The Internal Revenue Service (“IRS”) released proposed regulations changing the analysis of whether a partner bears the economic risk of loss for a partnership liability under IRC Section 752. Also, the proposed regulations address amendments to the disguised sale rules of IRC Section 707. Many of the significant changes outlined in the proposed regulations, which could have wide-ranging potential impacts on leveraged partnerships in various industries if finalized, have already received harsh critiques from tax law practitioners.
In determining a partner’s share of a recourse partnership liability, the proposed regulations provide that obligations to make a payment for a partnership liability generally will not be recognized under IRC Section 752 unless a six-prong test is met indicating that the terms of the payment obligations are commercially reasonable and not designed solely to obtain tax benefits. A partner would also need to have sufficient net worth, aside from the value of its partnership interest, before the partner could be allocated partnership recourse liabilities. However, this net worth requirement does not apply to individuals or decedent’s estates.
The six-prong test includes the satisfaction of the following: (1) the partner at issue must maintain commercially reasonable net worth for the entire term of the payment obligation or must be subject to commercially reasonable restrictions on transfers of assets for nominal consideration; (2) the partner must periodically document his financial condition to the lender; (3) the term of the partner’s payment obligation must not end before the term of the partnership’s liability; (4) the partner’s payment obligation itself must not require that the partnership or any other obligor hold liquid assets that exceed that person’s reasonable needs; (5) the partner must receive arm’s-length consideration in exchange for assuming the payment obligation; and (6) the partner must be liable for no less than the full amount of the payment obligation. The final prong of the test eliminates the use of “bottom-dollar” guarantees.
One of the most controversial portions of the proposed regulations involves the elimination of the use of “bottom-dollar” guarantees of partnership liabilities. A “bottom-dollar” guarantee is a guarantee of the last dollars of a partnership’s debt. “Bottom-dollar” guarantees are favorable to partners because they involve less risk. Generally, a guarantor’s obligation does not arise under a “bottom-dollar” guarantee until all of the creditor’s attempts to collect from the borrower have failed to produce a specified minimum amount. As proposed, the new regulations would treat any guarantee other than a guarantee of 100% of the relevant liability as a prohibited “bottom-dollar” guarantee, including any combination of arrangements that effectively splits the economic risk of loss arising from the guarantee among multiple parties.
The allocation of excess nonrecourse liabilities among partners has always been extremely flexible. Partnerships are able to allocate such liabilities in any manner that is “reasonably consistent” with allocations of other partnership items that have substantial economic effect. Under the new proposed regulations, however, a partner’s excess nonrecourse liability allocations would be determined through the calculation of the partner’s liquidation value percentage. A partner’s liquidation value percentage would be based on the percentage such partner would receive if the partnership were liquidated, its assets were sold for their respective fair market values and all of the proceeds from such sale were distributed to the partners. These calculations would be re-determined upon the occurrence of certain partnership interest issuance or redemption events outlined at Treas. Reg. Sec. 1.704-1(b)(2)(iv)(f)(5).
Disguised Sale Treatment
The proposed changes to the disguised sale rules include the property-by-property application of the 20% fair market value limitation and the elimination of reimbursement for debt-financed capital expenditures. Under the proposed regulations, a reduction of a partner’s share of a liability contributed by that partner will be taken into account as of the date of the contribution if the subsequent anticipated reduction is not subject to the entrepreneurial risks of the partnership’s operations. This reduction would increase the chance that the contribution is deemed a disguised sale. The debt-financed distribution exception would also be applicable in a tiered partnership setting under the proposed regulations.
The current regulations covering disguised sales outline four types of qualified liabilities that are excluded from disguised sale treatment. A new type of qualified liability would be added under the proposed regulations. A liability incurred in connection with the trade or business in which the property transferred to the partnership was used or held will be a qualified liability, provided that all material assets of the trade or business that were contributed to the partnership would now serve as a qualified liability for disguised sale purposes.
The proposed regulations also update the exception for preformation capital expenditures to explain how the exception applies to multiple property transfers, detail the meaning of “capital expenditures” for purposes of Treas. Reg. Sections 1.707-4 and 1.707-5, and coordinate the interaction between the exception for preformation capital expenditures and rules addressing liabilities traceable to capital expenditures.
Finally, the proposed regulations would institute an ordering rule providing that any distributed proceeds are deemed to be first distributions of loan proceeds, coordinating the leverage distribution rule and various disguised sale exceptions of Treas. Reg. Section 1.707-4.
Effective Date & Transitional Rule
The proposed regulations will apply for all transfers occurring on or after the date that the regulations are finalized. However, the final regulations under IRC Section 752 will enable taxpayers to continue using the current economic risk of loss rules for a 7-year period beginning on the date such regulations are finalized.
As currently drafted, the proposed regulations will have a significant impact on the application of the disguised sales rules as well as the allocation of partnership liabilities. These rules evidence the IRS and Treasury Department’s intent to eliminate the use of “bottom-dollar” guarantees and the use of the disguised sales rules to defer gain while maximizing liquidity and limiting continuing risk of loss.