October 14, 2019 IRS finalizes rules on partnership recourse liabilities and bottom dollar payments; reinstates prior rules on disguised sales The IRS has issued final regulations (TD 9877, "752 Final Regulations") on partnership liabilities that are treated as recourse liabilities under IRC Section 752, on the treatment of bottom dollar payments under IRC Section 752, and on when certain obligations to restore a deficit balance in a partner's capital account are disregarded under IRC Section 704. Concurrently with the issuance of the 752 Final Regulations, the IRS issued final regulations (TD 9876, "707 Final Regulations") withdrawing 2016 temporary regulations under IRC Section 707 on disguised sales of property to or by a partnership and reinstating the regulations previously in effect. Background IRC Sections 752 and 707 Under IRC Section 752 and its regulations, partnership liabilities are separated into two categories: (1) recourse liabilities (partnership liabilities for which a partner or related person bears the economic risk of loss (EROL)), and (2) nonrecourse liabilities (partnership liabilities for which no partner or related person bears EROL). A partner generally bears the EROL for a partnership liability if the partner (or a related person) is obligated to make a payment to any person within the meaning of Treas. Reg. Section 1.752-2. Such obligations include an obligation to restore a deficit capital account upon liquidation of the partnership under the IRC Section 704(b) regulations. Under IRC Section 707(a)(2)(B) and its regulations, related transfers of money or other property to and by a partnership that, when viewed together, are more properly characterized as a sale or exchange of property, will be treated either as a transaction between the partnership and one who is not a partner or between two or more partners acting other than in their capacity as partners (disguised sales). Regulatory history In January 2014, the IRS issued proposed regulations on both the treatment of partnership liabilities under IRC Section 752 and disguised sales of property under IRC Section 707 (2014 Proposed Regulations). See Tax Alert 2014-0294. In October 2016, after considering comments on the 2014 Proposed Regulations, the IRS issued final, temporary, and proposed regulations on disguised sales of property under IRC Section 707 and the treatment of partnership liabilities under IRC Section 752. See Tax Alert 2016-1715. The temporary regulations included rules concerning the treatment of "bottom dollar payment obligations" under IRC Section 752 (752 Temporary Regulations), as well as a new rule concerning the allocation of liabilities for purposes of IRC Section 707 (707 Temporary Regulations). The proposed regulations issued in 2016 included rules regarding when a payment obligation (other than a bottom dollar payment obligation) will be respected in determining whether a partner bears EROL with respect to a partnership liability (752 Proposed Regulations). In June 2018, the IRS issued a notice of proposed rulemaking (2018 Proposed Regulations) that proposed to withdraw the 707 Temporary Regulations and reinstate the rules previously in effect. 707 Final Regulations Under the IRC Section 707(a)(2)(B) rules, it is often important to determine the allocation of a liability assumed by a partnership, or a liability of a partnership used to fund a transfer of money to a partner, when determining if certain transfers are treated as consideration as part of a sale or property. For example, 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. The allocation of a partnership liability is also important for IRC Section 707(a)(2)(B) purposes when the proceeds of the liability are used to fund a transfer of money to a partner that contributed property to the partnership. The IRC Section 752 regulations provide rules for allocating liabilities among partners. 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 Treas. Reg. Section 1.752-3(a). The 707 Temporary Regulations provided that, for purposes of the IRC Section 707 disguised sale rules, a partner's share of a partnership liability generally would not exceed its share of the liability under the third tier of Treas. Reg. Section 1.752-3(a), based on the partner's share of partnership profits, even if the liability were a recourse liability to that partner. The 707 Final Regulations adopt the 2018 Proposed Regulations, returning to the rule in effect before the 707 Temporary Regulations, which stated, for purposes of allocating liabilities under the IRC Section 707 disguised sale rules, that a partner's share of a partnership liability includes the portion of the liability allocated to that partner under IRC Section 752 as a recourse liability. The 707 Final Regulations apply to any transaction for which all transfers occur on or after October 4, 2019. A partnership and its partners may apply the 707 Final Regulations to any transaction for which all transfers occur on or after January 3, 2017 (which was the effective date of the 707 Temporary Regulations). 752 Final Regulations The 752 Final Regulations adopt the rules in the 752 Temporary Regulations and the 752 Proposed Regulations with some changes in response to comments received. Bottom dollar payment obligations Like the 752 Temporary Regulations and the 752 Proposed Regulations, the 752 Final 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. The 752 Final Regulations revise the definition of a bottom dollar payment obligation to specifically address capital contribution obligations and deficit restoration obligations. Under the revised definition, a bottom dollar payment obligation includes, with respect to a capital contribution obligation and a deficit restoration obligation, any payment obligation other than one in which the partner is or would be required to (i) make the full amount of the partner's capital contribution or (ii) restore the full amount of the partner's deficit capital account. The 752 Final Regulations generally require taxpayers to disclose bottom dollar payment obligations by filing Form 8275, Disclosure Statement, with the partnership return for the tax year in which a bottom dollar payment obligation is undertaken or modified. The 752 Final Regulations clarify that identifying the payment obligation for which disclosure is made includes stating whether the obligation is a guarantee, a reimbursement, an indemnity or deficit restoration obligation. Qualification to satisfaction presumption In determining whether a partner (or related person) has a payment obligation with respect to a partnership liability, the IRC Section 752 regulations presume that the partner (or related person) will perform those obligations, irrespective of their net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (the satisfaction presumption). The 752 Final Regulations (adopting the rule of the 752 Proposed Regulations) also provide that the satisfaction presumption does not apply if 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 the obligation becomes due and payable. The 752 Final Regulations elaborate that the facts and circumstances to consider in determining a commercially reasonable expectation of payment include factors a third-party creditor would take into account when determining whether to grant a loan. Under the IRC Section 752 regulations in effect prior to the 752 Final Regulations, notwithstanding the satisfaction presumption, a disregarded entity's payment obligation was taken into account only to the extent of its net value. The 752 Final Regulations remove this specific rule and provide that the aforementioned limitation applies also to disregarded entities. Anti-abuse factors under Treas. Reg. Section 1.752-2(j)(3) A payment obligation of a partner (or related person) is not recognized if facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner's EROL with respect to that obligation or create the appearance of the partner or related person bearing the EROL when the substance is otherwise. The 752 Final Regulations (adopting the rules of the 752 Proposed Regulations) include a non-exclusive list of factors that may indicate a plan, including, very generally, when:
