Final rules out for partnership liability


The IRS released two sets of final regulations (TD 9876 and TD 9877) on Oct. 9 that address rules for disguised sales of property involving partnerships and the determination of whether an obligation is a recourse liability under Section 752.

The rules are critical for determining whether obligations result in a partner’s economic risk of loss (EROL) for a partnership liability under Section 752, which in turn affects a partner’s ability to deduct losses and receive tax-deferred cash distributions from the partnership. TD 9876 finalizes proposed regulations issued in June 2018 that had effectively suspended unpopular portions of temporary regulations from 2016 that generally treated all obligations as nonrecourse for disguised-sale purposes. TD 9877 finalizes the other aspects of the 2016 temporary and proposed regulations, which disregard many so-called bottom-dollar guarantees and provide rules concerning when a payment obligation is recognized in determining whether debt is recourse to a partner.

The final rules could have a significant impact on the disguised-sale analysis for certain leveraged distributions, and in situations in which a partnership assumes a liability of a partner or receives property subject to a liability where the liability is recourse to the contributing partner under Section 752. Although the issuance of final regulations would appear to settle the issue, the IRS indicated that they are continuing to study the treatment of liabilities in the context of disguised sales, so future guidance on this issue is possible.







Section 752 separates partnership liabilities into two categories: recourse and nonrecourse. A liability is treated as a recourse liability of a partner under the Section 752 regulations to the extent that a partner or a related person has EROL with respect to that liability. To determine whether a partner or a related person has EROL, the regulations look to whether the partner or related person would be required to pay if the partnership defaulted on the liability. Whether a partner is treated as having EROL for a partnership liability under Section 752 affects a partner’s ability to deduct losses and receive tax-deferred cash distributions from the partnership.

In evaluating whether a partner has EROL for a liability, the existing regulations presume that partners and related persons who have payment obligations actually perform those obligations, irrespective of their net worth, subject to certain limitations. A payment obligation may be disregarded or treated as an obligation of another person under pre-existing Treas. Reg. Sec. 1.752-2(j) if the facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner’s EROL with respect to the obligation or create the appearance of the partner or related person bearing the EROL when they substantively do not.




Proposed and temporary regulations



In January 2014, the IRS issued proposed regulations that would have established a very high threshold for a partner to be treated as having EROL for a liability. The 2014 proposed regulations set out a list of seven factors, each of which was required to be satisfied in order for a payment obligation to be respected. Proposed regulations issued in October 2016 would have replaced this “all-or-nothing” test with an anti-abuse rule in Treas. Reg. Sec. 1.752-2(j), which provides a list of non-exclusive factors that are to be weighed to determine whether the facts and circumstances indicate a plan to circumvent or avoid an obligation.

The allocation of a partnership’s liabilities can also have a significant impact on whether a partner is treated as receiving consideration in a disguised sale under Section 707(a)(2)(B). Prior to October 2016, Treas. Reg. Sec. 1.707-5(a)(2) provided separate approaches for determining a partner’s share of recourse and nonrecourse liabilities for the disguised-sale rules. A partner’s share of recourse liabilities was generally equal to the amount determined pursuant to the general liability allocation rules under Section 752. A partner’s share of nonrecourse liabilities was computed using the percentage used to determine the partner’s share of excess nonrecourse liabilities under Treas. Reg. Sec. 1.752-3(a)(3), which is generally a partner’s interest in partnership profits. Because the disguised-sale rules only potentially treat a net decrease in a partner’s share of partnership liabilities as disguised-sale proceeds, partners that were allocated recourse liabilities under Section 752 were effectively shielded from the disguised-sale rules.

Temporary regulations issued in October 2016 generally required partners to treat all partnership liabilities as nonrecourse liabilities for disguised-sale purposes (i.e., allocated solely in accordance with the partner’s share of partnership profits). The rules also did not permit a partner’s share of a partnership liability for Section 707 purposes to exceed the partner’s share of the partnership liability under Section 752 and applicable regulations. Thus, if another partner had EROL with respect to a liability, then no portion of that liability could be allocated to the contributing partner. The 2016 temporary regulations were effective for transactions with respect to which all transfers occurred on or after Jan. 3, 2017. They made it far more likely that a partnership's assumption of a partner's recourse liability would result in a disguised sale. They were also criticized for adopting a new approach for allocating liabilities without allowing public comments, and were among eight regulations that the IRS recognized as burdensome and identified for potential removal in response to President Donald Trump’s Executive Order 13789.

