AM 2014-003, LLC Debt and Member Guaranties

By Jorge Otoya, Bird Education Specialists in Taxation, LLC 

This AM was dated August 27, 2013, but released on April 4, 2014 and deals with the intersection of the at-risk rules of § 465 and LLC member guaranties.  Although this document does not have precedential effect, it does provide some insight into the IRS’s position on audit regarding the effect of LLC member guaranties on the at-risk basis of the members in the activity of an LLC.  AM 2014-003 tackles three queries:

Query 1: What happens under § 465 when an LLC member guaranties the debt of the LLC? 

Query 2: What if the LLC debt is “qualified nonrecourse financing”?

Query 3: What happens to the other members under Query 2 above?

Discussion (Query 1):

From a policy standpoint, if an LLC member guarantees the debt of the LLC (whether the LLC is treated as a partnership or a disregarded entity for federal income tax purposes), the member has assumed a real economic risk with respect to the guaranteed debt, assuming it is a “real” guarantee and that the member would not be entitled to some form of repayment if it had to come out of pocket as a result of the guarantee. 

But does this grant the member at-risk basis for section 465 purposes with respect to the guaranteed debt?  One would think from a policy perspective that the member should receive at-risk basis for its guarantee and treat a partnership liability for at-risk purposes consistent with the classification of such a liability as recourse under § 752. 

Proposed Treas. Reg. § 1.465-6(d) is potentially troubling in this regard.  It provides that a person is not at-risk for a guaranty with respect to an amount borrowed by another person, unless he actually comes out of pocket and has exhausted its legal rights against the primary obligor (the Guarantee Rule).  If the Guarantee Rule applies to members that guarantee LLC debt, this would mean that the guarantor member would not receive at-risk basis for such guarantee unless (i) he actually made a payment with respect to the guarantee; and (ii) exhausted his legal rights of subrogation against the LLC for his payment. 

As the AM indicates, in the partnership context, the example in Prop. Treas. Reg. § 1.465-24(a)(2)(ii) concludes that general partners include partnership debt in their amount at-risk because they are personally liable for such debt.  This treatment applies in the example even though general partners would have a legal recourse against the primary obligor who is the general partnership.   Although the general partners in the example are personally liable for the debt of the general partnership pursuant to state law they also have legal rights against the partnership if they had to make a payment to a partnership creditor.  Thus, they have the same recourse as a member who has guaranteed the debt of an LLC.  Interestingly, the general partners have not actually guaranteed the debt (and even though they are included in the relevant example, do not literally fall within the definition of the Guarantee Rule).  Nonetheless, from a policy perspective, it would not seem appropriate to treat taxpayers that have taken the same risk differently for at-risk purposes just because they are different types of owners.   

Indeed, in the AM, the IRS concludes as such…stating “a member who guarantees LLC debt becomes personally liable for the guaranteed debt and is in a position akin to the general partners...” and thus “a right to subrogation, reimbursement, or indemnification from the LLC (and only the LLC) does not protect the guaranteeing LLC member against loss within the meaning of § 465(b)(4).”  The IRS reasons that the Guarantee Rule was written prior to the proliferation of LLC Acts and thus it does not apply if an “LLC member guarantees LLC debt, the member has no rights of contribution or reimbursement, the guarantee is bona fide and enforceable by creditors of the LLC under local law, and the member is not otherwise protected against loss.”   This is not necessarily a great response for this taxpayer...

Discussion (Query 2 and 3):

Query 2 and 3 are essentially one in the same.  What happens to the members of an LLC when one of the members guarantees a debt that would otherwise qualify as qualified nonrecourse debt?  With respect to these queries, the IRS concludes that an LLC member guarantee of an LLC debt causes the debt to lose its qualified nonrecourse debt status because (i) the debt is no longer secured solely by real property but also by the assets of the guarantor; and (ii) a member is personally liable for repayment of the debt.  Accordingly, under the reasoning applied in Query 1, only the guarantor member receives at-risk basis.  

The other members do not receive at-risk basis with respect to this debt.  To the extent that such other member’s at-risk amount would decrease below zero, they would be required to pick up income.  This was the case for the taxpayer under audit that is the subject of this AM.  It seems that the audited taxpayers included the qualified nonrecourse debt in the at-risk basis of all of the members.  This is important because if there were deductions attributable to such debt, all of the members would have been allocated those deductions as well.   But under the AM, once the one member guarantees the debt, the debt (and any associated deductions) would be allocated solely to the guarantor. 

Observations:

What can the taxpayer do in this situation?  Query whether the taxpayer could avoid the income chargeback to the other members referenced in item 2, by arguing that the literal application of the Guarantee Rule applies.  Thus, the member guarantee has no effect on the qualified nonrecourse financing.  Typically, it is the policy of the IRS to follow its own proposed regulations on audit.   What do you think?

