On October 5, 2016, the IRS and the Department of the Treasury published Final Regulations, Temporary Regulations and Proposed Regulations governing so-called “disguised sales” of property from a partner to a partnership and allocations of partnership liabilities among partners. This complex new package of regulations replaces proposed regulations on this subject matter published in 2014 (the “Old Proposed Regulations”).

Executive Summary

Final Regulations: Exceptions to the Disguised Sale Rules

The Final Regulations supplement and revise existing regulations under Section 707 and Section 752 regarding the exceptions to the disguised sale rules. Under the existing regulations, a partner generally recognizes “disguised sale” gain on the receipt of any consideration (including relief of liabilities) other than partnership equity in exchange for a transfer of property to the partnership, except to the extent one or more of the exceptions to the disguised sale rules applies. Among other things, the Final Regulations

  • clarify the scope of the exception for reimbursement of capital expenditures,
  • add a new category of “qualified liability” to the exception for qualified liabilities,
  • mandate allocation of nonrecourse liabilities only under the most general “partner’s share of partnership profits” test to calculate the contributing partner’s disguised sale gain and
  • clarify the application of the exceptions to tiered partnerships, successive transfers of properties and anticipated reductions in a partner’s share of a liability.

The Final Regulations generally apply to transactions with respect to which all transfers occur on or after October 5, 2016.

Temporary Regulations, Part One: Allocation of Liabilities in Disguised Sales

The Temporary Regulations include guidance under Section 707 that allocates partnership liabilities among the partners in a manner that maximizes a partner’s disguised sale gain. Liabilities for which the partner bears the economic risk of loss, or for which no partner bears the economic risk of loss, under the principles of Section 752 are allocated in accordance with the partner’s share of partnership profits, while such partner is not allocated any portion of the liabilities for which other partners bear the economic risk of loss. This portion of the Temporary Regulations, which, among other things, will severely restrict the tax benefits of so-called “leveraged distributions,” applies to transactions with respect to which all transfers occur on or after January 3, 2017.

Temporary Regulations, Part Two: Bottom Dollar Payment Obligations

The Temporary Regulations include guidance under Section 752 that disregards any “bottom dollar payment obligation” of a partner in determining whether the partner bears the economic risk of loss for a partnership liability (and can therefore include the liability in the partner’s basis in its partnership interest). A bottom dollar payment obligation is, roughly speaking, a guarantee or similar obligation as to a partnership liability that applies to less than the full amount of the liability, and to a less risky portion of the liability. This portion of the Temporary Regulations generally applies to partnership liabilities incurred, assumed or guaranteed on or after October 5, 2016, subject to a limited seven-year grandfather rule for partners whose share of partnership liabilities exceeded their basis in their partnership interest immediately prior to October 5, 2016, and to a binding contract exception.

Proposed Regulations: Anti-Abuse Rules Where There is a Plan to Circumvent or Avoid an Obligation

The Proposed Regulations would significantly expand the scope of existing anti-abuse rules in the regulations under Section 704 and Section 752 where a partner has a plan to circumvent or avoid an obligation, in each case providing a list of non-exclusive factors to weigh in evaluating whether such an abusive plan exists. The proposed revisions to the regulations under Section 704 would disregard an abusive capital account deficit restoration obligation in testing whether partnership allocations of income, gain, loss and deduction will be respected for tax purposes and for determining whether the partner bears the economic risk of loss for partnership liabilities. The proposed revisions to the regulations under Section 752 would disregard an abusive payment obligation with respect to a partnership liability for purposes of testing whether the partner bears the economic risk of loss for the liability, and would withdraw the existing “net value” test for determining whether a partner bears the economic risk of loss where the partnership interest is held through a tax-disregarded entity. The proposed effective date of these provisions is generally the date they are published as final regulations.

