Proposed Treasury Regulations on Allocation of Partnership Liabilities and Disguised Sales · 2015....

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Proposed Treasury Regulationson Allocation of Partnership Liabilities

and Disguised Sales

Proposed on January 29, 2014

Presented by Robert A.N. CuddFebruary 4, 2014

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Proposed Regulations Affect Treatment of Allocation of Partnership Liabilities

� In response to perceived abuses regarding distributions by leveraged

partnerships such as those discussed in Canal Corporation v.

Commissioner, 135 T.C. No. 9 (August 5, 2010), in which the court imposed

penalties on a leveraged distribution of cash by a partnership because of a

lack of substance, the Internal Revenue Service proposed Treasury

Regulations under Sections 707 and 752 which dramatically change the

treatment of partnership liabilities.

� Transactions involving debt financed distributions by leveraged

partnerships often rely on a guarantee by the distributee partner of a

partnership liability , the proceeds of which are distributed. Under Setion

752 this causes the debt to be recourse debt allocable to the distributee

partner which in turn increases its basis. The guarantee may be a “bottom

dollar” guarantee or a “vertical slice” of a partnership liability.

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Proposed Regulations Affect Treatment of Allocation of Partnership Liabilities

� Leveraged transactions also rely on the deemed satisfaction rule of Treas.

Reg. 1.752-2(b)(6) and the anti-abuse rule of 1.752-2(j) for the proposition

that the economic ability of a partner to make a payment obligation, such

as a guarantee, is not relevant in determining whether the payment

obligation should be respected.

� Excess nonrecourse liabilities are currently allocable under Treas. Reg.

1.752-3(a)(3) in accordance with profits, taking into account all the facts

and circumstances relating to the economic arrangement of the partners.

Currently, the Treasury Regulation provides two regimes for allocating

profits: the significant item test or the reasonably expected deductions

test. The Treasury is concerned that those tests might not reflect the

partner’s share of profits actually used to repay the nonrecourse liability.

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Major Features of Proposed Regulations

� The Proposed Regulations contain for 4 major provisions:

– The first set and arguably the most important changes of the Proposed

Regulations amend the allocation of recourse partnership liabilities

under Sec. 752 of the Code and Treas. Reg. Sec. 1.752-2.

– The second set of provisions relate to the allocation of excess

nonrecourse liabilities under Treas. Reg. 1.752-3(a)(3) replacing the

current provisions based on profits with one based on a liquidation

value percentage.

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Major Features of Proposed Regulations

– The third set of provisions of the Proposed Regulations is the

technical and clarifying changes to the Sec. 707 disguised sales

regulations relating to the exceptions for debt financed distributions

under Treas. Reg. Sec. 1.707-5 and 1.707-4 dealing with preformation

expenses.

– The fourth set of provisions of the Proposed Regulations is the

effective date provisions including the 7-year transitional rule relating

to allocation of recourse partnership liabilities.

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Treatment of Recourse Liabilities

� Proposed Treas. Regulations retains the constructive liquidation approach

of the current regulations ((1.752-2(b)(1)) but new recognition and net

value requirements are imposed by Prop. Treas. Reg. Sec. 1.752-2(b)(3)(ii)

and (iii).

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Recognition of Payment Obligations

� Prop. Treas. Reg. Sec. 1.752-2(b)(3)(ii) requires the partner or related

person to satisfy 7 requirements for a payment obligation to be

recognized. The first 5 requirements are designed to ensure that the

partner is treated the same as an unrelated third party under the same

obligations and are generally referred to as the “commercial

requirements.”

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� Prop. Treas. Reg. Sec. 1.752-2(b)(3)(ii)(A)-(E) sets forth the five

commercial requirements.

A. The partner or related person is:

� Required to maintain a commercially reasonable net worth

throughout the term of the payment obligation; or

� Subject to commercially reasonable contractual restrictions on

transfers of assets for inadequate consideration.

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B. The partner or related person is required periodically to provide

commercially reasonable documentation regarding the partner’s or

related person’s financial condition.

C. The term of the payment obligation does not end prior to the term

of the partnership liability.

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D. The payment obligation does 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.

E. The partner or related person received arm’s length consideration for

assuming the payment obligation.

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In addition to the commercial requirements, other requirements apply to

guarantees and indemnities.

� Prop. Treas. Reg. Sec. 1.752-3(b)(ii)(F) and (G) are directed at partial

guarantees, such as “bottom dollar” and vertical slice guarantees and

indemnities, and these provisions are the heart of the Prop. Reg. Sec. 752.

