IRS issues regulations drastically changing partnership taxation rules

Earlier this week, the IRS released long-awaited guidance on liability allocations under Internal Revenue Code section 752 and disguised sales under section 707. These regulations represent some of the most substantial changes to partnership taxation in years. This Tax Alert provides an overview of the two significant items addressed in these regulations. Additional analysis and commentary will be issued once this guidance has been evaluated in greater detail.

The first change addresses debt allocations under section 752 and affects and curtails so-called “bottom-dollar” guarantees. These changes are effective on Oct. 5. However, the temporary regulations will allow partners to get basis for “vertical slice” guarantees and provide a seven-year transition period.

The second change affects the disguised sale rules under section 707. Strictly for purposes of this section, the regulations will treat all debt as nonrecourse. This change becomes effective 90 days from the date the temporary regulations are published in the Federal Register (Oct. 5). The new rule will severely limit the effectiveness of leveraged partnerships and the debt-financed distribution exception to the disguised sale rules.

These provisions are discussed in detail below.

Debt allocations under section 752

Under the temporary regulations (Regulation section 1.752-2T), “bottom-dollar payment obligations” are not recognized for purposes of debt allocations under section 752. A bottom-dollar payment obligation, or bottom guarantee, is an arrangement in which a partner guarantees the least risky portion of the debt. Such transactions are typically entered into to defer recognition of a negative capital account, thereby delaying the recognition of “phantom income” (i.e., taxable income without the corresponding cash).

Example: Guarantee of first and last dollars. A, B and C are equal members of a limited liability company, ABC, that is treated as a partnership for federal tax purposes. ABC borrows $1,000 from Bank X. Partner A guarantees payment of up to $300 if any amount of the full $1,000 liability is not recovered by the bank. Partner B guarantees payment of up to $200, but only if the bank otherwise recovers less than $200.

  • A is obligated to pay up to $300 if, and to the extent that, any amount of the $1,000 partnership liability is not recovered by Bank X. Since A’s guarantee covers the riskiest portion of the debt, it would be respected under the temporary regulations, and the $300 liability would be allocated to A for basis purposes.
  • However, because B is obligated to pay up to $200 only if, and to the extent that, the bank otherwise recovers less than $200 of the $1,000 partnership liability (a bottom-dollar guarantee), B’s guarantee does not satisfy the requirements under the temporary regulations and B’s guarantee is not recognized. As a result, B does not receive a special allocation of the $200 for basis purposes; rather, that debt is allocable to all partners as nonrecourse debt.

Limited exceptions

Under the temporary regulations, if a payment obligation doesn’t put the obligor “on the hook” for any portion of the first dollar of the debt, the obligor generally will not get basis credit for the debt. An exception applies for vertical slice guarantees. If the partner guarantees a percentage of each dollar of a liability — for example, 10 percent of every dollar — he will get basis credit for the guaranteed debt under the section752 rules. However, the vertical slice percentage has to be fixed for every dollar of debt and cannot be on a sliding scale.

The temporary regulations also include another exception to the bottom-dollar guarantee prohibition for cases where the guarantee is indemnified. “If a partner or a related person has a payment obligation that would be recognized but for an indemnity or reimbursement or similar arrangement, and the partner or related person is liable for at least 90 percent of their initial payment obligation,” then it will be recognized as a good payment obligation.

Transition relief

The temporary regulations preserve the seven-year transition rule included in the proposed regulations. Under the relief, “any partner whose allocable share of partnership liabilities under Regulation section 1.752-2 exceeds its adjusted basis in its partnership interest on the date” the regulations are effective will be deemed a “transition partner.” Transition partners can continue to apply the existing section 752 rules for seven years or until they zero out their negative tax capital account.

Impact on DROs

Offering a preview of the regulations, panelists from the Treasury Department at a tax conference held last week by the American Bar Association said the new bottom-dollar guarantee rules will apply to deficit restoration obligations (DROs). The regulations provide that if a DRO isn't recognized for section 752 purposes, in other words, if the DRO does not qualify as recourse debt, it also wouldn't be recognized for section 704 purposes.

Disguised sales

Under current law, with careful planning, taxpayers can essentially sell a business without triggering current gain by entering into a leveraged partnership with a would-be buyer. The business/asset is contributed to the partnership, which then borrows money (essentially the sales price of the business), and distributes borrowed funds to the seller. The transaction does not constitute a disguised sale as long as the would-be seller is on the hook for the borrowing. The debt is then allocated back to the seller/contributing partner, who defers taxation on the “disguised sale.”

Under the newly issued temporary regulations, all debt is treated as nonrecourse for purposes of disguised sales, thus curtailing the effectiveness of many leveraged partnership structures by limiting the applicability of the debt-financed distribution exception under Regulation section1.707-5(b). This is a major rule change which effectively eliminates leveraged partnerships. The new rule means that the maximum amount of debt that could be allocated to the partner is the debt that would be allocated to it based on its share of profits. A guarantee will no longer serve to shelter the gain for disguised sale purposes.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.