Editor: Kevin D. Anderson, CPA, J.D.
A partner's share of partnership liabilities increases the partner's basis in the partnership. Further, certain liability allocations may increase a partner's at-risk basis under Sec. 465. In highly leveraged partnerships, bottom-dollar payment obligations have been used by partners to increase their at-risk basis in a partnership to use loss allocations or to receive nontaxable cash distributions.
Example 1: Partnership ABC borrows $800 from a third-party lender to purchase Property X. The total purchase price of Property X is $1,000 with $200 funded with equity contributions from Partners A, B, and C. Additionally, Partner A executes a bottom-dollar payment obligation with the third-party lender for $100. Under the terms of the bottom-dollar payment obligation, Partner A will not be obligated to pay the third-party lender until the value of Property X drops below $100. Under the general liability allocation rules, Partner A's bottom-dollar payment obligation would result in a $100 recourse liability allocation to Partner A with the remaining $700 treated as a nonrecourse liability.
The result in the above example occurs because, under Regs. Sec. 1.752-2(a), if a partner bears the economic risk of loss for a liability, the liability is recourse to that partner. In general, a partner bears the economic risk of loss to the extent that, if the partnership's assets became worthless and its liabilities became due and payable, a partner would be obligated to satisfy all or part of the liability. Under these general rules, Partner A's bottom-dollar payment obligation would create economic risk of loss because Partner A would be obligated to pay $100 if the property became worthless and the liability became due and payable.
Since a bottom-dollar payment obligation requires the guarantor to satisfy its obligation only to the extent the collateral value falls below the guarantee level, the guarantor arguably has minimal risk of ultimately being called upon to remit payment to the lender. In an effort to curtail this perceived abuse, in October 2016 Treasury and the IRS published temporary regulations under Sec. 752. Final regulations were published in the Federal Register on Oct. 9, 2019 (T.D. 9877). The final regulations, while mostly consistent with the temporary regulations, include a number of important provisions regarding bottom-dollar payment obligations. Ultimately, though, under these regulations, Partner A in Example 1 will not be treated as bearing the economic risk of loss attributable to the $100 bottom-dollar payment obligation.
The final regulations
Under the final regulations, a bottom-dollar payment obligation generally does not create an economic risk of loss for the guarantor, and, therefore, the bottom-dollar payment obligation does not result in the allocation of a recourse liability to the guarantor. Regs. Sec. 1.752-2(b)(3)(ii)(C)(1) defines a bottom-dollar payment obligation as any payment obligation other than one in which the partner or related person is or would be liable up to the full amount of that partner's or related person's payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied. Additionally, arrangements using tiered partnerships, intermediaries, senior and subordinate liabilities, or similar arrangements to convert what would be a single liability into multiple liabilities may be considered to create a bottom-dollar payment obligation in situations where the facts and circumstances demonstrate a principal purpose of avoiding having at least one of the liabilities being treated as a bottom-dollar payment obligation.
Importantly, there is an exception to the general "all or nothing" test described in the regulations. Regs. Sec. 1.752-2(b)(3)(ii)(B) provides that a guarantee (or similar arrangement) that is treated as a bottom-dollar payment obligation under the general rule, where the partner or related person is liable for at least 90% of the partner's or related person's payment obligation is still recognized as a payment obligation under Regs. Sec. 1.752-2(b)(3). Thus, if the obligor's ultimate liability under the guarantee (or similar arrangement) is reduced by no more than 10% of the total liability as the result of an indemnity, reimbursement agreement, or similar arrangement made by another partner, then the partner's obligation for the remaining amount is still recognized as a payment obligation potentially creating an economic risk of loss. Similarly, a bottom-dollar payment obligation does not result simply because a maximum amount is placed on the partner's or related person's payment obligation. Additionally, a bottom-dollar payment obligation does not result merely because there is a right of proportionate contribution running between partners or related persons who are co-obligors for a payment obligation for which each of them is jointly and severally liable.
The manner in which Treasury and the IRS define a bottom-dollar payment obligation has created significant risk that guarantees or similar arrangements with real economic substance may nonetheless be treated as bottom-dollar payment obligations.
Example 2: In year 1, Partnership PRS is formed with two partners, Partner A and Partner B, and holds property subject to a mortgage of $500. The bank requires Partner A and Partner B to each guarantee $250. Under Regs. Sec. 1.752-2(b)(3), the payment obligations and resulting recourse liability allocation are as shown in the table "Partners' Payment Obligations" (below).
