The IRS has issued final (TD 9787), final and temporary (TD 9788), and proposed (REG-122855-15) regulations relating to disguised sales of property to or by a partnership under Section 707 and to the treatment of partnership liabilities under Section 752. Among other topics, the regulations address the allocation of liabilities assumed by (or taken subject to) a partnership under the disguised sale rules, the relevance of "bottom-dollar" guarantees for allocating partnership liabilities, and the situations in which payment obligations with respect to partnership liabilities may be disregarded for purposes of allocating partnership liabilities. In addition, the regulations address certain deficiencies and ambiguities in the disguised sale rules, mainly with respect to the treatment of preformation capital expenditures.

Background

Section 707(a)(2)(B) and its regulations treat transfers of money or other property between a partnership and one or more of its partners as a sale or exchange of property (and not, for instance, as a contribution to and distribution by the partnership) if the transfers are properly characterized as such. The Section 707 regulations also provide rules for the treatment of the assumption of (or taking subject to) a liability for purposes of determining the consideration received in a disguised sale.

Section 752 and its regulations address the consequences of increases and decreases in a partner's share of partnership liabilities, as well as increases and decreases of a partner's individual liabilities by reason of an assumption of (or taking subject to) a liability by the partnership or the partner. The Section 752 regulations also provide rules for determining a partner's allocable share of a partnership liability. Parts of the regulations are effective for certain transactions occurring on or after October 5, 2016, and other parts of the regulations are effective for certain transactions occurring 90 days after October 5, 2016.

The recently issued final, temporary, and proposed regulations address topics covered in proposed regulations (REG-119305-11) under Section 707 and Section 752 issued by the Service in 2014 (the 2014 Proposed Regulations). For detailed coverage of those proposed regulations, see Tax Alert 2014-294.

Partner's share of partnership liabilities for purposes of Section 707(a)(2)(B)

In a major change to the 2014 Proposed Regulations, the temporary and proposed Section 707 regulations modify the manner in which liabilities are allocated among partners for purposes of the Section 707 disguised sale regulations. As discussed later, under the temporary and proposed Section 707 regulations, solely for purposes of the disguised sale rules, to the extent liabilities are not allocated to another partner as recourse liabilities under the Section 752 regulations, the liabilities are allocated to a partner only in proportion to that partner's share of partnership profits under Reg. Section  1.752-3(a)(3). This rule applies regardless of whether the partnership liability is a recourse or nonrecourse liability.

If, in connection with a transfer of property by a partner, a partnership assumes (or takes property subject to) a liability that is not a "qualified liability," the partnership is generally treated as transferring consideration to the partner from whom the liability is assumed (or taken subject to) in a taxable sale or exchange to the extent the liability is not allocated to the partner immediately after the transfer. For these purposes, it is necessary to determine how such liability is allocated among the partners.

The Section 752 regulations provide rules for allocating liabilities among partners. Very generally, the Section 752 regulations distinguish between recourse liabilities (i.e., liabilities for which a partner or related person is treated as bearing the economic risk of loss) and nonrecourse liabilities (i.e., liabilities for which no partner or related person is treated as bearing the economic risk of loss). Recourse liabilities are allocated to the partner (or partner related to the person) that is treated as bearing the risk of economic loss with respect to the liability, whereas nonrecourse liabilities are allocated in accordance with the three-tier allocation rules of Reg. Section 1.752-3(a). Under Reg. Section 1.752-3(a)(1), the first tier, a nonrecourse liability is allocated by reference to a partner's share of minimum gain. Under Reg. Section 1.752-3(a)(2), the second tier, a nonrecourse liability is allocated by reference to the Section 704(c) built-in gain a partner would recognize if the property subject to the nonrecourse liability were disposed of solely in satisfaction of the liability. Under Reg. Section 1.752-3(a)(3), the third tier, any remaining nonrecourse liabilities are allocated by reference to a partner's share of partnership profits. The third tier rule describes three specific methods of determining a partner's share of profits for this purpose: (i) the "significant item" method (which generally permits an allocation to be made in a manner consistent with the allocation of some significant item of partnership income or loss that has substantial economic effect), (ii) the "alternative" method (which generally permits an allocation to be made in the manner in which deductions attributable to the nonrecourse liability are reasonably expected to be allocated), and (iii) the "additional" method (which generally permits an allocation to be made by reference to the manner in which Section 704(c) built-in gain in the property subject to the liability would be allocated, to the extent not allocated under the second tier).

