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Issue 1, 2014  |  Table of Contents

Don't Bet Your Bottom Dollar
By John Estridge, CPA

On Jan. 29, 2014, proposed regulations under Internal Revenue Code Section 752 were issued by the U.S. Treasury Department and the Internal Revenue Service, which would preclude partners of partnerships (and members of limited liability companies) from utilizing customary guarantees of partnership debt to bolster the tax basis of partnership interests1. If finalized in current form, the totality of these proposed changes would have far-reaching effects on the fundamental allocation methodologies for recourse and nonrecourse partnership liabilities. Without proper planning, owners of partnership interests with negative tax basis capital accounts could find themselves having to recognize significant gains due to the proposed changes. All owners of partnership interests should discuss the impact of the proposed regulations with their tax advisors. 

Current Law

A partner’s allowable losses are limited to the amount of their tax basis2. Importantly, §752 enables a partner’s tax basis in his partnership interest to be increased by his allocable share of partnership liabilities (or decreased by a net reduction of allocable liabilities). A partner is allocated a partnership recourse liability to the extent they bear the “economic risk of loss” for such liability, as determined under a hypothetical “constructive liquidation” analysis3. Partnership nonrecourse liabilities are those for which no partner bears the “economic risk of loss” and are allocated according to a separate three-tier allocation methodology.

Under the hypothetical “constructive liquidation” analysis, it is assumed that the partnership liquidates with all partnership assets (including cash) having no value and all debts coming due. Under the perspective of this worst-case scenario, whether a partner’s debt guarantee is top dollar (highest risk) or bottom dollar (lowest risk), identical recourse liability allocation is achieved.

Impact of Proposed Regulations

Authors of the proposed regulations articulated explicit concern that some partners have entered into payment obligations solely to obtain tax benefits, described as being “not commercial.” This assertion provides that a partner guarantee will only convey recourse liability allocations if the following six factors are present:
  1. The partner or related person must maintain a commercially reasonable net worth throughout the term of the payment obligation or be subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration.
  2. The partner or related person is required periodically to provide commercially reasonable documentation regarding the partner’s or related person’s financial condition.
  3. The term of the payment obligation does not end prior to the term of the partnership liability.
  4. 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.
  5. The partner or related person received arm’s length consideration for assuming the payment obligation.
  6. In the case of a guarantee or similar arrangement, 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.

Undermining bottom guarantees (and vertical slice guarantees), the sixth factor’s effect is to require exclusive, top-dollar risk if a payment obligation is to be respected.

The proposed regulations also expand the net value requirement under §1.752-2(k) to every partner other than an individual or decedent’s estate (currently applicable only to disregarded entities). A partner’s obligation in which all six factors are present is allowable only to the extent of the partner’s net value, exclusive of any value attributable to the associated partnership. Additional guidance would need to clarify the types of documentation that would sufficiently establish a partner’s net value and the frequency at which the second factor must be administered.

Nonrecourse Liabilities

The proposed regulations would additionally provide new rules for allocation of nonrecourse liabilities, the detail of which is outside the scope of this article. In summary, the allowable allocation methods with respect to excess nonrecourse liabilities would be revised to eliminate the “significant item method” and the “alternative method,” while instead providing a significant conceptual change with the offering of a new allocation method driven by “liquidation value percentages.”

Proposed Applicability for Changes to Recourse Liability Treatment

The proposed regulations call for prospective application and include a seven-year transition period grandfathering the current treatment of recourse liabilities to the extent of a partner’s negative capital account, with certain adjustments, on the date the proposed regulations are finalized. During the transition period, partners would have the flexibility to modify existing arrangements or establish new guarantees while still falling under the purview of the grandfathered laws. Importantly, partnership, S-corporation or disregarded entity partners would lose applicability of the transition period if they experience, directly or indirectly, a 50 percent or greater ownership change.

1 REG-119305-11, 79 Fed. Reg. 4826 (1/30/14)
2 I.R.C. §704(d)
3 Reg. §1.752-2(b)

About the Author
John Estridge is a director in Katz, Sapper & Miller’s Real Estate Services Group. John's background includes tax planning, research, and compliance, as well as financial statement compilation and financial modeling. Connect with him on LinkedIn.