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Partnership Debt Allocations and New IRS
Regulations: Minimizing Tax Consequences
THURSDAY, DECEMBER 7, 2017, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
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Dec. 7, 2017
Partnership Debt Allocations and New IRS Regulations
Nickolas Gianou
Skadden Arps Slate Meagher & Flom, Chicago
[email protected]
Brian Krause, Partner
Skadden Arps Slate Meagher & Flom, New York
[email protected]
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Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
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5 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Beijing / Boston / Brussels / Chicago / Frankfurt / Hong Kong / Houston / London
Los Angeles / Moscow / Munich / New York / Palo Alto / Paris / São Paulo / Seoul
Shanghai / Singapore / Tokyo / Toronto / Washington, D.C. / Wilmington
Partnership Debt Allocations and New IRS Regulations
December 7, 2017
Brian Krause & Nickolas Gianou
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6 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Background on Sections 707 and 752
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7 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Partnership
Assets w/ basis of
$100 and FMV of
$1000
• Section 721: Exchange of
Assets for an interest in
Partnership is generally tax-
free both to Partnership and
Contributing Partner (but see
Section 721(b)).
• Section 722: Contributing
Partner takes a “substituted
basis” in the partnership
interest it receives (i.e., its
basis in the partnership
interest equals its basis in the
property contributed).
• Section 723: Partnership
takes a “carryover basis” in
the asset contributed (i.e., the
same basis in the asset as
Contributing Partner’s basis in
the asset prior to the
contribution).
Partnership
Interest
Contributing Partner
Other
Partners
Overview of Partnership Provisions—Contributions
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8 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Overview of Partnership Provisions—Distributions
Partnership
• Section 731: Recipient
Partner does not recognize
gain on a distribution of cash,
except to the extent that the
amount of money (or FMV of
“marketable securities”)
distributed exceeds Recipient
Partner’s basis in his
Partnership interest.
• Section 733: For non-
liquidating distributions,
Recipient Partner’s basis in its
interest in Partnership is
reduced by the amount of
money and the basis of other
property distributed to
Recipient Partner.
Recipient Partner Other
Partners
Cash
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9 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Disguised Sales – Key Exception to Nonrecognition
• As a consequence of the foregoing rules, absent an exception, a
partner would generally be able to contribute appreciated property to a
partnership and receive cash distributions from that partnership up to
the partner’s basis in the property, all without recognizing any gain.
E.g.:
− Partner A contributes Appreciated Property with a basis of $100
and FMV of $1000 to Partnership, and Partner B Contributes
$1000 dollars. Under the general rules, Partnership could
distribute up to $100 of cash to Partner A (or more if Partnership
has liabilities that are allocated to Partner A; see discussion of
Section 752 below) before Partner A recognizes any gain.
• The disguised sale rules of Sections 707(a)(2)(B) and the regulations
thereunder are an important exception. These rules treat certain
contributions and related distributions as together being part of taxable
sale of property.
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10 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Disguised Sales Generally
• Section 707(a)(2)(B) – If
− (i) there is a direct or indirect transfer of money or other
property by a partner to a partnership,
− (ii) there is a related direct or indirect transfer of money or
other property by the partnership to such partner (or
another partner), and
− (iii) the transfers described in (i) and (ii), when viewed
together, are properly characterized as a sale or exchange
of property,
then the transactions will be treated as occurring between
the parties (either the partner and the partnership or two or
more partners) acting other than in their capacity as
members of the partnership.
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11 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Disguised Sales – Regulatory Landscape
• Treas. Reg. § 1.707-2 – Disguised payments for services [Reserved]
• Treas. Reg. § 1.707-3 – General rules related to disguised sales of
property by partners to partnerships
• Treas. Reg. § 1.707-4 – Rules related to guaranteed payments;
preferred returns, operating cash flow distributions, and
reimbursements of preformation expenditures
• Treas. Reg. § 1.707-5 – Rules related to liabilities
• Treas. Reg. § 1.707-6 – General rules related to disguised sales of
property by partnerships to partners
• Treas. Reg. § 1.707-7 – Disguised sales of partnership interests
[Reserved]
• Treas. Reg. § 1.707-8 – Disclosure rules
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12 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Disguised Sales – Tests for Identifying a Sale
• Facts and circumstances test – Treas. Reg. § 1.707-3(b)
− Must show
» (1) that the transfer of money or other consideration would not have
been made but for the transfer of property; and
» (2) In cases in which the transfers are not made simultaneously, the
subsequent transfer is not dependent on the entrepreneurial risks of
partnership operations.