PLR 201421001 and Rev. Rul. 99-5

By Jorge Otoya, Bird Education Specialists in Taxation, LLC

A Trust goes in for a ruling to address various partnership related issues dealing with the formation of a securities partnership that resulted from certain trust distributions.  Below is a brief summary of the facts and issues the IRS addressed, including a noteworthy observation.  Many representations were made that appear to water down the value of the ruling:

Facts

A trust that holds, cash, securities, and 100% interest in a limited liability company (treated as a disregarded entity) that holds mainly securities is required to distribute all of its assets less a contingency reserve to its beneficiaries as a result of the death of all but one of the beneficiaries in a beneficiary group.  The securities are actively traded within the meaning of section 1092(d)(1) and will continue to be after the distributions.  Given the reserve, it plans to make these distributions in steps.  Step 1:  Form Series LLC X (Series X) and Series LLC Y (Series Y).  The trust and the disregarded entity contribute to Series X certain equity securities and to Series Y fixed income securities.  Step 2: Trust will distribute out the ownership in Series X and Series Y to the beneficiary groups.  By default, two partnerships will be formed upon the distribution with the beneficiary groups as the partners because each Series X and Y will have multiple owners.   Step 3: At the election of the beneficiaries, the Trust will subsequently either (i) make subsequent in-kind distributions to the beneficiary group for them to keep; or (ii) contribute the in-kind distributions to the new partnership

1.) Taxpayer:  On Step 1 formation, will Series X and Y be treated as disregarded entities prior to distribution to beneficiaries?  IRS: Yes.  (Taxpayer represented that each series would be treated as a juridical entity under the Proposed Regulations.

2.) Taxpayer:  On Step 2, will the formation of Series X partnership and Series Y partnership be accomplished by a deemed distribution of the assets of each series and a recontribution of those assets to a new partnership by the beneficiaries?  IRS: Yes.  Under Rev. Rul. 99-5 principles.

3.) Taxpayer: On Step 3, will the subsequent in-kind contributions to the new partnerships on behalf of the beneficiaries be treated as a distribution of assets to the beneficiaries followed by a subsequent contribution by those beneficiaries of the distributed property to the existing partnerships?  IRS..Yes, under the principles we used to answer #2 above.

4.) Taxpayer: If Yes on Step 2, is the partial-netting approach of aggregation reasonable under our facts?  IRS: Yes, but don’t play games with it.

5.) Taxpayer: If Yes on Step 2, can the new partnerships use aggregation on the property contribution for purposes of section 704(c)?  IRS: Sure, but don’t play games with it and keep sufficient records to comply with mixing bowl rules.

6.) Taxpayer: If Yes on Step 2, are the beneficiaries treated as eligible partners even though their contributions were deemed asset contributions?  Under this designation, a partner does not recognize gain on the distribution of marketable securities in excess of outside basis if other requirements are satisfied.  These requirements are meant to weed out partnerships that are not fully engaged in investment.  IRS: Yes.

Observation:

At first glance, this PLR does not seem to have wide spread applicability, given that it deals with certain investment partnerships.  One item, however, is particularly noteworthy.  Specifically, the IRS based its conclusion on Item 2 above on the principles of Situation 1 of Revenue Ruling 99-5.  The facts of Situation 1 include the sale of 50% of the ownership interest in a single member limited liability company without liabilities.  This is a taxable sale and there is some degree of uncertainty as to whether the principles of Situation 1 would apply to a tax-deferred transaction.  In this regard, this PLR gives us a recent glimpse of the view of the IRS’s on this issue.

Series-ly: Are Series LLCs Starting to Gain More Steam? State of the Law Revisited...

Jorge Otoya, Bird Education Specialists in Taxation

Summary:

I have noticed an uptick in questions this past tax season on series Limited Liability Companies (Series LLCs).  A Series LLC is a relatively new kid in school and much still remains to be answered about their behavior.  It has been a little over 3 years since the Treasury proposed regulations with respect to the income tax classification of a series of domestic Series LLCs, a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business.   (REG-119921-09, 26 CFR Part 301 (September 14, 2010).  In this blog I revisit the state of the law with respect to Series LLCs and outline the proposed regulations, which essentially provide that a series that meets its requirements, irrespective of whether it is a juridical person, will be treated as an entity formed under local law for federal tax purposes, and thus able to determine its classification under Treas. Reg. § 1.301.7701-1 and general federal tax principles. 

Background:  

Series LLCs

Delaware enacted the first series LLC statutes in 1996 and we witnessed the birth of a new baby.  Subsequently, several states had their own baby by enacting their own “series statutes” which allow the formation of a “series organization” able to establish separate series underneath it.  These types of entities are known by different names, depending on the relevant state…series LLCs, segregated account companies, segregated portfolio companies, and protected cell companies, to name a few (for purposes of this blog I will refer to all of these as Series or Series LLCs).    However, despite their different labels, series share three common characteristics.  First, a series can have different classes of ownership interests.  Second, each class of ownership interest may be tied to a specific group of assets or business operations, each potentially housed in a separate series.  Third, a creditor is limited only to the assets of the debtor series to satisfy its claim (as long as the requirements of the series statute are satisfied). 

Lets take an example.  Assume that a real estate sponsor wishes to offer investors the opportunity to participate in three different real estate asset types: (1) rental; (2) development; and (3) investment.  The sponsor could set up three separate real estate funds to house each specific type of asset.  Alternatively, the sponsor could simply establish a separate series to house each asset type.  Under the latter, the series organization could issue three different types of ownership interests or series, each representing a different asset type.  For example, series A could represent an interest in rental real estate; series B could represent an interest in the construction business; and series C in real estate investment.   

