IRS proposes changes to liability allocation rules

The IRS has issued long-anticipated changes to the § 752 regulations. These proposed regulations would significantly impact how partnerships allocate liabilities to their owners for at-risk and basis purposes. The intent of the proposed regulations is to end so-called “paper guarantees” and to ensure that guarantees are commercially reasonable in order to be respected for at-risk purposes.

While only proposed at this time, if adopted, these changes would curtail the use of bottom guarantees, impose net worth requirements on guarantors, and potentially affect how nonrecourse liabilities are allocated. Bottom guarantees are sometimes used to defer the recognition of negative tax capital accounts, thereby delaying the recognition of phantom income.

To accomplish the IRS’s objectives, the proposed regulations:

  • Require that the payment obligation (i.e., guarantee) meets six factors in order to be recognized for purposes of § 752, and
  • State that the payment obligation is only recognized to the extent of the net value of the partner or related guarantor.

Several commentators have suggested these regulations will dramatically change partnership taxation. While they will restrict certain planning techniques, we are of the opinion the regulations will have a much smaller impact on routine partnership structuring than many are predicting. Additionally, the regulations include a new seven-year transition period that allows taxpayers to protect negative capital accounts existing at the time the regulations are adopted as final.

The following is a brief synopsis of the major provisions in the proposed regulations.

Six-factor test

Under the proposed regulations, a payment obligation must meet all of the following requirements to be recognized for purposes of § 752.

  1. The partner or related person must maintain a commercially reasonable net worth through the term of the debt or be subject to commercially reasonable restrictions on transfers of assets for inadequate consideration. See discussion below for application of this provision to individuals and estates.
  2. The guarantor must periodically provide reasonable documentation to the partnership regarding their financial condition.
  3. The term of the obligation does not end prior to the term of the liability.
  4. The payment obligation does not require the primary obligator (the partnership) or any other obligator to hold money or other liquid assets that exceed the reasonable needs of the obligator.
  5. The guarantor receives arm’s-length consideration for entering into the guarantee.
  6. No indemnity or reimbursement arrangement exists with another party.

Commentary: Several of these factors do not appear to be how taxpayers regularly structure their transactions and may be difficult to implement if adopted as final. For example, the rules would require a fee to be paid for credit support in order for the resulting payment obligation to work. Often, it is standard commercial practice for an owner to guarantee entity-level obligations without receiving a fee for doing so. In addition, it is likely in many situations, guarantors will be unwilling to provide their financial information regarding their net worth to the partnership. In the regulations, the IRS does not provide any guidance as to what constitutes “reasonable documentation.”

Net value requirement

Currently, guarantees made by disregarded tax entities are respected only to the extent of the disregarded entity’s net worth. Guarantees made by any other taxpayer are assumed to be valid. The proposed regulations extend the net value requirement to all partners or related entities, other than individuals and decedent’s estates. While individuals and estates are not currently included in this net value requirement, the IRS has requested comments on whether or how to extend this requirement in the final regulations. We are of the opinion that the net value requirement will likely be extended to individuals in the final regulations.

Bottom guarantees

The proposed regulations would end bottom guarantee arrangements where partners guarantee the least risky portion of the debt. Such transactions are typically entered into in order to defer recognition of a negative capital account.

Example: Guarantee of first and last dollars. A, B, and C are equal members of limited liability company ABC that is treated as a partnership for federal tax purposes. ABC borrows $1,000 from Bank. A guarantees payment of up to $300 of the ABC liability if any amount of the full $1,000 liability is not recovered by Bank. B guarantees payment of up to $200, but only if 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. Since A’s guarantee covers the riskiest portion of the debt, it would be respected under the proposed 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, 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 proposed 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.

Change in allocation rules for nonrecourse debt

Nonrecourse debt is allocated under a complex three-tier methodology. The third tier generally provides partnerships a great deal of latitude in the allocation process. The proposed regulations would restrict this latitude and generally require that this step be allocated in accordance with a partner’s share of assets under a liquidation approach.

The rules under Tier III are usually of particular interest to partners that have contributed built-in gain property to the partnership. Since the changes described in the preceding paragraph should not impact the built-in gain portion of this allocation, this measure of protection against negative capital accounts remains in place.

Effective date and relief provision

The proposed regulations are not effective until adopted in final form, and they provide a transition rule that permits partners to grandfather an amount equal to the partner’s negative tax capital as it exists immediately before finalization and apply that amount for seven years.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.