− Regulations outline ten “facts and circumstances that may tend to
prove the existence of a sale”
• Two-year presumption – Treas. Reg. § 1.707-3(c)
− Transfers made within two years are presumed to be a sale unless the
facts and circumstances “clearly establish” otherwise
» Triggers disclosure requirement under Treas. Reg. § 1.707-8
− Transfers outside of two years are presumed not to be part of a sale
unless the facts and circumstances clearly establish otherwise
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13 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Disguised Sales – Key Safe Harbors (1.707-4)
• Certain distributions are exempt from disguised-
sale treatment even if made within the two-year
presumption period
• A distribution will generally not be treated as
disguised sale proceeds for a related contribution
to the extent the distribution:
− Represents a reasonable guaranteed payment or
preferred return;
− Consists of operating cash flow; or
− Represents reimbursement for preformation capital
expenditures (capex made on the contributed property
in the two years preceding the contribution)
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14 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Disguised Sales – General Rules for Liabilities (1.707-5)
• Assumption of “qualified liabilities” generally does not give rise
to disguised sale proceeds.
• Assumption of “nonqualified liabilities” does give rise to
disguised sale proceeds in the amount of the liability that is
allocable to other partners under Section 752 (discussed below)
• If the partner receives even a dollar of disguised sale
consideration (either actual consideration, e.g., cash or
property, or through an assumption and shift of non-qualified
liabilities), a portion of any assumed and shifted qualified
liabilities are “tainted” and treated as disguised sale proceeds
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15 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Disguised Sales – Debt-Financed Distributions (1.707-5(b))
• Treas. Reg. 1.707-5(b): One of the provisions that makes
(or made) leveraged partnership transactions possible.
− Under the rule, cash proceeds traceable to a liability incurred by the
partnership and distributed to a partner within 90 days of the
incurrence can be treated as disguised sale proceeds only to the
extent they exceed the partner’s share of the liability
• Prior to the 2016 Final Treasury Regulations:
− a partner’s share of a recourse liability of the partnership was
determined in accordance with the allocation of recourse liabilities
under Section 752 (discussed below), and
− a partner’s share of a nonrecourse liability of the partnership was
determined in accordance with the allocation of excess
nonrecourse deductions (i.e., the third tier of allocations of
nonrecourse deductions under Section 752).
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16 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Overview of Partnership Provisions—Liabilities
Partnership
• Section 752: A partner whose
“allocable share” of partnership
liabilities increases is treated as
having contributed money to the
partnership, and a partner whose
“allocable share” of partnership
liabilities decreases is treated as
receiving a distribution from the
partnership.
• Treas. Reg. 1.752-1, 2: Where a
single partner or a related person
bears the economic risk of loss for a
partnership liability, the partner’s
allocable share of that liability (for
purposes of Section 752) is 100%.
• Sections 722 and 733: A partner’s
basis in its partnership interest is
increased by any money contributed
(including money deemed contributed
pursuant to Section 752), and its basis
is reduced by any money distributed
(including money deemed distributed
under Section 752).
Guarantor Partner Other
Partners
Bank
Existing Loan of
$1500, otherwise
non-recourse to all
partners.
Guarantor Partner
guarantees*
Partnership’s loan
from Bank
Deemed
Contribution of Cash
*Subject to various
anti-abuse rules that
will be discussed
Deemed Distribution
of Cash
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17 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Allocation of Partnership Liabilities—Section 752
• As noted above, the allocation of liabilities can be relevant both to:
− determining whether there is a disguised sale in connection with a
contribution of property, and
− even if there is no disguised sale issue (e.g., no contribution or no
distribution that is treated as part of a sale), determining the
consequences of the deemed contributions and distributions that
result from liability shifts.
• The allocation of a partnership liability among the partners depends on
whether the liability is a “recourse” or “nonrecourse” liability under Section
752.
• A liability is a recourse liability to the extent that any partner (or a related
person) bears the “economic risk of loss” for such liability.
• A liability is a nonrecourse liability to the extent that NO partner (or related
person) bears the “economic risk of loss”.
