Partnership Prop. Regs Would Change Rules on Disguised Sales and Allocation of Liabilities.

(Parker Tax Publishing February 14, 2014)

On January 29, the IRS issued lengthy proposed regulations on disguised sales of property to or by a partnership, as well as proposed regulations dealing with the treatment of partnership liabilities. The aim of the proposed regulations is to address certain deficiencies and technical ambiguities in the current regulations and issues in determining a partner's share of liabilities under Code Sec. 752. The proposed regulations affect partnerships and their partners and, if adopted, would substantially affect the tax treatment of many partnership transactions. The regulations, issued in REG-119305-11 (1/30/11), are not effective until finalized.

Proposed Changes to the Recourse Liability Rules

Under Reg. Sec. 1.752-2, a partner's share of a recourse partnership liability equals the portion of the liability, if any, for which the partner or related person bears the economic risk of loss. A partner generally bears the economic risk of loss for a partnership liability to the extent the partner, or a related person, would be obligated to make a payment if the partnership's assets were worthless and the liability became due and payable. Subject to an anti-abuse rule and the disregarded entity net value requirement, Reg. Sec. 1.752-2(b)(6) assumes that all partners and related persons will actually satisfy their payment obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (i.e., the satisfaction presumption). Thus, for purposes of allocating partnership liabilities, Reg. Sec. 1.752-2 adopts an ultimate liability test under a worst-case scenario. Under this test, the regulations would generally allocate an otherwise nonrecourse liability of the partnership to a partner that guarantees the liability even if the lender and the partnership reasonably anticipate that the partnership will be able to satisfy the liability with either partnership profits or capital.

The IRS believes that the approach of the existing regulations is not appropriate given that, 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. The concern is that some partners or related persons have entered into payment obligations that are not commercial solely to achieve an allocation of a partnership liability to such partner.

Certain Factors Must Be Present for Liabilities To Be Recognized

As a result, the proposed regulations provide a rule that obligations to make a payment with respect to a partnership liability (excluding those imposed by state law) will not be recognized for purposes of Code Sec. 752 unless certain factors are present. According to the IRS, these factors, if satisfied, will establish that the terms of the payment obligation are commercially reasonable and are not designed solely to obtain tax benefits. Specifically, the rule requires a partner or related person to maintain a commercially reasonable net worth during the term of the payment obligation or be subject to commercially reasonable restrictions on asset transfers for inadequate consideration. In addition, the partner or related person must provide commercially reasonable documentation regarding its financial condition and receive arm's-length consideration for assuming the payment obligation. The rule also requires that the payment obligation's term must not end before the term of the partnership liability and that the primary obligor or any other obligor must not be required to hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor. The rule would also prevent certain so-called bottom-dollar guarantees from being recognized for purposes of Code Sec. 752.

OBSERVATION: A bottom-dollar guarantee is a guarantee of the last dollar of debt. It usually provides that the guarantor is not obligated to make any payments until all attempts at collection have failed to produce repayment to the lender of a specified amount.

Because the IRS feels that because certain partners or related persons might attempt to use certain structures or arrangements to circumvent the rules included in the proposed regulations with respect to bottom-dollar guarantees, the IRS has also revised the anti-abuse rule in Reg. Sec. 1.752-2(j) to address the use of intermediaries, tiered partnerships, or similar arrangements to avoid the bottom-dollar guarantee rules.

Prop. Regs Extend Net Value Requirement

The IRS noted that the satisfaction presumption does not apply to disregarded entities and believes that rule should be extended to other circumstances. Thus, the proposed regulations turn off the satisfaction presumption by extending the net value requirement of Reg. Sec. 1.752-2(k) to all partners or related persons, including grantor trusts, other than individuals and decedents' estates for payment obligations associated with liabilities that are not trade payables. The net value requirement of Reg. Sec. 1.752-2(k) provides that, in determining the extent to which a partner bears the economic risk of loss 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.

In situations in which the satisfaction presumption is turned off, the proposed regulations provide that the partner's or related person's payment obligation is recognized only to the extent of the partner's or related person's net value as of the allocation date. A partner or related person that is not a disregarded entity is treated as a disregarded entity for purposes of determining net value.

OBSERVATION: The IRS considered further extending the net value requirement to partners and related persons that are individuals and decedent's estates, but decided not to require such persons to comply with the net value requirement because of the nature of personal guarantees. However, applying this less restrictive standard to individuals and decedent's estates may disadvantage other entities that enter into partnerships with individuals or decedents' estates. Thus, the IRS is requesting comments on whether the final regulations should extend the net value requirement to all partners and related persons.

Payment Obligations Reduced by Any Reimbursement Right

In determining the amount of any obligation of a partner to make a payment to a creditor or a contribution to the partnership with respect to a partnership liability, Reg. Sec. 1.752-2(b)(1) reduces the partner's payment obligation by the amount of any reimbursement that the partner would be entitled to receive from another partner, a person related to another partner, or the partnership. After considering whether a right to be reimbursed for a payment or contribution by an unrelated person (for example, under an indemnification agreement from a third party) should be taken into account in the same manner, the IRS has concluded that any source of reimbursement that effectively eliminates a partner's payment risk should cause a payment obligation to be disregarded. Therefore, the proposed regulations provide that a partner's payment obligation is reduced by the amount of any right to reimbursement from any person.

