Allocating debt when a disregarded entity is a partner

Often, partnership interests are owned through a disregarded entity, such as a single-member LLC (SMLLC) or a qualified S corporation subsidiary, which will allow the entity’s owner to be the partner for income tax purposes while effectively limiting liability for the partnership’s underlying debts.

Regs. Sec. 1.752-2(k) provides that in determining the extent to which a partner who owns an interest through a disregarded entity bears the economic risk of loss for a partnership recourse liability, payment obligations of the disregarded entity (including a disregarded SMLLC) are taken into account under Sec. 752 only to the extent of the disregarded entity’s net value as of the allocation date. (However, this rule does not apply to an obligation of a disregarded entity to the extent that its owner otherwise is required to make a qualifying payment with respect to the entity’s obligation.)

The net value of a disregarded entity is the fair market value (FMV) of all its assets that may be subject to creditors’ claims under local law, including the disregarded entity’s enforceable rights to contributions from its owner and the FMV of an interest in a partnership, excluding the disregarded entity’s interest in the partnership for which the net value is being determined and the net FMV of property pledged to secure a partnership liability. This amount is then reduced by all obligations of the disregarded entity (regardless of priority) that do not constitute Regs. Sec. 1.752-2(b)(1) payment obligations of the disregarded entity.

Timing of the net value determination

If a partnership interest is held by a disregarded entity, and the partnership has or incurs a liability, all or a portion of which may be allocable to the owner of the disregarded entity, the disregarded entity’s net value must be initially determined on the allocation date. After the net value of a disregarded entity is initially determined, the net value must be redetermined if any of the following valuation events occur:

1. The disregarded entity receives a more than de minimis contribution of property (other than property pledged to secure a partnership liability), unless the contribution is followed immediately by a contribution of equal net value by the disregarded entity to the partnership for which the net value of the disregarded entity otherwise would be determined, taking into account any obligations assumed or taken subject to in connection with such contributions.
2. The disregarded entity makes a more than de minimis distribution of property (other than property pledged to secure a partnership liability), unless the distribution immediately follows a distribution of equal net value to the disregarded entity by the partnership for which the net value of the disregarded entity otherwise would be determined, taking into account any obligations assumed or taken subject to in connection with such distributions.
3. There is a change in the legally enforceable obligation of the owner of the disregarded entity to make contributions to the disregarded entity.
4. There is an incurrence, refinancing, or assumption of an obligation of the disregarded entity that does not constitute a Regs. Sec. 1.752-2(b)(1) payment obligation of the disregarded entity.
5. There is a sale or exchange of a non-de minimis asset of the disregarded entity (in a transaction that is not in the ordinary course of business). In this case, the net value of the disregarded entity may be adjusted only to reflect the difference, if any, between the FMV of the asset at the time of the sale or exchange and the FMV of the asset when the net value of the disregarded entity was last determined. The adjusted net value is taken into account as of the allocation date.

Planning tip: As previously discussed, when a disregarded entity owns an interest in a partnership, changes in the disregarded entity’s net value may cause the partnership’s debt to be reallocated among the partners. Since increases and decreases in a partner’s share of partnership debt are treated as contributions and distributions of money, the reallocation of debt may have unintended consequences — for example, the disguised-sale rules or the hot-asset rules may come into play.

Allocation date

The allocation date is the earlier of:

1. The first date occurring on or after the date on which the requirement to determine the net value of a disregarded entity arises (either initially or due to a valuation event) on which the partnership otherwise determines a partner’s share of liabilities; or
2. The end of the partnership’s tax year in which the requirement to determine the net value of a disregarded entity arises.

A partner that may be treated as bearing the economic risk of loss for a partnership liability of a disregarded entity must provide information to the partnership as to the entity’s tax classification and the net value of the disregarded entity that is appropriately allocable to the partnership’s liabilities on a timely basis.

Example 1. Allocating partnership debt when a disregarded entity is a partner: In year 1, H forms ERE LLC, a disregarded SMLLC to which she has contributed $100,000. Also in year 1, ERE contributes $100,000 in exchange for a general partner interest in F Limited Partnership (F), which has a calendar year end. R and M each contribute $100,000 in exchange for limited partner interests in F. F’s partnership agreement provides that only ERE (the general partner) is required to make up any deficit in its capital account.

In January, year 2, F borrows $300,000 from a bank and purchases $600,000 of nondepreciable property. The $300,000 debt is secured by the property and is also a general obligation of F. F makes payments of interest only on this debt (funded by additional capital contributions by its partners) during year 2. F determines its partners’ shares of the $300,000 debt at the end of its tax year, at which time ERE holds no other assets other than its interest in F.

Since ERE is a disregarded entity, H is treated as the partner in F for federal tax purposes. Only ERE has an obligation to make a payment on account of the $300,000 debt if F were to constructively liquidate. Therefore, H is treated as bearing the economic risk of loss for F’s $300,000 debt only to the extent of ERE’s net value. Because ERE’s net value is zero at the end of year 2, when F determines its partners’ shares of its debt, H is not treated as bearing the economic risk of loss for any portion of F’s $300,000 debt. As a result, F’s $300,000 debt is characterized as nonrecourse and allocated to the partners as required under Regs. Sec. 1.752-3.

Example 2: Assume the same facts as in Example 1, except that on Jan. 1, year 3, H contributes $250,000 to ERE and on Jan. 5, year 3, ERE borrows $100,000 and uses the $350,000 to purchase land. F pays interest only on its $300,000 debt during year 3. As of Dec. 31, year 3, ERE’s only assets are its interest in F and the land, the value of which has declined to $275,000. F has a net tax loss in year 3 (again funded by additional capital contributions) and determines its partners’ share of its $300,000 debt at the end of its tax year, Dec. 31, year 3.

H’s $250,000 contribution to ERE is a more than de minimis contribution of property to the disregarded entity, so it, as well as the debt incurred by ERE, are valuation events. So ERE’s value must be redetermined as of the end of F’s tax year. At that time, ERE’s net value is $175,000 ($275,000 land FMV minus $100,000 debt). So, $175,000 of F’s $300,000 debt is recharacterized as recourse and allocated to H. The remaining $125,000 of debt remains characterized as nonrecourse and is allocated to F’s partners under the Regs. Sec. 1.752-3 rules for allocating nonrecourse debt.

Proposed regulations eliminate the net value rule

The IRS has proposed that Regs. Sec. 1.752-2(k) (the net value rule for disregarded entities) be removed (see REG-122855-15). Instead, the extent to which a partner with little or no net value should be allocated a share of the partnership’s liabilities will be addressed under Prop. Regs. Sec. 1.752-2(j)(3)(iii).  

This case study has been adapted from PPC’s Tax Planning Guide — Partnerships, 32d Edition (March 2018), by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, Twila A. Bollinger, William R. Bischoff, and Cheryl McGath, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).