IRS finalizes partnership liability regulations
TAX ALERT |
The IRS and Treasury have issued definitive, final regulations addressing the use of ‘bottom dollar guarantees’ when allocating partnership liabilities. Such arrangements, which were viewed as abusive, are relevant for purposes of determining whether there is a ‘disguised sale’ to a partnership, and in allocating partnership liabilities to enable partners to claim tax losses.
The new, final disguised sale rules are the same as those previously proposed, in 2018, as a replacement for controversial disguised sale regulations issued in 2016.
The new final rules for allocating liabilities generally, where there is a bottom dollar guarantee, are similar to the regulations proposed in 2016 as a replacement for the controversial temporary regulations issues a few months earlier.
To summarize the new, final rules:
A partner who receives debt-financed distributions can avoid treating the distribution as a disguised sale if the partner guarantees the debt or is otherwise economically liable for its repayment, as long as the guarantee is not a ‘bottom dollar guarantee’. Although there are highly technical rules involved with that determination, the key concept is that most loans secured by property do not become completely worthless, since there is often some residual value in the property. Accordingly, a ‘bottom dollar’ guarantee that only applies if the loan (or the property securing it) becomes completely or almost completely worthless is not recognized as a true economic liability.
The same principles apply for purposes of allocating partnership liabilities generally, for example, where a partner wants to claim additional outside basis, based on an allocation of partnership liabilities, in order to use his share of partnership losses or deductions.
Importantly, the final regulations revise the definition of a ‘bottom dollar payment obligation’ to include both a capital contribution obligation and a deficit restoration obligation in certain cases.
In particular, the new restriction would apply where either such obligation is not one that would require the partner “to make the full amount of the partner’s capital contribution or to restore the full amount of the partner’s deficit capital account”. This is particularly noteworthy for those partners that have executed limited deficit restoration obligations – obligations requiring the partner to restore a specified amount of a negative capital account balance, but not necessarily an unconditional obligation to restore any amount of a negative capital account balance. An example would be an obligation that would require the partner to restore up to a $100,000 of their negative capital account balance. In such cases, the new final regulations could be read to suggest that such a ‘limited’ obligation would fall under the definition of a bottom dollar payment obligation and be disregarded. This interpretation might apply, under the literal language of the final regulations, even if the partner’s ‘limited’ obligation to restore a negative capital account balance was, at the time of execution of the obligation, in excess of that partner’s negative capital account. Such an interpretation might apply ‘retroactively’ even to periods in which the limitation was not yet reached, if it might be applicable in the future, as and when the partner’s negative capital account increased to an amount greater than the restoration obligation.
Importantly, this change could be retroactive. The definition of bottom dollar payment obligations is effective for “liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken with respect to a partnership liability on or after Oct. 5, 2016, other than liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken pursuant to a written binding contract in effect prior to that date.”
Although these final regulations have been anticipated for some time, and largely track prior proposals, partnerships and their partners should take note of the revisions to the definition of bottom dollar guarantees, particularly as they may apply to limited deficit restoration obligations, potentially with retroactive effect.