The Internal Revenue Service (IRS) issued regulations last October (the 2016 Regulations) that significantly alter the landscape of allocations of partnership liabilities and the disguised sale rules. The 2016 Regulations generally tighten those rules and severely restrict transactions or structures that the IRS considers noncommercial or abusive. For example, the regulations effectively end the use of leveraged partnership transactions, which would have allowed cash to be extracted from a partnership tax-free to a partner who contributes property to the partnership or in a transaction that is economically similar to a redemption of the partner’s interest in the partnership. They also generally disregard noncommercial guarantees, including so-called bottom-dollar guarantees, in allocating partnership liabilities.
There is, however, good news as well. Specifically, the 2016 Regulations add a new category of qualified liabilities (the New Qualified Liability), the assumption of which by a partnership generally would not trigger the disguised sale rules. The IRS recently issued a private letter ruling that provides some detail as to the scope of this new category.
The Disguised Sale Rules and Qualified Liabilities
Under the disguised sale rules, when, in connection with a contribution of property to a partnership, the contributing partner receives cash or other property from the partnership, the contribution and the distribution may be aggregated and treated in part as a disguised sale of the property to the partnership. In such situations, the contributing partner would recognize current gain (or loss) with respect to the contributed property. For these purposes, a partnership’s assumption of (or taking property subject to) a partner’s liability (other than a qualified liability) is considered a distribution of cash to the contributing partner to the extent such liability exceeds the contributing partner’s allocable share of that liability immediately after the contribution.
In contrast, if a partnership assumes (or takes property subject to) a qualified liability, the disguised sale rules generally are not triggered. Accordingly, the classification of a liability as a qualified or a nonqualified liability is important for purposes of the disguised sale rules. Prior to the 2016 Regulations, qualified liabilities generally included:
- Any liability incurred at least two years prior to the contribution (and the assumption of the liability), provided that the liability has encumbered the contributed property throughout the two-year period.
- Any liability incurred within the two-year period but not in anticipation of the contribution, provided that the liability has encumbered the contributed property throughout the period.
- Any liability that is allocable to capital expenditures with respect to the contributed property.
- Any liability incurred in the ordinary course of a trade or business in which the contributed property is used or held, provided that all assets material to the continuation of such trade or business are also contributed to the partnership.
The 2016 Regulations and the New Qualified Liability
The 2016 Regulations add as a fifth category a liability that is incurred in connection with a trade or business in which the property transferred to the partnership is used or held, provided that (i) the liability is not incurred in anticipation of the transfer and (ii) all material assets related to that trade or business are transferred. A liability incurred within two years of the transfer generally is presumed to be incurred in anticipation of the transfer of property to the partnership, unless the facts and circumstances clearly establish otherwise.
In applying the existing categories of qualified liabilities, it has not always been entirely clear what it means for a liability to encumber the transferred property. Practitioners have at times advised that a liability be secured by all of the assets in a trade or business, even if lenders do not explicitly require such, in order to meet the encumbrance requirement. The New Qualified Liability dispenses with the encumbrance requirement, and thus is a welcome addition in that regard alone. Further, the New Qualified Liability requires only that the liability be incurred “in connection with,” as opposed to “in the ordinary course of,” the trade or business. The phrase “in connection with” is not explicitly defined in the 2016 Regulations. Compared with “in the ordinary course of,” “in connection with” seems to encapsulate a broader scope of liabilities. For example, if a partner incurs a liability to construct a new headquarters building for its business, that liability may be considered a qualified liability under the “in connection with” language, provided the other requirements are met. In contrast, such liability probably would not be considered as incurred “in the ordinary course of” the trade or business.
The term “in connection with,” when used in other contexts, has generally been broadly construed by the IRS and courts. For instance, Section 174 of the Internal Revenue Code allows deductions of research and experimental expenditures paid or incurred in connection with a taxpayer’s trade or business. The Supreme Court, in interpreting that phrase for purposes of Section 174, permitted deductions for expenditures even though, at the time those expenditures were incurred, the taxpayer’s activities did not rise to the level of a trade or business.
A Recent PLR
The IRS recently released a private letter ruling — PLR 201714028 — that indicates a willingness to give broad interpretation to this phrase for purposes of the disguised sale rules. In the private letter ruling, a company (which appears to be a partnership for tax purposes) is planning to transfer cash and all of its material operating assets to a partnership in exchange for partnership interests. In connection with the transfer, the partnership will assume a certain amount of the company’s liabilities. Some of the liabilities were originally incurred to make distributions (presumably to the owners of the company) in connection with the company’s formation, and have been subsequently refinanced. The remaining liabilities have been incurred to acquire assets, make improvements, pay expenses and otherwise operate the company’s business. The company has also regularly distributed cash to its members in proportion to their ownership interests. The company represented that the liabilities were incurred years before the transfer, and were not incurred in anticipation of the transfer. The IRS ruled that all of the liabilities that will be assumed by the partnership in connection with the company’s transfer of cash and all of its material operating assets are New Qualified Liabilities.
Liabilities incurred to fund the operations of a trade or business generally are understood to be liabilities incurred in connection with such trade or business. The PLR is significant in that it suggests liabilities incurred in part to fund distributions (out of the trade or business) also are considered incurred in connection with the trade or business. Even though the PLR states that most of the liabilities were incurred in connection with the operation of the company’s business, they can also be considered to be incurred to fund cash distributions to the company’s members, because money is fungible. Although the practical reach of the New Qualified Liability remains to be seen, the PLR may signal the IRS’ willingness to construe the phrase “in connection with” broadly in its application.