IRS changes course on disguised sale liability rules
IRS reverses key aspect of their position on disguised sales
TAX ALERT |
The IRS and Treasury have formally proposed to reverse a key and controversial aspect of their position on disguised sales, affecting how recourse debt is taken into account under those rules. Technically, this reversal would be made by withdrawing temporary regulations issued in 2016, and reverting to longstanding disguised sale rules in effect before that time. The most important reversal is that a partner’s liability to bear the economic cost of repaying a recourse loan (if the partnership could not repay) would be a positive factor that could prevent that loan or the distribution of its proceeds to the partner from causing a disguised sale. Absent such a rule, a partner contributing property to a partnership, and getting loan proceeds from a partnership loan that he was economically required to repay if the partnership could not, could be treated as selling the property for the loan proceeds, despite the potential obligation to repay the loan proceeds.
Under the temporary regulations now proposed to be withdrawn, some recourse loans could have been taken into account to reduce or eliminate a disguised sale, but only to the extent of the partner’s interest in partnership profits, which might be far less than the proportion of the loan the partner was economically liable for, if the partnership failed to repay. For example, a partner might have only a 10 percent interest in partnership profits but might have guaranteed 100 percent of a partnership liability, and only 10 percent of the loan would have been a mitigating factor, not 100 percent.
Apart from this important change, the rules limiting so-called “bottom dollar guarantees” for disguised sale purposes, and for purposes of liability allocations generally, will remain. Those rules generally limit the ability to take into account a guarantee or similar repayment obligation if it represents a limited obligation that arises only after a certain level of initial losses.
For a more detailed analysis of the disguised sale rules as modified by the 2016 regulatory package (including the rules now proposed to be withdrawn) see our prior alert: New IRS rules for disguised sales and partnership liabilities.
For some additional detail, see below.
New proposed regulations (see REG-131186-17) would, if finalized, replace the current temporary regulations with the prior final regulations concerning the allocation of liabilities for disguised sale purposes.
Under the disguised sale rules, certain contributions of property to a partnership followed by a distribution to the contributing partner can be recharacterized as a sale or exchange rather than a tax free contribution. These rules generally involve a facts and circumstances test, including 10 factors identified in the applicable regulations, and may occur whether the distribution is of actual cash or property, or a deemed distribution of cash resulting from a transaction involving the assumption of liabilities. In certain cases, a partner’s allocation of liabilities has the potential to impact the disguised sale treatment, for instance, the receipt of cash may be disregarded if it is accompanied by an increase in the partner’s share of partnership liabilities. This makes sense because the partner is thus viewed as potentially liable to return that cash.
For many years, prior to the temporary regulations issued in 2016 and now proposed to be withdrawn, recourse liabilities, including nonrecourse liabilities guaranteed by a partner, for disguised sale purposes were generally allocated in the same fashion as they were with respect to a partner’s basis – that is, based on each partner’s share of downside economic risk of loss in a “worst case” scenario where all of the partnerships assets become worthless.
Under the current temporary regulations, now proposed to be withdrawn but which as written are effective for transactions on or after Jan. 3, 2017, all liabilities (recourse and nonrecourse) are required to be allocated for disguised sale purposes in accordance with the partner’s percentage interest in the partnership. Thus, a partner’s obligation to repay loan proceeds would not be taken into account if it were higher than the partner’s share of partnership profits, which was a frequent occurrence in practice. In some cases this rule could produce results that were criticized as irrational or even absurd. Of course, most importantly, they made it easier for the IRS to find a disguised sale.
As part of President Trump’s Executive Order regarding the identification and reduction of tax regulatory burdens, the current temporary disguised sale regulations were identified and selected by Treasury as regulations warranting reconsideration. Accordingly, the newly issued proposed regulations propose to rescind the current temporary regulations, and reinstate the previous final regulations allocating recourse liabilities for disguised sale purposes the same way they are allocated generally, described generally above. While these proposed regulations would not rescind the current temporary regulations until 30 days after the date the proposed regulations are published in the Federal Register, according to the notice of proposed rulemaking, taxpayers may rely on these proposed regulations now for all transactions occurring on or after Jan. 3, 2017. Thus, the proposed withdrawal is essentially effective now.
However, while these proposed regulations may come as welcome relief from a complex set of temporary regulations, it is important to note that they would only rescind the existing temporary disguised sale regulations. The rules concerning “bottom dollar guarantees,” which are contained in a separate set of temporary regulations, would not be rescinded. In addition, the underlying issue of concern to the IRS and Treasury may not go away, and the government could seek to limit disguised sales, particularly involving so-called “leveraged partnerships” using another approach.