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18 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Allocation of Partnership Liabilities—Section 752 (cont’d)
• “Economic risk of loss” is a term of art:
− Generally, a partner bears the economic risk of loss for a
partnership liability if the partner or related person would
be obligated to make a payment to any person (or a
contribution to the partnership), and would not be entitled
to reimbursement from another partner or person related
to another partner, assuming a deemed liquidation of the
partnership in which the assets of the partnership become
worthless and all debt of the partnership was required to
be repaid in full
− Risk of loss can be created by, among other things, deficit
restoration obligations, guarantees, and pledges of the
partner’s assets, and also exists where the partner is the
lender
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19 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Allocation of Recourse and Nonrecourse Liabilities
• Generally, recourse liabilities are allocated to the partner or partners that bear the
economic risk of loss for such liability, to the extent the partner or partners bear
the economic risk of loss.
• Nonrecourse liabilities, for general liability allocation purposes (but, as described
below, not for disguised sale purposes), are allocated according to a 3-tier
waterfall:
• First tier: an amount equal to a partner’s share of the “partnership minimum gain”
attributable to that liability is allocated to the partner (very generally, the amount by which
a nonrecourse liability exceeds the book basis of an encumbered property).
• Second tier: then, an amount equal to the partner’s share of the pre-contribution built in
gain that would be allocated to such partner under Section 704(c) if the property subject
to the nonrecourse liability were sold in full satisfaction of the liability and for no other
consideration.
• Third tier: any remaining “excess nonrecourse liabilities” are allocated in accordance with
the partner’s share of partnership profits.
− As an alternative to allocating in accordance with share of partnership profits, the Section
752 regulations permit alternative (and generally more flexible ) methods of allocation. For
example, allocations can be made in accordance with the partner’s share of a “significant
item.” As described below, however, the new temporary Section 707 regulations do not
permit the use of the alternative methods for disguised sale purposes.
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20 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Guarantees Generally
• As the rules described above suggest, a partner will ordinarily be incentivized to cause itself
be allocated as much partnership debt as possible, which both:
− minimizes the likelihood of having (or minimizes the consequences of having) a disguised sale;
and
− minimizes the likelihood of otherwise receiving taxable deemed or actual distributions.
• Traditionally, the most common way for a partner to maximize its debt allocation was to
guarantee the debt
• The rules generally assume that the partner will make good on its guarantee
• Pre-Existing Anti-Abuse Rules
− Treas. Reg. § 1.752-2(j)(1)): “An obligation of a partner or related person to make a
payment may be disregarded or treated as an obligation of another person for
purposes of this section if facts and circumstances indicate that a principal purpose of
the arrangement is to eliminate the partner’s economic risk of loss with respect to that
obligation or create the appearance of the partner or related person bearing the
economic risk of loss when, in fact, the substance of the arrangement is otherwise.
− Treasury Reg. § 1.752-2(j)(3): “An obligation of a partner to make a payment is not
recognized if the facts and circumstances evidence a plan to circumvent or avoid the
obligation.”
− The IRS has sought to apply this anti-abuse rule with some success.
» See, e.g., Canal Corp. v. Comm’r.
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21 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Generic Leveraged Partnership Structure
Partnership
Bank
Owner Investor
Assets w/ basis of
$0 and FMV $2000
Asset w/ basis of
$1500 and FMV of
$2000
Loan of $1800
$1800 of loan
proceeds
Owner
Guarantees
Loan 1 1
2
2
3
1. Owner contributes
appreciated property and
Investor contributes other
property to Partnership in
exchange for interests in
Partnership.
2. Partnership borrows cash
from unrelated Bank.
− Owner guarantees
Partnership’s borrowing.
3. Partnership distributes
$1800 of loan proceeds to
Owner.
Result under prior law: Owner
does not recognize any gain.
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22 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Brief Introduction to the “Bottom Dollar Guarantee”
• A “Bottom Dollar Guarantee” is a guarantee of debt only to the extent that a
certain minimum amount is not received from the primary obligor.
• Consider the following example:
• Guarantor executes a Bottom Dollar Guarantee of $200 of an Obligor’s $2000 loan.
• If the Obligor repays $200 or more of the $2000 it owes, the Guarantor has no liability.
• If the Obligor repays $150 of the $2000 it owes, the Guarantor has an obligation to pay
$50.
• If the Obligor repays $0 of the $2000 it owes, the Guarantor has an obligation to pay
$200.
• Bottom Dollar Guarantees were commonly used to make a partner bear the economic
risk of loss for a partnership liability under the Section 752 rules, while limiting the
partner’s actual economic risk with respect to the guarantee.
