Last month, the Internal Revenue Service (IRS) issued partnership tax regulations (the "New Regulations") that will impact long-standing business arrangements among partners in a partnership, including members of LLCs taxed as partnerships and limited partners in private equity funds, hedge funds, and UPREITs.
The New Regulations relate specifically to allocations of partnership liabilities among partners and so-called disguised sales of property to partnerships and make a number of significant changes to the current rules. The two most momentous changes are that the New Regulations:
- significantly alter how partnership liabilities are allocated among partners by (i) effectively eliminating a partner's ability to obtain tax basis through the use of a "bottom" guarantee and (ii) providing certain anti-abuse rules that may allow the IRS to disregard a partner guarantee or other payment obligation; and
- significantly limit a taxpayer's ability to obtain a debt-financed distribution following the contribution of appreciated property to a partnership.
Allocation of Partnership Liabilities
Under the tax law, partners can receive an increased tax basis in their partnership interest from allocations of partnership-level liabilities. An increased basis can permit partners to receive tax-free cash distributions and/or loss allocations from the partnership that are in excess of the cash contributed by the partner to the partnership. Although these benefits must be recaptured eventually, a basis increase through the allocation of partnership liabilities can provide a valuable timing benefit to partners.
A partnership liability is allocated among the partners of a partnership by one of two regimes, depending on whether the liability is "recourse" or "nonrecourse." A partnership liability is nonrecourse to the extent that no partner bears the economic risk of loss for such liability. An example of a nonrecourse liability would the debt of an LLC that no member of the LLC has any personal obligation to pay. Nonrecourse liabilities are generally allocated among partners in accordance with how they share profits. Conversely, a partnership liability is recourse to the extent that a partner bears the economic risk of loss for such liability. Not surprisingly, recourse liabilities are allocated among the partners according to how they share the economic risk of loss.
A partner bears the economic risk of loss for a partnership liability to the extent that the partner would be obligated to make a payment with respect to the liability if all of the assets of the partnership became worthless and the liability became due and payable. Under prior law, for purposes of making this determination, all contractual obligations of a partner, such as a guarantee, were taken into account. Moreover, it was common that, in order to minimize the actual economic risk of the guarantee, the partner-guarantor might structure the guarantee as a "bottom" guarantee, whereby the partner-guarantor would be responsible for making a payment only to the extent the lender did not receive a set minimum amount.
For example, if a partnership had a $100 liability (secured by property worth $200), a partner might agree to a bottom guarantee of $50. In this case, if the partnership defaulted on the liability, and the lender was able to recover at least $50 from the property securing the liability, then the partner would owe nothing under the guarantee. If, however, the lender was repaid less than $50 (e.g., $20), then the partner would be obligated to make up the difference (i.e., $30 if the lender was repaid only $20). Prior to the New Regulations, the partner-guarantor in this example would have been allocated $50 of the partnership liability on account of his guarantee, providing the partner-guarantor with $50 of tax basis. This was the case even though, as a practical matter, given the size of the guarantee and the value of the property securing the liability, it was unlikely that the partner-guarantor would ever have to pay out of pocket in satisfaction of the guarantee.
Under the New Regulations, however, except in certain limited circumstances, a bottom guarantee does not result in the guarantor-partner receiving additional tax basis equal to the full amount of the guarantee. As many bottom guarantees have been undertaken largely to enable the partner-guarantor to receive additional basis, this change to the existing liability-allocation rules will likely have a significant impact on partners, such as real estate and other investors, who have been relying on bottom guarantees. Fortunately, while the provisions of the New Regulations that disregard bottom guarantees were effective as of October 5, 2016, there is a transition rule that grandfathers existing bottom guarantee arrangements for up to seven years.
The New Regulations maintain the existing rules that "top" or "first-dollar" guarantees and "vertical-slice" guarantees (i.e., a guarantee of a portion of each dollar of the partnership liability) cause the guaranteed portion of the debt to be allocated to the partner-guarantor. Also, certain bottom guarantees of partnership debt where the partner-guarantor is on the hook for at least 90% of the debt are still permitted. That being said, under proposed regulations (which would be effective when finalized) issued as part of the New Regulations, the IRS has provided a rather strong anti-abuse rule that may cause even top, vertical-slice, or other permitted guarantees to be disregarded. Under these proposed regulations, a guarantee or other obligation of a partner will not be respected if the facts and circumstances evidence a plan to circumvent or avoid the obligation. Additionally, the New Regulations make clear that if a partner's ability to repay is uncertain, the IRS may use that fact as evidence of a plan to circumvent or avoid a payment obligation.
Under the partnership tax rules, contributions and distributions to and from partnerships are generally tax-free events. One of the exceptions to this general rule is the so-called disguised sale rule, which recharacterizes a contribution of property to a partnership as a taxable sale where the contributing partner receives distributions of cash (or other property) that are, in substance, consideration for the contribution. This being tax law, there are exceptions to the exception.
One of the more significant exceptions to the disguised sale rule is the debt-financed distribution exception. Under this exception, if a partner contributes property to a partnership, the partnership incurs a debt, and all or a portion of the debt proceeds are shortly thereafter transferred to the contributing partner, the transfer of money is non-taxable (i.e., not part of a "disguised sale") to the extent that the amount of money transferred does not exceed the partner's allocated share of the partnership liability.
Prior to the New Regulations, a partner who contributed property to a partnership and soon thereafter received a non-pro-rata cash distribution could avoid gain recognition by guaranteeing partnership liabilities at least up to the amount of the cash distribution. The New Regulations, however, significantly limit a partner's ability to take advantage of this exception by treating all liabilities as nonrecourse liabilities for purposes of the disguised sale rules, even in cases where a partner has guaranteed 100% of the debt. As such, a non-pro-rata distribution of borrowed funds by a partnership to a property-contributing partner within two years of the contribution could result in a disguised sale, despite any guarantee by the partner.
These new rules with respect to disguised sales will be applicable to any transactions where all of the transfers (contribution and distribution) take place on or after January 3, 2017.
The changes made by the New Regulations may have a profound effect on partners and partnerships going forward, particularly with respect to a partner's ability to use a guarantee to obtain tax basis or avoid a disguised sale. We therefore recommend that taxpayers consider the impact the New Regulations could have on their existing or future partnership ventures.