� Under Prop. Treas. Sec. 1.752-3(b)(ii)(F) and (G) a guarantee or indemnity

and/or reimbursement agreement will be recognized if and to the extent

ANY amount of the partnership liability is not otherwise satisfied. This

means that if any part of the obligation subject to the guarantee or

indemnity can be satisfied from any other source the guarantee or

indemnity will not be recognized and the partnership liability would then

be viewed as a nonrecourse liability.11


Payment Obligations and Net Value

� There is a limited exception from this rule for rights of contribution

running between partners or related persons who are co-obligors with

respect to a payment obligation for which each of them is faulty and

severally liable.

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Net Value Requirement

� Prop. Treas. Sec. 1.752-2(b)(3)(iii)(B) amends the deemed satisfaction rule

of Treas. Reg. Sec. 1.752-2(b)(6) by adding a net value requirement similar

to the current rule for disregarded entities under Treas. Reg. Sec. 1.752-

2(k) to determine whether the partner bears the risk of loss other than a

trade payable. Thus, except for an individual or a decedent’s estate, a

payment obligation of a partner or related person will only be respected

as causing the partner to bear the risk of loss to the extent of the partner’s

net value. The net value requirement will apply to the payment obligation

of all partners including a partner that is a disregarded entity owned by an

individual or decedent’s estate.

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Example 3 of Recourse Debt Rules under Prop. Treas. Reg. Sec. 1.752-2(f)

� Example 3 illustrates the basic rules with an allocation of a recourse loan

under the constructive liquidation rules for a general partnership. Both

the general partner and the limited partner are business entities, and the

general partner meets the net value test. Under this example all of the

recourse loan is allocated to the general partner even though the limited

partner guarantees the loan and is allocated 80% of the loses until its

capital account is reduced to zero.

� In example 3, the limited partner’s guarantee is limited to the amount the

lender cannot recover from the partnership or the general partner.

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� Under state law, the general partner would be required to make a

contribution to the partnership equal to the $15,000 principal amount of

the loan. Since the general partner satisfies the net value test all of the

$15,000 liability is allocated to the general partner.

� It should be noted that the general partner would not be allocated the

$15,000 liability if it failed the net value test even if it were required to

make a capital contribution under state law. Even if the general partner

did not satisfy the net value test, none of the $15,000 liability would be

allocated to the limited partner because its guarantee would fail the

recognition requirement of Prop. Treas. Reg. 1.752-2(b)(3)(ii)(F).

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� Example 10 illustrates the difference between a guarantee of first and last

dollars by A and a bottom tier guarantee by B, members of a three

member limited liability company. It is assumed that A and B waive

contribution rights , the net value test is met, and the commercial

requirements are satisfied. A guarantees $300 of $1,000 liability if any

amount of the full $1,000 liability is not recovered by the lender.

� A’s guarantee is recognized under the recognition rules since A is required

to pay $300 if the lender does not recover the full $1,000 principal

amount.

� B’s guarantee is not recognized under the 1.752-2(b)(3)(ii)(F) because B is

only required to make a payment if the lender recovers less than $200 of

the $1,000 liability. $700 of the $1,000 loan is treated as non-recourse

and allocated under Prop. Reg. Sec. 1.752-3.

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� Example 11 has the same facts as example 10 and illustrates the effect of

an indemnification by one member (C) of another member’s (A)

guarantee. The example assumes the net value test and the commercial

requirements are satisfied by both A and C. A guarantees $300 of $1,000

debt and C agrees to indemnify A up to $50 and to indemnify B fully with

respect to its $200 guarantee. The example analyzes C’s indemnity

without regard to its effect on A’s guarantee.

� Example 11 concludes that C’s indemnify should be recognized under

1.752-2(b)(3)(ii)(G) because A’s guarantee obligation would be recognized

but for C’s indemnity and because C is obligated to pay A on its indemnity

if A pays any amount on its guarantee. Since C’s indemnity is recognized it

is treated as modifying A’s guarantee.

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� A’s modified guarantee is then viewed as an obligation to make a payment

only if the lender recovers less than $250. Thus, A’s guarantee is not

recognized because a portion of the partnership liability could be satisfied

by C’s indemnity which is something other than A’s guarantee. This is a

disturbing result because a relatively small indemnity by C of $50 destroys

all of A’s $300 guarantee.

� Example 11 also concludes that C’s indemnity of B’s guarantee is not

recognized because B’s “bottom-dollar” guarantee is not recognized.

