/>iRecently, the Treasury Department and IRS released final regulations (89 Fed. Reg. 231) on the allocation of partnership recourse liabilities and related-party rules under Section 752 (the Final Regulations). The Final Regulations resolve some ambiguities by implementing ordering and tie-breaking provisions to determine which partner has the “economic risk of loss” with respect to a recourse liability.
Background
Section 752 and its accompanying regulations require a partnership to allocate its liabilities among its partners, generally resulting in an increase to a partner’s basis in the partnership interest. Section 752 is critical for two reasons. First, a partner cannot deduct partnership losses in excess of their basis, and second, a partner that receives any cash distribution in excess of their basis will recognize gain.
Critical to the operation of Section 752 and its regulations is the separation of liabilities into “recourse” and “nonrecourse” liabilities. A recourse liability will be allocated among the partners that bear the “economic risk of loss” (EROL). Generally, a partner bears the EROL for a recourse liability where the partner would be obligated to pay a creditor if all the partnership assets became worthless, and the liability became due.
Key Highlights of Final Regulations
1. Overlapping EROL
Prior Section 752 regulations failed to address a situation where more than one partner bears the EROL for the same liability. The Final Regulations adopt a proportionality rule to address this situation. Specifically, the Final Regulations multiply the recourse liability amount by a fraction with the partner’s EROL in the numerator and aggregate partner EROL in the denominator.
Example: A and B are partners in AB Partnership. AB Partnership borrows $100 from a bank. A guarantees the full $100 while B guarantees only $50, thus A bears $100 EROL and B bears $50 EROL. The Final Regulations allocate $67 to A ($100 x $100/$150) and $33 to B ($100 x $50/$150).
2. Tiered Partnerships
The Final Regulations also resolve ambiguity around recourse liability allocation where a partner in an upper-tier partnership (UTP) is also a partner in a lower-tier partnership (LTP). The prior regulations were unclear as to whether LTP was required to allocate all or a portion of the liability directly to the partner or to the UTP.
The Final Regulations clarify this ambiguity by continuing the proportionality rule and requiring that LTP liabilities are allocated to the UTP in an amount equal to the sum of (i) LTP liabilities the UTP directly bears the EROL plus (ii) any other liability amount to which a partner of a UTP bears the EROL so long as this partner is not also a partner in the LTP.
Example: A and B are 90% and 10% partners, respectively, in UTP. UTP and A are 90% and 10% partners, respectively, in LTP. LTP borrows $100. A and B provide personal guaranties for LTP’s $100 debt. The Final Regulations require LTP to allocate $50 of the LTP liability to A (by virtue of A’s direct interest and guarantee) ($100 x $100/$200) and allocate $50 to UTP (by virtue of B’s guarantee) ($100 x $100/$200).
3. Related-Partner Exception
The Final Regulations also seek to clarify the related-partner exception that resulted from IPO II v. CIR, 122 T.C. 295 (2004). The Final Regulations provide that if a taxpayer has a direct or indirect interest in a partnership, and that taxpayer also has a direct EROL for a partnership liability, then that taxpayer will be treated as unrelated to all other direct and indirect partners when allocating partnership liabilities.
Example: A wholly owns B Corp. and C. Corp. A and C Corp. are partners in Partnership AC. Partnership AC borrows $100. A and B Corp. provide guaranties for the amount. The Final Regulations would provide that A and C Corp. are unrelated and none of A’s or B Corp.’s EROL would be attributed to C Corp. Therefore, A is the only partner with EROL for the $100.