Expanded Summary of the Regulations

Final Regulations

Background: Existing Disguised Sale Regulations Prior to Adoption of the Final Regulations

If property is transferred by a partner to a partnership, and the partnership makes one or more transfers of money or other consideration to the partner that are described in Treas. Reg. § 1.707-3(b), the property transfer generally is treated as a disguised sale of property, in whole or in part, by the partner to the partnership. As a result, the transferor partner may be required to recognize gain or loss for federal income tax purposes, in whole or in part, even if the transaction otherwise might qualify for non-recognition treatment under Section 721. For these purposes, if the partnership assumes debt of the transferring partner or takes the property subject to debt, the partnership generally is treated as having transferred consideration to the partner to the extent the debt assumed (or to which the property is subject) exceeds the partner’s share of the debt immediately after the transfer.

Certain exceptions and limitations to these rules apply. In particular,

  • Subject to certain limitations, a transfer of consideration is not treated as part of a disguised sale to the extent it represents a reimbursement of capital expenditures incurred with respect to the transferred property within the two-year period preceding the date of the transfer (the “capital expenditure reimbursement exception”).
  • If the partnership assumes or takes property subject to “qualified liabilities,” the amount of the assumption which is treated as disguised sale consideration is limited or, in certain cases, reduced to zero (the “qualified liability exception”).
  • If the consideration transferred by the partnership to the partner is traceable to debt incurred by the partnership, the amount of such consideration which is treated as disguised sales proceeds generally is limited to the amount by which such consideration exceeds the partner’s share of such debt immediately after the transfer (the “debt-financed distribution exception”).

Revisions to the Capital Expenditure Reimbursement Exception

Property-by-property application of limitations under the capital expense reimbursement exception. Under prior Treasury regulations, consideration transferred by a partnership to a partner as a reimbursement of preformation capital expenditures of the transferor partner does not result in a disguised sale under the capital expense reimbursement exception. The capital expense reimbursement exception is limited, however, to an amount of consideration not exceeding 20 percent of the fair market value of the transferred property, unless the transferred property has a fair market value that does not exceed 120 percent of the partner’s tax basis in such property. The Final Regulations adopt a proposal in the Old Proposed Regulations requiring a property-by-property application of the 20 percent limitation and the 120 percent test with respect to the capital expenditure reimbursement exception to disguised sale treatment.

Notwithstanding the property-by-property requirement of the Final Regulations, limited aggregation of property is permitted for administrative convenience. In particular, aggregation is permitted for those assets whose fair market value is not greater than 1% of the total fair market value of all aggregated assets, but only to the extent that the total fair market value of the aggregated property is not greater than the lesser of (i) 10 percent of the total fair market value of all property (other than money and marketable securities) transferred by the partner to the partnership or (ii) $1,000,000. The aggregation method must be reasonable and must not be part of a plan a principal purpose of which is to avoid sale treatment.

No double dip. The Final Regulations also provide that to the extent any qualified liability is used by a partner to fund its preformation capital expenditures and economic responsibility for that liability shifts to another partner, the exception for preformation capital expenditures does not apply. A liability is considered traceable to capital expenditures if the liability proceeds either (i) are traceable to the capital expenditures under the interest rate tracing rules of Temp. Treas. Reg. § 1.163-8T or (ii) are actually used to fund the capital expenditures. Prior rules might have allowed a partner to (a) borrow in order to fund capital expenditures, (b) contribute the property and the liability to the partnership in exchange for a capital expenditure reimbursement and (c) claim an exception for the entire amount of the qualified liability assumption, as well as the entire amount of the capital expenditure reimbursement.

Definition of capital expenditures. Consistent with a proposal in the Old Proposed Regulations, capital expenditures are defined to include capital expenditures within the meaning of the Code and Treasury Regulations, including capital expenditures the taxpayer elects to deduct (but not deductible expenditures the taxpayer elects to capitalize).

Request for comments. The Treasury Department and the IRS are considering whether the capital expenditure reimbursement exception is appropriate and request comments regarding the policy justifications for keeping or removing the exception and the effects that removal might have on partnership formation transactions.

Ordering rule. Consistent with a proposal in the Old Proposed Regulations, the debt-financed distribution exception to the disguised sale rules is applied before the application of the capital expenditure reimbursement exception.

