On January 29, 2014, the Internal Revenue Service (IRS) proposed Treasury regulations under Section 752 of the Code which would change the way in which both partnership recourse and nonrecourse liabilities are allocated. The proposed changes are a dramatic departure from the current regulatory regime for allocating partnership liabilities.
Under current law, recourse liabilities are allocated to the partner which bears the risk of loss under a constructive liquidation scenario where the partnership assets are deemed to be worthless. A partner is treated as bearing the risk of loss to the extent of the amount of the liability the partner may be required to repay, including a bottom dollar guarantee. The partner is treated as being able to satisfy its payment obligations without regard to the net value of its assets.
The proposed regulations substantially curtail the ability of taxpayers to structure debt financed distributions by partnerships in which the distributee partner guarantees a bottom portion or slice of a partnership liability. In effect, the proposed partnership regulations under Section 752 of the Code require the guarantee be a first and last dollar guarantee to be recognized. For example, a partner guarantee of $300 of a $1,000 partnership liability would only be recognized if the partner is required to pay the lender up to $300 to the extent the lender fails to recover the full amount of the loan and no other person is required to pay that amount or reimburse the partners. In addition, the partner will only be treated as bearing the risk of loss to the extent it satisfies the net value test. Finally, guarantees must satisfy certain commercial requirements.
The proposed Section 752 regulations also alter the manner in which nonrecourse obligations can be allocated. Under current rules nonrecourse debt obligations are allocated among the partners in accordance with the manner in which they share profits. For this purpose, profits may be allocated in accordance with the allocation of some significant item or in accordance with the allocation of deductions relating to the nonrecourse liability.
Under the Section 752 proposed regulations, nonrecourse debt obligations of a partnership would be allocated in accordance with a partners "liquidation value percentage". The liquidation value percentage would be based upon the amount of cash a partner would receive on a hypothetical liquidation in which all of the assets of the partnership are sold at their fair market value in taxable transactions, the liabilities of the partnership are satisfied. This allocation model could be very different than an allocation based on the profits of the partnership. In addition, the Proposed Regulations under Section 752 require that the liquidation value percentage be adjusted upon the occurrence of contributions, distributions, and liquidation of the partnership which could require multiple appraisals of partnership property and assumptions regarding what a partner might receive on liquidation.
The proposed regulations under Section 752 of the Code dealing with recourse obligations provide a limited 7-year transition rule which may be elected by the transition partner and the transition partnership to protect the transition partner from certain adverse tax consequences as a result of the reduction of its share of recourse debt. There are no transition rules with respect to the proposed regulation's treatment of nonrecourse debt.
The changes of the proposed regulations under Section 752 will substantially restrict or prohibit debt financed distributions by partnerships and will cause unintended consequences and administrative difficulties in the case of nonrecourse partnership liabilities. Partnership and limited liability company agreements will need to be redrafted to take into account the provisions of the proposed regulations.