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Example 12 of Recourse Debt Rules Under Prop. Treas. Reg. 1.752-2(f)

� Example 12 disallows recognition of a partial guarantee in which is a

vertical slice of a partnership liability as opposed to a bottom-dollar

guarantee. The member guarantees 25 percent of each dollar of the

$1,000 liability not recovered by the lender.

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Anti-Abuse Provisions of Prop. Treas. Reg. 1-752-2(j)(4)

� Prop. Treas. Reg. Sec. 1.752-2(j)(4) expands the anti-abuse rule to prevent

arrangements designed to convert a single liability with more than one

liability to avoid the rules of Prop. Treas. Reg. Sec. 1.752-2(b)(3)(ii)(F) and

(G).

� The proposed anti-abuse rule is expanded to prevent tax payers from

structurally dividing a single partnership liability into multiple liabilities so

that the payment recognition rules can be satisfied on a tranche by

tranche basis.

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Effective Dates and Transitional Rules on Recourse Debt

� The effective dates of the Proposed Regulations under Sec. 707 and 752

are the date the Proposed Regulation are published as final rules in the

Federal Register.

� A special transitional rule applies to the changes made to the allocation of

recourse liabilities under Proposed Treas. Reg. 1.752-2(l)(2). That section

provides for a 7-year transition period from the date the regulations

become final if elected by the Transition Partner and the Transition

Partnership to the extent that the Transition Partners adjusted

Grandfathered amount.

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Effective Dates and Transitional Rules on Recourse Debt

� The Grandfathered amount is the amount of the transition partner’s share

of liabilities immediately prior to the effective date in excess of its

adjusted basis in its partnership interest under Sec. 705 of the Code.

� Commentators have expressed confusion over the 7-year rule because it

would appear to be unnecessary given the general effective date rule for

liabilities issued or assumed prior to the effective date. It appears that

the drafters may have omitted language to the effect that any change in a

partnership liability or payment obligation after the effective date would

vitiate the general effective date provision and therefore require reliance

on the 7-year transition rule.

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Treatment of Nonrecourse Liabilities

� Under the current rule, the allocation of partnership profits must be

reasonably consistent with allocations of some other significant item of

partnership income or in accordance with the allocation of deductions

with respect to the nonrecourse liabilities.

� The proposed treatment of excess nonrecourse obligations under Prop.

Treas. Reg. Sec. 1.752-3(a)(3) is a fundamental change in the allocation of

partnership nonrecourse liabilities which under the current Treas. Reg.

Sec. 1.752-3(a)(3) is based on the partner’s share of the partnership’s

profits.

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� The first two sentences of Treas. Reg. 1.752-3(a)3 are not changed by the

proposed752 regulations. Importantly, the second sentence which

remains provides the general rule that the partner’s interest in

partnership profits is determined by taking into account all the facts and

circumstances relating to the economic arrangement of the partners.

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� Since the Proposed Regulations purport to be allocating partnership

nonrecourse liabilities in accordance with profits under the general rule, it

is unclear whether failure to allocate nonrecourse debt in accordance with

the liquidation value percentage would not be recognized. As noted, the

liquidation value percentage is designed to implement the general

provisions of Treas. Reg. Sec. 1.752-3(a)(3). See also Treas. Reg. Sec.

1.704-1(b)(1)(i) and 1.704-1(b)(3) in which allocation of profits and losses

are recognized as having substantial economic effect if they are in

accordance with a “partner’s interest in the partnership,” the “PIP” rules.

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� A Partner’s “liquidation value percentage” is determined upon formation

of the partnership and must be redetermined on a capital account

revaluation event described in Treas. Reg. Sec. 1.704-(b)(2)(iv)(f) including

contributions, distributions, liquidation, or grant of a partnership interest

for services. The liquidation value percentage is the ratio of (expressed as

a percentage) of the liquidation value of the partner’s interest divided by

the aggregate liquidation value of all of the partner’s interests.

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� Any change in a partner’s share of a partnership nonrecourse liability as a

result of capital account revaluation event is taken into account in

determining the tax consequences of the event that give rise to the

change. Thus, for example, a contribution or distribution by or to one

partner could result in the recognition of gain by that partner as well as

another partner under Sec. 752.

� The liquidation value is the amount of cash the partner would receive if

immediately after formation or the capital account revaluation event the

partnership sold all of its assets for cash at fair market value, satisfied all

of its liabilities, paid a third party to assume all of its 1.752-7 liabilities in a

fully taxable transaction and liquidated.

