) in determining the partner’s share of partnership liabilities for disguised-sale purposes. T.D. 9788 also contains temporary regulations providing guidance on the treatment of “bottom dollar payment obligations” under Sec. 752.

The proposed regulations incorporate the text of the temporary regulations and also make various changes to the 2014 proposed regulations in response to comments received on rights of reimbursement, arrangements to circumvent or avoid an obligation, deficit restoration obligations, exculpatory liabilities, and net value.

Applicability Dates

The final regulations under Sec. 707 apply to any transaction for which all transfers occur on or after Oct. 5, 2016. The final regulations under Sec. 752 apply to liabilities that are incurred by a partnership, that a partnership takes property subject to, or that are assumed by a partnership on or after Oct. 5, 2016, other than liabilities incurred by a partnership, that a partnership takes property subject to, or that are assumed by a partnership pursuant to a written contract in effect before that date.

The temporary regulations are effective Oct. 5, 2016, and their provisions have various dates of applicability. The proposed regulations will generally be effective when they are published as final regulations, but partnerships and their partners may rely on them before they are finalized. However, the rules in Regs. Sec. 1.752-2(k) (regarding the effect of obligations of a disregarded entity on a partner’s share of recourse liabilities) still apply to disregarded entities until the proposed regulations are published as final regulations.