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):
- 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;
- Is required periodically to provide commercially reasonable documentation regarding its financial condition;
- Payment obligation must not end prior to the term of the partnership liability;
- 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;
- Must receive arm’s length consideration for assuming the payment obligation;
- 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
- 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…
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