The IRS has finalized regulations (T.D. 10014) under Section 752 relating to recourse liabilities of a partnership and special rules for related persons.
The Dec. 3, 2024, regulations adopt, with certain modifications, proposed regulations (REG-136984-12) issued in December 2013. The regulations cover liability allocations in situations where multiple partners bear an economic risk of loss (EROL) for the same liability, situations where a non-partner who bears EROL for a partnership liability is related to multiple partners, as well as certain modifications to the rules that govern which taxpayers are treated as related persons for purposes of recourse liability allocations. The rules in these regulations do not represent a sea change in the manner in which partnerships allocate liabilities but offer welcome technical clarification on recourse liability allocations for taxpayers in closely held businesses or tiered structures.
Overlapping EROL
The final regulations clarify how a liability is allocated between multiple partners who bear EROL for all or part of the liability. As a general matter, a partner’s share of recourse liabilities is equal to the portion of the liability for which the partner or related person bears the EROL. However, the regulations were previously silent on how a liability was to be allocated where multiple partners bore EROL for the same portion of a liability. The new regulations adopt a “proportionality rule” that was previously a part of the proposed regulations. Under this proportionality rule, the portion of a partnership liability for which a partner bears EROL is equal to the total amount of the partnership liability multiplied by a fraction equal to the partner’s individual EROL over the sum of the EROL borne by all partners.
Example: A and B are unrelated equal members of AB, an LLC classified as a partnership for U.S. federal income tax purposes. The LLC partnership AB borrows $1,000 from an unrelated third party. Member [AM1] A guarantees $1,000 of the liability and Member B guarantees $500, with each bearing EROL for their respective guarantees. Using the proportionality rule, Member A would be allocated $667 of the liability ($1,000 x ($1,000/ $1,500)) and Member B would allocated $333 ($1,000 x ($500/$1,500)).
Tiered partnerships
The final regulations also clarify how a lower-tier partnership (LTP) allocates a liability if a partner of an upper-tier partnership (UTP) is also a partner of the LTP and that partner bears EROL with respect to an LTP liability. It was previously unclear whether the LTP was required to allocate the liability directly to the partner, the UTP, or both. The final regulations adopt a rule from the prior proposed regulations that the partnership must allocate the recourse liability to its direct partner instead of allocating any amount to the UTP.
Example: A and B are unrelated equal partners in a UTP. The UTP and Partner A are both equal partners in an LTP. The LTP borrows $1 million from a third party and Partners A and B both guarantee the entire liability and bear EROL of $1 million. Under the proportionality rule, Partners A and B would both have a recourse liability of $500,000 from the LTP ($1 million x ($1 million/$2 million)). The LTP allocates $500,000 of the recourse liability to Partner A and $500,000 to UTP and in turn, UTP allocates the $500,000 to Partner B only.
Related party rules
A partnership liability is allocated to a partner under the rules for recourse liabilities if a partner or a person related to the partner bears EROL for the liability. The existing regulations provide that a person is related to a partner if that person bears a relationship specified in Section 267(b) or 707(b)(1), with certain modifications including substituting an 80% common ownership threshold.
Limitations on constructive ownership
The final regulations add additional modifications to the tests for related person status, providing that constructive stock ownership rules under Section 267(c)(1) and Section 1563(e)(2) are disregarded in determining whether a partnership or corporate subsidiary of a partnership is treated as owned by its partner if the subsidiary bears direct EROL for a partnership liability.
Example: X, a corporation, owns 80% of partnership PRS. PRS owns all the outstanding stock of Y, another corporation. PRS borrows $5,000 from a third party and Y guarantees the liability. Prior to the final regulations, X was treated as a related person to Y through the constructive ownership rules of Section 267(c)(1) and could be treated as having EROL by virtue of Y’s guarantee of PRS’s liability. Under the final regulations, corporations X and Y are no longer treated as related persons and Y’s guarantee no longer causes X to be treated as having EROL for the PRS’s liability.