As mentioned above, one of the benefits from using a series is that it shields the assets housed in a series from claims a creditor may have against another series.  Using the example above, if a creditor had a construction related claim against series B, he or she would be limited to the assets of that series only.  The creditor would not be able satisfy his or her claim with the assets of series A or C.  But liability protection can also be achieved by using other types of legal entities.  For example, one could form a single member limited liability company (SMLLC).  So, why form a series over a SMLLC?  Perhaps there is a tax advantage?  Well maybe…   But creating and operating a series is generally not driven by tax reduction.    Instead, series LLCs typically have lower state filing fees and take less time to organize and set up than their distant cousin, the SMLLC.  However, the use of series also creates some uncertainty with respect to the classification of the series organization and the separate series underneath it for federal income tax purposes.   

The Check the Box Regulations

In 1997, Treasury simplified the law with respect to the classifications of an entity for federal income tax purposes by issuing the Check the Box regulations (the CTB Regulations).  Prior to the CTB Regulations, taxpayers had to consider a multitude of factors in determining the classification of an entity and the answer depended on the specific facts and circumstances in each case.  In many cases, it was uncertain whether the chosen classification would ultimately be respected.  As we all know, the CTB Regulations are a much-celebrated piece of guidance in this area because they provide taxpayers with certainty by allowing eligible entities to elect their own classification by simply checking a box on Form 8832.  However, despite their celebrated status, the CTB Regulations do not provide certainty with respect to series LLCs. 

A bit more background may be in order.  The CTB Regulations allow an “eligible” entity to elect its own classification.  A prerequisite for achieving eligible entity status is that an entity must be a "separate" entity.  Can a series be a "separate" entity under the CTB Regulations???  In this regard, the CTB Regulations provide that whether an organization is a separate entity is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law. (Treas. Reg. § 301.7701-3(a)(1)).  In the same breath, however, the CTB Regulations also warn taxpayers that an entity formed under local law is not always recognized as a separate entity for federal tax purposes. (Treas. Reg. § 301.7701-3(a)(3)).  For example, an organization formed by a state is not recognized as a "separate" entity for federal tax purposes if it is an integral part of the state. (Ibid).  It is unclear under these provisions whether a series can qualify as a "separate" entity, given that it is typically not a juridical entity under state law.  In other words, even though a given series may have its own name and potentially distinct business purpose, it is not recognized as a local law entity, and therefore might not be a "separate" entity for federal tax purposes. 

Proposed Regulations:

The proposed regulations attempt to resolve this uncertainty with respect to the tax classification of domestic series and certain (not all) foreign series.  They do so by treating a series as an entity formed under local law, irrespective of whether the series is a juridical entity. This treatment would enable a series to determine its treatment under the CTB Regulations and under general tax principles.

Requirements 

In order for a series to be treated as an entity formed under local law under the proposed regulations, it must be organized or established under U.S. law or under the law of any state. (Prop. Treas. Reg. § 301.7701-1(a)(5)(i)). An entity established under the laws of a foreign jurisdiction can only be treated as an entity formed under local law under the proposed regulations if its arrangements or other activities would result in its classification as an insurance company within the meaning of § 816(a) or § 831(c) if it were a domestic company. (Prop. Treas. Reg. § 301.7701-1(a)(5)(ii)).  Whether a series, that is treated as an entity formed under local law, is recognized as a "separate" entity for federal income tax purposes will be determined under the CTB Regulations and under general tax principles. (Prop. Reg. § 301.7701-1(a)(5)(iii)). 

A "series" is defined by the proposed regulations as a segregated group of assets and liabilities established pursuant to a “series statute” by agreement of a “series organization.” (Prop. Treas. Reg. § 301.7701-1(a)(5)(viii)(C)).    A "series" includes a series, cell, segregated account, or segregated portfolio, including a cell, segregated account, or segregated portfolio that is formed under the insurance code of a jurisdiction or is engaged in an insurance business. (Ibid).  However, a "series" does not include a segregated asset account of a life insurance company. (Ibid). 

A "series organization" is defined as a juridical entity that establishes and maintains a series (or under which a series is established and maintained). (Prop. Reg. Treas. § 301.7701-1(a)(5)(viii)(A)).  A "series organization" includes a series LLC, series partnership, series trust, protected cell company, segregated cell company, segregated portfolio company, or segregated account company. (Ibid).

A "series statute" is defined as a statute of a state or foreign jurisdiction that explicitly provides for the organization or establishment of a series of a juridical person and explicitly permits that:

• Members or participants of the series organization have rights, powers or duties with respect to the series;
• A series to have separate rights, powers, or duties with respect to specified property or obligations; and
• The segregation of assets and liabilities such that none of the debts and liabilities of the series organization (other than liabilities to the state or foreign jurisdiction related to the organization or operation of the series organization, such as franchise fees or administrative costs) or of any other series of the series organization are enforceable against the assets of a particular series of the series organization. (Prop. Reg. Treas. §  301.7701-1(a)(5)(viii)(B)).

