On December 13, 2013, the Internal Revenue Service and U.S. Department of the Treasury issued proposed regulations under Section 752 regarding recourse liabilities of a partnership and the special rules for related persons (Proposed Regulations).  The Proposed Regulations provide guidance as to when and what extent a partner is treated as bearing the economic risk of loss (EROL) for a partnership liability when multiple partners bear the EROL for the same partnership liability (overlapping EROL).  The Proposed Regulations also provide guidance as to when a partner has a payment obligation with respect to a liability or makes a nonrecourse loan to the partnership (and no other partner bears the EROL for that liability) and such partner is related to another partner in the partnership.

On December 13, 2013, the Internal Revenue Service (IRS) and U.S. Department of the Treasure (Treasury) issued the proposed regulations under Section 752 regarding recourse liabilities of a partnership and the special rules for related persons (Proposed Regulations).  The Proposed Regulations address the uncertainty related to treating a partner as bearing the economic risk of loss (EROL) for a partnership liability when there are multiple partners that bear the EROL for the same partnership liability (overlapping EROL).  The Proposed Regulations also address when a partner has a payment obligation with respect to a liability or makes a nonrecourse loan to the partnership (and no other partner bears the EROL for that liability) and such partner is related to another partner in the partnership.

The Proposed Regulations have generally been well received by practitioners, who view them as clarifying issues raised by the U.S. Tax Court’s decision in IPO II v. Commissioner, 122 T.C. 295 (2004) (IPO II), with respect to the “related-partner exception” under Treas. Reg.§ 1.752-4(b)(2)(iii). 

Section 752—Generally

Under Section 752, a partner may include her share of partnership liabilities in the basis of her partnership liabilities.  The determination of a partner’s share of partnership liabilities is therefore important in determining, for example, the partner’s ability to deduct partnership losses under Section 704(d) and whether a distribution of cash from the partnership will result in the recognition of gain under Section 731.  Section 752(a) provides that any increase in a partner’s share of partnership liabilities (or an increase in a partner’s individual liabilities by reason of the assumption by the partner of partnership liabilities) will be considered a contribution of money by the partner to the partnership.  Section 752(b) provides that any decrease in a partner’s share of partnership liabilities (or a decrease in a partner’s individual liabilities by reason of the assumption by the partner of partnership liabilities) will be considered a distribution of money to the partner by the partnership.

The rules for determining a partner’s share of partnership liabilities differ depending on whether the liability is recourse or nonrecourse.  Treas. Reg. § 1.752-1(a) provides that a partnership liability is a recourse liability to the extent that any partner or related person bears the EROL for that liability under Treas. Reg. § 1.752-2.  To the extent that no partner or related person bears the EROL for a liability, the liability is nonrecourse.  The Proposed Regulations address only the allocation of recourse liabilities.

Treas. Reg. § 1.752-2(a) provides that a partner’s share of a recourse liability equals the portion of that liability, if any, for which the partner or related person bears the EROL.  Treas. Reg. § 1.752-2(b)(1) provides that a partner bears the EROL for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment on the partnership obligation to any person or a contribution to the partnership (payment obligation) because the liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or a person that is related to another partner.  Under this rule, EROL borne by a person who is related to a partner is attributed to the partner even if the partner itself has no EROL.  As described below, complexities arise when such a related person is related to multiple partners.

Overlapping Economic Risk of Loss

The existing regulations are unclear as to how multiple partners share a liability when each has EROL with respect to such liability.  This could occur, for example, if two or more partners guarantee the same liability.  The IRS and Treasury believe that former temporary regulations that preceded the final Section 752 regulation issued in 1991 provide an appropriate rule for overlapping EROL situations.  Former Temp. Treas. Reg. § 1.752-1T(d)(3)(i) provided that “if the aggregate amount of the economic risk of loss that all partners are determined to bear with respect to a partnership liability (or portion thereof) ... exceeds the amount of such liability (or portion thereof), then the economic risk of loss borne by each partner with respect to such liability shall equal the amount determined by multiplying the amount of such liability (or portion thereof) by the sum of such amounts for all partners.”  The Proposed Regulations seek to bring back this rule.

Tiered Partnerships

The Proposed Regulations recognize that the current rules regarding allocating liabilities in a tiered partnership structure may also result in overlapping EROL.

Treas. Reg. § 1.752-2(i) provides that if an upper-tier partnership owns (directly or indirectly through one or more partnerships) an interest in a lower-tier partnership, the liabilities of the lower-tier partnership are allocated to the upper-tier partnership in an amount equal to the sum of: (i) the amount of the EROL that the upper-tier partnership bears with respect to the liabilities and (ii) the amount of any other liabilities with respect to which partners of the upper-tier partnership bear the EROL.  Treas. Reg. § 1.752-4(a) further provides that an upper-tier partnership’s share of the liabilities of a lower-tier partnership (other than any liability of the lower-tier partnership that is owed to the upper-tier partnership) is treated as a liability of the upper-tier partnership for purposes of applying Section 752 and the regulations thereunder to the partners of the upper-tier partnership.  Thus, under the current rules, a recourse liability of a lower-tier partnership is allocated to an upper-tier partnership if the upper-tier partnership, or one of its partners, bears the EROL for the liability.

