IN-DEPTH: IRS Revamps Partnership Disguised Sale Rules and Partnership Liability Regs

(Parker Tax Publishing October 2016)

The IRS has issued final regulations under Code Sec. 707 and Code Sec. 752 regarding disguised sales of partnership property. In addition, the IRS has issued temporary and proposed regulations concerning how partnership liabilities are allocated for purposes of the disguised sale rules, and when certain liabilities are disregarded or treated as recourse liabilities. The final and temporary regulations are generally effective on October 5, 2016, and taxpayers may rely on the proposed regulations until finalized. T.D. 9787 (10/5/16); T.D. 9788 (10/5/16); REG-122855-15 (10/5/16).

Background

Code Sec. 707 and related regulations provide rules concerning "disguised sales" of property to or by a partnership. A disguised sale can occur when there is a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner. Such a transfer is considered a disguised sale if the transfer to the partners would not have been made but for the transfer of property to the partnership and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.

Certain transactions involving partnership liabilities, however, are not classified as disguised sales. For example, if a partner transfers property to a partnership, the partnership incurs a liability and all or a portion of the proceeds of that liability are traceable to a transfer of money or other consideration to the partner, the transfer of money or other consideration is taken into account for purposes of the disguised sale rules only to the extent that the amount of money or the fair market value of other consideration exceeds the partner's allocable share of the partnership liability (i.e., the debt-financed distribution exception). The disguised sale rules also generally exclude certain types of liabilities from disguised sale treatment. Generally, a partnership's assumption of a qualified liability, or a partnership's taking property subject to a qualified liability, in connection with a transfer of property by a partner to the partnership is not treated as part of a disguised sale.

In determining a partner's share of a partnership liability for disguised sale purposes, regulations provide separate rules for a partnership's recourse liability and a partnership's nonrecourse liability. Generally, a partner's share of a partnership's recourse liability equals the partner's share of the liability under Code Sec. 752 and the related regulations. A partner's share of a partnership's nonrecourse liability is determined by applying the same percentage used to determine the partner's share of the excess nonrecourse liabilities, which are generally determined in accordance with the partner's share of partnership profits.

In T.D. 9787, the IRS issued final regulations under Code Sec. 707 and Code Sec. 752 that substantially adopt proposed regulations (REG-119305-11) published in January 2014 (2014 proposed regulations). The final regulations provide guidance under Code Sec. 707, relating to disguised sales of property to or by a partnership, and under Code Sec. 752, relating to allocations of excess nonrecourse liabilities of a partnership to partners for disguised sale purposes. The IRS has also issued, in T.D. 9788, temporary regulations concerning how liabilities are allocated for purposes of Code Sec. 707 and when certain obligations are recognized for purposes of determining whether a liability is a recourse partnership liability under Code Sec. 752. The temporary regulations also provide guidance on the treatment of "bottom dollar payment obligations."

Finally, the IRS withdrew a portion of the 2014 proposed regulations to the extent not adopted by the final regulations, and has published new proposed regulations (REG-122855-15) under Code Sec. 752 (2016 proposed regulations). The new proposed regulations address when certain obligations to restore a deficit balance in a partner's capital account are disregarded under Code Sec. 704 and when partnership liabilities are treated as recourse liabilities under Code Sec. 752.

An in-depth discussion of the final, temporary, and proposed regulations follows.

I. Final Regulations

Preformation Capital Expenditures and Capital Expenditure Qualified Liabilities

The regulations under Code Sec. 707 provide several exceptions to a transaction being labeled a disguised sale, such as the exception for reimbursements of preformation expenditures in Reg. Sec. 1.707-4(d). Under that exception, transfers of money or other consideration from a partnership to reimburse a partner for certain capital expenditures and costs incurred by the partner (preformation capital expenditures) were not considered disguised sales. The exception generally applies only to the extent the reimbursed expenditures do not exceed 20 percent of the fair market value (FMV) of the transferred property (i.e., the 20 percent limitation). This limitation does not apply where the FMV of the property does not exceed 120 percent of the partner's adjusted basis in that property when it is transferred (i.e., the 120 percent test).