Under the now-superseded Section 707 and 752 regulations, for purposes of the disguised sale rules, a nonrecourse liability that was assumed (or taken subject to) was allocated only under the third tier and without reference to the additional method, and a recourse liability was allocated under the rules generally applicable to recourse liabilities. Under the newly issued final Section 707 and 752 regulations, for purposes of the disguised sale rules, a liability that is assumed (or taken subject to) and that is not allocated to another partner as a recourse liability is always treated as a nonrecourse liability and allocated to a partner under the third tier without reference to the significant item method, the alternative method or the additional method. In other words, a liability assumed by (or taken subject to) a partnership in connection with a transfer of property by a partner to a partnership will now be allocated to the transferring partner, for purposes of the disguised sale rules, only to the extent the liability is not allocated to another partner as a recourse liability, and then only in proportion to the transferring partner's share of partnership profits, determined without regard to any of the three methods described previously. The preamble to the temporary Section 707 regulations makes clear that the decision to require all partnership liabilities to be treated as nonrecourse liabilities and to determine partners' shares based on Reg. Section 1.752-3(a)(3) for disguised sale purposes was to prevent the use of "leveraged partnership" transactions. In such a transaction, for example, a partner would contribute property to a partnership subject to a non-qualified liability, but avoid or minimize disguised sale treatment by entering into an obligation (in many cases non-commercial) that would cause the liability to be allocated to the contributing partner as a recourse liability. The preamble also states that Treasury and the IRS are continuing to study the effect of contingent liabilities with respect to the disguised sale rules.

Other changes to the disguised sale rules

Preformation capital expenditures funded by a qualified liability are not reimbursable to the extent economic responsibility for the qualified liability is borne by a partner other than the transferring partner. Prior to the 2014 Proposed Regulations, commentators had questioned whether a transferor of property to a partnership was eligible to be reimbursed for capital expenditures under Reg. Section 1.707-4(d) when those expenditures were funded by a transferred qualified liability and either the economic responsibility for the qualified liability shifted to another partner or the debt was paid by the transferee partnership (sometimes referred to as the "double dip" issue). The final Section 707 regulations include a limitation on the exception for reimbursement of preformation capital expenditures, providing that, to the extent such capital expenditures are funded by a partner with the proceeds of any type of transferred qualified liability (not just a capital expenditure qualified liability), the exception only applies to the extent the reimbursement does not exceed the transferring partner's share of the qualified liability. For these purposes, the proceeds of a qualified liability are treated as funding a capital expenditure whether the proceeds are traceable to the expenditure under the interest tracing rules of Reg. Section 1.163-8T or the proceeds are actually traceable to the expenditure.

Preformation capital expenditure exception. A transfer of money or other consideration by a partnership to a partner is not treated as part of a disguised sale to the extent the transfer is made to reimburse a partner for certain "preformation capital expenditures." These are generally defined as capital expenditures incurred by the partner with respect to contributed property within the two-year period prior to the contribution. In both the prior and the newly finalized disguised sale regulations, the exception includes a limitation, such that the reimbursement cannot exceed 20% of the fair market value of the relevant property (as of the time of its transfer). This limitation does not apply if the basis of the property does not exceed 120% of the fair market value of the property.

The final regulations make several clarifications and changes to these rules. First, the exception applies on a property-by-property basis, subject to a new aggregation rule that may apply in limited circumstances.

Second, the regulations provide a "step-in-the-shoes" rule, whereby certain transferees may apply the exception to the extent the transferor could have used the exception. Under this rule, when a partner acquires property and assumes a liability, or takes property subject to a liability, from another person in connection with a nonrecognition transaction under Sections 351, 381(a), 721 or 731, the partner "steps in the shoes" of the transferor for purposes of determining the status of preformation capital expenditures in respect of contributed property and qualified liabilities in respect of liabilities assumed by (or taken subject to) a partnership.

