On January 29, 2014, the U.S. Department of the Treasury and the Internal Revenue Service issued far-reaching and extremely taxpayer-adverse proposed regulations dealing with the allocation of partnership recourse and nonrecourse liabilities.  In many cases, the proposed changes may result in the recognition of taxable gain by partners or limit a partner’s ability to take partnership losses into account.  All taxpayers who have negative tax basis capital accounts or who have entered into or will enter into guarantees, deficit restoration obligations (DROs) or similar obligations with respect to partnership liabilities should consult with their tax advisors as to the potential impact of the proposed changes.

On January 29, 2014, the U.S. Department of the Treasury and the Internal Revenue Service issued far-reaching and extremely taxpayer-adverse proposed regulations dealing with the allocation of partnership recourse and nonrecourse liabilities under Section 752 (the Proposed Regulations).  (Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended, or to Treasury Regulations promulgated thereunder.)  The Proposed Regulations also include changes to the partnership disguised sale rules that generally clarify the existing rules.

A partner’s allocable share of partnership liabilities is taken into account in the partner’s tax basis in the partnership interest.  A reduction in a partner’s allocation of partnership liabilities is treated as a deemed cash distribution to the partner under Section 752(b).  In addition, Section 704(d) limits the amount of partnership losses that can be taken into account by a partner to the partner’s tax basis in the partnership.  Accordingly, to the extent the proposed changes result in a reduction in a partner’s allocable share of partnership liabilities, they have the potential to trigger gain for many partners with negative tax basis capital accounts or limit a partner’s ability to take losses into account.

The Proposed Regulations will apply prospectively from the date they are published as final regulations.  In addition, the Proposed Regulations provide for a seven-year transition period with respect to the changes to the partnership recourse debt allocation rules during which certain obligations may still be taken into account under the existing rules.

Partnership Recourse Liabilities

Under the current Section 752 regulations, a partnership liability is allocated to a partner as a partnership recourse liability to the extent that such partner bears the “economic risk of loss” for the liability under a relatively mechanical “constructive liquidation test.”  Pursuant to Treas. Reg. § 1.752-2(b), a partner is treated as bearing the economic risk of loss for a partnership liability to the extent that, if the partnership’s assets were worthless and the partnership liquidated, the partner or a related person would be obligated to make a payment because the liability becomes due and payable.  For this purpose, obligations of the partner or a related person with respect to the liability, including obligations to the lender, the partnership or other partners, are taken into account.  Treas. Reg. § 1.752-2(b)(6) sets forth a general presumption that a partner or related person will in fact satisfy an obligation to make a payment to a creditor or the partnership in connection with the constructive liquidation of the partnership irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation.  For obligations entered into by entities that are disregarded as separate from their owners, however, Treas. Reg. § 1.752-2(k) limits the allocation of partnership recourse debt on account of such obligations to the extent of the net value of the disregarded obligor.

In contrast to the current relatively mechanical and administrable partnership recourse debt allocation rules, the Proposed Regulations would impose a six-factor test, some of which are entirely subjective, in order for a payment obligation to be taken into account in determining whether a partner or related person bears the economic risk of loss for a partnership liability.  Specifically, a payment obligation such as a guarantee or indemnity must satisfy the following six requirements to be taken into account:

1. The obligor must maintain a commercially reasonable net worth throughout the term of the payment obligation, or be subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration.

2. The obligor must be required to periodically provide commercially reasonable documentation regarding the obligor’s financial condition.

3. The term of the obligation must not end prior to the term of the partnership liability.

4. The payment obligation must not require that the primary obligor or any other obligor with respect to the partnership liability directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor.

5. The obligor must receive arm’s length consideration for assuming the payment obligation.

6. In the case of a guarantee or similar arrangement, the obligor must be liable up to the full amount of such obligor’s payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied. 

The sixth factor noted above is extremely broad and would prevent any obligation that is not a “top” guarantee or similar arrangement from being taken into account.  As a result, a “bottom guarantee,” including a guarantee of the bottom 99% of a partnership liability, would be disregarded under the Proposed Regulations.  A “vertical slice” guarantee (i.e., 50% of every dollar of shortfall) would also not be recognized.  In addition, the Proposed Regulations provide that, if there is more than one obligor, even a “top” guarantee or similar obligation would be disregarded unless the obligors are jointly and severally liable.  The Proposed Regulations further provide that a “top” guarantee must be disregarded if the obligor has any right of indemnification from any person with respect to the guarantee.  This would presumably preclude an obligor from insuring an obligation.  Although the status of deficit restoration obligations is not specifically addressed in the Proposed Regulations, they may also be adversely affected.

The Proposed Regulations also impose the Treas. Reg. § 1.752-2(k) net value requirement currently applicable only to disregarded entities on any partner, other than an individual or decedent’s estate, that enters into an obligation with respect to a partnership liability.  Accordingly, to the extent that an obligation is taken into account under the six-factor test described above, the allocation of a partnership liability on account of the obligation entered into by such a partner or related person will be limited to such obligor’s net value.  In addition, the Proposed Regulations require that an obligor subject to the net value requirement must provide information to the partnership as to the obligor’s net value that is appropriately allocable to the partnership’s liabilities on a timely basis.

The changes to the partnership recourse debt rules will apply prospectively with respect to obligations imposed or undertaken on or after the date final regulations are published, other than liabilities incurred or assumed and payment obligations imposed or undertaken pursuant to a written binding contract.  Although the precise scope of this rule is not clear, it may allow certain existing guarantees under “debt maintenance agreements” to be grandfathered, provided they are not altered after the date final regulations are published.