• Contrast the Bottom Dollar Guarantee with:
• First dollar guarantees: lender may go after guarantor if any amount of the liability is
unrecovered from the obligor
• Vertical slice guarantees: a percentage of each unrecovered dollar is guaranteed
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23 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
(Over) Simplified Bottom-Dollar Guarantee Structure
UP-REIT
Partnership
REIT Real Estate with $0
basis, FMV of
$2000 subject to
nonrecourse liability
of $1,800
PRIOR LAW
Historic Owners have held real
estate for several years. The real
estate has a zero basis and is
subject to an $1,800 nonrecourse
qualified liability.
1. Historic Owners contribute
property to UP-REIT
Partnership, a large
partnership with a diversified
real-estate portfolio in
exchange for a small interest
in UP-REIT Partnership and
UP-REIT Partnership pays off
the liability.
2. To prevent gain on the liability
shift, under prior law, Historic
Owners enter into a “Bottom-
Dollar Guarantee” of UP-REIT
Partnership’s other liabilities.
Historic Owners Guarantee
Bank Loan to UP-REIT
Partnership, to the extent
Bank collects less than
$1,800 on the loan.
Historic
Owners
1
Bank
Outstanding unsecured
loan of $50,000.
2
*Bottom Dollar Guarantees or the opportunity to
enter into such guarantees in the future may also
be desirable when property is contributed but
remains subject to a pre-contribution liability, if
there is a later liability shift because of changes in
the contributing partner’s 704(c) amount
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24 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Brief Overview of the 2014 Proposed Regulations
• “Payment Obligation Standards” of Proposed Treasury Reg. § 1.752-2(b)(3): In order for a liability
to be treated as a recourse liability of a partner, all of the following must be true:
− The partner’s obligation to repay must require partner to maintain “commercially reasonable” net worth
throughout period of payment obligation.
− The obligation must subject the partner to “commercially reasonable” restrictions on transfers for low or
no consideration.
− The obligor partner must provide “commercially reasonable” documentation regarding financial
condition on a periodic basis.
− The term of payment obligation must not end prior to the term of the partnership liability.
− The partner’s payment obligation must not require any other primary obligor or other obligor with
respect to partnership liability to hold money or other liquid assets in an amount that exceeds the
reasonable needs of such obligor. AND
− The partner must receive arm’s length consideration for entering into the payment obligation.
• Importantly, the Payment Obligation Standards would have applied for all purposes, not just for
purposes of exceptions to disguised sale treatment.
• Each Payment Obligation Standard was a necessary prerequisite for qualification as a recourse
liability. In other words, if any one of the Payment Obligation Standards was not met to any extent,
then a liability would be treated as fully nonrecourse.
• In contrast, although the Tax Court in Canal Corp. referenced many facts similar to the Payment
Obligation Standards, it was the sum total of these facts that the Tax Court found dispositive under
the -2(j) anti-abuse regulation.
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25 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Brief Overview of the 2014 Proposed Regulations (cont’d)
• In addition to the Payment Obligation Standards, the Proposed
Regulations specifically targeted “Bottom Dollar Guarantees.” Prop.
Reg. § 1.752-2(b)(3)(ii)(F) would have required that a partner must be
liable up to the full amount of the partner’s payment obligation, if and
to the extent that any partnership liability is not satisfied in order for
the obligation to be respected.
• In addition, a “Net Value Requirement” would have recognized
payment obligations of a partner or related person “only to the extent
of the net value of the partner or related person as of the allocation
date”. Former Prop. Reg. § 1.752-2(k).
• Certain changes were made to permissible methods of allocating
excess nonrecourse liabilities, including the removal of allocation in
accordance with a significant item of income.
• These portions of the 2014 Proposed Regulations received a
relatively negative reception from many tax practitioners.
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26 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Brief Overview of New Regulations
• On October 4, 2016, the Treasury released a sweeping package of proposed,
temporary, and final regulations that drastically change the rules described above.
• Key Provisions of the Regulations:
− Final Regulations:
» Section 707:
> Capex amendments (20% imitation applied property-by-property; contributions of partnership interests;
overlap with qualified liabilities)
> De minimis exception to taint of qualified liabilities
> Step-into-shoes rules for capex and qualified liabilities
> New category of qualified liability
> Alternative methods of allocating nonrecourse liabilities not available for disguised sale purposes
− Temporary Regulations:
» Section 707:
> All liabilities allocated as tier 3 nonrecourse
» Section 752:
> Bottom Dollar Guarantees disregarded
− Proposed Regulations:
» Section 752: New anti-abuse rule for disregarded guarantees and other payment obligations
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28 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Overview of New Section 752
Regulations
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29 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
New Temporary 752 Regs—Bottom Dollar Guarantees
• For all purposes of Section 752 (not just for disguised sale purposes), “bottom
dollar payment obligations” (“BDPOs”) will not taken into account for
determining whether a liability is recourse to a partner, subject to certain
exceptions.
