IRS Finalizes Regs on Partnership Disguised Sales and Recourse Liabilities

(Parker Tax Publishing October 2019)

The IRS issued final disguised sale regulations, replacing unfavorable temporary regulations that had been issued in 2016 in T.D. 9788 with final regulations that were in effect before the issuance of T.D. 9788. The IRS also issued final regulations addressing (1) when certain obligations to restore a deficit balance in a partner's capital account are disregarded under Code Sec. 704, (2) when partnership liabilities are treated as recourse liabilities under Code Sec. 752, and (3) how bottom dollar payment obligations are treated under Code Sec. 752. T.D. 9876; T.D. 9877.

Background

On January 30, 2014, the IRS issued proposed regulations (REG-119305-11) relating to disguised sales of property to or by a partnership and concerning the treatment of partnership liabilities (2014 proposed regulations). The 2014 proposed regulations were intended to clarify the application of the disguised sale rules under Code Sec. 707 and also contained rules regarding the sharing of partnership recourse and nonrecourse liabilities under Code Sec. 752.

On October 5, 2016, the IRS issued final disguised sale regulations under Code Sec. 707 concerning disguised sales, as well as regulations under Code Sec. 752 regarding the allocation of excess nonrecourse liabilities of a partnership to a partner for disguised sale purposes (T.D. 9787). Also on October 5, 2016, the IRS issued final and temporary regulations (T.D. 9788) implementing a new rule on the allocation of liabilities for Code Sec. 707 purposes (707 temporary regulations) and rules on the treatment of bottom dollar payment obligations (752 temporary regulations). The 707 temporary regulations proved unpopular with practitioners. Finally, on October 5, 2016, the IRS withdrew the 2014 proposed regulations under Reg. Sec. 1.752-2 and published new proposed regulations (REG-122855-15) cross-referencing the 707 temporary regulations (707 proposed regulations) and the 752 temporary regulations and addressing (1) when certain obligations to restore a deficit balance in a partner's capital account are disregarded under Code Sec. 704 and (2) when partnership liabilities are treated as recourse liabilities under Code Sec. 752 (752 proposed regulations).

On June 19, 2018, the IRS withdrew the 707 temporary regulations and issued proposed regulations (REG-131186-17) reinstating the regulations concerning how partnership liabilities are allocated for disguised sale purposes that were in effect before the 707 temporary regulations were issued (2018 proposed regulations). The 2018 proposed regulations also withdrew proposed regulations (REG-122855-15) that incorporated by cross reference the 707 temporary regulations.

Summary of Applicable Law

Code Sec. 752 separates partnership liabilities into two categories: recourse liabilities and nonrecourse liabilities. Under Reg. Sec. 1.752-1(a)(1), a partnership liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss (EROL) for that liability under Reg. Sec. 1.752-2. Reg. Sec. 1.752-1(a)(2) provides that a partnership liability is a nonrecourse liability to the extent that no partner or related person bears the EROL for that liability under Reg. Sec. 1.752-2.

A partner generally bears the EROL for a partnership liability if the partner or related person has an obligation to make a payment to any person within the meaning of Reg. Sec. 1.752-2(b). For these purposes, an obligation to restore a deficit capital account on liquidation of the partnership under the Code Sec. 704(b) regulations is taken into account (deficit restoration obligation). Further, Reg. Sec. 1.752-2(b)(6) presumes that partners and related persons who have payment obligations actually perform those obligations, irrespective of their net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (the satisfaction presumption). However, the satisfaction presumption is subject to an anti-abuse rule in Reg. Sec. 1.752-2(j) under which a payment obligation of a partner or related person may be disregarded or treated as an obligation of another person if a principal purpose of the arrangement is to eliminate the partner's EROL with respect to that obligation or create the appearance of the partner or related person bearing the EROL when the substance is otherwise. Under the existing rules, the satisfaction presumption is also subject to a disregarded entity net value requirement under Reg. Sec. 1.752-2(k) under which, for purposes of determining the extent to which a partner bears the EROL for a partnership liability, a payment obligation of a disregarded entity is taken into account only to the extent of the net value of the disregarded entity as of the allocation date that is allocated to the partnership liability.