However, where a partner of the upper-tier partnership is also a partner in the lower-tier partnership, and such partner bears EROL for a liability of the lower-tier partnership, the current rules do not address how the lower-tier partnership should allocate such liability between the upper-tier partnership and the partner.  In this instance, Prop. Treas. Reg. § 1.752-2(i)(2) provides that the lower-tier partnership should allocate the liability directly to the partner.  Thus, the Proposed Regulations prevent the lower-tier partnership from allocating the liability to an upper-tier partnership.

Related Party Rules

Constructive Ownership of Stock

Treas. Reg. § 1.752-4(b)(1) provides that a person is related to a partner if the partner and the person bear a relationship to each other specified in Section 267(b) or 707(b)(1), except that 80 percent is substituted for 50 percent or more in each section in applying the constructive ownership rules.  Furthermore, a person’s family is determined by excluding siblings, and Sections 267(e)(1) and 267(f)(1)(A) are disregarded.

Section 267(c)(1) provides that stock owned directly or indirectly by or for a partnership is considered as owned proportionately by or for its partners.  Thus, under the current rules, if a partnership owns all of the stock of a corporation, a partner that owns 80 percent or more of the interests in the partnership is considered to be related to the corporation.  If the corporation has a payment obligation with respect to a liability of its partnership owner or the corporation lends to the partnership and the EROL for the liability is not borne by another party, any partner that is treated as related to the corporation is treated as bearing the EROL for the partnership liability under Treas. Reg. § 1.752-2.

However, the IRS and Treasury believe that a partner in a partnership that owns stock in a corporation that is a lender to the partnership or has a payment obligation with respect to a liability of its partnership owner should not be treated as related, through ownership of the partnership interest, to the corporation.  Thus, Prop. Treas. Reg. § 1.752-(b)(1)(iv) provides that for purposes of Treas. Reg. § 1.752-4(b)(1), Section 267(c)(1) is disregarded in determining whether a partner in a partnership is considered as owning stock in the corporation that is a lender or has a payment obligation with respect to a liability of its partnership owner.

Relation to Multiple Partners

Treas. Reg. § 1.752-4(b)(2)(i) provides that if a person is related to more than one partner in a partnership, the related party rules in Treas. Reg. § 1.752-4(b)(1) are applied by treating the person as related only to the partner with whom there is the highest percentage of related ownership (greatest percentage rule).  Where two or more partners have the same percentage of related ownership and no other partner has a greater percentage, the regulation provides that a partnership liability is allocated equally among such partners.

The Proposed Regulations remove the greatest percentage rule because the IRS and Treasury agreed with comments that the ultimate determination of a person’s relatedness to a partner should not be based on which partner has the highest percentage of related ownership and agreed that removal of the greatest percentage rule eases the administrative burden in determining precise ownership percentages.  Instead, the greatest percentage rule was replaced with Prop. Treas. Reg. § 1.752-4(b)(3), which provides that if a person is a lender or has a payment obligation for a partnership liability and the person is related to more than one partner in a partnership, the partnership liability is shared equally among the partners.

Related Partner Exception

Treas. Reg. § 1.752-4(b)(2)(iii) provides that persons owning interests directly or indirectly in the same partnership are not treated as related persons for purposes of determining the EROL borne by each of them for the liabilities of the partnership (related partner exception).  The Tax Court in IPO II explained that the purpose of the related partner exception is to prevent the shifting of basis from a partner who bears EROL to a related partner who does not.  The IRS and Treasury acknowledge that IPO II could be read expansively (beyond the facts of the case), so that the related partner exception would turn off the attribution of EROL between related partners even when none of the related partners directly bear the EROL for a partnership liability.  Such an interpretation could lead to unintended results, such as causing intercompany debts to be treated as nonrecourse because no partner alone owns 80 percent or more of the lending company and the partners are not treated as related to each other.  Under the Proposed Regulations, an owner of a partnership interest (directly or through one or more other partnerships) would not be treated as related to another owner of an interest in the same partnership (directly or through one or more partnerships) with respect to that portion of a partnership liability for which the latter has a payment obligation or is the lender.  Thus, the related partner exception should apply to sever a relationship between two partners only where one partner has a payment obligation or is a lender with respect to a partnership liability, such as was the case in IPO II.  This rule is not explicitly stated in the text of the Proposed Regulations, but it is illustrated in the examples.  Prop. Treas. Reg. § 1.752-4(b)(2) also clarifies that an indirect interest in a partnership is an indirect interest through one or more partnerships.

Effective Date

The Proposed Regulations will apply to liabilities incurred or assumed by a partnership on or after the date that they are published as final regulations in the Federal Register.  Comments on the Proposed Regulations are due by March 17, 2014.

Conclusion

The Proposed Regulations provide rules on a few discrete liability allocation issues that the existing regulations do not directly address or leave somewhat ambiguous.  As such, the Proposed Regulations are welcome guidance, even though they do not address many other circumstances that may result in inappropriate allocation of liabilities in a manner that does not reflect the EROL of the partners.  Meanwhile, we await the outcome of a guidance project that we understand Treasury is undertaking that could more significantly change how a partner’s share of debt is determined under Section 752, such as potential net worth requirements and the treatment of bottom dollar guarantees.