The related-party exception
Prior to its amendment in the recent final regulations, Treas. Reg. Sec. 1.752-4(b)(2) provided that persons owning interests directly or indirectly in the same partnership were not treated as related persons for purposes of determining the EROL borne by each of them for the liabilities of the partnership (the “related partner exception”). The recent final regulations alter the language in the related partner exception to clarify that the related partner exception should only apply where a partner has a direct payment obligation or is the lender with respect to a partnership liability.
Example: A, an individual, owns 100% of corporation X. Individual A and corporation X are members of P, an LLC treated as a partnership for U.S. federal income tax purposes. P borrows $2,000 from a third party. A guarantees payment on the full amount of the liability. A directly bears EROL for P’s liability at the partnership level and therefore under the related party exception, the individual A and the corporation X are not treated as related persons for purposes of determining whether X has EROL for P’s liability. A is allocated the full $2,000 liability at P. If A were not a direct partner in P, then the related party exception would not apply, and X might be treated as having EROL by virtue of being a related person to A.
Multiple related partners
Prior to their recent amendment, if a person was related to more than one partner in a partnership, the related party rules were applied by treating the person as related only to the partner with whom there was the highest percentage of related ownership (“greatest percentage rule”). If multiple partners held the same highest percentage ownership, those partners shared the liability equally. The recent final regulations remove the greatest percentage rule, so that a person who bears EROL for a partnership liability may be treated as a related person to multiple partners with whom it shares a greater than 80% relationship, even if those relationship percentages are not identical. Further, rather than having each partner that is related to the person bearing EROL share the liability equally (regardless of their relative interests in the partnership), the recent final regulations provide that the related partners are treated as bearing EROL for that liability based on their interests in partnership profits.
Example: A owns 85% of B, a corporation, and 90% of C, another corporation. Corporations B and C are partners in PRS, with B holding a 50% interest and C holding a 10% interest, respectively. The individual, A, bears EROL for a PRS liability. Prior to the repeal of the greatest percentage rule, this liability would have been allocated solely to C. However, under the recently finalized regulations, both B and C can be treated as having EROL by virtue of their relationship to A and share in that liability based on their relative interests in PRS’s profits.
Ordering rule
Finally, the final regulations adopt an ordering rule to attempt to minimize confusion on how the proportionality rule interacts with the multiple-partner rule and how the multiple partner rule interacts with the related-partner exception. Treas. Reg. Sec. 1.752-4(e) provides that the determination of a partner’s share of a recourse liability should be applied in the following order:
- Determine whether any partner directly bears EROL for the partnership liability and if so, apply the related partner exception
- After applying the related partner exception, determine the amount of EROL each partner is considered to bear under the multiple partner rule
- After EROL is determined under steps 1 and 2, use the proportionality rule to determine EROL when the sum of the partners EROL exceeds the partnership liability
Given the potential complexity in applying the various rules contained in the recently finalized regulations, an ordering rule is certainly welcome to provide guidance in situations in which these rules may overlap.
Applicability dates and next steps
These final regulations generally apply to any liability incurred or assumed by the partnership on or after Dec. 2, 2024, with exceptions for (1) liabilities incurred or assumed pursuant to a written binding contract in effect prior to Dec. 2, 2024, and (2) certain debt refinances. However, a partnership may choose the apply the final regulations to all of its liabilities on any return (including an amended return on an administrative adjustment request) filed after Dec. 2, 2024. Partnerships and taxpayers holding interests in partnerships should consider the historic allocation of partnership liabilities and consider whether retroactively applying the recent final regulations could result in a more favorable liability allocation profile. In any case, these regulations provide some additional clarity and improve the administrability of partnership liability allocations in complex situations where a partnership’s lender is a partner or is related to one or more partners, including tiered structures.
The final regulations could be targeted under an executive order from President Donald Trump to review recent regulations, but taxpayers should be prepared to comply with the final regulations until and unless formal guidance rescinds them.
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