Revisions to the Qualified Liability Exception

New category of qualified liability “not incurred in anticipation of” the transfer. The Final Regulations add a new category of qualified liability: a liability 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 the property transferred to the partnership was held or used, all of whose material assets are transferred to the partnership. If the liability was incurred by the partner within the two-year period prior to the earlier of the date the partner agrees in writing to transfer the property or the date the partner transfers the property to the partnership, then the partner must disclose the treatment of the liability as a qualified liability in the partner’s tax return.

Exception to tainting of qualified liabilities. A portion of a qualified liability that is assumed by a partnership (or that property contributed to the partnership is subject to) can be treated as disguised sale consideration if, ignoring the qualified liability, the transaction includes other disguised sale consideration (e.g., cash or assumption of nonqualified liabilities). Under the Final Regulations, if a partnership assumes (or takes property subject to) both qualified and nonqualified liabilities in connection with a transfer of property to the partnership, and the transfer is treated as a sale solely due to the partnership’s assumption of (or taking of property subject to) nonqualified liabilities, no portion of the qualified liabilities will be treated as sale consideration if the total amount of all nonqualified liabilities that the partnership assumes or takes property subject to does not exceed the lesser of (i) 10 percent of the total amount of all qualified liabilities assumed or (ii) $1,000,000. This new rule is designed to provide relief where a partnership assumes or takes property subject to a minimal amount of nonqualified liabilities, but a material amount of qualified liabilities. In the absence of this exception, a portion (which may be material) of the qualified liability would be treated as disguised sale consideration.

Allocation of Nonrecourse Liabilities in Calculating Disguised Sale Gain.

Prior law. The existing regulations under Section 752 allocate nonrecourse liabilities of a partnership among the partners (1) first, in accordance with their shares of “partnership minimum gain” under Section 704(b) and the regulations thereunder, (2) second, in accordance with the gain that would be allocated to the partners under the principles of Section 704(c) if all partnership properties subject to the debt were disposed of in exchange for no consideration other than satisfaction of the liabilities and (3) third, under the rules for “excess nonrecourse liabilities.” Excess nonrecourse liabilities are generally allocated among the partners in accordance with their interests in partnership profits, taking into account all relevant facts and circumstances, but can instead be allocated under the “significant item” method, the “alternative” method or the “additional” method set forth in existing regulations. In applying the disguised sale rules, the prior regulations under Sections 707 and 752 determine a partner’s share of a nonrecourse liability transferred to the partnership using the allocation rules for excess nonrecourse liabilities, except the “additional” method cannot be used for this purpose.

Old Proposed Regulations. The Old Proposed Regulations proposed to eliminate the significant item, alternative and additional methods for allocating excess nonrecourse liabilities and replace them with an allocation of excess nonrecourse liabilities in accordance with the partners’ “liquidation value percentages.” A partner’s liquidation value percentage would be the hypothetical relative share of the liquidation proceeds the partner would receive if, immediately after the most recent event upon which the capital accounts of the partners were determined (or permitted to be redetermined) the partnership had sold all of its assets and liquidated.

Final Regulations. The Final Regulations do not adopt the liquidation value percentage method for allocating excess nonrecourse liabilities proposed by the Old Proposed Regulations. Instead, they leave the significant item, alternative and additional methods intact and unchanged but bar their use in applying the disguised sale rules. As a result, the exclusive method for allocating nonrecourse liabilities among partners in determining a partner’s gain in a disguised sale transaction is in accordance with the partners’ interests in partnership profits, taking into account all relevant facts and circumstances.

Request for comments. The preamble to the Proposed Regulations (discussed below) indicates that the IRS may issue future rulings describing reasonable methods or safe harbors for applying the “partners’ interests in partnership profits” method and requests comments regarding appropriate methods or safe harbors.

Step-in-the-Shoes Rules for Non-Recognition Transactions

For purposes of applying the capital expenditure reimbursement exception and determining whether a liability is a qualified liability, a partner steps in the shoes of the person from which it acquired property or a liability in non-recognition transactions described in Section 351, 381(a), 721 or 731.

