Commercially reasonable expectation of payment under final Sec. 752 regulations

By Thomas A. Orr, CPA, Seattle

Editor: Kevin D. Anderson, CPA, J.D.

On Oct. 9, 2019, final regulations were published in the Federal Register, providing guidance on when partnership liabilities are recognized as recourse under Sec. 752 (T.D. 9877). One of the most significant changes from the prior regulations is the requirement of a commercially reasonable expectation of payment.

Under Regs. Sec. 1.752-2(b)(6), it is generally assumed that all partners and related persons that have payment obligations will actually perform their obligations, irrespective of their actual net worth, unless the facts and circumstances indicate that either there is a plan to circumvent or avoid the obligation or there is not a commercially reasonable expectation that the obligor will have the ability to make the required payments under the terms of the obligation if it becomes due and payable. This facts-and-circumstances test is separate from the updated anti-abuse rules in Regs. Sec. 1.752-2(j) and provides a new and interesting set of challenges for taxpayers and practitioners alike. These issues are especially concerning for partnerships subject to the centralized partnership audit regime, due to the potential for imputed underpayment obligations if liability allocations are incorrect.

Relevant regulatory history

The new rule requiring a commercially reasonable expectation of payment is a significant departure from the comparable provision in the previous final regulations, in that it applies to all partners and is not strictly a net value test. Under the previous regulations, the expectation of satisfaction, under Regs. Sec. 1.752-2(b)(6), was subject to an anti-abuse rule and a net value test for disregarded entities. The new regulations modify and expand the anti-abuse rule and essentially replace the net value test for disregarded entities with the requirement of a commercially reasonable expectation of payment. While the anti-abuse rule changes are outside the scope of this item, it is worth discussing the net value test for disregarded entities as a point of comparison.

Under the prior regulations, business entities disregarded from their owners under Sec. 856(i) or 1361(b)(3) or under Regs. Secs. 301.7701-1 through 301.7701-3 had their payment obligations respected only "to the extent" that the entity had sufficient net value as of the specific allocation date, in addition to meeting the other criteria of Regs. Sec. 1.752-2. Net value was essentially defined as the fair market value (FMV) of all the disregarded entity's assets, excluding the partnership interest, less all obligations of the disregarded entity, excluding the obligations being tested. The "to the extent" language meant that, even if a disregarded entity did not have sufficient net value to cover the full amount of its payment obligation, the obligation could be partially respected, up to the amount of net value.

Given the limitation of applying this test only to disregarded entities, taxpayers could, in theory, turn an obligation that was partially or fully treated as nonrecourse due to the net value test into a recourse obligation simply by making the entity a regarded entity. Depending on the facts, this could be as simple as electing either C corporation or S corporation status for the previously disregarded entity. For the sake of argument, this analysis assumes that the entity conversion and resulting change to the liability allocation would not run afoul of the anti-abuse rules in place at the time.

In the 2014 proposed regulations (REG-119305-11), the net value test was expanded to include any partner or related person, other than an individual or a decedent's estate. These proposed regulations also required partners to provide the partnership with a statement of the net value of the partner or related person with a payment obligation in order for the partnership to properly allocate its liabilities. Among the public comments on the proposed regulations was a suggestion that if the net value requirement was retained, it should apply to all partners, including individuals and estates. Other commenters raised concerns about privacy, stating that having to provide sensitive financial information to the partnership would be "unnecessarily intrusive."

The proposed regulations also contained a "presumed anti-abuse rule," which provided that evidence of a plan to circumvent or avoid an obligation is deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation that the payment obligor will have the ability to make the required payments if the payment obligation becomes due and payable. On this point, a commenter indicated that a "presumed" anti-abuse rule created uncertainty, as anti-abuse rules are generally not proactively asserted by taxpayers. In other words, taxpayers do not generally view their arrangements as being abusive, and thus it is the IRS that asserts the application of the anti-abuse rule, not the taxpayer.

Commercially reasonable expectation of payment

Recognizing both the confusion of the presumed anti-abuse rule and the burden of requiring partners to provide their detailed financial information to partnerships, the final regulations significantly modified those provisions. The 2019 final regulations provide the facts-and-circumstances-based test of a commercially reasonable expectation of payment rather than the net value test from the prior regulations and the 2014 proposed regulations. Unlike the net value test, this test allows consideration of future income streams, in addition to current value, as of a liability determination date. The rule requiring a commercially reasonable expectation of payment is separate from the updated anti-abuse rules, meaning taxpayers should proactively apply the rule to payment obligations of their partners.

The preamble to the 2019 final regulations provides that a determination of the ability to pay may be based on documents such as balance sheets, income statements, cash flow statements, credit reports, and projected future financial results. The preamble also clarifies that the determination is not limited solely to these types of documents. Additionally, Regs. Sec. 1.752-2(k)(1) states that the facts and circumstances to be considered include factors that a third-party creditor would take into account when determining whether to grant a loan.

