On June 19, 2018, Treasury and the Internal Revenue Service (IRS) published proposed regulations (REG-131186-17) (2018 Proposed Regulations) concerning the manner in which partnership liabilities are allocated among the partnership’s partners for purposes of applying the disguised sale rules. The disguised sale rules, if applicable, generally operate to recast what would otherwise be a nontaxable contribution or distribution of property between a partnership and a partner as a taxable sale of the property for US federal income tax purposes. The manner in which partnership liabilities are allocated is often relevant in determining the extent to which the disguised sale rules apply and the amount of gain recognized in the disguised sale. Accordingly, the 2018 Proposed Regulations are an important development for partnerships and partners in any transaction involving a purported contribution or distribution of property between a partnership and a partner.
To appreciate the impact of the 2018 Proposed Regulations, a brief summary of the rules governing the allocation of partnership liabilities is necessary.
The manner in which a partnership liability is allocated generally depends on whether the partnership liability is considered recourse or nonrecourse. A partnership liability is considered recourse to the extent that a partner or related person bears the economic risk of loss (EROL) for the liability. Recourse liabilities are allocated to the partner considered to bear the EROL for the liability. To the extent that no partner or related person bears the EROL for a partnership liability, the liability is considered a nonrecourse liability. Nonrecourse liabilities generally are allocated among the partners in accordance with their respective share of partnership profits.
In general, all state law and contractual obligations, including guarantees, indemnities, and reimbursement obligations of a partner or a related person, are taken into account for purposes of determining whether a partner bears the EROL for a partnership liability and, hence, whether the liability is recourse or nonrecourse. However, the liability allocation rules include an anti-abuse rule, under which an obligation of a partner or a related person may be disregarded if the obligation lacks substance. Further, as discussed below, since 2014, the IRS has issued a number of regulation packages, including proposed and temporary regulations, targeting perceived abuses relating to the allocation of partnership liabilities under the EROL test, including for purposes of the disguised sale rules.
Many of the perceived abuses related to obligations that Treasury and the IRS considered to be tax motivated and lacking commerciality, such as “bottom dollar” guarantees and similar obligations pursuant to which a partner’s or related person’s obligation did not apply to the first dollar of the liability. Such obligations were frequently used in connection with contributions of encumbered property to a partnership, such as an “UPREIT” partnership, to provide the contributing taxpayer with the EROL for the encumbering liability and to thereby avoid recognition of gain on the contribution.
Treasury and the IRS were also concerned with perceived abuses of the EROL test in connection with “leveraged partnership” transactions, which were intended to allow a taxpayer to extract equity value from appreciated property on a tax-deferred basis through debt-financing. These transactions typically involved (1) a taxpayer’s contribution of appreciated property to a partnership in exchange for a partnership interest, (2) a related debt-financed distribution by the partnership to the taxpayer, and (3) a guarantee or other obligation of the taxpayer that purportedly provided the taxpayer with the EROL for the debt, which EROL purportedly allowed the taxpayer to avoid the application of the disguised sale rules with respect to the contribution of property and the related debt-financed distribution. See, for example, Canal Corp. & Subsidiaries, 135 T.C. 199 (2010).
On January 30, 2014, Treasury and the IRS issued proposed regulations (REG-119305-11) (2014 Proposed Regulations) that, in relevant part, would have prevented partners from being considered to have EROL on account of non-commercial payment obligations, such as bottom dollar payment obligations. Thereafter, on October 5, 2016, Treasury and the IRS issued temporary regulations (T.D. 9788) (2016 Temporary Regulations) under which bottom dollar payment obligations are generally disregarded for purposes of the EROL test.
In addition, the 2016 Temporary Regulations include special rules that apply for purposes of allocating partnership liabilities in connection with the disguised sale rules. Under these special rules, in the case of a taxpayer who contributes property to a partnership, any EROL of the taxpayer with respect to the partnership’s liabilities is effectively disregarded for purposes of applying the disguised sale rules to the contribution, which, in many cases, has the effect of increasing the extent to which the disguised sale rules apply to the contribution and the amount of gain recognized on the disguised sale. These special rules effectively put an end to leveraged partnership transactions.
On April 1, 2017, President Trump issued the “Executive Order on Identifying and Reducing Tax Regulatory Burdens,” directing Treasury to review all significant tax regulations issued on or after January 1, 2016, and to act to alleviate the burdens of such regulations that impose undue financial burdens or complexity or that exceed the authority of the IRS. As part of its review, Treasury identified the 2016 Temporary Regulations as meeting these criteria and issued the 2018 Proposed Regulations in response.
The 2018 Proposed Regulations, if finalized, would remove the special rules in the 2016 Temporary Regulations pertaining to allocations of liabilities in connection with the disguised sale rules. Hence, under the 2018 Proposed Regulations, a partner’s allocation of partnership liabilities for purposes of the disguised sale rules would be once again determined giving effect to the EROL test (as modified by the 2016 Temporary Regulations with respect to bottom dollar payment obligations). The 2018 Proposed Regulations also include a taxpayer-favorable rule that allows taxpayers to apply the 2018 Proposed Regulations in lieu of the 2016 Temporary Regulations to any transaction to which the 2016 Temporary Regulations would otherwise apply. In other words, taxpayers now have the option to choose which set of regulations apply.
Eversheds Sutherland Observation: The 2018 Proposed Regulations reopen certain planning opportunities under the EROL test for taxpayers seeking to mitigate the impact of partnership liability allocations under the disguised sale rules. The 2018 Proposed Regulations also give new life to leveraged partnership transactions. Taxpayers seeking to extract equity value from appreciated property on a tax-deferred basis should consider whether a leveraged partnership structure is a viable alternative.
Eversheds Sutherland Observation: The 2018 Proposed Regulations would not alter the treatment of bottom dollar payment obligations under the 2016 Temporary Regulations. As a result, such obligations continue to be subject to complex limitations intended to prevent taxpayers from obtaining or shifting the EROL with respect to a partnership liability.
Eversheds Sutherland Observation: Because taxpayers can choose whether to apply the 2016 Temporary Regulations or the 2018 Proposed Regulations for purposes of applying the disguised sale rules, parties to a contribution to, or distribution from, a partnership should consider having an express agreement indicating which regulations will be applied in determining the US federal income tax treatment of the transaction, as the consequences may differ based on which regulations are applied.