The final Section 707 regulations similarly provide rules regarding the availability of the exception for reimbursements of preformation capital expenditures when a partner transfers its interest in a lower-tier partnership (LTP) to an upper-tier partnership (UTP) in a Section 721 nonrecognition transaction. If the partner transferred property to LTP with respect to which the exception for reimbursements of preformation capital expenditures was available, the transferring partner is deemed to have transferred the relevant property to UTP and is eligible for the exception for reimbursements of preformation capital expenditures to the same extent the partner could have been so reimbursed by LTP.

Qualified liability determination on transfer of partnership interest. As noted, the transfer of a qualified liability generally is not treated as giving rise to disguised sale consideration. Expanding on the step-in-the-shoes rules, the final Section 707 regulations provide that the status of qualified liabilities carries over to certain transferees. For instance, when a partner transfers its interest in LTP to UTP, the liabilities transferred to UTP are treated as qualified liabilities to the extent they would be qualified liabilities if they had been transferred by UTP in connection with a transfer by LTP of all of its property to UTP. Certain categories of qualified liabilities depend on whether a liability was incurred in anticipation of a transfer of property to a partnership. The final Section 707 regulations specify that, for these purposes, the relevant inquiry is whether the partner anticipated transferring its interest in LTP to UTP at the time the liability was incurred by LTP (and not whether LTP anticipated that the partner would transfer its interest in LTP to UTP).

New qualified liability category. The final Section 707 regulations add a new category of qualified liabilities to the existing four categories. The new category includes liabilities not incurred in anticipation of the transfer of property to a partnership, but incurred in connection with a trade or business in which property transferred to the partnership was used or held, but only if all the assets related to that trade or business are transferred (other than assets that are not material to a continuation of the trade or business). The final Section 707 regulations provide that a qualified liability in this new category (as well as a qualified liability in the pre-existing category for liabilities not incurred in anticipation of the transfer to the partnership) is subject to disclosure if incurred within the two-year period prior to the transfer.

Qualified liabilities are not treated as disguised sale proceeds due to a shift of de minimis nonqualified liabilities. If transfers of money or other property between a partner and a partnership are treated as in part a sale (including a disguised sale), then, under the pre-existing Section 707 regulations, a portion of any qualified liabilities assumed by (or taken subject to) the partnership is also treated as consideration received in a sale or exchange. The final Section 707 regulations add a de minimis exception to this rule, which applies if the total amount of all liabilities other than qualified liabilities that the partnership assumes (or takes subject to) is the lesser of: (A) 10% of the total amount of all qualified liabilities the partnership assumes (or takes subject to) or (B) $1 million.

Anticipatory reductions of share of liability. The final Section 707 regulations largely adopt the 2014 Proposed Regulations' change to the determination of when to take into account, for disguised sale purposes, a subsequent reduction in a partner's share of liabilities.

Comments requested regarding the reimbursement of preformation capital expenditures. In addition to these changes to the disguised sale rules, the preamble to the final Section 707 regulations indicates that Treasury and the IRS are considering the extent to which the exception for reimbursement of preformation capital expenditures is an appropriate exception and request comments on whether the exception should continue to exist. The preamble also expresses concern that the exception is subject to potential abuses and notes that Treasury and the IRS will continue to study this issue.

Section 752 economic risk of loss and bottom-dollar payment obligations

In addition to the Section 707 disguised sale rules, including changes to the manner in which liability shares are determined for disguised sale purposes, final and temporary regulations issued under Section 752 (in TD 9788) make extensive changes to the rules previously used to determine whether a liability is a recourse liability of a partnership.

The Section 752 regulations make an initial classification of liabilities (setting aside certain contingent liabilities) as recourse or nonrecourse, depending on whether any partner (or related person) bears the economic risk of loss with respect to the liability. In general, a recourse liability is allocated to the partner that bears the economic risk of loss for that obligation, while a nonrecourse liability is allocated among the partners under the three tiers described previously. In determining whether a partner bears the economic risk of loss for a liability, the Section 752 regulations take into account obligations of a partner (or related persons) to make payments in respect of a partnership liability.