Proposed Changes to Nonrecourse Liability Rules

Reg. Sec. 1.752-3 contains rules for determining a partner's share of a nonrecourse liability of a partnership, including the partner's share of excess nonrecourse liabilities under Reg. Sec. 1.752-3(a)(3). 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). Similar to the significant item method, a partnership agreement is allowed to allocate nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liability.

Significant Item Method and Alternative Method Not Appropriate for Allocating Excess Nonrecourse Liabilities

According to the IRS, the allocation of excess nonrecourse liabilities in accordance with the significant item method and the alternative method may not properly reflect a partner's share of partnership profits that are generally used to repay such liabilities because the allocation of the significant item may not necessarily reflect the overall economic arrangement of the partners. Therefore, the proposed regulations remove the significant item method and the alternative method from Reg. Sec. 1.752-3(a)(3).

Liquidation Value Percentage Would Determine Partner's Interest in Profits

The IRS noted the difficulty in determining a partner's interest in partnership profits in other than very simple partnerships and concluded that an appropriate proxy of a partner's interest in partnership profits, and one that can provide the needed certainty, is a partner's liquidation value percentage. Thus, in order to have a bright-line measure of a partner's interest in partnership profits, the proposed regulations adopt a liquidation value percentage approach. Thus, a partner's liquidation percentage, determined upon formation of the partnership and redetermined upon the most recent occurrence of an event described in Reg. Sec. 1.704-1(b)(2)(iv)(f)(5) (i.e., revaluations made principally for a substantial non-tax business purpose), whether or not the capital accounts of the partners are adjusted, would be used to determine a partner's interest in partnership profits. A partner's liquidation value percentage is the ratio (expressed as a percentage) of the liquidation value of the partner's interest in the partnership to the liquidation value of all of the partners' interests in the partnership.

OBSERVATION: According to the IRS, the liquidation value approach may not precisely measure a partner's interest in partnership profits, but the IRS believes that the approach is a better proxy than the significant item and alternative methods and is still administrable. The IRS is asking practitioners for comments on other methods that reasonably measure a partner's interest in partnership profits that are not overly burdensome. In addition, the IRS is requesting comments on whether exceptions should be provided to exclude certain events from triggering a redetermination of the partners' liquidation values.

Proposed Changes to Disguised Sale Rules

In 1992, the IRS issued final regulations under Code Sec. 707(a)(2) relating to disguised sales of property to and by partnerships. No major changes have been made to the rules since then.

Reg. Sec. 1.707-3 generally provides that 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 is treated as a sale of property by the partner to the partnership if, based on all the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of the property and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.

The IRS noted that there are certain deficiencies and technical ambiguities in the existing regulations under Reg. Secs. 1.707-3, 1.707-4, and 1.707-5, and that it is seeking to fix these items with the proposed regulations.

New Ordering Rule Would Apply Debt-Financed Distribution Exception First

There are several exceptions to the disguised sale rules. One of the exceptions is Reg. Sec. 1.707-5(b), which generally provides that a distribution of money to a partner is not taken into account for purposes of the disguised sale rules to the extent 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. This is known as the debt-financed distribution exception. Under a special rule in the existing regulations, if a partnership transfers to more than one partner pursuant to a plan all or a portion of the proceeds of one or more liabilities, the debt-financed distribution exception is applied by treating all the liabilities incurred pursuant to the plan as one liability. Thus, partners who are allocated shares of multiple liabilities are treated as being allocated a share of a single liability, to which any distributee partner's distribution of debt proceeds relates, rather than a share of each separate liability.

According to the IRS, there is uncertainty as to whether the amount of money transferred to a partner that is traceable to a partnership liability is reduced by any portion of the amount that is also excluded from disguised sale treatment under one or more of the other exceptions in Reg. Sec. 1.707-4 (e.g., because the transfer of money is also properly treated as a reasonable guaranteed payment). Thus, the proposed regulations provide that treatment of a transfer should first be determined under the debt-financed distribution exception, and any amount not excluded under that exception should be tested to see if such amount would be excluded under a different exception in Reg. Sec. 1.707-4. This ordering rule, the IRS said, will ensures that the application of one of the exceptions in Reg. Sec. 1.707-4 does not minimize the application of the debt-financed distribution exception.

