Although There Are Aspects of the Regulations that Practitioners and Taxpayers Still Disagree With, There Are Others that Are an Improvement on What Was Proposed Earlier.
From 2013 through 2014, the IRS and the U.S. Department of the Treasury issued proposed regulations regarding debt allocations in response to what the IRS and the Treasury saw as significant abuses with respect to certain partnership tax positions. The proposed regulations were not well-received by some, as can be seen from a review of the comments, including the observation that the proposed regulations, particularly those issued in 2014, represented a significant departure from current practice. The rules were in part finalized, in part withdrawn, in part re-issued as proposed regulations, and in part re-issued as temporary regulations in October 2016. Although there are aspects of the regulations that practitioners and taxpayers still disagree with, there are others that are an improvement on what was proposed earlier. The below discussion focuses on the recently issued proposed and temporary regulations regarding debt allocations under section 752 and does not discuss the disguised sales regulations.
Clarifying the Significance of Recourse vs. Non-Recourse Debt
The regulations regarding the allocation of debt for partners apply in a different manner depending on whether the debt is considered recourse or non-recourse. A partnership debt is recourse when a partner or a person related to a partner bears economic risk of loss for the debt. Conversely, a debt is non-recourse if no partner or person related to a partner bears economic risk of loss for the debt. Generally, a recourse debt will be allocated to the partner who bears economic risk of loss for the debt. In contrast to recourse debts, non-recourse debts are generally allocated pursuant to a three-tier system, based on a partner’s share of minimum gain, the amount of any taxable gain that would be allocated to a partner under section 704(c), and, then, generally a partner’s share of profits.
Impact of Guarantees of Debt
One aspect of the existing debt allocation rules that the IRS and the Treasury intended to address was that the debt allocation regulations assumed that, if a partner or a related party had a payment obligation under a guarantee, the partner or related party would be able to satisfy the payment obligation. At the same time, a disregarded entity’s guarantee was only respected as an obligation of its owner to the extent of the disregarded entity’s net value, without including the value of the interest in the partnership.
In the proposed regulations issued in 2014, very detailed requirements were imposed on a partner guaranteeing debt in order to allow the guarantee to be viewed as a recourse debt for purposes of the debt allocation regulations. These requirements included maintaining a commercially reasonable net worth or being subject to transfer restrictions, providing commercially reasonable documentation regarding financial condition, the guarantee must last as long as the debt, a guarantee fee must be paid, and the guarantee must be for the full amount of the debt.
2016 Temporary and Proposed Regulations
The recently issued temporary and proposed regulations address certain key provisions with respect to qualifying guarantees. One of the most significant provisions is for bottom guarantees, which are broadly defined under the 2016 temporary regulations and are no longer permitted, except under certain favorable grandfathering exemptions. Generally, bottom guarantees that were in existence prior to the issuance of the temporary regulations may remain in existence for the life of the debt. Certain reporting requirements may apply. However, no new bottom guarantees may be used for federal income tax purposes, from the effective date of the temporary regulations forward, because the IRS view was that bottom guarantees were used in an abusive way. The IRS believed that these guarantees were used essentially to give partners basis in a partnership even when they did not actually have any economic risk of loss because, for example, they were only guaranteeing the bottom $10 of a $100 debt. Furthermore, the IRS was concerned that bottom guarantees were a creation of tax planning and were meaningless to lenders and for others in typical commercial transactions.
The temporary regulations, unlike the 2014 proposed regulations, permit the guarantee of a vertical slice of partnership liability and an arrangement where the guarantor retains 90 percent or more of the economic risk of loss for the debt. Commentators had argued for allowing a guarantee of a smaller piece than 90 percent to be effective, but that was not adopted in the temporary regulations. The ability to guarantee a vertical slice is nevertheless helpful for partners going forward when the partners desire to guarantee only a percentage of the debt.
The 2016 proposed regulations adopt many of the factors found in the 2014 proposed regulations for delineating the necessary criteria to determine whether a guarantee will be respected. Because none of the factors are determinative in deciding whether an obligation subject to a guarantee will be respected, it remains a facts-and-circumstances test, with no safe harbors or assurances that one factor is more compelling than any other in treating the guarantee as significant enough that the guarantor may allocate a portion of the debt subject to the guarantee.
Additionally, the proposed regulations remove the net-value requirements and instead provide a new presumption in the anti-abuse rules regarding disregarded entities. The proposed regulations’ presumption states that evidence of a plan to avoid an obligation is deemed to exist if facts and circumstances would lead a reasonable person to think that the payment obligor (which includes disregarded entities) will not make the required payment. This anti-abuse rule has added uncertainty because it is common for parties to use disregarded entities to shield general partners and others from liability under state law. Commentators have raised questions as to whether the seemingly routine use of a disregarded entity when the underlying partnership incurs debt could be deemed a plan to avoid an obligation pursuant to the anti-abuse rule.
While the temporary regulations issued in 2016 provide some needed clarifications, certain matters remain unclear. Certainty was provided for bottom guarantees, which are broadly defined under the 2016 temporary regulations and are no longer are permitted, except under certain favorable grandfathering exemptions. Guaranteeing a vertical slice of debt is still permitted, which is helpful for partners when structuring guarantees where certain partners desire to guarantee only a percentage of the debt. Although the rigid requirements of the 2014 proposed regulations for guarantees are not in effect, similar criteria have been adopted by the temporary regulations and should be carefully evaluated in determining whether a guarantee will be respected. Thus, partners and partnerships should carefully evaluate the factors provided in the temporary regulations and the overall commercial reasonableness of the guarantees and other provisions involving the allocation of basis with respect to debt of a partnership prior to making their allocations.
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