The 752 Temporary Regulations included an anti-abuse rule in Treas. Reg. Section 1.752-2(j)(2) that applied at the Commissioner's discretion to treat a partner as bearing the EROL with respect to a partnership liability in certain circumstances. Very generally, the rule allowed the Commissioner to treat a partner as bearing EROL with respect to a partnership liability, if a payment obligation actually provided a creditor with additional security for its loan and either (1) a principal purpose of the obligation was to permit other partners to include a portion of the loan in their basis or (2) another partner (or related person) entered into an obligation whose principal purpose was to cause the obligation to be disregarded. The 752 Final Regulations retain the anti-abuse rule but remove the language permitting it to be applied only at the Commissioner's discretion. Deficit restoration obligation factors As discussed, the 752 Final Regulations include rules under Treas. Reg. Section 1.704-1 providing that capital contribution obligations and deficit restoration obligations are not respected if they are bottom dollar payment obligations. Similar to the final rules for purposes of IRC Section 752, the 752 Final Regulations also include a rule under Treas. Reg. Section 1.704-1 that capital contribution obligations and deficit restoration obligations are not respected if the facts and circumstances otherwise indicate a plan to circumvent or avoid such obligation. They provide a non-exclusive list of factors that may indicate a plan to circumvent or avoid the obligation, consisting of the following:
The 752 Final Regulations added the exception to the third factor for when a transferee partner assumes the obligation. The IRS emphasized in the Preamble that the weight to be given to any particular factor depends on the particular facts and the presence or absence of any particular factor is not, in itself, necessarily indicative of whether the obligation is respected. Effective dates The final regulations under Treas. Reg. Section 1.704-1 are effective for partnership tax years ending on or after October 9, 2019. The final regulations under Treas. Reg. Section 1.752-2 on bottom dollar payment obligations are generally effective for partnership liabilities incurred or assumed and payment obligations imposed or undertaken with respect to a partnership liability on or after October 5, 2016. The October 5 2016 effective date does not apply to liabilities incurred or assumed by a partnership or payment obligations imposed or undertaken under a written binding contract in effect before that date (although partnerships may apply the rules to all of their liabilities as of the beginning of the partnership's first tax year ending on or after October 5, 2016). The final regulations under Treas. Reg. Section 1.752-2 retain a seven-year transition rule, included in the 2016 Temporary Regulations. That rule, very generally, permits a partnership not to apply the rule for bottom dollar payment obligations in determining whether a partner bears EROL with respect to a partnership liability, to the extent the allocation of partnership liabilities respecting the bottom dollar payment obligation exceeded the partner's outside basis as of October 5, 2016 (the grandfathered amount). For example, if, as of October 5, 2016, a partner has a negative $10 tax capital account and has a bottom dollar payment obligation that, if respected, would cause the partner to be allocated $25 of partnership liabilities, the partner's outside basis would be $15 and the grandfathered amount would be $10 (or an amount equal to the partner's negative tax capital account). The final regulations under Treas. Reg. Section 1.752-2 on the changes to the satisfaction presumption and the anti-abuse rules are effective for partnership liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after October 9, 2019. That effective date does not apply to liabilities incurred or assumed by a partnership or payment obligations imposed or undertaken under a written binding contract in effect before that date (although taxpayers may apply these rules to all of their liabilities as of the beginning of the partnership's first tax year ending on or after October 5, 2016). Implications 707 Final Regulations The 707 Final Regulations effectively return the situation to the status quo before the 2016 Temporary Regulations. The effective date of the rule is rather complicated to follow, but the upshot is that taxpayers may take into account a partner's share of partnership liability that is recourse to the partner for purposes of the disguised sale rules at all times since the 707 Temporary Regulations. 752 Final Regulations The 752 Final Regulations generally adopt the rules in the 2016 Proposed Regulations. The rules represent a fundamental shift from the prior approach to identifying when a partner is treated as bearing the EROL of partnership liabilities under IRC Section 752, which was based on the satisfaction presumption and the analysis of which partner (or related person) had a payment obligation with respect to any portion of a partnership liability. The 752 Final Regulations effectively add to the satisfaction presumption a test of whether there is a commercially reasonable expectation of payment; they also focus, not on who would bear EROL if a partnership is unable to pay a partnership liability, but rather on whether a payment obligation has a significant non-tax purpose and represents a significant economic risk to the obligor. The prior rules under IRC Section 752 were administrable, mechanical and clear. The 752 Final Regulations will require judgment calls, facts-and-circumstances analyses, and, most likely, will result in significant taxpayer uncertainty. 704(b) Final Regulations The 704(b) Final Regulations generally adopt the rules in the 2016 Proposed Regulations. Unlike the 752 Final Regulations, which are generally effective for obligations entered after the regulations' finalization, these regulations would apply to pre-existing deficit restoration obligations, creating further uncertainty as to whether existing arrangements will be regarded in accordance with their original form. ———————————————
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