Prop. regs. restore allocation of partnership liabilities in disguised sales

Editor: Mark G. Cook, CPA, CGMA

In April 2017, President Donald Trump issued Executive Order (EO) 13789 to identify and reduce tax regulatory burdens. The secretary of the Treasury was tasked with reviewing “all significant tax regulations issued by the Department of the Treasury on or after January 1, 2016,” that imposed undue financial burden on taxpayers, added undue complexity to the federal tax laws, or exceeded the IRS’s statutory authority.

Eight regulations were identified that met at least one of the EO’s first two requirements. One of those eight was the Sec. 752 temporary regulations (T.D. 9788) on liabilities recognized as recourse partnership liabilities that generally would provide rules for how liabilities are allocated under Sec. 754 solely for purposes of disguised sales under Sec. 707.

On June 19, 2018, the IRS issued proposed regulations (REG-131186-17) under Sec. 707 regarding allocation of partnership liabilities that are characterized as disguised sales. These regulations, if finalized, will remove the temporary Sec. 707 regulations from October 2016, withdraw the proposed regulations issued at the same time (REG-122855-15), and essentially restore the prior rules.

A disguised sale occurs when a partner(s) engages in a transaction or transactions that, when viewed together with a partnership, involve property and are characterized as the sale or exchange of property (Sec. 707(a)(2)(B)). A disguised-sale transaction is treated as a transaction between the partnership and one who is not a partner or two or more partners acting other than in their capacity as members of a partnership.

Regs. Sec. 1.707-5 deals primarily with the rules related to liabilities. Under the 2016 proposed and temporary regulations, the nonrecourse partnership liabilities must be allocated in accordance with the partners’ share of partnership profits, determined by taking into account all facts and circumstances related to the economic arrangement of the partners. This essentially allocates liabilities in the same manner as excess nonrecourse liabilities subject to certain restrictions. The proposed and temporary regulations were designed to eliminate leveraged partnership transactions.

Furthermore, the 2016 regulations had placed limits on the ability to classify debt as recourse to a partner, by adding a seven-factor anti-abuse rule, presuming an avoidance plan if certain net value tests are met, and adding anti-abuse factors specific to deficit restoration obligations.

Under the version of Prop. Regs. Sec. 1.707-5(a)(2) issued with REG-131186-17 in June 2018, the separate rules regarding a partnership’s recourse and nonrecourse liabilities are brought back. Below are the proposed rules under Prop. Regs. Sec. 1.707-5(a)(2):

(i) Recourse liability. A partner’s share of a recourse liability of the partnership equals the partner’s share of the liability under the rules of section 752 and the regulations thereunder. A partnership liability is a recourse liability to the extent that the obligation is a recourse liability under §1.752-1(a)(1) or would be treated as a recourse liability under that section if it were treated as a partnership liability for purposes of that section.

(ii) Nonrecourse liability. A partner’s share of a nonrecourse liability of the partnership is determined by applying the same percentage used to determine the partner’s share of the excess nonrecourse liability under §1.752-3(a)(3). A partnership liability is a nonrecourse liability of the partnership to the extent that the obligation is a nonrecourse liability under §1.752-1(a)(2) or would be a nonrecourse liability of the partnership under §1.752-1(a)(2) if it were treated as a partnership liability for purposes of that section.

To further illustrate this, Prop. Regs. Sec. 1.707-5 revises Examples 2 and 3, below:

Example (2). Partnership’s assumption of recourse liability encumbering transferred property.

(i) C transfers property Y to a partnership. At the time of its transfer to the partnership, property Y has a fair market value of $10,000,000 and is subject to an $8,000,000 liability that C incurred, immediately before transferring property Y to the partnership, in order to finance other expenditures. Upon the transfer of property Y to the partnership, the partnership assumed the liability encumbering that property. The partnership assumed this liability solely to acquire property Y. Under section 752 and the regulations thereunder, immediately after the partnership’s assumption of the liability encumbering property Y, the liability is a recourse liability of the partnership and C’s share of that liability is $7,000,000.

(ii) Under the facts of this example, the liability encumbering property Y is not a qualified liability. Accordingly, the partnership’s assumption of the liability results in a transfer of consideration to C in connection with C’s transfer of property Y to the partnership in the amount of $1,000,000 (the excess of the liability assumed by the partnership ($8,000,000) over C’s share of the liability immediately after the assumption ($7,000,000)). . . .

Example (3). Subsequent reduction of transferring partner’s share of liability.

(i) The facts are the same as in Example 2. In addition, property Y is a fully leased office building, the rental income from property Y is sufficient to meet debt service, and the remaining term of the liability is ten years. It is anticipated that, three years after the partnership’s assumption of the liability, C’s share of the liability under section 752 will be reduced to zero because of a shift in the allocation of partnership losses pursuant to the terms of the partnership agreement. Under the partnership agreement, this shift in the allocation of partnership losses is dependent solely on the passage of time.

(ii) Under paragraph (a)(3) of this section, if the reduction in C’s share of the liability was anticipated at the time of C’s transfer, was not subject to the entrepreneurial risks of partnership operations, and was part of a plan that has as one of its principal purposes minimizing the extent of sale treatment under §1.707-3 (that is, a principal purpose of allocating a large percentage of losses to C in the first three years when losses were not likely to be realized was to minimize the extent to which C’s transfer would be treated as part of a sale), C’s share of the liability immediately after the assumption is treated as equal to C’s reduced share.

What has not changed from the 2016 regulations are the rules regarding “bottom dollar” guarantees that partners used to increase their tax basis in the partnership. These rules will remain in effect under the new proposed regulations and as outlined in Regs. Sec. 1.752.

The 2016 Sec. 707 temporary regulations are proposed to be removed 30 days following the date the new regulations are published as final. The amendments to Regs. Sec. 1.707-5 are proposed to apply to any transaction for which all transfers occur on or after 30 days following the date these regulations are published as final. However, a partnership and its partners may apply all the rules in the proposed regulations in lieu of the 2016 Sec. 707 temporary regulations to any transaction for which any transfer occurred on or after Jan. 3, 2017.

EditorNotes

Mark G. Cook, CPA, CGMA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.