Because of concerns that partners were undertaking payment obligations viewed as non-commercial solely for debt-allocation purposes, the 2014 Proposed Regulations established seven factors that needed to be satisfied for a payment obligation of a partner (or related person) to be recognized, taking an "all or nothing" approach; i.e., if the factors were not met, the liability would be treated as nonrecourse. Two of the factors related to certain guarantees, indemnifications or similar arrangements for less than 100% of the liability. These two factors were generally considered to be directed at "bottom-dollar" guarantees, notwithstanding that the 2014 Proposed Regulations did not use that term to define those arrangements. The newly issued Section 752 regulations eschew the seven-factor "all or nothing" approach of the 2014 Proposed Regulations and, in their place, establish a more tailored rule providing that "bottom-dollar payment obligations" (as defined in the temporary regulations) are generally not regarded for purposes of Section 752. The proposed Section 752 regulations (REG122855-15) also modify the anti-abuse rule of Reg. Section 1.752-2(j) by adding a non-exclusive list of factors that are to be weighed in determining whether a payment obligation should be respected.

New rules for bottom-dollar payment obligations. The temporary Section 752 regulations define bottom-dollar payment obligations to include any payment obligation under a guarantee or similar arrangement when the partner (or related person) is not liable up to the full amount of the payment obligation in the event of non-payment by the partnership. In addition, a facts-and-circumstances test looks to whether certain arrangements using tiered partnerships, intermediates, senior or subordinate liabilities, or similar arrangements have a principal purpose of avoiding the characterization of a payment obligation as a bottom-dollar payment obligation. Any payment obligation under Reg. Section 1.752-2, including an obligation to make a capital contribution and a Section 704(b) deficit restoration obligation, could be a bottom-dollar payment obligation.

Exceptions to bottom-dollar payment obligation characterization: a de-minimis rule, a vertical slice rule and a limited amount payment obligation. In response to comments, the temporary Section 752 regulations provide three exceptions under which a payment obligation would otherwise be treated as a bottom-dollar payment obligation and not given effect for purposes of Section 752. The first exception is when a partner's payment obligation is not reduced by more than 10% as the result of the arrangement. For example, if a partner (Partner A) guarantees all of a partnership liability and another partner (Partner B) indemnifies Partner A for no more than 10% of Partner A's payment obligation, Partner A's payment obligation will not be treated as a bottom-dollar payment obligation. The second exception applies when the payment obligation is for a fixed percentage of every dollar, i.e., a so-called "vertical slice" of a liability (e.g., 50% of each dollar of a liability that is not otherwise satisfied) or when there is a right of proportionate contribution running between partners or related persons who are co-obligors with respect to a payment obligation when there is joint and several liability. Finally, a payment obligation that is limited in amount is not treated as a bottom-dollar payment obligation simply as a result of that feature.

Anti-abuse rule. The preamble to the temporary Section 752 regulations notes a concern that partners might agree among themselves to create a bottom-dollar payment obligation to cause a liability to be treated as a nonrecourse liability. To address this concern, the temporary Section 752 regulations provide an anti-abuse rule that only the IRS can apply. The anti-abuse rule is intended to prevent affirmative use of the general nonrecognition of bottom-dollar payment obligations to permit partners other than those directly or indirectly liable for a partnership liability to include a portion of a liability in their basis. For example, if one person (Partner A) has a payment obligation, another person (Partner B) might enter into a payment obligation intended to cause the payment obligation of Partner A to be treated as a bottom-dollar payment obligation and thus disregarded; the anti-abuse rule might apply in such an instance.

New disclosure requirement. The temporary Section 752 regulations require the partnership to disclose to the IRS all bottom-dollar payment obligations with respect to its liabilities. The disclosure must be on a completed Form 8275 and attached to the partnership return for the tax year in which the bottom-dollar payment obligation is undertaken or modified.

Elimination of "all or nothing" approach. The 2014 Proposed Regulations would not have respected a payment obligation unless certain listed requirements were met. The proposed Section 752 regulations (REG-122855-15) would eliminate the "all or nothing" approach of the 2014 Proposed Regulations and recognize a partner's (or related person's) payment obligation if the facts and circumstances evidence a plan to circumvent or avoid the obligation. The proposed regulations include a non-exclusive list of factors that may indicate such a plan, including, very generally, when: (1) the partner (or related person) providing a payment obligation is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment; (2) such partner (or related person) is not required to provide commercially reasonable documentation regarding its financial condition to the benefited party; (3) the payment obligation terminates at a specified time or is terminable by the provider, when events occur increasing the risk of loss to the guarantor or benefited party; (4) the primary obligor (or related person) holds money or other liquid assets in excess of the reasonably foreseeable needs of the primary obligor; (5) the payment obligation does not provide a timely remedy to the benefited party; (6) the payment obligation does not result in any substantial change to the terms of the liability; or (7) the creditor or other benefited party does not receive executed documents with respect to the payment obligation no later than a commercially reasonable period after the creation of the obligation.