− Reasoning: IRS generally views such arrangements as lacking significant non-tax
commercial business purpose
• BDPO defined: “[A]ny payment obligation other than one in which the partner or
related person is or would be liable up to the full amount of such partner’s or
related person’s payment obligation if, and to the extent that, any amount of the
partnership liability is not otherwise satisfied”.
− Includes tiered partnerships, intermediaries, senior and subordinate liabilities and
other obligations involving multiple liabilities if the liabilities were incurred as part of a
common plan to avoid having at least one of the liabilities be treated as a bottom-
dollar payment obligation
• Disclosure is required of all BDPOs that are incurred or modified (including
obligations that are recognized under the 90% rule on the following slide)
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30 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
New Temporary 752 Regs—Exceptions
• Exceptions: An obligation is not treated as a BDPO merely because:
− Capped Obligations: a maximum amount is placed on the obligation
− Vertical Slice Guarantees: the obligation is stated as a fixed percentage of every dollar of
the partnership liability to which such obligation relates
− Certain Rights of Contribution: there is a right of proportionate contribution running
between co-obligors with respect to a payment obligation for which each of them is jointly
and severally liable
• 90% risk retention exception: Additionally, a BDPO is nevertheless recognized if:
− The payment obligation would otherwise be recognized, but for the effect of an indemnity,
reimbursement agreement, or similar arrangement, AND
− Taking into account the indemnity or reimbursement agreement, the partner or related
person remains liable for at least 90% of the partner’s or a related person’s initial payment
obligation (i.e., the amount of the payment obligation determined without regard to the
indemnity or reimbursement obligation).
• Anti-Abuse Rule:
− Finally, an anti-abuse rule allows the IRS to respect certain payment obligations that
otherwise would be disregarded under the new rules, if the obligation was structured
purposefully to allow the related liability to be treated as nonrecourse (e.g., where a
principal purpose to have other partners include the debt in their basis)
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31 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
New Temporary 752 Regs—Effective Dates and Expiration
• Immediate effectiveness for new obligations:
− The new bottom dollar guarantee rules became effective immediately for all liabilities
incurred/assumed by a partnership, and payment obligations undertaken by partner,
after Oct. 4, 2016
• Grandfathering of preexisting liabilities/obligations and those under contract:
− The new rules do not apply to liabilities incurred/assumed and payment obligations
undertaken prior to Oct. 5, 2016, nor do they apply to liabilities/obligations incurred
pursuant to a written binding contract in effect prior to Oct. 5, 2016
» Note, however, that post-Oct. 4 modifications or refinancings of existing
debts/payment obligations are generally not grandfathered
• Seven-year transitional relief: The regulations contain a seven-year transition rule for
partners with negative tax capital accounts:
− To the extent a partner’s negative tax capital account (i.e., the excess of its allocable
share of partnership liabilities over its adjusted basis in its partnership interest) as of
Oct. 5, 2016, a partner may continue to apply prior law to debts and payment
obligations incurred even after Oct. 4, 2016, but only for seven years thereafter
− The amount for which this transitional rule is available is reduced as a partner’s
negative tax capital is reduced following Oct. 4, 2016
• Expiration if not finalized sooner: Oct. 4, 2019
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32 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
New Proposed 752 Regs—General Anti-Abuse Rule
• Under the proposed regulations, even if an obligation passes muster under the
BDPO rules, it must also be tested under a more general anti-abuse rule
• The new proposed regulations differ from the 2014 proposed regulations
− Abandon the “all-or-nothing” approach and instead create a non-exclusive list of 10
factors in a new anti-abuse rule indicating plan or intention to avoid payment
obligation, including:
» Lack of commercially reasonable restrictions to protect likelihood of payment
» Unilateral right to terminate payment obligation (unless objective factors)
» Obligor holds excess assets
» Inability of creditor to pursue remedies
» Credit support did not modify borrowing terms
» Beneficiary of credit support did not receive relevant documents within reasonable
time
− Net-value requirement replaced with a presumption: evidence of a plan to
circumvent or avoid an obligation is deemed to exist no reasonable expectation that
obligor will have the ability to satisfy the obligation
• Effective: when published in final form
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33 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Overview of New Section 707
Regulations
Page 34
34 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
New Temporary 707 Regs—All Liabilities
Nonrecourse
• The most significant change in the new Section 707 regulations
(contained in the temporary portion of the reg package) is that for
disguised sale purposes, all liabilities are treated as nonrecourse
• Guarantees, even guarantees fully recognized under the new final and
proposed 752 regulations, no longer can prevent a shift in liabilities for