Tiered Partnerships

Capital expenditure reimbursements. In the case of tiered partnerships, for purposes of applying the capital expenditure reimbursement exception, where a partner transfers to a partnership (the lower-tier partnership) property with respect to which such partner incurred capital expenditures and, within the 2-year period beginning on the date upon which such partner incurred the capital expenditures, such partner transfers an interest in such lower-tier partnership to another partnership (the upper-tier partnership) in a non-recognition transaction under Section 721, the upper-tier partnership “steps in the shoes” of the transferring partner. Additionally, the transferring partner may be reimbursed by the upper-tier partnership for preformation capital expenditures to the extent the partner could have been reimbursed by the lower-tier partnership under the capital expenditure reimbursement exception.

Qualified liabilities rule—deemed transfer of all property of lower-tier partnership. In the event of a transfer of an interest in a lower-tier partnership to an upper-tier partnership, the contributing partner’s share of a liability from a lower-tier partnership is treated as a qualified liability to the extent the liability would be a qualified liability had the liability been assumed by (or property subject to the liability been contributed to) the upper-tier partnership in connection with a transfer by the lower-tier-partnership of all of its property to the upper-tier partnership. This rule is significant because in some cases, a liability constitutes a qualified liability only if it is assumed (or property subject to the liability is contributed) in connection with a transfer of the relevant trade or business.

Qualified liabilities rule—incurred in anticipation of a transfer to upper-tier partnership. An additional rule provides that, for purposes of determining whether a liability was incurred in anticipation of the transfer of an interest in a lower-tier partnership to an upper-tier partnership, the determination is based on whether the partner in the lower-tier partnership anticipated transferring that interest to the upper-tier partnership at the time the liability was incurred by the lower-tier partnership.

Debt-financed distribution exception. If a partner transfers property to a partnership, and the partnership incurs a liability and all or a portion of the proceeds of such liability is allocable to a transfer of consideration to the partner made within 90 days of incurring the liability, the transfer of consideration to the partner is taken into account as part of a disguised sale only to the extent that the amount of consideration exceeds the partner's allocable share of the partnership liability. For purposes of testing this 90 day requirement in connection with the debt-financed distribution exception, an upper-tier partnership’s share of the liability of a lower-tier partnership that is treated as a liability of the upper-tier partnership under Treas. Reg. § 1.752-4(a) is treated as having been incurred on the same day the liability was incurred by the lower-tier partnership.

Anticipated Reductions of Partnership Liabilities

The Final Regulations modify rules that determine a partner’s share of a liability immediately after the partnership assumes (or takes property subject to) that liability by narrowing the rule that takes into account a subsequent reduction of the partner’s share of the liability. In particular, under the Final Regulations, such a subsequent reduction is required to be taken into account only if it is not subject to the entrepreneurial risks of partnership operations.

Effective Dates

The Final Regulations under Section 707 apply to any transaction for which all transfers occur on or after October 5, 2016. The Final Regulations under Section 752 apply to liabilities that are incurred by a partnership, assumed by a partnership, or that a partnership takes property subject to on or after October 5, 2016, other than liabilities incurred or assumed pursuant to a written binding contract in effect prior to that date.

Temporary Regulations

The Temporary Regulations dramatically change the manner in which recourse liabilities are allocated for purposes of applying the disguised sale rules and limit the use of “bottom dollar” guarantees of debt and similar arrangements to qualify the debt as recourse debt that is allocated to the guarantor under Section 752.

Partner’s Share of Partnership Liabilities for Purposes of Applying Disguised Sale Rules

General rule. The Temporary Regulations mandate that for disguised sale purposes, partners determine their share of any partnership liability, whether recourse or nonrecourse, in the manner in which excess nonrecourse liabilities are allocated under Treas. Reg. § 1.752-3(a)(3), as amended by the Final Regulations as described above. This rule allocates liabilities solely in accordance with the partner’s allocable share of partnership profits and without regard to any guarantee or other arrangement under which the transferor partner retains the economic risk of loss with respect to the liability. However, the Temporary Regulations further provide that a partner’s share of a partnership liability does not include any amount of a liability for which another partner bears the economic risk of loss for the partnership liability under Treas. Reg. § 1.752-2.