The final regulations clarify that for purposes of applying the rule requiring a commercially reasonable expectation of payment, disregarded entities are included as payment obligors. In addition to entities disregarded under Sec. 856(i) or 1361(b)(3) or under Regs. Secs. 301.7701-1 through 301.7701-3, payment obligors also now include "a trust to which subpart E of part I of subchapter J of chapter 1 of the Code applies." The 2019 final regulations provide two examples to illustrate the application of these rules; both involve disregarded entities (Regs. Sec. 1.752-2(k)(2), Examples 1 and 2).

The first is an example of an undercapitalized disregarded entity with a general partner interest in a limited partnership. A forms a domestic limited liability company, named LLC, with a contribution of $100,000. A has no liability for LLC's debts, and LLC has no enforceable right to a contribution from A. LLC is properly treated as a disregarded entity under Regs. Sec. 301.7701-3(b)(1)(ii). LLC subsequently contributes the $100,000 to a limited partnership, named LP, in exchange for a general partnership interest in LP. The partnership agreement provides that only LLC is required to restore any deficit in its capital account. LP then borrows $300,000 from a bank and purchases nondepreciable property for $600,000. The $300,000 obligation is secured by the purchased property, and LP makes only interest payments on the debt. Thus, as of the applicable liability determination date, the balance of the debt is still $300,000.

Under the constructive liquidation rules of Regs. Sec. 1.752-2(b)(1), the purchased property is assumed to be worthless, and thus LLC's deficit restoration obligation would initially be deemed to create a $300,000 payment obligation. For federal income tax purposes, A is treated as the partner of LP; however, since Regs. Sec. 1.752-2(k)(1) explicitly provides that payment obligors include disregarded entities, the rule requiring a commercially reasonable expectation of payment is applied to LLC. In other words, A's wherewithal to satisfy the obligation is irrelevant, since the commercially reasonable expectation of payment must exist at the payment obligor level, LLC in this case. Since LLC has no assets other than the interest in LP, it has no assets with which to satisfy its payment obligation, and thus the obligation fails to have a commercially reasonable expectation of payment. As a result, the liability is characterized as nonrecourse under Regs. Sec. 1.752-1(a)(3).

The second example in the regulations is substantially identical to the first example, with one important modification: In addition to holding the interest in LP, LLC also holds rental real property worth $475,000 subject to a $200,000 liability, which is reasonably expected to earn $20,000 of net rental income each year. In this case the regulations conclude that there is a commercially reasonable expectation of payment of the full $300,000 payment obligation by LLC. Note this is true even though the obligor, in theory, would have only $295,000 of net assets, projected to the end of the first full year of LP's operations. The real property is worth $475,000 and subject to a liability of $200,000, so if LLC were to immediately liquidate the real estate, it would presumably net $275,000. The net rental income is projected to be $20,000 per year, so if it is assumed the liability determination date is the end of the year and all net rental income for that year is available to satisfy the debt, LLC would still have only $295,000 of net assets.

Challenges for taxpayers and practitioners

A question not explicitly addressed in either the 2019 final regulations or the preamble is whether the criteria of a commercially reasonable expectation of payment are meant to be an all-or-nothing test, also known as a cliff test. The net value test of the prior regulations and the 2014 proposed regulations was explicitly a "to the extent of" test, meaning that an obligation could be respected as a recourse liability of a partner to the extent that partner had sufficient net value to cover the obligation. Any excess over that amount was treated as nonrecourse, resulting in a bifurcation of the obligation where the net value of the obligor was less than the balance of the obligation.

While the regulations do not explicitly state that the test is a cliff test, Example 2 implies that it is. The example states that the full $300,000 of the obligation is respected as recourse. This conclusion is reached even though the entity could only reasonably be deemed to have $295,000 in available assets to satisfy the obligation if it became immediately due in full. If any doubt existed about whether this was a cliff test, Holly Porter, IRS associate chief counsel (Passthroughs and Special Industries), said, "I will confirm it is a cliff test," at a New York State Bar Association conference in New York on Jan. 28, 2020, in reference to the rules requiring a commercially reasonable expectation of payment (Yauch and Sheppard, "IRS Clarifies Aspects of Partnership Debt Regs," 166 Tax Notes Federal 799 (Feb. 2, 2020)).

While the facts of Example 2 potentially illustrate a favorable implication of the cliff test, it is not difficult to imagine more taxpayer-unfavorable circumstances. Take, for example, a limited partnership where the general partner has an unlimited deficit restoration obligation that results in a $1,000,000 payment obligation under the constructive liquidation rules set forth in Regs. Sec. 1.752-2(b)(1). If the general partner is a disregarded entity whose only asset is corporate stock with an FMV of $500,000, then even though the general partner could presumably satisfy half of that obligation, there is a significant risk that none of the obligation would be respected as a recourse obligation. Under the previous net value test, the same facts would have resulted in a $500,000 recourse liability allocation to the general partner and a $500,000 nonrecourse allocation among the partners.

