The IRS issued temporary regulations under Sec. 707 (T.D. 9788) on Oct. 5, 2016. Under those temporary disguised-sale regulations, a partner's economic risk of loss generally is not taken into account when determining the partner's share of the partnership's liabilities for purposes of applying the disguised-sale rules. Instead, liabilities generally are allocated in the same manner as excess nonrecourse liabilities, subject to certain restrictions (see Temp. Regs. Sec. 1.707-5T(a)(2)). This generally results in liabilities being allocated, for disguised-sale purposes, in accordance with each partner's interest in partnership profits.
The temporary disguised-sale regulations represent a significant change from prior law, which generally gave effect to a partner's economic risk of loss. The preamble to these regulations describes the change as arising from the IRS's concern that certain taxpayers were entering into "leveraged partnership transactions in which the contributing partners or related persons enter into payment obligations that are not commercial solely to achieve an allocation of the partnership liability to the partner, with the objective of avoiding a disguised sale." The preamble further asserts that the new liability allocation method better reflects the economic deal between or among the partners because "[i]n most cases, a partnership will satisfy its liabilities with partnership profits, the partnership's assets do not become worthless, and the payment obligations of partners or related persons are not called upon."
Although the temporary disguised-sale regulations generally do not recognize a contributing partner's economic risk of loss, they do recognize another partner's economic risk of loss when calculating the liabilities allocable to the contributing partner. As stated in a Nov. 27, 2016, "clarification" to the temporary regulations, liabilities are allocated by "applying the same percentage used to determine the partner's share of the excess nonrecourse liability under [Regs. Sec.] 1.752-3(a)(3) (as limited in its application to this paragraph [Temp. Regs. Sec. 1.707-5T](a)(2)), but such share shall not exceed the partner's share of the partnership liability under [Sec.] 752 and applicable regulations (as limited in the application of [Regs. Sec.] 1.752-3(a)(3) to this paragraph (a)(2))."
Under the clarification, it appears that a partner's liability allocation for disguised-sale purposes is equal to the lesser of (1) the partner's share of the liability as determined under the Sec. 752 recourse liability rules or (2) the partner's share of the liability as determined based upon the partner's interest in partnership profits. The application of this rule produces anomalous results.
Example 1: A and B each contribute property to the AB partnership with a fair market value of $200 and tax basis of $0. Each property is subject to a $100 nonrecourse liability guaranteed by the partner contributing that property, and each liability is treated as a nonqualified liability under Regs. Sec. 1.707-5(a). Temp. Regs. Sec. 1.707-5T(a)(2) refers to a "partner's share of a liability," indicating that the rules operate on a liability-by-liability basis. Therefore, if A and B share profits equally, A's share of the nonrecourse debt would be $100 (50% of each liability), but because B guaranteed its $100 liability assumed by the partnership, it would appear A is entitled only to the lesser of its Sec. 752 share of partnership liabilities ($100) or 50% of the debt for which no other partner bears the risk of loss (50% of A's $100 liability, or $50).
A, apparently, would report $50 of disguised-sale proceeds, even though A bears the economic risk of loss for its $100 liability assumed by the partnership. For A to be allocated the full $100 liability under these new rules, B would need to secure a release from its guarantee prior to the contribution. This may not be commercially feasible if the creditor has required B's guarantee as a condition of the borrowing.
A's recognition of $50 of gain in Example 1 does not appear to be in accordance with the Sec. 707 legislative history, which indicates that a contributing partner's economic risk of loss should be taken into account. The 1984 House Conference Report states:
The conferees wish to note that when a partner of a partnership contributes property to the partnership and that property is borrowed against, pledged as collateral for a loan, or otherwise refinanced, and the proceeds of the loan are distributed to the contributing partner, there will be no disguised sale under the provision to the extent the contributing partner, in substance, retains liability for repayment of the borrowed amounts (i.e., to the extent the other partners have no direct or indirect risk of loss with respect to such amounts) since, in effect, the partner has simply borrowed through the partnership. [H.R. Rep't No. 98-861, 98th Cong., 2d Sess. 862 (1984)]
Recommended changes in future regulations
To address the result highlighted in Example 1, the IRS should consider the continued use of the Sec. 752 economic-risk-of-loss rules for disguised-sale purposes. The preamble to the temporary regulations states that the new Sec. 752 rules do not recognize certain payment obligations such as "bottom dollar payment obligations" (generally, a partner's payment obligation if the partner is not liable up to the full amount of that obligation) because the IRS believes those obligations generally lack a significant nontax commercial business purpose. It seems clear that the government is focused on what it perceives to be noncommercial payment obligations in both Temp. Regs. Secs. 1.707T and 1.752T. Given this common focus, the IRS can accomplish its stated goals by respecting payment obligations recognized under Temp. Regs. Sec. 1.752T for purposes of Temp. Regs. Sec. 1.707T.
Example 2: With the same facts as Example 1 and assuming both A's and B's guarantees are respected payment obligations under Temp. Regs. Sec. 1.752T, A should not recognize any disguised-sale gain because it is allocated its $100 liability for disguised-sale purposes. However, if A's guarantee is determined to be a "bottom dollar payment obligation" under Temp. Regs. Sec. 1.752-2T(b)(3)(ii)(C), then A would recognize disguised-sale proceeds equal to the difference between its allocation of its assumed liability as an excess nonrecourse liability ($50) over the total assumed debt ($100), producing $50 of disguised-sale gain.
There is no evident policy reason for allowing a partner's use of its economic risk of loss with regard to a liability to defer gain outside the disguised-sale rules (e.g., by using recourse debt to increase outside tax basis under Secs. 752(a) and 705 and receive tax-deferred cash distributions) while not allowing that partner to use that same economic risk of loss to defer gain under the disguised-sale rules. Further, recognizing economic risk of loss for Sec. 752 purposes while not recognizing it for disguised-sale purposes introduces unneeded complexity and produces results that appear inconsistent with the Sec. 707 legislative history. Based on this analysis, the authors believe the IRS should consider recognizing a contributing partner's economic risk of loss when the temporary disguised-sale regulations are finalized.
Editor's note: These regulations were identified as burdensome by the Treasury Department in July 2017 and are being reviewed for possible modification or withdrawal. See "Treasury Identifies 8 Regulations as Burdensome."
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.