You may have noticed that the definition I've described of a "series statute" focuses on the specific provisions of the series statute and not on whether the entity actually accomplishes the requirements (emphasis supplied).  For example, in certain states, in order for the debts and liabilities of the series organization or of any series to be enforceable against the assets of a series or series organization, a series is required to maintain adequate records that show the segregated assets and liabilities contained within each series.  The failure to maintain these records would allow a creditor to enforce his or her rights against the assets of all series.  Additionally, if assets of a series are used as collateral for a debt obligation of another series, this cross-collateralization would defeat the liability protection provided to the series under state law.   The proposed regulations further provide that an election, agreement, or other arrangement that permits debts and liabilities of other series or the series organization to be enforceable against the assets of a particular series, or a failure to comply with the record keeping requirements for the limitation on liability available under the relevant series statute, will be disregarded in determining whether there is a series. (Prop. Reg. Treas. §  301.7701-1(a)(5)(viii)(C)). Thus, the proposed regulations could result in a classification system that treats entities formed under the laws of the same state law equally, notwithstanding that the entities have a different economic standing.

Information Statement

If a series is treated as an entity formed under local law under the proposed regulations, the series organizer and the series are required to file a statement for each taxable year containing the identifying information with respect to the series organization as prescribed by the IRS, including information required by the statement and its instructions. (Prop. Reg. Treas. §  301.7701-6(a)).  The proposed regulations do not specifically provide what information is required to be included in the statement. 

However, in the preamble to the proposed regulations, Treasury and IRS indicate that they are tentatively considering requiring both the series organization and the series to provide (i) the name, address, and taxpayer identification number of the series organization and each of its series and status of each as a series of a series organization or as the series organization; (ii) the jurisdiction in which the series organization was formed; and (iii) an indication of whether the series holds title to its assets or whether title is held by another series or the series organization and, if held by another series or the series organization, the name, address, and taxpayer identification number of the series organization and each series holding title to any of its assets.  The statement must be filed on or before March 15 of the year following the period for which the return was made. (Prop. Reg. Treas. §  301.6071-2(a)). The due date of the statement will therefore be the same for taxpayers that file a return for the entire year or for a portion of the year. 

Effective Date and Transition Rule

The proposed regulations generally apply on the date they are published as final regulations in the Federal Register. (Prop. Reg. Treas. §  301.7701-1(f)(3)).  The preamble indicates that if on the effective date, taxpayers are treating their classification inconsistent with their classification as determined under the final regulations a taxpayer will be required to change its classification.  Moreover, the preamble warns that general tax principles will apply to determine the tax consequences of the conversion, potentially resulting in income recognition.  For example, this would be the case if a series organization and its underlying series were previously treated as one partnership for federal tax purposes, and under the final regulations are required to convert to multiple partnerships.  In such case, despite the general non-recognition treatment of partnership divisions, gain may be recognized in certain situations under the “mixing bowl” rules of §§ 704(c)(1)(B) and 737. 

There is, however, a transition rule that applies if a series established its classification prior to, September 14, the date the proposed regulations were published in the Federal Register. (Prop. Reg. Treas. §  301.7701-1(f)(3)(ii)(A)). The transition rule will apply provided that:

1      The series (independent of the series organization or other series in the series organization) conducted business or investment activity, or, in the case of a foreign series, more than half of the business of the series was issuing insurance or annuity contracts or reinsuring the risks underwritten by insurance companies on and prior to the date on which the regulations become final;

2      In the case of a foreign series, the series’ classification was relevant (as defined in Treas. Reg. § 301.7701-3(d)) and more than half of the business of the series was issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies for all taxable years beginning with the taxable year that includes the date on which the regulations become final;

3      No owner of the series treats the series as an entity separate from any other series of the series organization or from the series organization for purposes of filing any federal income tax returns, information returns, or withholding documents in any taxable year;

4      The series and series organization had a reasonable basis (within the meaning of § 6662) for their claimed classification; and

5      Neither the series nor any owner of the series nor the series organization was notified in writing on or before the date on which the regulations become final, that the classification of the series was under examination. (Ibid).

Taxpayers that meet these requirements are able to continue to treat the series organization and its underlying series as originally classified. (Ibid).  The transition rule will cease to apply, however, on and after the date on which there is a change of ownership. (Ibid).  (Prop. Reg. Treas. §  301.7701-1(f)(3)(ii)(B)). For this purpose, a change of ownership will occur if any person or persons who were not owners of the series prior to September 14, 2010, own in the aggregate an interest of 50% or more in the series organization (or series). (Ibid).  The term interest is defined in the regulations a capital or profits interest in the case of a partnership and an equity interest measured by vote or value in the case of a corporation. (Ibid).

What this Means For You and Your Clients

The final regulations could result in a change to the existing classification of a series organization and its underlying series.  Whether a series will be treated as a separate partnership under the proposed regulations may largely depend on the manner in which the deal is structured and on the particular state statute in which the series is established.  For example, under Delaware state law, a member of a series organization may be treated as having property rights with respect to the assets of the series (as opposed to property rights only to the series ownership interest).  This factor tends to show that a certain series and the members of a series organization, that have tracking rights with respect to specific assets of a particular series, constitute a separate partnership for federal income tax purposes.  

