On January 29, 2014, the Internal Revenue Service and Treasury Department issued a notice of proposed rule-making, which has created substantial controversy, particularly in the real estate industry and professionals representing participants in it. The proposed regulations interpreting Section 752 of the Code, if adopted in the form proposed, would drastically change the way that partnership-level debt, both recourse and nonrecourse, is allocated among partners under existing regulatory provisions, creating both significant problems and possible opportunities. This Alert is a general description of how the regulations affect partners and partnerships (and other entities taxed as partnerships); a related GT Alert more specifically discusses the possible impact of the proposed regulations on the REIT industry.
Background. The way in which partnership level debt is allocated among partners has very important implications for partners (including members of limited liability companies and other entities that have elected to be treated as partners), both in terms of the way they share in operating income and more importantly operating losses, and especially in terms of the income tax consequences when members join and leave an entity. Generally speaking, a partner’s share of partnership level debt is considered part of his, her or its tax basis in the partnership interest. Losses reduce this tax basis and can only be currently deducted to the extent of the partner’s positive basis in the partnership interest. If a partner’s share of liabilities is reduced, that reduces the tax basis of his or her partnership interest; when tax basis is reduced to zero, a further reduction of liabilities results in taxable gain. When a person joins a partnership through a contribution of encumbered property, the person may recognize currently taxable “phantom gain” when the person’s share of liabilities is reduced (comparing the person’s allocable share of overall partnership liabilities after the contribution to the liabilities encumbering the property contributed.) Similarly, existing partners in a partnership may recognize gain when a contribution is made under circumstances that shift some of the pre-existing partnership liabilities to the new contributing partner(s). Similar effects can occur in the context of a distribution of property that shifts the allocation of liabilities.
Under the current regulations, which have been in place without major changes for many years, the allocation of partnership liabilities is made through the following process:
- Determine whether a liability is “fully recourse,” “fully nonrecourse” or “partially recourse.”
- For this purpose, a fully recourse liability is one where the partner, or a related person to the partner, bears the entire economic risk of loss, taking into account rights of contribution from other members of the partnership or related persons. For example, in a simple four-person equal general partnership, which incurs liabilities that have no contractual provisions to the contrary, each partner would normally be considered to bear the risk of loss of 25% of the partnership’s liabilities, and could include that portion of the debt in his, her, or its income tax basis in the partnership interest.
- A fully nonrecourse liability is one where the lender can look only to the entity’s assets, or a subset thereof, rather than a partner’s individual assets held outside the partnership, for satisfaction of the partner’s claim in the event of default. Barring contractual provisions to the contrary, most liabilities of a limited liability company are nonrecourse for this purpose. As discussed below, existing regulations provide substantial flexibility to the partners with regard to allocating nonrecourse liabilities.
- A partially recourse liability is one where a partner, or group of partners, bears some risk of loss for the liability, but not for the full amount thereof. Partial recourse liabilities can be either “top dollar,” where the lender is guaranteed by a partner from the first dollar of what would otherwise be its loss up to a defined amount of loss, beyond which the lender continues to bear the risk of loss, or “bottom-dollar,” where the lender must bear the first losses, and the partner’s individual liability only kicks in after the lender’s losses exceed a specified threshold. Partially recourse liabilities are considered, under current regulations, to be two liabilities; the recourse portion is considered “junior” to the nonrecourse portion in the case of “top-dollar” guarantees, while the nonrecourse portion is considered “junior” to the recourse portion in the case of “bottom-dollar” guarantees. Each portion is allocated according to the appropriate rules for that category.
Use of “bottom-dollar” guarantees. “Bottom-dollar” guarantees of partnership level debt have been particularly useful in facilitating tax-free contributions of leveraged property to partnerships.
Example: Existing partnership, comprised of Alan, Beth and Chuck, each with a one-third interest in all items of profits, losses, and capital, owns real estate that has a basis and fair market value of $20 million, subject to non-recourse debt of $5 million, so that total partnership equity is $15 million. Dan joins the partnership, contributing property with a tax basis of $1 million, and fair market value of $5.67 million, which is subject to nonrecourse debt of $4 million, receiving a ten percent interest in the partnership (and all material items therein, except as noted).
On the above facts, with nothing more, Dan would have an immediately taxable gain of $400,000. Following the transfer of Dan’s property to the partnership, the existing debt on that property is allocated to him to the extent that the debt balance of $4 million exceeds his tax basis of $1 million in the property, i.e., $3 million. He is also entitled to include ten percent of the remaining post-contribution partnership debt, or $600,000 in his share of liabilities. Thus, his net decrease in liabilities is $400,000 ($4 million pre-contribution less $3.6 million post-contribution), which amount would, absent anything else, be considered an immediately taxable gain. However, under existing regulations, he could defer this taxable gain by agreeing to assume personal liability for $400,000 of the partnership’s debt. It would not matter whether the assumption was a “top-dollar” guarantee, i.e., agreement to indemnify a particular lender for the first $400,000 of loss if the loan is not paid off by the partnership or with the proceeds from a foreclosure sale, or a “bottom-dollar” guarantee, under which, for example, Dan would agree to indemnify the lender on his contributed property for losses that exceed $3.6 million. Under the circumstances, while both obligations seem reasonably safe to undertake, the latter is much more so, since Dan’s obligation would only accrue if the value of the property dropped substantially. Alan, Beth and Chuck are not immediately affected by the reduction in their share of partnership liabilities, since it merely reduces their bases in their partnership interests rather than resulting in immediate gain.