Each partner's guarantee is fully recognized under Regs. Sec. 1.752-2(b)(3) as a recourse liability allocable to the respective partner, and there is no remaining liability amount to be allocated as a nonrecourse liability.
In year 2, Partner A sells a small interest in Partnership PRS to Partner C. Partner C agrees to indemnify Partner A for $20 of Partner A's $250 guarantee corresponding with Partner C's acquisition of a partnership interest. There is no change in the loan balance, as shown in the table "Partners' Payment Obligations After Sale to C" (below).
Note that as a result of Partner C's indemnification of Partner A for $20, $20 of Partner A's payment obligation and the subsequent recourse liability allocation shifts to Partner C. Partner A's payment obligation when adjusted for Partner C's indemnity is $230, which is 92% ($230 payment obligation ÷ $250 initial payment obligation) of Partner A's initial payment obligation. Because A's payment obligation is now less than his initial payment obligation, it has become a bottom-dollar payment obligation. However, because A's payment obligation is greater than or equal to 90% of his initial obligation, it is still recognized as a payment obligation for at-risk basis purposes. The entire liability is allocated as recourse with no remaining liability amount to be allocated as nonrecourse.
In year 3, all facts are the same as year 2 except for a reduction in the liability owed to the bank from $500 to $300. This reduces both Partner A's and Partner B's initial payment obligations to $150 each, as shown in the table "Partners' Payment Obligations in Year 3" (below).
In this example, Partner A's payment obligation when adjusted for Partner C's indemnity is $130, which is roughly 87% ($130 payment obligation ÷ $150 initial payment obligation) of Partner A's initial payment obligation. Thus, Partner A's guarantee has now become a bottom-dollar payment obligation that is not recognized as a payment obligation because A's payment obligation falls under 90% of his initial obligation. The result is the disallowance of Partner A's guarantee being treated as an obligation creating an economic risk of loss. See the table "Payment Obligations After Adjusting for Partner C's Indemnity" (below) for the redetermined payment obligation allocations.
Each partner's payment obligation is then redetermined by excluding Partner A's payment obligation, and because Partner B's total guarantee was $250, Partner B is reallocated up to that amount of recourse liability. This situation also results in $30 of the liability remaining after recourse allocation, to be allocated as a nonrecourse liability.
Pitfall or planning opportunity?
Without thoughtful review and careful planning, taxpayers risk inadvertently creating a bottom-dollar payment obligation where real economic risk of repayment exists. Where maximizing recourse liability allocations is desired, the final regulations may limit the partner's ability to achieve this goal.
However, these rules may also present an opportunity to avoid creating an economic risk of loss and instead maximize the total nonrecourse liability allocations. Where nonrecourse liability characterization is preferred, for example, if cash distributions are being made to nonguarantor partners, the partners may be able to create a bottom-dollar payment obligation. Intentionally creating a bottom-dollar payment obligation where a guarantee is otherwise required, for example, if a bank requires a partner guarantee, would cause the guarantee to be disregarded for tax purposes, resulting in an increase to the total nonrecourse liabilities to be allocated.
When considering intentionally creating a bottom-dollar payment obligation, it is worth noting that, in any case where a bottom-dollar payment obligation exists, Regs. Sec. 1.752-2(b)(3)(ii)(D) requires disclosure of the bottom-dollar payment obligation via Form 8275, Disclosure Statement. Regardless of the partner's objectives, it is also important to consider the anti-abuse rules contained within the final regulations. In addition to the rules in Regs. Sec. 1.752-2(b)(3)(ii)(C)(1)(iv) described above, taxpayers must be mindful of the general anti-abuse rules under Regs. Sec. 1.752-2(j). Under the anti-abuse rules, an obligation of a partner or related person to make a payment may be disregarded or treated as an obligation of another person if the facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the partner's economic risk of loss when, in substance, the arrangement is otherwise.
Ultimately, the final regulations increase the burden of analysis for partnerships and their tax advisers. Additional care and scrutiny surrounding liability guarantees, indemnities, and reimbursement agreements are required. However, in certain situations, with appropriate planning and analysis, these final regulations may provide added flexibility in liability allocations.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.