Additionally, the final regulations will play an important role in structuring a taxpayer’s business going forward.  For instance, the real estate fund sponsor of our example above could consider using a SMLLC to conduct each of its activities (rental, construction, and investment).  Assume that the fund is determined to be the sole owner of each SMLLC (and that it does not elect to be treated as an association taxable as a corporation under the CTB Regulations) so that each LLC is disregarded as separate from the fund.  Under state law, each LLC ought to be afforded liability protection from the creditors of the other LLCs and the fund.  Although certain economies available through the use of a series may be lost, others may be gained.  The fund and each disregarded entity ought to be treated as one partnership for federal income tax purposes.  The same may not be true with the use of the series, which could result in the treatment of the series organization and each series type as a separate partnership for federal income tax purposes (The investors in series A, series B, and series C are treated as separate partnerships). The resulting cost of this treatment could exceed the cost savings of using a series in the first place.

Request for Comments

Lastly, in the Preamble, the Treasury and the IRS have requested comments with respect to the proposed regulations in general and specifically with respect to the following issues, each of which should be considered as part of our client discussions:

1      Whether a series organization should be recognized as a separate entity for Federal tax purposes if it has no assets and engages in no activities independent of its series;

2      The appropriate treatment of a series that does not terminate under local law purposes when it has no members associated with it;

3      The entity status for federal tax purposes of foreign cells that do not conduct insurance businesses and other tax consequences of establishing, operating and terminating all foreign cells;

4      How federal employment tax issues and similar technical issues should be resolved. 

5      How series and series organizations will be treated for state employment tax and related purposes and how that treatment should affect the federal employment tax treatment of series and series organizations. 

6      What issues could arise with respect to the provision of employee benefits by a series organization or series;

7      The requirement for series organization and each series of the series organization to file a statement and what information should be included on the statement. 

Conclusion

The items for comments requested by Treasury indicate that there are still a myriad of unsolved mysteries applicable to Series LLCs.  It is hoped that as Series LLCs begin to gain more steam in real estate and other ventures, that there will be a more pressing need to address these questions and to finalize the Regulations.  But for now, this issue is in the freezer, behind the ice-cream, meat, and peas and carrots…guidance is not expected any time soon.  

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Treasury and IRS issue Proposed Regulations on Disguised Sales and Partnership Liability Allocations

Jorge Otoya, Bird Education Specialists in Taxation, LLC

Summary

On January 30, 2014, Treasury and the IRS issued Proposed Regulations with respect to the disguised sale rules and the rules for allocating partnership liabilities (REG-119305-11).  A major driving force behind these Proposed Regulations was the IRS’s victory in Canal Corporation and Subsidiaries, formerly Chesapeake Corporation and Subsidiaries v. Commissioner, 135 T.C. No. 9. (2010).  In Canal, the Tax Court shot down a leveraged partnership structure by concluding that the contributing partner did not have a payment obligation with respect to the partner’s indemnity in large part because the terms of the indemnity were not commercially reasonable.  

The result was not pretty…the property transferred to the partnership was held to be a disguised sale under IRC § 707(a)(2)(B)…so the taxpayer was required to recognize gain from the disguised transfer.  And to add injury to injury, the Tax Court upheld the imposition of a penalty for substantial understatement of income tax, despite the fact that the taxpayer obtained a lengthy (and very expensive, $800K, I’m in the wrong business, lottery-like, but you probably couldn’t retire on) “should” opinion from its tax advisor.

What Do the Proposed Regulations Propose Do?

The Proposed Regulations include new and modified rules that attempt to clarify the operation of the disguised sale rules for partnerships; include big “Canal-inspired” changes to the partnership debt allocation rules; and eliminate planning opportunities for taxpayers that want to extract equity from property contributed to a partnership on a tax-deferred basis. 

I. Disguised Sales

A. Background

Generally, a contribution of property to a partnership in exchange for an interest in the partnership is not a recognition event.  (§ 721(a)).  Nonrecognition also applies to distributions of property by a partnership to its partners.  (§ 731).  However, nonrecognition is not extended to transfers that are in substance a sale of property between a partner and a partnership.  (§ 707(a)(2)(B)).

The Regulations under § 707(a)(2)(B) treat a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to such partner as a sale of property if based on all of the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of property and in the case of non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risk of the partnership.  (Treas. Reg. § 1.707-1(b)(1)(i)).

B. Debt-Financed Distributions

One exception to disguised sale treatment applies under existing Regulations for certain debt-financed distributions.  Generally, if a distribution to a partner is debt-financed and the partnership incurred the debt within 90 days of the distribution, the distribution would not be considered part of a disguised sale to the extent it does not exceed the distributee partner’s share of the liability (determined under § 752).  (Treas. Reg. § 1.707-5(b)(1)). This is the exception that the taxpayer in Canal attempted to qualify for in order to defer income recognition while monetizing its property.  One of the keys to success in this structure is making sure that the liability in question is allocated to the contributing partner under § 752.  