Changes Made to Exception for Preformation Capital Expenditures

Currently, Reg. Sec. 1.707-4(d) provides an additional exception to the disguised sale rules for reimbursements of preformation expenditures. Under that exception, transfers to reimburse a partner for certain capital expenditures and costs incurred are not treated as part of a sale of property (i.e., the exception for preformation capital expenditures). The proposed regulations amend the exception for preformation capital expenditures to address three issues. First, the proposed regulations provide how the exception for preformation capital expenditures applies in the case of multiple property transfers. The exception generally applies only to the extent the reimbursed capital expenditures do not exceed 20 percent of the fair market value of such property at the time of the contribution. This fair market value limitation, however, does not apply if the fair market value of the contributed property does not exceed 120 percent of the partner's adjusted basis in the contributed property at the time of the contribution. The provision applies to the single property for which the expenditures were made. Accordingly, in the case of multiple property contributions, the proposed regulations provide that the determination of whether the fair market value limitation and the exception to the fair market value limitation apply to reimbursements of capital expenditures is made separately for each property that qualifies for the exception. Second, the proposed regulations clarify the scope of the term "capital expenditures," and lastly, the proposed regulations provide a rule coordinating the exception for preformation capital expenditures and the rules regarding liabilities traceable to capital expenditures.

Addition of a New Qualified Liability Type

Reg. Sec. 1.707-5(a)(6) provides four types of liabilities that are qualified liabilities that are generally excluded from disguised sale treatment. With respect to two of the types of liabilities, there is a requirement that the liabilities encumber the transferred property. That requirement exists where a liability is incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all the assets that are material to that trade or business are transferred to the partnership (i.e., ordinary course qualified liability). According to the IRS, the requirement that the liability encumber the transferred property is not necessary to carry out the purposes of the disguised sale rules when a liability was incurred in connection with the conduct of a trade or business, provided the liability was not incurred in anticipation of the transfer and all the assets material to that trade or business are transferred to the partnership. Accordingly, the proposed regulations add an additional definition of qualified liability to account for this type of liability.

Netting Rules Apply to Disguised Sales

Reg. Sec. 1.752-1(f) provides for netting of increases and decreases in a partner's share of liabilities resulting from a single transaction. Under that rule, increases and decreases in partnership liabilities associated with a merger or consolidation are netted by the partners in the terminating partnership and the resulting partnership to determine the effect of a merger under Code Sec. 752. The IRS believes that similar netting rules should apply with respect to the disguised sale rules and, accordingly, the proposed regulations extend the principles of Reg. Sec. 1.752-1(f) to determine the effect of the merger under the disguised sale rules.

New Rules for Tiered Partnerships

The proposed regulations add additional rules regarding tiered partnerships. First, they clarify that the debt-financed distribution exception applies in a tiered partnership setting. Second, the proposed regulations provide rules regarding the characterization of liabilities attributable to a contributed partnership interest. Currently, a partner that contributes an interest in a partnership (lower-tier partnership) to another partnership (upper-tier partnership) must take into account its share of liabilities from the lower-tier partnership. The IRS believes it is appropriate to treat the lower-tier partnership as an aggregate for purposes of determining whether the upper-tier partnership's share of the liabilities of the lower-tier partnership are qualified liabilities. Thus, the proposed regulations provide that a contributing partner's share of liabilities from a lower-tier partnership is treated as qualified liabilities to the extent the liability would be a qualified liability had the liability been assumed or taken subject to by the upper-tier partnership in connection with a transfer of all of the lower-tier partnership's property to the upper-tier partnership by the lower-tier partnership.

Clarification of Anticipated Reduction Rule

Under the existing disguised sale rules, a partner's share of a liability assumed or taken subject to by a partnership is determined by taking into account certain subsequent reductions in the partner's share of the liability. Specifically, a subsequent reduction in a partner's share of a liability is taken into account if (1) at the time the partnership incurs, assumes, or takes property subject to the liability, it is anticipated that the partner's share of the liability will be subsequently reduced; and (2) the reduction is part of a plan that has as one of its principal purposes minimizing the extent to which the distribution or assumption of, or taking property subject to, the liability is treated as part of a sale (the anticipated reduction rule). According to the IRS, practitioners are uncertain as to when a reduction is anticipatory because it is generally anticipated that all liabilities will be repaid.

Under the proposed regulations, a reduction that is subject to the entrepreneurial risks of partnership operations is not an anticipated reduction. The proposed regulations also provide that, if within two years of the partnership incurring, assuming, or taking property subject to the 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, then the reduction will be presumed to be anticipated, unless the facts and circumstances clearly establish that the decrease in the net value was not anticipated. Any such reduction must be disclosed.

Effective Date and Transition Rules

The proposed regulations are not effective until finalized. In addition, the proposed regulations provide transitional 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 proposed regulations are finalized. Under this transitional relief, the partner can continue to apply the existing regulations under Reg. Sec. 1.752-2 for a seven-year period to the extent the partner's allocable share of partnership liabilities exceeds the partner's adjusted basis in its partnership interest on the date the proposed regulations are finalized. The amount of partnership liabilities subject to transitional relief will be reduced for certain reductions in the amount of liabilities allocated to that partner under the transition rules and, upon the sale of any partnership property, for any excess of tax gain (including Code Sec. 704(c) gain) allocated to the partner less the partner's share of amount realized. (Staff Editor Parker Tax Publishing)

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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