The 2014 proposed regulations provided that the determination of whether the 20 percent limitation and the 120 percent test applied to reimbursements of capital expenditures was made, in the case of multiple property transfers, separately for each property that qualified for the exception (property-by-property rule). Practitioners generally supported the property-by-property rule but noted that in some circumstances the approach could be burdensome and recommended limited aggregation of certain property.

The final regulations adopt the proposed rule and permit aggregation to the extent that, in general: (1) the total FMV of the aggregated property does not exceed the lesser of 10 percent of the total FMV of all property (excluding money and marketable securities) transferred by the partner to the partnership or $1,000,000; (2) the partner consistently applies a reasonable aggregation method that is consistently applied; and (3) the aggregation is not designed to avoid the disguised sale rules. The final regulations also provide that no single property's FMV can exceed 1 percent of the total FMV of the aggregated property.

In addition to the property-by-property rule, the 2014 proposed regulations provided a rule coordinating the exception for preformation capital expenditures with a rule regarding capital expenditure qualified liabilities (i.e. a liability that is allocable under the rules of Reg. Sec. 1.163-8T to capital expenditures) under existing Reg. Sec. 1.707-5(a)(6)(i)(C). Generally, such qualified liabilities are not treated as part of a disguised sale, but the 2014 proposed regulations provided that to the extent a partner funded a capital expenditure through a capital expenditure qualified liability and economic responsibility for that borrowing shifts to another partner, the exception for preformation capital expenditures would not apply because there is no outlay by the partner to reimburse.

Generally, a liability allocable to capital expenditures with respect to the property transferred to the partnership by the partner is a qualified liability (capital expenditure qualified liability), and the partnership may take property subject to such a liability without triggering the disguised sale rules. The final regulations adopt and broaden a rule in the 2014 proposed regulations coordinating the exception for preformation capital expenditures with the capital expenditure qualified liability rule, and provide that, to the extent any qualified liability under Reg. Sec. 1.707-5(a)(6) is used by a partner to fund capital expenditures and economic responsibility for that borrowing shifts to another partner, the exception for preformation capital expenditures does not apply. Under the final regulations, capital expenditures are treated as funded by the proceeds of a qualified liability to the extent the proceeds are either traceable to the capital expenditures under Reg. Sec. 1.163-8T or are actually used to fund the capital expenditures, irrespective of the tracing requirements under Reg. Sec. 1.163-8T. However, under an anti-abuse provision, if capital expenditures and a qualified liability are incurred with a principal purpose to avoid the requirements of this coordinating rule, the capital expenditures are deemed funded by the qualified liability.

The final regulations also provide that when a partner acquires property, assumes a liability, or takes property subject to a liability from another person in connection with certain nonrecognition transactions, the acquiring partner succeeds to the status of the other person for purposes of applying the exception for preformation capital expenditures and for determining whether a liability is a qualified liability under Reg. Sec. 1.707-5(a)(6) (the "step-in-the-shoes" rule). As a result, Rev. Rul. 2000-44 is superseded.

Various methods may be used to determine a partner's share of the excess nonrecourse liabilities. Under one method, a partner's share of excess nonrecourse liabilities is determined in accordance with the partner's share of partnership profits. For this purpose, the partnership agreement may specify the partners' interests in partnership profits so long as the interests so specified are reasonably consistent with allocations (that have substantial economic effect under the Code Sec. 704(b) regulations) of some other significant item of partnership income or gain (i.e., the significant item method). Alternatively, excess nonrecourse liabilities may be allocated among the partners in the manner that deductions attributable to those liabilities are reasonably expected to be allocated (i.e., the alternative method).

For purposes of allocating excess nonrecourse liabilities, the 2014 proposed regulations removed the significant item method and the alternative method under Reg. Sec. 1.752-3(a)(3), but provided a new approach based on a partner's liquidation value percentage. In response to practitioners' concerns that the new method could be subject to manipulation, the final regulations under Reg. Sec. 1.752-3 do not adopt the proposed liquidation value percentage approach for determining partners' interests in partnership profits, and instead retain the significant item method and the alternative method. However, due to concerns of abuse, the final regulations provide that the significant item method and the alternative method do not apply for purposes of determining a partner's share of a partnership liability for disguised sale purposes.

