Proposed Treasury Regulations on Allocation of Partnership Liabilities and Disguised Sales · 2015. 2. 12. · Proposed Regulations Affect Treatment of Allocation of Partnership Liabilities
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Polsinelli PC. In California, Polsinelli LLP
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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Recognition of Payment Obligations
� 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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Recognition of Payment Obligations
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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Recognition of Payment Obligations
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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Recognition of Payment Obligations
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
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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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Example 3 of Recourse Debt Rules under Prop. Treas. Reg. Sec. 1.752-2(f)
� 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 of Recourse Debt Rules under Prop. Treas. Reg. Sec. 1.752-2(f)
� 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 of Recourse Debt Rules under Prop. Treas. Reg. Sec. 1.752-2(f)
� 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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Example 11 of Recourse Debt Rules under Prop. Treas. Reg. Sec. 1.752-2(f)
� 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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Treatment of Nonrecourse Liabilities
� 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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Treatment of Nonrecourse Liabilities
� 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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Treatment of Nonrecourse Liabilities
� 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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Treatment of Nonrecourse Liabilities
� 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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Treatment of Nonrecourse Liabilities
� 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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Various Amendments To Section 707 Regulations
– 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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Various Amendments To Section 707 Regulations
� 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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