Brave New World for Partnership Debt Allocation Tax Planning
In October 2016, the Treasury Department published a package of final, temporary, and proposed regulations that are regarded by many as the most substantial changes to partnership tax law since the 1980s. Common tax-deferred planning techniques involving so-called bottom-dollar guarantees, and partnership transaction structures that rely upon certain exceptions to disguised sale treatment are no longer viable. Worse yet, partners with negative tax capital accounts who do not – or cannot – restructure guarantees to abide by the more restrictive requirements will be forced to recognize taxable gain after a seven-year period of transition “relief,” if not sooner.
This commentary highlights what are arguably the two most significant areas of change, but it is not intended to summarize all aspects of the new regulations. For a complete understanding of how the new regulations impact you, please contact your KSM advisor.
Bottom Guarantees – Do Not Bet Your Bottom Dollar
The operative word in the introductory title is “brave,” as the Treasury Department and IRS now expect increased risk to be taken by partners seeking special allocations of partnership debt. Prior to the publication of the new regulations, partners could utilize bottom-dollar guarantees and other similar arrangements to attract debt allocations with minimal risk. Final and temporary regulations under IRC Section 752 now respect only obligations of joint and several liability, top-dollar guarantees, or vertical slice guarantees as recourse liabilities; all other liabilities will be treated as nonrecourse.
Whether debt is treated as recourse or nonrecourse for purposes of Section 752 is critical, as recourse debt is solely allocated to partners who bear the economic risk of loss under a hypothetical, worst-case liquidation analysis in which partnership assets are deemed worthless and all debts come due. Nonrecourse debt, by comparison, is allocated according to a separate three-tier methodology which, absent minimum gain or 704(c) built-in gain, generally results in a potentially less desirable pro-rata allocation. Therefore, it stands to reason that if liabilities shift from being treated as recourse to nonrecourse, partners who previously relied upon special allocations of recourse debt may find themselves with deficient liability allocations relative to their negative tax capital accounts, the consequence of which will be forced recognition of taxable gain. Also worth noting is a new disclosure requirement in which certain “bottom dollar payment obligations” must be disclosed on Form 8275 and attached to partnership tax returns.
- Effective Date
- The new rules pertaining to bottom dollar payment obligations generally apply for new debts incurred or assumed by a partnership on or after Oct. 5, 2016.
- Importantly, transition relief is available for partners with negative capital accounts whose allocable share of recourse liabilities exceeds their adjusted basis as of Oct. 5, 2016. The extent of this excess (the “Grandfathered Amount”) cannot increase, and sales of partnership property that trigger built-in gains will cause a reduction in the Grandfathered Amount.
Partnership Disguised Sales – Not a Blessing in Disguise
The new regulations also introduce severe limitations to available debt allocation methods for partnership transactions seeking to avoid disguised sale treatment. Solely for purposes of Section 707 disguised sales, all debt is treated as nonrecourse and can only be allocated according to a partner’s share of partnership profits (pro-rata, generally). Because otherwise recourse debt must be treated as nonrecourse for this purpose and thus cannot be specially allocated to a property-contributing partner, it is extremely unlikely that so-called “leveraged partnership” transactions that are dependent on the debt-financed distribution exception under Section 707 will be entirely tax-deferred.
Now more than ever, taxpayers seeking to contribute encumbered property to partnerships must enter such transactions with eyes wide open to ensure they don’t run afoul of the new regulations and trigger unanticipated taxable gain. A little bravery doesn’t hurt, either.
- Effective Date
- The new rules pertaining to disguised sales are generally effective for any transaction with respect to which all transfers occur on or after Jan. 3, 2017.
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