disguised sale purposes
• This means that an assumption of any nonqualified liability will
always cause the related contribution to be treated in part as a
taxable disguised sale
• Similarly, a debt-financed distribution in excess of the partner’s pro
rata share of the liability (based on share of profits) will trigger a
partial sale if not otherwise exempt under the disguised sale rules
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35 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
New Temporary 707 Regs—Allocation of Liabilities
• All liabilities are generally treated as Section 752 “excess
nonrecourse liabilities”—i.e., allocated under “tier 3”
− Under new final regulations, Treas. Reg. 1.752-3 has
been amended so that the alternative methods for
allocating excess nonrecourse liabilities in tier 3 (e.g.,
“significant item” method) do not apply for disguised
sale purposes
• A contributing partner’s share of liabilities is reduced,
however, by any amount with respect to which any other
partner has the risk of loss
• In other words, a contributing partner’s guarantee cannot
help, but guarantees by other partners can hurt
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36 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Result of attempted leveraged partnership structure (same
example as above) under new Temporary 707 Regulations
Partnership
Bank
Owner Investor
Assets w/ basis of
$0 and FMV $2000
Asset w/ basis of
$1500 and FMV of
$2000
Loan of $1800
$1800 of loan
proceeds
1. Notwithstanding Owner’s
guarantee of the loan, for
purposes of applying the
disguised sale rules, the
$1800 liability is treated as
nonrecourse.
2. The nonrecourse liability, for
disguised sale purposes is
allocated according to “tier 3”
of the nonrecourse liability
allocation under Section 752.
3. Assuming Owner owns 1/11 of
the Partnership, Owner is
allocated $163 of the Bank
Loan.
4. Owner is treated as receiving
a distribution of $1637 ($1800
- $163) that is part of a
disguised sale. Owner
recognizes gain as if it sold
81.85% (1637/2000) of the
property.
Owner
Guarantees
Loan
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37 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
New Temporary 707 Regs—Effective Dates and
Expiration
• The new temporary regulations have a 90-day delayed effective date
− The regulations are effective for “any transaction with respect to which all transfers
occur on or after January 3, 2017”
• Because “all transfers” are required to occur on or after January 3, 2017 in order to be
subject to the new regulations, certain transactions are grandfathered even where a part
of the transaction takes place after the January 3, 2017 effective date
− E.g., contribution made before Jan. 3, but debt-financed distribution and related
guarantee not made until after Jan. 3.
• But because the 752 temporary regulations are immediately effective, any guarantee
would need to pass muster under those regulations even if the transaction can be
grandfathered for 707 purposes
• Expiration if not finalized sooner: Oct. 4, 2019
• Possible Repeal: According to a report issued by the Secretary of the Treasury on October
2, 2017, Treasury is “considering whether the proposed and temporary [707] regulations
should be revoked and the prior regulations reinstated”
• By contract, although Treasury will continue to study the temporary 752 regulations on
BDPOs, it does not expect to propose substantial changes to those regulations
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38 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—Ancillary Disguised Sale
Issues
• In addition to the significant changes in the temporary
regulations, Treasury issued final Section 707 regulations
that address a number of ancillary issues, many (but not all)
of which were resolved in a taxpayer-favorable manner:
− Capex amendments (20% imitation applied property-by-
property; contributions of partnership interests; overlap
with qualified liabilities)
− De minimis exception to taint of qualified liabilities
− Step-into-shoes rules for capex and qualified liabilities
− New category of qualified liability
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39 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—Capex Rules (Background)
• An important exception to the disguised sale rules is the
“preformation capital expenditure” exception
• This exception permits a contributing partner to receive
distributions from the partnership as reimbursement for
capital expenditures made by the partner within two years of
the contribution
− In general, the exception is available for expenditures only
up to 20% of the value of the contributed property
− However, the 20% limitation does not apply if the
property’s FMV is less than 120% of its basis
• The final regulations address a number of issues with the
“capex” exception
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40 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—Capex Rules (20%
Limitation)
• 20% Limitation Tested Property-by-Property
− Under the final regulations, when multiple properties are
contributed in a single transaction, the 20% capex
limitation is generally tested on a property-by-property
basis, not in the aggregate
− Depending on the facts, this rule may be taxpayer-
favorable or taxpayer-unfavorable (see examples
below)
− No guidance as to what constitutes a “property”
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41 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—Capex Rules (20% Limitation
Examples)
• EXAMPLE 1
• Facts: X owns two assets. Asset 1 (FMV $200, basis $170) and Asset 2
(FMV $200, basis $150). X bought each asset for $200 each within the last
two years.
