The U.S. Treasury Department and the Internal Revenue Service issued final and temporary regulations (the “2016 Regulations”) on October 5, 2016 addressing the partnership disguised sale and debt allocation rules.1 The 2016 Regulations limit or, in some cases, eliminate taxpayers’ ability to achieve tax deferral in certain partnership structures where deferral previously was available.
Background: Allocation of Partnership Debt
Section 752 of the Internal Revenue Code of 1986, as amended (the “Code”), provides that partnership debt allocable to a partner gives rise to a deemed cash contribution by that partner to the partnership. This deemed contribution increases the partner’s basis in the partnership interest (referred to as a partner’s “outside basis”). A partner’s outside basis impacts the partner’s ability to receive cash distributions without gain recognition and to utilize loss allocations, among other things. The Section 752 regulations (the “Debt Allocation Rules”) allocate partnership debt to the extent a partner (or related person) bears the economic risk of loss with respect to the debt. For instance, a partner typically would be allocated the full amount of a partnership debt to the extent the partner provides a full guarantee of the debt, unless the facts and circumstances indicate a plan to circumvent or avoid the guarantee obligation. A more complex regime applies to the allocation of nonrecourse debt (that is, debt for which no partner bears the economic risk of loss).
Bottom Dollar Guarantees No Longer Recognized Under Debt Allocation Rules
Previously, under a common bottom dollar guarantee structure, a partner could include the guaranteed amount in the partner’s allocable share of the partnership debt (and therefore outside basis), even if the partner were not obligated to make payment unless the lender failed to recover an agreed-upon minimum amount. As a result, a partner could potentially receive a debt allocation equal to the guaranteed amount despite being exposed to a relatively low degree of economic risk.
In response, the 2016 Regulations require that “bottom dollar payment obligations” be ignored for purposes of determining a partner’s debt allocation and therefore outside basis. The 2016 Regulations generally define a bottom dollar payment obligation as any guarantee other than one where the partner (or a related person) would be liable for the full amount of the partner’s payment obligation if any amount of the guaranteed partnership obligation were not otherwise satisfied. There is a notable exception for guarantees where another person is obligated to reimburse the partner (or a related person) for a portion of the guaranteed amount, provided that the partner (or related person) still remains liable for at least ninety percent (90%) of the initial payment obligation. The 2016 Regulations also require partnerships to disclose bottom dollar payment obligations and, if applicable, details concerning an arrangement for which the above exception applies.
The 2016 Regulations could impact structures where bottom dollar guarantees are used, which are particularly prevalent in the real estate industry. For instance, without sufficient outside basis, a partner contributing appreciated real estate assets to a partnership might be required to recognize taxable gain if the assets are leveraged and the debt is allocated away to other partners. Alternatively, admission of a new partner could cause an allocation of debt away from current partners, thereby triggering a deemed distribution (and gain) to the current partners; a bottom dollar guarantee can no longer shield this gain and prevent this result. Also, even in the absence of immediate tax risk, a contributing partner’s low outside basis may limit the extent to which the partner can take valuable depreciation and amortization deductions generated by the partnership.
Attack on the Leveraged Distribution: Pro Rata Allocation of Debt Required in Disguised Sale Context
Current law provides that a partner may contribute appreciated property to a partnership without immediate tax (that is, on a tax-deferred basis) and, separately, a partner may receive a distribution of cash tax-free to the extent of outside basis. However, pursuant to Section 707(a) of the Code and the regulations thereunder (the "Disguised Sale Rules"), a contribution by and contemporaneous distribution to the same partner may be treated as a taxable sale if the partnership would not have made the distribution but for the initial contribution. In the case of nonsimultaneous transactions, a distribution generally will cause taxable sale treatment if it occurs within two years of the initial contribution.
One exception to disguised sale treatment is the so-called “debt-financed transfer” rule, which overrides the Disguised Sale Rules when a contributing partner receives proceeds from a third-party borrowing, but only to the extent the borrowing is allocated to the partner under the Debt Allocation Rules. Under current law, partners seeking tax deferral under the debt-financed transfer exception could therefore guarantee the borrowing or, instead, rely on an allocation under the “significant item of income” provision, which provides that a debt allocation will be respected if reasonably consistent with a significant item of partnership income or gain.
The 2016 Regulations put harsh limitations on partners’ ability to defer tax under the debt-financed transfer rule. These regulations require that, solely for purposes of the Disguised Sale Rules, all partnership debt must be treated as nonrecourse and therefore must be allocated in accordance with the partners’ share of partnership profits. Notwithstanding the provision that all debt be treated as nonrecourse, a partner cannot include partnership debt for which another partner bears the economic risk of loss. As a result, in the context of a disguised sale, which could include the acquisition of a business operated in partnership form (including certain joint ventures), and rollovers of partnership assets and interests, a debt allocation no longer can be made based on whether that partner provides a guarantee or a significant item of income or gain.
The 2016 Regulations addressing bottom dollar guarantees are effective for liabilities incurred on or after October 5, 2016 (except in the case of a liability incurred pursuant to a written binding agreement entered into before that date). Pursuant to a transition rule, a partner may apply the previous Debt Allocation Rules for seven years if and to the extent the partner’s share of partnership debt exceeds the partner’s outside basis (without respect to partnership debt) on October 5, 2016. The 2016 Regulations addressing debt-financed transfers will apply to any transaction pursuant to which all transfers occur on or after January 3, 2017.