The Proposed Regulations would clarify that the debt-financed distribution exception of Treas. Reg. § 1.707-5(b)(1) applies before the exceptions of Treas. Reg. § 1.707-4.  (Prop. Treas. Reg. § 1.707-5(b)(3)).  So, a taxpayer would first determine whether a transfer of money or other consideration is excluded from disguised sale treatment as a debt-financed distribution, and then any amount that is not so excluded would then be tested under the exceptions for guaranteed payments, reasonable preferred returns, operating cash flow distributions, and reimbursement for preformation expenditures. (Prop. Treas. Reg. § 1.707-5(g), Example 11, illustrates the ordering rule).

C. Exception for Preformation Expenditures

Another exception to disguised sale treatment applies for transfers made to reimburse a partner for preformation expenditures that are incurred during the two-year period prior to the transfer of property and that are incurred for (i) partnership organizational costs and syndication costs; or (ii) for capital expenditures related to the property contributed to the partnership (the Cap-Ex Exception).  (Treas. Reg. 1.707-4(d)).  Generally, reimbursable capital expenditures are limited to 20% of the fair market value of the contributed property, determined at the time of the contribution. (Ibid).  However, this 20% limitation does not apply if the property has not appreciated in value by more than 20%. (Ibid). 

The Proposed Regulations provide that the 20% limitation applicable to reimbursable capital expenditures and the determination of whether property has appreciated in value by more than 20% are both made on a property-by-property basis. (Prop. Treas. Reg.  §1.707-4(d)(1)(ii)(B)).  So, if a taxpayer contributes multiple properties to a partnership, it must apply these rules separately to each property.

The Proposed Regulations also would confirm that the definition the term “capital expenditure” is the same as the definition of such term under the Code and Regulations (except that such term includes capital expenditures that a taxpayer has elected to deduct and does not include deductible expenses that a taxpayer has elected to capitalize).  (Prop. Treas. Reg. §§ 1.707-4(d)(3) and 1.707-5(a)(6)(i)(C)).  So for example, under the Proposed Regulations, a taxpayer would not reduce its reimbursable capital expenditures by expenditures that were deductible or recovered through amortization or depreciation.      

D. The Double-Dip

As discussed above in the Background section, a transfer of property to a partnership and a transfer to a partner could be treated as a disguised sale.  For this purpose, if a partnership assumes or takes property subject to a partner liability that is not qualified, the partnership would be treated as transferring consideration to the partner if liability is allocated to the other partners (determined under the § 752 rules with some modifications).  (Treas. Reg. § 1.707-5(a)(1)).  However, this rule does not apply if a partnership assumes or takes property subject to a qualified liability (as long as the transfer is not otherwise treated as a disguised sale under any other provision).  (Ibid). 

One type of qualified liability is a liability that is allocable under the rules of Treas. Reg. § 1.163-8T to capital expenditures with respect to the property transferred to the partnership (a Capital Expenditure Qualified Liability).  (Treas. Reg. § 1.707-5(a)(6)(i)(C)).  You may have noted that a Capital Expenditure Qualified Liability and the Cap-Ex Exception both relate to capital expenditures attributable to contributed property.

Under current law, there is a great deal of uncertainty about whether partners can double-dip to take advantage of both exceptions, especially if a partner is able to extract from the partnership more than his equity in the contributed property…a result that seems at odds with the congressional intent behind the disguised sale rules.  Informally, Treasury and IRS officials have objected to the double-dip on grounds that in order for the Cap-Ex Exception to apply, a transfer to a partner must be made to reimburse such partner for capital expenditures.  And if such expenditures were debt-financed and the economic responsibility for that debt shifts to another partner under § 752, there would be no economic outlay to reimburse.

Consistent with those comments, Prop. Treas. Reg. § 1.707-4(d)(2) provides that a transfer of money or other consideration by a partnership to a partner is not made to reimburse a partner for capital expenditures funded by a Capital Expenditure Qualified Liability to the extent such transfer exceeds the partner’s share of the liability (as determined under § 1.707-5(a)(2)).  No double-dip for you!

E. Qualified Liabilities

Speaking of qualified liabilities, the Proposed Regulations add a new type of liability to the list.  The new qualified liability would be one that was not incurred in anticipation of the transfer of 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 material assets related to the trade or business are transferred.  (Prop. Treas. Reg. § 1.707-5(a)(6)(i)(E)).  This type of liability was added to the list because “IRS and the Treasury Department believe the requirement that the liability encumber the transferred property is not necessary to carry out the purposes of section 707(a)(2)(B)…” with respect to such a liability.  A partnership must disclose the treatment of such a liability as a qualified liability, if a partner incurred the liability within the two-year period prior to the date of the transfer (or written agreement to transfer).  (Prop. Treas. Reg. § 1.707-5(a)(7)(ii)).

F. Anticipated Reductions

The Proposed Regulations would answer the question of whether the anticipation that liabilities will be repaid from ongoing partnership operations will reduce a partner’s share of liabilities for purposes of Treas. Reg. § 1.707-5(a)(3).  Because such a repayment is generally subject to the entrepreneurial risks of the partnership, the Proposed Regulations would not treat it as an anticipated reduction.  (Prop. Treas. Reg. § 1.707-5(a)(3)(B)). 