Final Regs Attempt to Mitigate Effect of Shifting Liabilities

The IRS noted that, under the temporary regulations, because a partner cannot be allocated 100 percent of the liabilities for purposes of Code Sec. 707, some amount of both qualified and nonqualified liabilities may shift among partners, potentially triggering the disguised sale rules. To mitigate this effect, the final regulations include a rule under Reg. Sec. 1.707-5(a)(5) that does not take into account qualified liabilities as consideration in transfers of property treated as a sale when the total amount of all liabilities other than qualified liabilities that the partnership assumes, or takes subject to, is the lesser of 10 percent of the total amount of all qualified liabilities the partnership assumes or takes subject to, or $1,000,000.

Anticipated Reduction of Liabilities

For purposes of the disguised sale rules, a partner's share of a liability assumed or taken by a partnership is determined by taking into account certain subsequent reductions in the partner's share of the liability. The 2014 proposed regulations provided that if, within two years of the partnership assuming, taking property subject to, or incurring a liability, a partner's share of the liability is reduced due to a decrease in the partner's or a related person's net value (as described in Reg. Sec. 1.752-2(k)) then the reduction will be presumed to be anticipated and generally must be disclosed under Reg. Sec. 1.707-8. Because the temporary regulations provide that a partner's share of any liability for disguised sale purposes is determined in accordance with the partner's interest in partnership profits under Reg. Sec. 1.752-3(a)(3), net value is not relevant in determining a partner's share of partnership liabilities for disguised sale purposes, and the final regulations do not retain the net value component of the anticipated reduction of share of liabilities rule.

Disguised Sales of Property by a Partnership to a Partner

Under Reg. Sec. 1.707-6, rules similar to those provided in Reg. Sec. 1.707-3 apply in determining whether a transfer of property by a partnership to a partner and one or more transfers of money or other consideration by that partner to the partnership are treated as a disguised sale of property, in whole or in part, to the partner. In the preamble to the 2014 proposed regulations, the IRS requested comments on whether, for purposes of Reg. Sec. 1.707-6, it is inappropriate to take into account a transferee partner's share of a partnership liability immediately prior to a distribution if the transferee partner did not have economic exposure with respect to the partnership liability for a meaningful period of time before appreciated property is distributed to that partner subject to the liability. Because under the temporary regulations a partner's share of all liabilities is determined for disguised sale purposes in accordance with the partner's interest in partnership profits under Reg. Sec.1.752-3(a)(3), the transitory nature of a partner's share of nonqualified liabilities is no longer an issue and the final regulations do not make substantive changes to Reg. Sec. 1.707-6.

II. Temporary Regulations

Elimination of Leveraged Partnership Transaction Abuses

In conjunction with the issuance of temporary regulations, the IRS withdrew portions of the 2014 proposed regulations relating to Code Sec. 752 and issued new proposed regulations under Code Sec. 752 in its place. These new proposed regulations are meant to address certain abuses of concern to the IRS. One abuse relating to disguised sales revolves around the debt-financed distribution exception under Reg. Sec. 1.707-5(b). Under this exception, a distribution of money to a partner by a partnership is not taken into account for purposes of the disguised sale rules to the extent that the distribution is traceable to a partnership borrowing and the amount of the distribution does not exceed the partner's allocable share of the liability incurred to fund the distribution. According to the IRS, the legislative history to Code Sec. 707, upon which the debt-financed distribution exception is based, contemplates a contributing partner borrowing through the partnership rather than engaging in a disguised sale when the partner, in substance, retains liability for repayment of the borrowed amounts. According to the IRS, this exception has been abused through leveraged partnership transactions in which the contributing partners or related persons enter into payment obligations that are not commercial solely to achieve an allocation of the partnership liability to the partner, with the objective of avoiding a disguised sale. The IRS cites the case of Canal Corp. v. Comm'r, 135 T.C. 199 (2010) for this proposition.