Arguably, the old net value test better reflected the true economics than the cliff test in the final regulations. While the net value test had the shortcoming of not considering future income flows that creditors would take into account, it did have the advantage of a simplified test for taxpayers and practitioners to make proper liability determinations. With the final regulations, practitioners must advise their clients to consider "factors a third party creditor would take into account when determining whether to grant a loan." For taxpayers not in the business of lending, this can be a significant challenge, as any facts-and-circumstances analysis inevitably results in differing treatment when essentially the same facts are presented to different taxpayers.

For example, consider the general partner referenced above whose only asset is $500,000 of stock available to satisfy a $1,000,000 payment obligation. What if that stock is expected to pay $50,000 of dividends every year? Or the stock is that of a startup company whose price has been experiencing exponential growth? Either of these would be factors a third-party creditor would consider when deciding to make a loan, but without expertise in lending, it may be difficult for a partnership to determine at what point a partner's payment obligation crosses the "commercially reasonable expectation of payment" line and suddenly becomes respected as a recourse obligation.

The challenge of determining whether a commercially reasonable expectation of payment exists is not exclusively applied to general partners or to disregarded entities; the updated rules literally apply to all partners and all payment obligations. As illustrated above, the facts-and-circumstances nature of the test makes it challenging for taxpayers and practitioners to apply with consistency. In order to properly classify obligations, a taxpayer must first determine which obligations exist. Obligations may arise from state law, the partnership operating agreement, loan documents, separate guarantees, indemnities, etc. Once all obligations are identified, taxpayers then need to determine for each obligation whether the obligor has a commercially reasonable expectation of being able to make payment. This is a time-consuming and onerous process for taxpayers, especially for those with multiple liabilities and obligors. The proper designation of these liabilities is crucial for several reasons.

All partners are subject to the Sec. 704(d) basis limitation, which includes, as a component, each partner's share of liabilities. Failure to properly classify a liability as recourse or nonrecourse may result in an over- or under-allocation of that liability to the partners. This in turn could result in a number of errors including overstating allowable losses claimed by the partner, gain recognized on cash distributions, or incorrect gain recognized on sale of a partnership interest. For partners subject to the Sec. 465 at-risk limitation, errors in categorization between recourse and nonrecourse may also result in incorrect allowance of losses or incorrect triggering of recapture amounts.

For partnerships subject to the centralized partnership audit regime rules, even if incorrect categorization does not result in an error in taxable income, it can still give rise to an imputed underpayment. In fact, Example 7 in Regs. Sec. 301.6225-1(h) describes a $100 partnership liability that was initially reported as a recourse liability, but, upon examination, the IRS determined the liability was nonrecourse. In that example, the $100 adjustment "is treated as a $100 increase in income because such recharacterization of a liability could result in up to $100 in taxable income." Use of the words "could result" shows that the burden shifts to the taxpayer to establish whether there was an impact of the mischaracterization at the partner level. Even though the mischaracterization may not have any taxable income effect on any of the partners' returns for the tax year in question, the default treatment is still an imputed underpayment.

Barring modification or a push-out election, the partnership would pay tax on the imputed underpayment amount at the highest applicable rate for the tax year in question. It is possible for the partnership to request a modification of the imputed underpayment under Regs. Sec. 301.6225-2, but the burden of proof for showing that the change in liability allocation did not impact the taxable income of the partners is shifted to the partnership. The time and effort undertaken by the partnership at that point will almost certainly be greater than the amount of time it would have taken to get the liability allocation correct initially. So, as with many things in life, an ounce of prevention is worth a pound of cure.

Carefully assessing partners' ability to pay

The 2019 final regulations represent a significant change from the prior regulations and from the 2014 proposed regulations. On the one hand, the new rule requiring a commercially reasonable expectation of payment is more economically realistic in its consideration of future sources of income in addition to current net value. However, the cliff test element will now cause payment obligations that would have previously been partially respected as recourse to be entirely treated as nonrecourse if a commercially reasonable expectation of payment does not exist for the full amount of the obligation. The facts-and-circumstances nature of the test makes it difficult for both taxpayers and practitioners to apply correctly. That difficulty is only more concerning for partners, given the implications it has for their Secs. 704(d) and 465 limitations.

For partnerships subject to the centralized partnership audit regime rules, a disagreement with the IRS on what constitutes a commercially reasonable expectation of payment may result in an imputed underpayment. Even if the initial imputed underpayment does not ultimately result in a tax liability, it will be burdensome to prove that result to the IRS. Thus, partnerships should carefully consider whether their partners actually have a commercially reasonable expectation of being able to fulfill their payment obligations. Practitioners should carefully advise their clients on the risks created, at both the partnership and partner level, by failing to properly analyze and categorize payment obligations.

EditorNotes

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 kdanderson@bdo.com.

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

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