In June 2018, the IRS issued proposed regulations which proposed to remove the liability allocation approach for disguised sales contained in the 2016 temporary regulations and to reinstate the liability allocation rules contained in the final regulations prior to the 2016 temporary regulations. The 2018 proposed regulations allowed a partnership and its partners to apply all the rules in the proposed regulations, in lieu of the 2016 temporary regulations, to any transaction with respect to which all transfers occurred on or after Jan. 3, 2017.




Payment obligations and bottom dollar guarantees under the final rules



The final rules in TD 9877 adopt the portion of the 2016 proposed regulations providing the non-exclusive factors under Treas. Reg. Sec. 1.752-2(j), with a few clarifications. The weight to be given to a particular factor depends on the particular case, and the presence or absence of any particular factor, in itself, is not necessarily indicative of whether a payment obligation is recognized. TD 9877 also addresses when certain obligations to restore a deficit balance in a partner’s capital account are disregarded under Section 704(b).

Prior to amendment in TD 9877, a payment obligation of a disregarded entity was only taken into account to the extent of the net value of the disregarded entity under Treas. Reg. Sec. 1.752-2(k). Under TD 9877, the extent to which a disregarded entity has EROL for a liability is no longer limited to the net value of that disregarded entity. Rather, Treas. Reg. Sec. 1.752-2(k) now provides that a payment obligation will not be recognized only if the facts and circumstances indicate that, at the time the partnership must determine a partner’s share of partnership liabilities, there is not a commercially reasonable expectation that the payment obligor will have the ability to make the required payments under the terms of the obligation if it becomes due and payable. This must take into consideration factors that a third-party creditor would take into account when determining whether to grant a loan. Whereas the net value rule previously in Treas. Reg. Sec. 1.752-2(k) only applied to disregarded entities, the new rule regarding a commercially reasonable expectation of repayment applies to all partners, regardless of their entity classification.

TD 9877 also finalized temporary regulations issued in October 2016, which were set to expire, restricting “bottom-dollar guarantees” from being recognized as recourse liabilities under Treas. Reg. Sec. 1.752-2(b)(3), subject to certain exceptions. A bottom-dollar guarantee is a payment obligation other than one in which the partner or related person would be liable for up to the full amount of such partner’s payment obligation if any amount of the partnership liability were not satisfied. The final regulations also revised the definition of a bottom-dollar payment obligation to include certain obligations of a partner to contribute capital to a partnership that resemble bottom-dollar payment obligations.

Generally, the regulations finalized under TD 9877 apply to liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after Oct. 9, 2019. The final regulations provide specific applicability dates and transition rules for bottom-dollar obligations. Additionally, the final regulations provide that changes to the Section 704(b) regulations generally apply to partnership taxable years ending on or after Oct. 9, 2019. Particular attention needs to be given to the effective date rules because they are complicated




Liability allocations under the disguised sale rules



TD 9876 adopted the 2018 proposed regulations, removing the unfavorable 2016 temporary rules and reinstating the liability allocation rules for disguised sales that were in effect prior to October 2016. The final regulations confirm that partners are to take allocations of recourse liabilities into account for purposes of the disguised sale rules. The final regulations apply to any transaction with respect to which all transfers occur on or after Oct. 4, 2019 (the date that the 2016 temporary regulations expire), and continue to provide that partnerships and their partners may apply these regulations to any transactions with respect to which all transfers occurred on or after Jan. 3, 2017 (the applicability date of the 2016 temporary regulations). Note that the IRS and Treasury Department also indicated that they are continuing to study the treatment of liabilities in the context of disguised sales, and so future guidance on this issue is possible.




Next steps


The final regulations provide a degree of certainty and could have a significant impact in certain circumstances. Taxpayers should particularly consider how the rules affect the disguised sale analysis for certain situations involving leverage where a partnership assumes a recourse liability of a partner. Although the IRS has not announced an intent to issue further guidance, it has indicated that it will continue to study the issue, suggesting that the rules may evolve in the future.





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