Additionally, a reduction in a partner’s share of liabilities that results from the decrease in the net value of a partner or related person’s net value (see below discussion for the proposed regulations with respect to liability allocations under § 752 which impose a net value requirement) that takes place within two years of the partnership incurring, assuming, or taking property subject to a liability, is presumed to be an anticipated reduction and must be disclosed.  Taxpayers would be allowed to rebut the presumption by clearly establishing based on facts and circumstances that the reduction was not anticipated.  (Prop. Treas. Reg. § 1.707-5(a)(3)(ii)). 

II. Partnership Liabilities

A. Background

One of the distinguishing features of using a partnership to conduct business is that a partner is allowed to add its share of partnership liabilities to the basis of its partnership interest.  This is favorable because a partner is generally allowed to deduct partnership losses and receive distributions of money from the partnership on a tax-free basis but only to the extent that the partner has sufficient basis in its partnership interest.  (§§ 704(d) and 731(a), respectively).  Moreover, the allocation of partnership liabilities also plays a significant role in applying the disguised sale rules.

As a result, determining how to allocate partnership liabilities is an important exercise and one that is engaged in with frequency.  The allocation rules that apply depend on whether the liability is recourse or nonrecourse.  A liability is recourse to the extent that a partner or related person bears an economic risk of loss for the liability.  (Treas. Reg. § 1.752-1(a)(1)).  If no partner or related person bears an economic risk of loss, the liability is nonrecourse.  (Treas. Reg. § 1.752-1(a)(2)).  

Generally, a partner or related person bears an economic risk of loss for a partnership liability to the extent the partner would have a payment obligation if the partnership hypothetically liquidated under the assumption that the assets of the partnership are worthless and the liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or a person related to that other partner.  (Treas. Reg. § 1.752-2(b)(1)).  A partner’s share of recourse liabilities will equal the portion of such liability, if any, for which the partner or related person bears the economic risk or loss.  (Treas. Reg. § 1.752-2(a)(1)).  A liability that is a nonrecourse liability is allocated to the partners according to three separate rules or tiers. (Treas. Reg. § 1.752-3).

B. Recourse Liabilities

Treasury and IRS do not believe this hypothetical liquidation is realistic because “in most cases, a partnership will satisfy its liabilities with partnership profits, the partnership’s assets do not become worthless, and the payment obligations of partners or related persons are not called upon.”  (Preamble).  Notably, these rules have been around for a while and have provided an administrable way to allocate partnership liabilities.  Also, I can't help to think how odd that statement sounds, given the stink of the economy of recent memory. 

Nonetheless, the Tax Court’s decision in Canal may indicate that these rules need to be modified.  Treasury and IRS seem to be alluding to Canal in the Preamble to the Proposed Regulations, stating that “[t]he IRS and the Treasury Department are concerned that some partners or related persons have entered into payment obligations that are not commercial solely to achieve an allocation of partnership liabilities to such partner.”    

The challenge for Treasury and IRS is to reign in payment obligations that are abusive while keeping the rules administrable.  The result under the Proposed Regulations...Treasury maintains the hypothetical liquidation approach, but adds additional requirements in order for a partner’s payment obligation to be respected.

1. Requirements for Economic Risk of Loss

Under Prop. Treas. Reg. § 1.752-2(b)(3)(ii), generally in order for a partner or related person’s payment obligation for a partnership liability to be recognized, the partner or related person(’s):

1. Is required to maintain a commercially reasonable net worth throughout the term of the payment obligation or must be subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration; 
2. Is required periodically to provide commercially reasonable documentation regarding its financial condition;
3. Payment obligation must not end prior to the term of the partnership liability;
4. Payment obligation cannot require that any obligor directly or indirectly hold money or other liquid assets in an amount in excess of such obligor’s needs;
5. Must receive arm’s length consideration for assuming the payment obligation;
6. Would be liable for the full amount of its payment obligation with respect to its guarantee or similar arrangement, if and to the extent that any amount of the liability is not otherwise satisfied (additional rules apply); and
7. Would be liable for the full amount of its payment obligation with respect to its indemnification, reimbursement right, or similar arrangement, if and to the extent that any amount of the indemnitee’s or other benefitted party’s payment obligation is satisfied (additional rules apply).

Items 6 and 7 would eliminate the use of so-called bottom-dollar guaranties or indemnities because those types of arrangements would not subject a partner or related person to the full amount of its payment obligation if any amount of the liability (or payment obligation with respect to indemnities) becomes due.  For example, under a bottom-dollar guarantee a partner could guarantee $100 of an $800 partnership liability but only if the lender recovers less than $100.  This partner’s payment obligation is not recognized under Prop. Treas. Reg. §§ 1.707-(b)(3)(ii)(F) because the partner would not be liable for the full amount its payment obligation ($100) if any amount of the liability becomes due.  Suppose the creditor recovers $500 of the $800 liability from the partnership.  In this case, the partner would not be required to make a payment because the lender did not recover less than $100.  