Effect on leveraged distributions. Under the debt-financed distribution exception described above, a transfer of property to a partnership, coupled with a transfer of consideration from the partnership to the partner that is debt-financed by the partnership, does not result in a disguised sale to the extent of the partner’s share of the liability for the debt that financed the distribution. Under the prior rules, a partner could be allocated such liability in its entirety if the partner bore the “economic risk of loss” for the liability, such as through a guarantee (i.e., a recourse liability of the partner). The Temporary Regulations effectively treat any leveraged distribution paid in connection with a transfer of property to the partnership as disguised sale proceeds to the extent such distribution is not made in proportion to the partners’ respective allocable shares of partnership profits.

Contingent liabilities. The Temporary Regulations reserve with respect to the treatment of Treas. Reg. § 1.752-7 contingent liabilities for disguised sale purposes and the preamble indicates that the IRS will continue to study this issue in connection with future guidance projects.

Effective date. The changes regarding the allocation of liabilities for disguised sale purposes are effective for any transaction as to which all transfers occur on or after January 3, 2017.

Bottom Dollar Guarantees

General rules. The Temporary Regulations substantially adopt the restrictions proposed in the Old Proposed Regulations on certain guarantees and indemnities referred to as “bottom dollar payment obligations,” and provide that these payment obligations are not recognized as causing the obligor to bear economic risk of loss for the purposes of allocating recourse liabilities. Such restrictions are intended to eliminate guarantee and similar arrangements intended to result in recourse liability allocations to a partner in situations that are viewed as non-commercial and/or lacking in meaningful risk of loss. The new term “bottom dollar payment obligation” generally includes any guarantee or similar arrangement with respect to a partnership liability unless the guarantor partner (or related person) is or would be liable up to the full amount of such partner’s (or related person’s) payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied. A “bottom dollar payment obligation” also includes an indemnity or similar arrangement, unless the indemnitor partner (or related person) is or would be liable up to the full amount of such partner’s (or related person’s) payment obligation if, and to the extent that, any amount of the indemnitee’s payment obligation is satisfied. The Temporary Regulations further provide that a “bottom dollar payment obligation” includes an arrangement with respect to a partnership liability that uses tiered partnerships, intermediaries, senior and subordinate liabilities, or similar arrangements to convert what would otherwise be a single liability into multiple liabilities so as to avoid causing a payment obligation to be treated as a bottom dollar payment obligation.

Exceptions. A partner’s right to be reimbursed up to 10 percent of its payment obligation will not, by itself, cause such partner’s obligation to be treated as a bottom dollar payment obligation. For example, if a partner guarantees 100 percent of a partnership liability and another partner agrees to indemnify the partner for up to 10 percent of that guarantee obligation (including the first 10 percent), the guarantee may still be respected for purposes of allocating liabilities.

Additionally, each of the following features of an obligation will not, in itself, cause an obligation to be a bottom dollar payment obligation: (i) the obligation is a “vertical slice” guarantee (i.e., a guarantee stated as a fixed percentage of every dollar of the liability), (ii) the obligation is capped or (iii) the obligor has a right of proportionate contribution with respect to a joint and several liability (in which case the obligor would be treated as bearing economic risk of loss for only the portion of the obligation for which it does not have a right of contribution).

Anti-abuse rule. The Temporary Regulations include an anti-abuse rule intended to prevent partners from structuring a guarantee or indemnity arrangement to intentionally meet the bottom dollar payment obligation definition in order to purposefully cause a partnership liability to be treated as nonrecourse. Under the anti-abuse rule, a partner’s (or related person’s) guarantee, indemnity or similar contractual obligation that falls within the bottom dollar payment obligation definition will nonetheless be treated as a recourse obligation if:

  • The partner or related person undertakes the contractual obligation so that the partnership may obtain or retain a loan;
  • The contractual obligation significantly reduces the risk to the lender that the partnership will not satisfy its obligations under the loan (or a portion thereof); and
  • Either (i) one of the principal purposes of using the contractual obligation is to attempt to permit other partners to include a portion of the loan in the basis of their partnership interests or (ii) another partner (or related person) enters into a payment obligation and a principal purpose of the arrangement is to cause the first partner’s contractual obligation to be treated as a bottom dollar payment obligation and, thus, be disregarded.