After considering the comments on the 2014 proposed regulations suggesting that the regulations be narrowly tailored to address abuse concerns relating to disguised sales, the IRS concluded that, for disguised sale purposes only, it is appropriate for partners to determine their share of any partnership liability, whether recourse or nonrecourse under Code Sec. 752, in the manner in which excess nonrecourse liabilities are allocated under Reg. Sec. 1.752-3(a)(3), as limited for disguised sale purposes in the final regulations under Code Sec. 752. For purposes of the disguised sale rules, this allocation method reflects the overall economic arrangement of the partners more accurately than the current regulations or the 2014 proposed regulations. In most cases, a partnership will satisfy its liabilities with partnership profits, the partnership's assets do not become worthless, and the payment obligations of partners or related persons are not called upon. This is true, the IRS said, whether: (1) a partner's liability is assumed by a partnership in connection with a transfer of property to the partnership or by a partner in connection with a transfer of property by the partnership to the partner; (2) a partnership takes property subject to a liability in connection with a transfer of property to the partnership or a partner takes property subject to a liability in connection with a transfer of property by the partnership to the partner; or (3) a liability is incurred by the partnership to make a distribution to a partner under the debt-financed distribution exception in Reg. Sec. 1.707-5(b).

Accordingly, under the temporary regulations, a partner's share of any partnership liability for disguised sale purposes is the same percentage used to determine the partner's share of the partnership's excess nonrecourse liabilities under Reg. Sec. 1.752-3(a)(3), as limited for disguised sale purposes under the final regulations. Thus, the temporary regulations treat all partnership liabilities, whether recourse or nonrecourse, as nonrecourse liabilities solely for disguised sale purposes under Code Sec. 707.

"Bottom-Dollar" Guarantees Aren't Recognized as Payment Obligations

Under the 2014 proposed regulations, a partner's or related person's payment obligation with respect to a partnership liability would not have been recognized under Reg. Sec. 1.752-2(b)(3) unless seven factors (recognition factors) were satisfied. Two of the seven recognition factors imposed certain additional requirements on contractual obligations outside a partnership agreement, such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors, other partners, or to the partnership (guarantee and indemnity recognition factors). These rules would also prevent certain so-called "bottom-dollar" payment obligations from being recognized for purposes of Code Sec. 752.

The temporary regulations retain the restriction relating to certain guarantees and indemnities, and refine the description of bottom-dollar payment obligations in response to practitioner concerns over the vague definition in the 2014 proposed regulations. Accordingly, the term "bottom dollar payment obligation" includes (subject to certain exceptions) any payment obligation other than one in which the partner or related person is or would be liable up to the full amount of such partner's or related person's payment obligation if, and to the extent that:

(1) any amount of the partnership liability is not otherwise satisfied in the case of an obligation that is a guarantee or other similar arrangement; or

(2) any amount of the indemnitee's or benefited party's payment obligation is satisfied in the case of an obligation which is an indemnity or similar arrangement.

The term also includes an arrangement with respect to a partnership liability that uses tiered partnerships, intermediaries, senior and subordinate liabilities, or similar arrangements to convert what would otherwise be a single liability into multiple liabilities if, based on the facts and circumstances, the liabilities were incurred:

(1) pursuant to a common plan, as part of a single transaction or arrangement, or as part of a series of related transactions or arrangements; and

(2) with a principal purpose of avoiding having at least one of such liabilities or payment obligations with respect to such liabilities being treated as a bottom dollar payment obligation.

The temporary regulations provide an exception for certain obligations meeting the above definitions if a partner or related person has a payment obligation that would be recognized (initial payment obligation) under Reg. Sec. 1.752-2T(b)(3) but for the effect of an indemnity, reimbursement agreement, or similar arrangement. Such bottom dollar payment obligation is recognized under Reg. Sec. 1.752-2T(b)(3) if, taking into account the indemnity, reimbursement agreement, or similar arrangement, the partner or related person is liable for at least 90 percent of the initial payment obligation.

The temporary regulations also provide an anti-abuse rule in Reg. Sec. 1.752-2T(j)(2) to ensure that if a partner actually bears EROL for a partnership liability, partners may not agree among themselves to create a bottom dollar payment obligation so that the liability will be treated as nonrecourse.