Other proposed modifications

The proposed Section 752 regulations also provide that evidence of a plan to circumvent or avoid a payment obligation is deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation that the payment obligor will have the ability to make the required payments if the payment obligation becomes due and payable.

The proposed Section 752 regulations would remove the existing "net value" rule in Reg. Section 1.752-2(k). The net value rule treats entities disregarded as separate from their sole owners as not bearing economic risk of loss with respect to a partnership liability to the extent the liability exceeds the net value of the disregarded entity. Rather, the proposed Section 752 regulations would create a new presumption under Reg. Section 1.752-2(j)'s anti-abuse rule whereby there would be a deemed plan to circumvent or avoid an obligation if there is not a reasonable expectation that a payment obligor will have the ability to make the required payments if the obligor's payment obligation become due and payable.

Along with the proposed Section 752 regulations, there are proposed regulations under Section 704 that would include factors similar to certain (but not all of) these factors in determining whether a partner is respected as having a deficit restoration obligation for purposes of the substantial economic effect requirements in Reg. Section 1.704-1.

Effective dates

The final Section 707 regulations (changing the rules on the preformation reimbursement exception, adding a fifth type of qualified liability, and providing an ordering rule and a tiered-partnership rule) apply to any transaction for which all transfers occur on or after October 5, 2016. The final Section 752 regulations (eliminating the use of the significant item method, the alternative method and the additional method for disguised sales purposes) apply to liabilities that are incurred, taken subject to, or assumed by a partnership on or after October 5, 2016, other than liabilities incurred, taken subject to, or assumed by a partnership under a written binding contract in effect prior to October 5, 2016.

The temporary Section 707 regulations (changing how liabilities are allocated for disguised sale purposes) apply to any transaction for which all transfers occur on or after the date that is 90 days after October 5, 2016.

The temporary Section 752 regulations (relating to payment obligations and the effect of bottom-dollar payment obligations) apply to liabilities assumed or incurred by a partnership and payment obligations imposed or undertaken with respect to a partnership liability on or after October 5, 2016, other than liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken under a written binding contract in effect prior to that date. A partnership may apply the temporary regulations to all of its liabilities as of its first tax year ending on or after October 5, 2016. The temporary Section 752 regulations include a limited seven-year transition rule (subject to certain exceptions) that, very generally, permits a partnership under certain conditions not to apply the temporary regulations to a partner to the extent: (1) the partner's share of liabilities for which the partner is treated as bearing the economic risk of loss, immediately prior to October 5, 2016, exceeds (2) the partner's adjusted basis in the partnership at that time.

Implications

The changes made to the Section 707 regulations are generally consistent with those proposed in the 2014 Proposed Regulations. By treating all partnership liabilities as nonrecourse liabilities for Section 707 purposes, except to the extent of another partner's payment obligation, the regulations effectively restrict the use of leveraged partnership transactions. Other changes made by the regulations provide needed clarification regarding the application of the preformation capital expenditure reimbursement rule and generally taxpayer favorable step-in-the shoes rules.

Changes made by the final and temporary Section 752 regulations represent a significant departure to rules that have been applied and used by taxpayers for more than two decades. Although Treasury and the IRS responded favorably to a large number of the concerns voiced by taxpayers and practitioners following the release of the 2014 Proposed Regulations, the new final and temporary Section 752 regulations are complex and will require a more detailed analysis, particularly regarding the potential application of the new bottom-dollar payment obligations, to determine the manner in which partnership liabilities are to be allocated both for transactional and compliance purposes. Existing partnerships will need to evaluate the manner in which their existing liabilities are allocated, including their effect on existing deficit restoration obligations, and to consider the new disclosure requirements for bottom-dollar payment obigations.

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