• Property-by-Property Result:
− Asset 1 is not substantially appreciated (120% of $170 = $204).
» Result: Entire $200 may be reimbursed.
− Asset 2 is substantially appreciated (120% of $150 = $180).
» Result: Only 20% of $200 or $40 may be reimbursed.
− Total amount qualifying under Treas. Reg. § 1.707-4(d): $240
• Aggregation Result:
− Total FMV would be $400 and total basis would be $320. The properties, in the
aggregate, are substantially appreciated (120% of $320 = $384).
− Result: Only 20% of $400 or $80 would qualify under Treas. Reg. § 1.707-4(d).
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42 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—Capex Rules (20% Limitation
Examples)
• EXAMPLE 2
• Facts: Same facts as Example 1 except basis of Asset 2 is $165, not $150.
• Property-by-Property Results:
− Asset 1 is not substantially appreciated (120% of $170 = $204).
» Result: Entire $200 may be reimbursed.
− Asset 2 is substantially appreciated (120% of $165 = $198).
» Result: Only 20% of $200 or $40 may be reimbursed.
− Total amount qualifying under Treas. Reg. § 1.707-4(d): $240
• Aggregation Results:
− Total FMV would be $400 and total basis would be $335. The properties, in the
aggregate, are not substantially appreciated (120% of $335 = $402).
− Result: Entire $400 would qualify under Treas. Reg. § 1.707-4(d).
Page 43
43 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—Other Capex Rules
• New Tiered Partnership Rules:
− If Partner contributes property on which he’s made capex to a lower-tier partnership
(LTP) and then contributes the LTP interests to an upper-tier partnership (UTP):
» UTP steps into the shoes of Partner with respect to capex (and so can be reimbursed
by LTP even though UTP did not incur the capex), and
» Partner can look-through UTP with respect to the capex (and so can be reimbursed
by UTP even though UTP does not own the contributed property)
• Overlap with Qualified Liabilities:
− One category of qualified liability is a liability incurred to make capital expenditures on
the contributed property
− Prior to the issuance of the new regulations, there was an open question as to the extent
to which a partner could both (i) avoid gain on a shift in such a liability under the
qualified liability rules, and (ii) receive cash reimbursements of the expenditures. If so,
this could represent a double-counting of the expenditures.
− The new regulations clarify in this case that the capex exception applies to distributions
only to the extent of the contributing partner’s share of the qualified liability
Page 44
44 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—De Minimis Exception to
Qualified Liability Taint
• As noted above, if a contributing partner receives even a dollar
of disguised sale consideration (including through a shift in
nonqualified liabilities), a portion of any assumed qualified
liabilities are tainted
• The new regulations contain a de minimis exception to this
rule:
− Qualified liabilities will not be tainted if the total amount of
nonqualified liabilities assumed by the partnership is the
lesser of 10% of all qualified liabilities assumed by the
partnership or $1 million.
• Because of the $1 million threshold, many transactions will
not benefit from this rule
Page 45
45 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—Step-into-Shoes Rule
• Prior to the new regulations, it was generally unclear when and to
what extent a transferee of property would step into the transferor’s
shoes with respect to preformation capex made by the transferor
• Similarly unclear was whether a qualified liability retained its status
as qualified when assumed by a transferee
• Previous guidance on both points was generally limited to 381
transactions (e.g., 368 reorganizations, 332 liquidations) and certain
other limited situations addressed in the prior regulations
− For example, unclear what happened in other nonrecognition
transactions, such as a 721 or 351 contribution or a 731
partnership distribution
• The new regulations clarify that a transferee steps into the
transferor’s shoes, both with respect to preform capex and qualified
liabilities, to the extent the property/liability was acquired/assumed in
a nonrecognition transaction under 721, 731, 351, and 381.