Disclosure requirement. Partnerships are required to disclose to the IRS all bottom dollar payment obligations (including those subject to an exception) and other specified information for the taxable year in which the bottom dollar payment obligation is undertaken or modified.

Effective date. The changes regarding bottom-dollar payment obligations are generally effective for liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken with respect to a partnership liability on or after October 5, 2016, subject to a binding contract exception. Partnerships may apply the provisions to all of their liabilities as of the beginning of their first taxable year of the partnership ending on or after October 5, 2016.

Grandfather rule. The Temporary Regulations provide transitional relief for any partner whose allocable share of partnership liabilities under Treas. Reg. § 1.752-2 exceeds its adjusted basis in its partnership interest on the date the Temporary Regulations are finalized. The partner may continue to apply the existing regulations under Treas. Reg. § 1.752-2 with respect to a partnership liability for a seven-year period to the extent that the partner’s allocable share of partnership liabilities exceeds the partner’s adjusted basis in its partnership interest on October 5, 2016. The amount of partnership liabilities subject to such relief will be reduced (i) for certain reductions in the amount of liabilities allocated to that partner and (ii) upon the sale of any partnership property, by the excess of any tax gain including Section 704(c) gain) allocated to the partner from such sale less that partner’s share of amount realized from such sale.

Proposed Regulations

Current Law

Under Section 752 and the Treasury Regulations thereunder, a partner is entitled to increase its adjusted basis in its partnership interest by liabilities that are considered recourse liabilities as to such partner because such partner bears the economic risk of loss for those liabilities.

Under Section 704(b) and the Treasury Regulations thereunder, certain allocations of losses and deductions to a partner may be made, and certain income and gain allocations may be avoided, if such partner has an obligation to restore a deficit balance in its capital account. That is, the existence of a deficit restoration obligation (“DRO”) on the part of a partner generally permits losses and deductions to be allocated to a partner in amounts in excess of the partner’s capital account balance because the DRO is considered to provide “economic substance” to the allocations for purposes of Section 704(b).

Old Proposed Regulations

The Old Proposed Regulations proposed a two prong test under Section 752 for determining whether a partner would be treated as bearing the economic risk of loss for a liability. First, the partner’s payment obligation with respect to the liability would have to satisfy a six factor test intended to assure that the payment obligation is made on commercially reasonable terms. Second, the partner would have to satisfy a minimum net value requirement. The Old Proposed Regulations did not include any provisions under Section 704.

Overview of Proposed Regulations

The Proposed Regulations provide rules that disregard obligations of a partner to satisfy partnership liabilities or to restore a deficit balance in such partner’s capital account in cases where such obligations are deemed to lack economic substance. In general, the Proposed Regulations are less restrictive and burdensome than the Old Proposed Regulations on these issues.

Proposed Amendments to Treas. Reg. § 1.752-2: Arrangements Part of a Plan to Circumvent or Avoid an Obligation

The Proposed Regulations expand the existing anti-abuse rule in Treas. Reg. § 1.752-2(j) to include a multi-factor test that, if met, would cause an “uncommercial” payment obligation to be disregarded because evidence indicates a plan to circumvent or avoid the payment obligation. The list of factors is derived from the mandatory commerciality requirements in the now withdrawn Old Proposed Regulations. Under the new proposed rule, these factors are weighed to determine whether a payment obligation should be respected. The list of factors is nonexclusive, and the presence or absence of any particular factor is not necessarily indicative of whether or not a payment obligation is recognized under Treas. Reg. § 1.752-2(b).