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� The difficulties of this approach are myriad. To determine the fair market

value of the partnership could require a continuous appraisal and no

convention to simplify this procedure if provided. Determining what a

partner would receive on liquidation may be difficult or impossible to

determine based on future contingencies or if the partnership uses a

“forced allocation” regime. Similarly, the effect of an adjustment of the

liquidation value percentage on capital accounts is unclear.

� Unlike the amendments made to the recourse debt regulations, no

transition rules are provided and the changes are effective for debt

obligations issued or assumed after the date the Proposed Regulations

become final. It is unclear to what extent changes to a nonrecourse debt

or an allocation of that debt would cause the new rules to apply.

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Example 2 of Nonrecourse Debt Rules Under Prop. Treas. Reg 1.752-3(c)

� This example is designed to illustrate a simple allocation of nonrecourse

liabilities with a distribution of property triggering a revaluation event.

� X and Y form a limited liability company and contribute $100. XY LLC

borrows $50 from an unrelated person on a nonrecourse basis. The

partners agree to allocate excess nonrecourse liabilities in accordance

with the partners’ liquidation value percentage. Since each partner’s

liquidation value is 50%, X and Y each have a $25 share of the $40

nonrecourse liability.

� This part of the example does little to clarify the rule and raises the

question of what allocation regime would apply if the members had not

agreed to use the liquidation value percentage regime.

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Example 2 of Nonrecourse Debt Rules Under Prop. Treas. Reg 1.752-3(c)

� The second part of the example involves a distribution of property with

fair market value of $400 to X when X and Y each own an interest in XY

with a fair market value of $600 and an adjusted basis of $320. The

distribution of the property triggers a capital account revaluation event

which causes the liquidation value percentages to be adjusted. The event

which caused the revaluation is taken into account in making the

adjustment to the liquidation value percentages. Thus, X has a liquidation

value percentage of 25 percent ($200 ÷ $800 = 25%) and X’s share of the

$40 nonrecourse liability decreases from $20 to then $10.

� X is deemed to receive a cash distribution of $10 under Sec. 752(b) but

recognizes no gain because its basis is $320.

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Example 2 of Nonrecourse Debt Rules Under Prop. Treas. Reg. 1.752-3(c)

� The example concludes that X’s basis in the land distributed is $310

presumably treating the distribution as a liquidation in which the basis in

the land is determined by reference to its basis in its partnership interest

($320 – $10 = $310).

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Various Amendments to Section 707 Regulations

� The proposed changes to the Sec. 707 regulations are in the nature of

clarifications rather than substantive changes.

� The Sec. 707 regulations provide several exemptions from the general rule

that a transfer of property by a partner to a partnership followed by a

transfer of cash or property to the partner within a 2-year period is

presumed to be a disguised sale of property under Sec. 707(a)(2)(B). The

most important of these exemptions is the debt finance distribution

exception under Treas. Reg. Sec. 707-5.

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Various Amendments To Section 707 Regulations

� The proposed clarifications to Treas. Reg. Sec. 707-5 involve the following:

– The single liability rule under example 10 of Prop. Treas. Reg. Sec. 707-

5(g) is illustrated.

– The ordering rule in which the debt finance exception rules are

applied before the other exceptions under Prop. Treas. Reg. Sec. 707-

5(b)(3) is established.

– Netting rules apply to partnership mergers under Prop. Treas. Reg.

1.707-(5)(f).

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– The anticipated reduction rule is expanded to include a decrease in a

partners net value within two years under Prop. Treas. Reg. See 707-

5(a)(3) and -5(b)(2)(iii).

– The addition of a new category of qualified liabilities as part of the

transfer of a trade or business in which the liabilities are not secured

under Prop. Treas. Reg. 1.707-5(a)(6)(E).

– The treatment of liabilities of tiered partnerships is clarified under

Prop. Treas. Reg. 1.707-5(b)(1).

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� The changes to Prop. Treas. Reg. 1.707-(4)(d) include the following:

– The exception for preformation capital expenditures which can be

reimbursed is applied on a property by property basis.

– The definition of preformation capital expenditures may include

capital expenditures which the taxpayer can elect to deduct.

– Partners cannot double count preformation reimbursements and debt

obligations funding preformation expenditures which are treated as

qualified liabilities.

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Proposed Treasury Regulations on Allocation of Partnership Liabilities and Disguised Sales · 2015....

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