New IRS rules for disguised sales and partnership liabilities
TAX ALERT |
The IRS has issued a complex package of new rules that fundamentally alter the disguised sale rules and some of the related rules for allocating recourse partnership liabilities (including liabilities of limited liability companies treated as partnerships). Newly issued (or modified) guarantees that are so-called ‘bottom dollar’ guarantees are immediately disregarded. In addition, after a 90-day transition period, the existing method of allocating recourse liabilities based on ‘risk of loss’ is replaced with a method that allocates recourse liabilities based on the partner’s participation in profits, as is the case with nonrecourse liabilities, but only for disguised sale purposes. More extensive proposed changes to the general rules for allocating liabilities, proposed in 2014, have been withdrawn for now, but are still under active consideration by the IRS.
Bottom dollar guarantees
A ‘bottom dollar payment obligation’ or bottom dollar guarantee is a guarantee that takes effect only if losses exceed a given percentage or amount of the total liability – such as a guarantee of a $100,000 nonrecourse loan that takes effect only to the extent losses on the underlying $100,000 property exceed $25,000.1 The ‘first loss’ guarantees of other parties cover the first $25,000 of losses, and the bottom dollar guarantee takes effect only to the extent total losses exceed $25,000, which might be highly unlikely. Under the prior regulations, such a guarantee would be treated as exposing the bottom dollar guarantor to $75,000 of economic risk, and would provide $75,000 of basis credit. In the context of a potential disguised sale, that might permit $75,000 of cash to be withdrawn and not treated as consideration paid for contributed property.
In contrast, a pro-rata guarantee of $75,000 of the full $100,000 of debt would expose the guarantor to 75 percent of any loss, no matter how small as a percentage of the total. That is, if there were a $10,000 loss, the guarantor would be responsible for $7,500. Such a pro-rata or capped guarantee would not be considered a bottom dollar guarantee. In addition, a first loss guarantee of the first $75,000 of losses would not be considered to be a bottom dollar guarantee.
The new regulations provide that, with certain exceptions, bottom dollar payment obligations are entirely disregarded for determining whether a partner has economic risk of loss with respect to a liability—both for purposes of the disguised sale rules and for purposes of allocating liabilities generally.2
This rule is effective immediately (i.e., to guarantees established or modified on or after Oct. 5, 2016). In addition, certain new disclosure requirements will apply to bottom dollar payment obligations established or modified on or after Oct. 5, 2016.3
Allocation of liabilities for disguised sale purposes
Beginning with certain transactions occurring on or after Jan. 3, 2017, the temporary regulations also make major changes to the way liabilities are allocated among the partners in a partnership for disguised sale purposes.
Typically, a disguised sale of property can occur if a partner contributes property to a partnership and also receives cash from the partnership, or is treated as receiving cash on account of various transactions involving the assumption of debt or the transfer of property subject to debt. In some cases, the receipt of cash is disregarded if it is accompanied by the partner’s bearing or increasing his share of partnership liabilities.
Prior to the new temporary regulations, recourse liabilities (and nonrecourse liabilities guaranteed by a partner or member) were allocated for disguised sale purposes in the same manner that they were allocated for partnership basis purposes—generally based on the share of economic downside risk borne by the partner. The new regulations provide that, for purposes of the disguised sale rules only, all liabilities are to be allocated in accordance with the partner’s percentage interests in partnership profits.4 In addition, no partner can be allocated a liability for which another partner bears the economic risk of loss with respect to the liability. Therefore, for disguised sale purposes, some liabilities may not be treated as allocable to any partner.
A major effect of this regulation package is to limit the popular tax planning technique of using leveraged partnerships to monetize business assets without triggering taxable gain (for more information on leveraged partnership transactions, see our prior coverage). Under the new temporary regulations, merely bearing the risk of loss will not prevent the application of the disguised sale rules. Taxpayers who are considering, or would be appropriate candidates to consider, transactions of this nature (not including the use of bottom dollar guarantees which are immediately prohibited) should keep in mind the deadline of Jan. 3, 2017.
The final regulations issued as part of this package make several minor changes and clarifications to other rules regarding disguised sales and the allocation of partnership liabilities. These changes are immediately effective, and include clarifications to the exceptions from disguised sale treatment of reimbursement to partners of preformation capital expenditures, the contribution of property subject to a liability, and debt-financed distributions. Although more extensive changes to the method of determining the partners’ percentage interest in partnership profits for purposes of allocating nonrecourse liabilities were proposed in the 2014 proposed regulations, the final regulations made no significant changes to existing law.
Additional proposed regulations, which will be the subject of future publications, may affect the classification of liabilities as recourse or nonrecourse, but will not be effective before they are finalized. Certain pro-taxpayer aspects of the proposed rules may, however, be relied upon by taxpayers in the interim.
2 Temp. Reg. section 1.752-2T(a)(3)(ii)
3 Temp. Reg. section 1.752-2T(a)(3)(ii)(D)
4 Temp. Reg. section 1.707-5T(a)(2)