Final Regulations

In T.D. 9876, the 2018 proposed regulations are adopted as final without change, except the applicability date has been revised. To avoid a lapse in rules for allocating partnership liabilities for disguised sale purposes, the final regulations in T.D. 9876 apply to any transaction with respect to which all transfers occur on or after October 4, 2019, the date that the 707 temporary regulations expired. Partnerships and their partners may apply the final regulations in T.D. 9876 to any transaction with respect to which all transfers occur on or after January 3, 2017, the applicability date of the 707 temporary regulations.

In T.D. 9877, the rules in the 752 temporary regulations and the 752 proposed regulations are adopted with some changes.

Under the 752 temporary regulations, taxpayers were required to disclose bottom dollar payment obligations on Form 8275, Disclosure Statement. The final regulations clarify that identifying the payment obligation with respect to which disclosure is made includes stating whether the obligation is a guarantee, a reimbursement, an indemnity, or a deficit restoration obligation. The final regulations also revise the definition of a bottom dollar payment obligation to specifically address capital contribution obligations and deficit restoration obligations. Under the final regulations, a bottom dollar payment obligation includes, with respect to a capital contribution obligation and a deficit restoration obligation, any payment obligation other than one in which the partner is or would be required to make the full amount of the partner's capital contribution or to restore the full amount of the partner's deficit capital account.

The 752 temporary regulations provided an anti-abuse rule under which, irrespective of the form of a contractual obligation, the IRS at its discretion may treat a partner as bearing the EROL with respect to a partnership liability in certain circumstances. In response to comments regarding uncertainty caused by the anti-abuse rule being applied at the IRS's discretion, the final regulations remove the discretionary language consistent with the rule in the regulations under Code Sec. 752 before the 752 temporary regulations were issued.

The 752 proposed regulations added a list of factors to the regulations under Code Sec. 704 specific to deficit restoration obligations to indicate when a plan to circumvent or avoid an obligation exists. One of the factors in the 752 proposed regulations is that the obligation ends, or could by its terms be terminated, before the liquidation of the partner's interest in the partnership or when the partner's capital account is negative. The final regulations add an exception to this factor when a transferee partner assumes the obligation.

The 752 proposed regulations included a list of factors to determine whether a partner's or related person's payment obligation with respect to a partnership liability would be recognized for purposes of Code Sec. 752. One of these factors is whether the partner or related person is required to provide commercially reasonable documentation regarding the partner's or related person's financial condition to the benefited party; another is the existence of a plan or arrangement in which the primary obligor or any other obligor with respect to the partnership liability directly or indirectly holds money or other liquid assets in an amount that exceeds the reasonable foreseeable needs of such obligor. The final regulations provide certain types of commercially reasonable documentation (balance sheets and financial statements) as examples of documents a lender would typically require. The final regulations also clarify that amounts are not held in excess of the reasonably foreseeable needs of an obligor if the partnership purchases standard commercial insurance, such as casualty insurance.

The satisfaction presumption in Reg. Sec. 1.752-2(b)(6) of the existing regulations is subject to a disregarded entity net value requirement under existing Reg. Sec. 1.752-2(k). The 752 proposed regulations proposed to remove Reg. Sec. 1.752-2(k) and instead create a new presumption under the anti-abuse rule in Reg. Sec. 1.752-2(j) under which 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 (including a disregarded entity) will have the ability to make the required payments if the payment obligation becomes due and payable (presumed anti-abuse rule). The final regulations amend Reg. Sec. 1.752-2(k) and clarify how the satisfaction presumption in Reg. Sec. 1.752-2(b)(6) relates to Reg. Sec. 1.752-2(k) in the final regulations. Amended Reg. Sec. 1.752-2(k) applies to all partners of a partnership, including partners that are disregarded entities or grantor trusts.

Under the final regulations, it is assumed that all payment obligors actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate that at the time the partnership determines a partner's share of partnership liabilities under Reg. Sec. 1.705-1(a) and Reg. Sec. 1.752-4(d) there is not a commercially reasonable expectation that the payment obligor will have the ability to make the required payments under the terms of the obligation if the obligation becomes due and payable. A partner or related person's ability to pay may be based on documents such as, but not limited to, balance sheets, income statements, cash flow statements, credit reports, and projected future financial results.

For a discussion of allocations attributable to recourse liabilities, see Parker Tax ¶25,115. For a discussion of transfers treated as disguised sales of property, see Parker Tax ¶25,520.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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