The Proposed Regulations also provide for a seven-year transition period, during which a partnership may choose not to apply the new partnership recourse debt allocation rules to an amount of partnership liabilities equal to an obligor partner’s negative tax basis capital account.  The amount of partnership liabilities to which the transition rule applies is reduced to the extent the built-in gain attributable to the obligor partner’s negative tax basis capital account is recognized.  In addition, if the obligor partner is a partnership, S corporation or disregarded entity, a 50% or more change in ownership of the obligor partner will terminate the transition period.  Because the seven-year transition rule applies only if elected by the partnership, partners that have entered into or will enter into guarantees and similar obligations with respect to partnership liabilities should take steps now to require that the partnership elect to apply the seven-year transaction rule if the Proposed Regulations are finalized and the partner so requests.

Partnership Nonrecourse Liabilities

A partnership liability is a nonrecourse liability to the extent that no partner or related person bears the economic risk of loss for that liability.  Under Treas. Reg. § 1.752-3(a), a partner’s share of partnership nonrecourse liabilities equals the sum of three “tiers” of allocations.  First, a partner is allocated an amount of nonrecourse liabilities of a partnership equal to the amount of such partner’s share of partnership minimum gain determined pursuant to Section 704(b).  Partnership minimum gain with respect to a liability is generally the excess of the amount of a nonrecourse liability over the Section 704(b) “book value” of property securing the liability.  Second, a partner is allocated an amount of the nonrecourse liabilities of a partnership equal to the amount of any taxable gain that would be allocated to the partner under Section 704(c) (or in the same manner as under Section 704(c) if partnership property is revalued) if the partnership disposed of all partnership property subject to nonrecourse liabilities for no consideration other than full satisfaction of the liabilities.  The second tier amount is often referred to as “Section 704(c) minimum gain.”  Finally, a partner’s share of the amount of nonrecourse liabilities that is not allocated to partners pursuant to the first or second tiers is determined in accordance with the partner’s share of partnership profits.  The partner’s interest in partnership profits is determined by taking into account all facts and circumstances related to the economic arrangement of the partners.

The current regulations provide that the partnership agreement may specify the partner’s interest in partnership profits for purposes of allocating excess nonrecourse liabilities provided the interest so specified is reasonably consistent with allocations (that have substantial economic effect under the Section 704(b) regulations) of some significant item of partnership income or gain (the Significant Item Method).  Alternatively, the current regulations provide that excess nonrecourse liabilities may be allocated among the partners in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated (the Alternative Method).  Additionally, the partnership may first allocate excess nonrecourse liabilities to a partner up to the amount of built-in gain that is allocable to the partner on Section 704(c) property or property for which reverse Section 704(c) allocations are applicable by virtue of a book-up (as described in Treas. Reg. § 1.704-3(a)(6)(i)) where such property is subject to the nonrecourse liability to the extent that such built-in gain exceeds the amount of gain taken into account under the second tier with respect to such property (the Excess Section 704(c) Method).

While the Proposed Regulations retain the Excess Section 704(c) Method for allocating excess nonrecourse liabilities, the Significant Item Method and the Alternative Method would both be eliminated.  Instead, the Proposed Regulations would allow a partnership to allocate excess nonrecourse liabilities based on the partners’ “liquidation value percentages.”  A partner’s initial liquidation value percentage would be equal to the partner’s percentage of partnership capital.  A partner’s liquidation value percentage would be required to be re-determined whenever a Section 704(b) revaluation event occurs (i.e., a disproportionate capital contribution or distribution), regardless of whether the partnership actually revalues its assets.  In addition, the Proposed Regulations impose an administrative burden on partnerships that must value all of the partnership’s assets any time a recalculation of the partners’ liquidation value percentages is required.

Partnership Disguised Sales

In addition to the proposed changes to the partnership debt allocation rules described above, the Proposed Regulations also include clarifications to the rules related to partnership disguised sale transactions under Section 707.  The most significant of these changes relates to the exception from disguised sale treatment for certain reimbursements of pre-formation capital expenditures set forth in Treas. Reg. § 1.707-4(d).

The current partnership disguised sale regulations provide that a reimbursement of pre-formation capital expenditures will not be treated as part of a sale of property by a contributing partner to a partnership if such expenditures are incurred during the two-year period preceding the transfer by the partner to the partnership and are incurred by the partner with respect to partnership organization and syndication costs described in Section 709, or property contributed to the partnership by the partner, but only to the extent the reimbursed capital expenditures do not exceed 20% of the fair market value of such property at the time of contribution.  The 20% of fair market value limitation does not apply, however, if the fair market value of the contributed property does not exceed 120% of the partner’s adjusted basis in the contributed property at the time of contribution.

The Proposed Regulations clarify that the 20% and 120% tests described above must be applied on a property-by-property basis and not on an aggregate basis.  In addition, the Proposed Regulations clarify that, to the extent a partner has funded a capital expenditure through a borrowing, the reimbursement of preformation expenditures exception to the disguised sale rules only applies to the extent the transfer of money or other consideration to the partner does not exceed the partner’s allocable share of the liability.

Conclusion

If finalized, the changes to the partnership debt allocation rules in the Proposed Regulations would be one of the most significant changes in partnership tax law in more than 20 years.  In contrast to the existing regulations that are largely mechanical and administrable, the proposed changes would impose unclear, subjective and, in some cases, non-commercial requirements on payment obligations commonly entered into by partners in order for such obligations to be taken into account.  The new subjective criteria introduced by the Proposed Regulations create a level of uncertainty that cannot serve the interests of proper administration of the tax laws.

In many cases, the proposed changes may result in the recognition of taxable gain by partners or limit a partner’s ability to take partnership losses into account as a result of a reduction in their allocable share of partnership liabilities.  All taxpayers who have negative tax basis capital accounts or who have entered or will enter into obligations with respect to partnership liabilities should consult with their tax advisors as to the potential impact of the Proposed Regulations.