    

2. DRE Rules Extended to Other Taxpayers

Under existing rules, it is assumed that a partner or related person that has a payment obligation with respect to a liability will make good on that obligation, regardless of such person’s net worth.  (Treas. Reg. § 1.752-2(b)(6)).  However, the assumption that a payment obligation will be performed does not apply to the payment obligation of a disregarded entity, which is taken into account only to the extent of the entity’s net value as of the allocation date.  (Treas. Reg. § 1.751-2(k)). 

The Proposed Regulations would extend this rule to certain other partners or related persons.  Specifically, the payment obligation of a partner or related person other than an individual or a decedent’s estate with respect to a partnership liability other than a trade payable is recognized only to the extent of the net value of the partner or related person as of the allocation date that is allocated to the partnership liability.  (Prop. Treas. Reg. § 1.752-2(b)(3)(iii)(B)).  This rule applies to grantor trusts as well.  (Part 8A of the Preamble).  Existing rules currently applicable to disregarded entities under Treas. Reg. § 1.752-2(k) would apply for purposes of determining the net value of the partner or related person as of the allocation date.  (Prop. Treas. Reg. § 1.752-2(b)(3)(iii)(B)).   

Note that this rule would apply in addition to requirement 1 described above (under which a taxpayer must have a commercially reasonable net worth throughout the term of the loan or is subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration). 

Importantly, the net value rule was not extended to individuals or a decedent’s estate.  However, Treasury and IRS have requested comments on whether they should.   

3. Right to Reimbursement

Generally, under existing rules, a partner’s payment obligation is reduced if the partner has a right to reimbursement from another partner or person related to another partner. (Treas. Reg. §1.752-2(b)(1)).  Prop. Treas. § 1.752-2(b)(1) would modify this rule so that a partner would only bear an economic risk of loss for a partnership liability to the extent the partner or related person would not be entitled to reimbursement from any other person.  This proposed rule would thus appear to include, for example, an insurance policy taken out by a partner from an unrelated party to insure the partner for any loss incurred with respect to its guaranty.

B. Nonrecourse Liabilities

As mentioned previously, a liability that is nonrecourse is allocated to the partners according to three separate rules or tiers.  The Proposed Regulations would take away a large part of the flexibility currently available to partnerships with respect to the allocation of nonrecourse debt under Treas. Reg. § 1.752-3(a)(3) (Tier 3).   For example, under Tier 3, excess nonrecourse debt can generally be allocated based on a partner’s share of partnership profits.  For this purpose, a partner’s share of profits is generally a facts and circumstances determination.  (Treas. Reg. § 1.752-3(a)(3)).  

Importantly, a partnership agreement is allowed to specify the partners’ interest in partnership profits to be used as long as the specified profits are reasonably consistent with allocations that have substantial economic effect of some other significant item of partnership income or gain. (Treas. Reg. § 1.752-3(a)(3)).  This “reasonably consistent” language allows taxpayers a great deal of flexibility in allocating excess nonrecourse liabilities under Tier 3.  Alternatively, partnership can allocate nonrecourse liabilities under Tier 3 in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated. (Ibid).  As we know, the regulations under § 704(b) also provide considerable flexibility in how to allocate such nonrecourse deductions. 

However, neither of these methods necessarily corresponds to a partner’s overall economic interest in partnership profits and often times can differ substantially.  Thus, the Proposed Regulations would eliminate these options.  Specifically, under Prop. Treas. Reg. § 1.752-3(a)(3), a partnership agreement may specify the partners’ interest in partnership profits for Tier 3 purposes only if the specified percentages are in accordance with the partners’ liquidation value percentage. 

A partners’ liquidation value percentage is the ratio of the liquidation value of the partner’s interest in the partnership divided by the aggregate liquidation value of all the partners’ interest in the partnership.  (Prop. Treas. Reg. § 1.752-3(a)(3)).  In turn the liquidation value of a partner’s interest in a partnership is the amount of cash the partner would receive with respect to the interest, if immediately after the formation of the partnership or a revaluation event, the partnership sold all of its assets for cash equal to the fair market value of such assets (taking § 7701(g) into account), satisfied all of its liabilities (other than liabilities described in Treas. Reg. § 1.752-7 (-7 Liabilities)), paid an unrelated party to assume all of its -7 Liabilities in a fully taxable transaction, and then liquidated. (Ibid).

The liquidation percentage would be determined upon the partnership’s formation and redetermined upon a revaluation event (irrespective of whether the partnership actually revalues). (Ibid).  Moreover, any change in a partners’ share of liability as a result of a revaluation event is taken into account in determining the tax consequences of the event that gave rise to such change. (Ibid).

III. Conclusion:

These Proposed Regulations do not apply until they are finalized and published in the Federal Register.  But they are a major departure from the existing Regulations and could have a big impact on you and partnership clients and planning arrangements.  I'd like to encourage you to submit comments below about how they could affect you or your clients and if you have any questions do not hesitate to reach out to us, we will be glad to assist.  We also have upcoming Webinar courses relating to property contributions to partnerships and we will cover these Proposed Regulations in greater detail…