Treasury and the IRS have issued proposed regulations significantly altering the analysis regarding whether a partner bears the economic risk of loss for a partnership liability under section 752. The proposed regulations also contain certain refinements to the disguised sale rules of section 707.
The proposed regulations effectively create, as part of the pre-existing “hypothetical liquidation test,” a three-step approach to determining whether and how much economic risk of loss regarding a partnership liability is allocable to a partner via certain contractual obligations, such as guarantees, indemnities, and reimbursement agreements. The first step tests the contractual obligation under a set of factors, which are presumably aimed at determining whether the obligation is commercially bona fide. If the obligation satisfies the commercially bona fide test, then the obligation is viewed as imparting economic risk of loss to a partner only to the extent of the net worth of such partner, although the pre-existing rule that presumes a partner as having sufficient net worth to satisfy fully the relevant obligation continues to apply for partners who are individuals. A duty to provide net worth information to the relevant partnership is proposed as well. The third step focuses on whether there are any other contractual obligations that, in certain circumstances, may reduce the economic risk of loss allocable to that partner.
The proposed regulations also eliminate the use of so-called “bottom-dollar” guarantees of partnership liabilities. The rules propose to eliminate all types of such guarantees (including vertical “bottom-dollar” guarantees). The rules take a broad view of the definition of a bottom-dollar guarantee in that they treat any guarantee other than a guarantee of 100% of the relevant liability as a prohibited “bottom-dollar” guarantee (including any combination of a guarantee and other arrangements that effectively split the economic risk of loss arising from the guarantee among multiple parties).
The proposed regulations also eliminate two of the alternative methods of allocating “tier 3” non-recourse liabilities and replace those with a new method focusing on the partners’ relative liquidation values in the partnership.
In light of the significant changes contained in the proposed regulations, there are broad transition rules proposed, including a 7-year period (which would start upon the finalization of the regulations) in which partnerships with certain partners can continue to use the current economic risk of loss rules under section 752.
The regulations can be accessed via: REG-119305-11.pdf