In addition the temporary regulations require the partnership to disclose to the IRS all bottom dollar payment obligations with respect to a partnership liability on a completed Form 8275, Disclosure Statement, attached to the partnership return for the taxable year in which the bottom dollar payment obligation is undertaken or modified.

III. 2016 Proposed Regulations

Right of Reimbursement

Reg. Sec. 1.752-2(b)(1) provides that, in general, 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 to any person (or a contribution to the partnership) because that 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 a related person to another partner. Under the 2014 proposed regulations, a partner would not bear the EROL under Reg. Sec. 1.752-2(b)(1) if the partner or related person is entitled to a reimbursement from "any person." Practitioners noted that a reimbursement from "any person" would include a reimbursement from the partnership, which is contrary to the intent of the regulations under Code Sec. 752; accordingly, the 2016 proposed regulations do not include the changes to Reg. Sec. 1.752-2(b)(1).

Arrangements Part of a Plan to Circumvent or Avoid an Obligation

Under the 2014 proposed regulations, a partner's or related person's payment obligation with respect to a partnership liability would not have been recognized under Reg. Sec. 1.752-2(b)(3) unless seven recognition factors were satisfied. Practitioners expressed concerns with this approach, noting that a partner could cause an obligation to deliberately fail one of the recognition factors so as to cause a liability to be treated as nonrecourse if such characterization potentially would be beneficial to such partner, even if that partner did, in fact, bear the EROL.

In response to these concerns, the 2016 proposed regulations move the list of factors to an anti-abuse rule in Prop. Reg. Sec. 1.752-2(j), other than the recognition factors concerning bottom dollar guarantees and indemnities, which are addressed in the temporary regulations. Under the anti-abuse rule, factors are weighed to determine whether a payment obligation should be respected. The 2016 proposed regulations also provide two additional factors that indicate when a plan to circumvent or avoid an obligation exists.

Deficit Restoration Obligations

The 2014 proposed regulations applied the list of recognition factors to all payment obligations under Reg. Sec. 1.752-2(b), including a deficit restoration obligation (DRO). A DRO is an obligation to the partnership that is imposed by the partnership agreement. In contrast, a guarantee or indemnity is a contractual obligation outside the partnership agreement. Because of this difference and based on practitioner comments on the 2014 proposed regulations, the 2016 proposed regulations refine the list of factors applicable to DROs and clarify the interaction of Code Sec. 752 with Code Sec. 704 regarding DROs.

Net Value Rules for Disregarded Entities Replaced With Anti-Abuse Rule

Reg. Sec. 1.752-2(k)(1) provides that, when 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. Methods for determining the net value of a disregarded entity are provided in Reg. Sec. 1.752-2(k)(1). The 2016 proposed regulations remove the Reg. Sec. 1.752-2(k) net value rules and instead provide a new presumption, under the anti-abuse rule in Reg. Sec. 1.752-2(j), which provides that evidence of a plan to circumvent or avoid an obligation is deemed to exist if the facts and circumstances indicate that there is no reasonable expectation that the payment obligor will have the ability to make the required payments if the payment obligation becomes due and payable. If such evidence exists or is deemed to exist, the obligation is not recognized under Reg. Sec. 1.752-2(b) and therefore the partnership liability is treated as nonrecourse.

Effective Dates and Transition Relief

The final and temporary regulations generally apply to any transaction or assumption of liabilities occurring on or after October 5, 2016. In addition, partnerships may apply the temporary regulations under Code Sec. 752 to all of their liabilities as of the beginning of the first tax year of the partnership ending on or after October 5, 2016.

The temporary regulations provide transition relief for any partner whose allocable share of partnership liabilities under Reg. Sec. 1.752-2 exceeds its adjusted basis in its partnership interest on the date the temporary regulations are finalized. Under this transitional relief, the partner can continue to apply the existing regulations under Reg. Sec. 1.752-2 with respect to a partnership liability for a seven-year period to the extent that the partner's allocable share of partnership liabilities exceeds the partner's adjusted basis in its partnership interest on October 5, 2016.

Partnerships and their partners may rely on the 2016 proposed regulations prior to the date they are finalized. However, the net value rules in Reg. Sec. 1.752-2(k) still apply to disregarded entities until the proposed regulations are finalized.

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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