Allocation of nonrecourse debt under current regulations. Existing regulations further provide that nonrecourse debt may, with certain exceptions, be allocated among partners in proportion to their shares of income, or any significant item of income, or in accordance with the manner in which it is reasonably expected that deductions attributable to the liability will be allocated (under rules relating to minimum gain chargebacks and related provisions of the allocation regulations). This rule has also provided substantial flexibility to partnerships.
Proposed regulations. The proposed regulations, if adopted as final regulations, would eliminate the tax planning opportunities described above. Substantial restrictions would be placed on both the ability to claim that debt was “recourse,” and on the ability to allocate basis attributable to nonrecourse debt in creative ways, both of which the Treasury and IRS have found “abusive” in at least some situations.
Effect on definition of “recourse liability.” With regard to the “recourse issue” the proposed regulations would add a number of tests that would have to be satisfied, beyond the issue of whether as a matter of state law the partner seeking recourse status has an enforceable obligation to make good on the partner’s obligations. Most importantly, the regulations require that the partner’s obligation must be liable up to the full amount of his or her payment obligation if any amount of partnership liability is not satisfied. This language would apparently eliminate the ability to create recourse liability for certain partners through “bottom-dollar” payment obligations.
Obligations of other parties to indemnify or otherwise financially assist the guaranteeing would significantly affect the treatment of debt under the proposed regulations. For example, if a partner makes a $400 “top-dollar” guarantee of a $1,000 debt, but has rights to indemnity from a third party of up to $20 of the partner’s economic loss, the assumption would not be considered to create a recourse liability for the partner, and the partner would not be entitled to include any part of the amount guaranteed in the basis of the partner’s partnership interest under the recourse rules.
The proposed regulations would impose these additional requirements before an obligation to reimburse a partnership’s lender for its losses sustained following default by the partnership will be considered to create a recourse liability for the obligor:
- The instruments creating personal liability must either require the obligor partner (or related person) to maintain a commercially reasonable net worth throughout the term of the obligation, or create commercially reasonably contractual restrictions on transfers of assets by the obligor for inadequate consideration.
- The obligor partner or related person must be required to periodically provide commercially reasonable documentation regarding the obligor partner’s financial condition.
- The term of the obligation must at least extend through the term of the partnership liability.
- The obligation-related documentation must not protect the obligor by requiring the partnership (or other primary obligor) to directly or indirectly hold money or other liquid assets in an amount that exceeds its reasonable needs.
Effect on allocation of nonrecourse liabilities
The proposed amendments to the regulations relating to allocation of nonrecourse liabilities (a class that is likely to expand if the foregoing proposals are adopted) eliminate the current regulations’ specific authorizations for partnerships to calculate partnership profits interests by reference to any significant item or class of income, or by reference to the manner in which it is reasonably expected that deductions attributable to those liabilities will be allocated. The only “safe harbor” for calculating profits interests recognized by the regulations (as proposed to be amended) is based on the partners’ respective “liquidation value percentages,” i.e., the amount that would be distributed to each partners if the partnership sold all of its assets for cash at fair market value, satisfied or provided for all of its liabilities, and then liquidated. Liquidation values established at the outset of a partnership would have to be redetermined upon occurrence of substantial contributions, distributions, grants of interests in the partnership for services or issuance of noncompensatory options, and as required by generally accepted accounting principles, where substantially all of the partnership assets consist of market securities and similar instruments. This approach is somewhat similar to one used to allocate profits under “target allocation” provisions found in many recently drafted partnership and LLC agreements.
While the “liquidation value percentage” approach is not technically mandatory under the language of the proposed amended regulations, and other ways of calculating profits interest are theoretically available, deviations from it in computing profits interest are likely to be quite risky if the regulations are adopted. However, it is clear that the IRS is still studying the issue, and has requested input from taxpayers and advisers on other appropriate methods of determining profit interests for purposes of debt allocation.
While the proposed regulations, if adopted as final regulations, would close off numerous planning opportunities that now exist, they could open other doors. For example, partnerships might be able to qualify for more favorable financing terms on generally non-recourse debt through having one or more partners provide credit support, without fear that such support would alter the parties’ expectations as to how income and loss will be allocated among themselves.
EFFECTIVE DATE: LIMITED TRANSITION RELIEF.
In general, the new rules limiting the ability to use partner-level obligations such as guarantees and indemnities in order to create “recourse” debt will apply to liabilities incurred or assumed by a partnership, and partner-level payment obligations imposed or undertaken with respect to a partnership liability on or after the effective date of the final regulations, with a customary binding contract exception. The regulations also provide a special “grandfather rule” available to partnerships that, on the effective date of the final regulations, have one or more partners that have negative capital accounts, i.e., the partners’ share of partnership liabilities under the prior regulations exceeds their tax basis in their partnership interests. Although the language is far from entirely clear, it appears that the intent of the grandfather rule is to allow such partnerships and their members to refinance existing debt, or incur additional debt, that would be allocated under the pre-existing, less restrictive regulations for a period of up to seven years without triggering gain that would otherwise result from applying the new rules to such refinanced or additional debt. Certain anti-abuse rules are included to reduce the so-called Grandfathered Amounts as a result of sales of partnership property, payment of pre-existing liabilities, or changes in membership of otherwise grandfathered partners that are legal entities rather than individuals, by 50 percent or more. If the transition rule concept is included in the final regulations, the language will need substantial clarification.
The new rules relating to use of liquidation value as a proxy for profits interest will apply to liabilities incurred or assumed by a partnership after the effective date of the final regulations, with no transition rule relief so far provided.