Page 46
46 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Final 707 Regulations—New Qualified Liability
• The regulations create a new class of qualified liabilities:
− “A liability that was not incurred in anticipation of the transfer of the
property to a partnership, but that was incurred in connection with a
trade or business in which property transferred to the partnership was
used or held but only if all the assets related to that trade or business are
transferred other than assets that are not material to a continuation of the
trade or business”
• Key requirements
− “not in anticipation of the transfer of the property to a partnership”
− “in connection with”
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48 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Practical Implications and Planning
Techniques
Page 49
49 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Immediate To-Dos for Existing Partnerships
• Partners and partnerships that have debt in their structures should undertake an evaluation of
the effects of the new Section 752 rules on those structures
− This is especially true for partnerships, including many UPREITs, that have debt-
maintenance guarantee-opportunity obligations with their partners. For these
partnerships, the stakes may be covenant breaches.
• Given that currently outstanding debt and payment obligations are grandfathered, the main
pressure points for existing partnerships will be modifications and refinancings; these are not
grandfathered and could trigger immediate application of the new rules (or application at the
end of the seven-year transition period; see next slide).
− Example: Partner X owns 10% of Partnership and has a basis in his partnership interest
of $40. Partnership has one nonrecourse liability of $1000, $200 of which is allocated to
Partner X because Partner X has undertaken a BDPO. Assume Partnership refinances
the debt with $1000 of new debt (to which same BDPO applies), and assume that the
seven-year transition rule discussed above does not apply (e.g., because the refinancing
took place more than seven years after the promulgation of the regulations).
− Result: Partner X’s BDPO is disregarded, meaning that Partner X’s share of the new
liability is only $100 (10% of $100). This causes Partner X to receive a $100 deemed
distribution, triggering $60 of gain.
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50 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Immediate To-Dos for Existing Partnerships (cont’d)
• Any partners that expect that they may want or need to rely on the seven-year
transitional relief will need to determine negative tax capital accounts as of Oct. 4,
2016, and will need to diligently track changes in those accounts and partnership
allocations that can reduce the maximum amount of guarantee that is available for
the benefit of the transitional rule
• Partners and partnerships should also begin planning for the expiration of the
seven-year period—what will the effect be for your partners at the end of the period
when the new rules immediately take effect, and how can that be mitigated?
− Example: Same facts as above, except assume the seven-year transition rule
initially applies to the refinanced debt and BDPO. If the debt remains
outstanding at the end of the seven-year period, the new rules will take effect
at that point, triggering the $50 of gain then, unless the BDPO is restructured
to comply with the new regulations.
− Restructuring of the payment obligation to satisfy the new rules, or maintaining
more partnership-level debt in order to provide sufficient debt allocations for
partners whose payment obligations do not satisfy the new rules, may be
required
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51 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Strategies for Dealing with the New 707 Rules—
Post-Effective Planning
• For non-grandfathered transactions, the new regulations largely
shut down the opportunity for tax-deferral through (i)
contributions of property subject to nonqualified liabilities, and
(ii) traditional debt-financed distributions occurring in
connection with a contribution of property.
• There are, however, some alternatives that could be considered
Page 52
52 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Leveraged Partnership Alternatives—Delayed Debt-
Financed Distribution
• Steps:
− Step 1: Partner contributes Property (free of nonqualified liabilities) to
Partnership
− Step 2: More than two years later, Partnership makes a debt-financed
distribution. Partner guarantees enough of the debt to give it sufficient basis to
absorb the distribution without recognizing gain.
• Considerations:
− Guarantee cannot be a BDPO or other guarantee that is disregarded under the
new Section 752 regulations.
− Even though the distribution is presumed not to be part of a sale (because it
occurs more than two years after the contribution), this presumption could be
rebutted if there is not sufficient entrepreneurial risk with respect to the
occurrence of the subsequent distribution.
» This means that the parties would have to take material business risk of the
later distribution not occurring or occurring on terms not initially anticipated.
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53 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Leveraged Partnership Alternatives—Debt
Structured as Qualified Liability
• Steps:
− Step 1: Partner borrows against property. Borrowing is secured by
Property.
− Step 2: More than two years later, Partner contributes Property to
Partnership, subject to the debt. Because the debt was incurred
more than two years earlier and secured the contributed Property,
the debt is a qualified liability.
• Considerations:
− Again, the contribution should not be so certain that there is not
significant entrepreneurial risk due to change in circumstances.