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On July 10, the IRS released a memorandum (ILM 202628009 (PDF - 157.36KB)) asserting that a limited partner’s conditional obligation to restore a deficit capital account balance is not a payment obligation under Reg. Section 1.752-2(b) when determining whether a partnership liability is recourse for purposes of Section 752.
Background
The fact pattern addressed in the memorandum involves a limited partnership with limited partners and a general partner.
Under the partnership agreement, no limited partner is liable for any partnership obligation, and a limited partner with a deficit Section 704(b) capital account balance is not required to restore that deficit upon liquidation of the partnership.
The agreement provides that, if a limited partner has a deficit Section 704(b) capital account balance, the general partner may demand the limited partner contribute cash to the partnership to restore the deficit balance. If the limited partner fails to make the contribution, the general partner may, but is not required to, withhold distributions otherwise payable to the limited partner up to an amount that would eliminate the deficit capital account.
Payment obligations under Reg. Sec.1.752-2
Under Reg. Section 1.752-2, a partner’s share of recourse partnership liability equals the portion of the liability for which the partner bears the economic risk of loss. One factor in determining whether a partner bears the economic risk of loss is whether the partner has a payment obligation with respect to the liability under Reg. Section 1.752-2(b).
Whether a partner has a payment obligation is determined by assuming the partnership constructively liquidates when the partnership’s liabilities become payable in full, its assets are worth zero, and the partnership disposes of all of its property in a fully taxable transaction for no consideration. The partner bears the economic risk of loss for a partnership liability to the extent that, upon the constructive liquidation of the partnership, the partner would be obligated to make a payment to any person, or a contribution to the partnership, and is not entitled to reimbursement from another partner.
In accordance with Reg. Section 1.752-2(b)(3), all statutory and contractual obligations relating to a partnership liability are taken into account for purposes of determining whether a partner has a payment obligation, and thus, bears the economic risk of loss for that partnership liability.
This includes contractual obligations outside the partnership agreement including guarantees, indemnifications, reimbursement agreements and other obligations running directly to creditors, to other partners or to the partnership; obligations imposed on a partner in a partnership agreement to make a capital contribution or restore a deficit capital account upon liquidation of the partnership as described in the Section 704(b) regulations; and payment obligations imposed by state or local law.
The Section 704(b) regulations describe an obligation where a partner is unconditionally required to restore a deficit balance in the partner’s Section 704(b) capital account following liquidation of the partner’s partnership interest by the end of the taxable year of the partnership’s liquidation (commonly referred to as a deficit restoration obligation, or DRO).
In addition, the regulations address situations where a partner may be treated as unconditionally obligated to restore the deficit balance in the partner’s capital account, including situations in which the partner is unconditionally required to make subsequent contributions to the partnership if the partner’s capital account has a deficit balance.
Application of conditional obligation to fund deficit capital account rules
The IRS determined that, based on the facts presented, the limited partner’s obligation was not recognized as a payment obligation for purposes of Reg. Section 1.752-2(b). The obligation was contingent on a discretionary demand by the general partner to restore the limited partner’s deficit capital account balance, and the partnership agreement did not require restoration of the deficit capital account upon liquidation.
As a result, the conditional DRO did not create an unconditional payment obligation under the Section 752 framework or the Section 704(b) regulations. Thus, the limited partner did not bear the economic risk of loss for the partnership liability.
This IRS memorandum is a reminder that partnership agreements and related contractual obligations must impose a real, enforceable and unconditional payment obligation before a partner will be treated as bearing the economic risk of loss for Section 752 purposes. Payment obligations that are discretionary, contingent or otherwise avoidable may not support a recourse liability classification or allocation.
Partnerships that rely on DROs, capital contribution requirements, guarantees or similar arrangements to support liability classifications and allocations should review their partnership agreements to confirm that the relevant provisions satisfy the unconditional requirements of the Section 752 and Section 704(b) regulations. Failure to satisfy those requirements could affect a partner’s (1) share of partnership liabilities, (2) outside basis computation, (3) ability to deduct losses, and (4) tax consequences resulting from a distribution from the partnership.
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