Factors that will be considered include

  • whether the partner is subject to commercially reasonable contractual restrictions that protect the likelihood of payment;
  • whether the partner is required to provide to the creditor commercially reasonable financial condition documentation;
  • whether the term of the payment obligation ends prior to the term of the partnership liability, or the partner has a right to terminate its payment obligation, if the purpose of limiting the duration of the payment obligation is to terminate such payment obligation prior to the occurrence of an event or events that increase the risk of economic loss to the partner or creditor;
  • whether there exists a plan or arrangement in which the primary obligor holds excessive liquid assets that exceed the reasonable foreseeable needs of the partner;
  • whether the payment obligation permits the creditor to promptly pursue payment following a payment default on the partnership liability;
  • whether, in the case of a guarantee, the terms of the partnership liability would be substantially the same had the partner not agreed to provide the guarantee; and
  • whether the creditor or other party benefiting from the obligation received executed documents within a commercially reasonable period of time.

The list of factors retains the “commercially reasonable” concept from the Old Proposed Regulations that commentators criticized as overly vague. In the preamble to the Proposed Regulations, the IRS maintains that this term is important, and moving the multi-factor test to an anti-abuse rule will limit the term’s application and alleviate ambiguity. In addition, the Proposed Regulations omit from the list of relevant factors the requirement in the Old Proposed Regulations that an arm’s length guarantee fee be paid.

An example demonstrates how the factors apply to a gratuitous guarantee. In the example, a partnership receives a loan from a bank, which is treated as nonrecourse debt. One partner subsequently guarantees the loan, but (i) the bank did not request the guarantee, (ii) the terms of the loan did not change as a result of the guarantee, (iii) the partner did not provide to the bank any paperwork documenting the guarantee, and (iv) the bank did not require any restriction on asset transfers by the partner. The example concludes that under these facts, evidence of a plan to circumvent or avoid the obligation exists, so the partner’s guarantee will not be recognized.

In lieu of the net value requirements proposed by the Old Proposed Regulations, the Proposed Regulations would deem the existence of a plan to circumvent or avoid a payment obligation if the facts and circumstances show that there is not a reasonable expectation that the payment obligor will have the ability to make the required payments if the payment obligation becomes due and payable. The Proposed Regulations also propose to withdraw existing Treas. Reg. § 1.752-2(k), which currently imposes a net value requirement on tax-disregarded entities through which a partner owns its partnership interest in order for a payment obligation of the tax-disregarded entity to be respected. The new rules include an example of an undercapitalized guarantor that is subject to this anti-abuse rule.

Proposed Amendments to Treas. Reg. § 1.704-1(b)(2)(ii): Deficit Restoration Obligations

The Proposed Regulations under Section 704(b) disregard a partner’s obligation to restore a deficit balance in its capital account to the extent such partner’s obligation is a bottom dollar payment obligation. The Proposed Regulations also add a facts and circumstances test similar to the proposed amendment to Treas. Reg. § 1.752-2 described above, but which is specially tailored to the analysis of DROs. Under this rule, a DRO may be disregarded—both for purposes of Section 704(b) and Section 752—if the facts and circumstances indicate a plan to circumvent or avoid the payment obligation. The Proposed Regulations further provide a non-exclusive list of factors that may indicate a plan to circumvent or avoid the payment obligation, including (i) the partner is not subject to commercially reasonable provisions for enforcement and collection of the obligation, (ii) the partner is not required to provide commercially reasonable documentation regarding the partner’s financial condition, (iii) the obligation ends or could, by its terms, be terminated before the liquidation of the partner’s interest in the partnership or (iv) the terms of the obligation are not provided to all the partners in the partnership in a timely manner.

Proposed Effective Date

The Proposed Regulations on recourse debt are proposed to apply to liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after the date the regulations are finalized. The Proposed Regulations on deficit restoration obligations are proposed to apply on or after the date the regulations are finalized. Taxpayers may rely on both sets of proposed rules prior to the date they are finalized, but Treas. Reg. § 1.752-2(k) (dealing with disregarded entities) continues to apply to disregarded entities until new regulations are published.