Recent final regulations under IRC Section 752 institute a new rule for allocating partnership recourse liabilities. This Alert highlights year-end considerations and implications of the new rules for the asset management industry.

IRC Section 752 final regulations: new rule for allocating partnership recourse liabilities

In October 2019, Treasury issued final regulations that provide guidance on how a partnership should allocate its liabilities among its partners under IRC Section 752. See Tax Alert 2019-1822. These regulations establish a new rule that imposes a "commercially reasonable expectation" of repayment standard for allocating a partnership's recourse liabilities.

A partnership generally allocates recourse liabilities to the partner(s) that ultimately bear the economic obligation to pay the partnership's liability if the partnership becomes completely worthless. Generally, this test under the old regime resulted in an allocation of a liability to a partner regardless of that partner's actual net worth (aside from partners that were disregarded for tax purposes).

The new rule, however, now looks to determine if a creditor would have a commercially reasonable expectation that the partner will have the ability to pay the obligation if the partnership is unable to do so - essentially forcing the partnership to assess whether the partner would have the ability to make the required payments if the obligations were to become due and payable.

New rule may cause some liabilities to be treated as nonrecourse

Partnerships should consider these rules specifically when their partners have been relying on recourse liability allocations to increase the tax bases of their partnership interests, which may have allowed partners to deduct losses exceeding their capital contributions, as well as take cash distributions on a tax-deferred basis. A shift in liabilities among partners due to the change in the IRC Section 752 regulations may, in some cases, cause partners to recognize taxable income.

If a partner fails the "commercially reasonable expectation" of repayment standard with respect to a liability, the liability will be treated as a nonrecourse liability for purposes of determining the partners' shares under IRC Section 752. A partner's share of a liability, as determined under the rules for nonrecourse liabilities, may differ from the partner's share as determined under the rules for recourse liabilities.

The rules for allocating nonrecourse liabilities are complex. They also contain certain elections that may allow partnerships to allocate a greater or lesser share of nonrecourse liabilities to certain partners, but these elections may not apply in all circumstances.

Partnerships with liabilities treated as recourse under the old regime should understand before year-end whether that treatment will continue under the new regime and, to the extent it will not, how the liabilities will be allocated among the partners under the new regime.

Asset management implications

It is common within the asset management industry for partnerships structured as Cayman LPs or Delaware LPs to treat their liabilities as recourse liabilities and to allocate these liabilities entirely to the general partner regardless of the general partner's net worth. If otherwise recourse liabilities are treated as nonrecourse liabilities under the new IRC Section 752 regulations, the liabilities will no longer be allocated entirely to the general partner. Instead, the liabilities will be allocated among all partners based on the IRC Section 752 rules for nonrecourse liabilities.

Practically speaking, as long as the nonrecourse liabilities exceed the cumulative overall book/tax difference for the fund, the likelihood, in most fact patterns, is that the general partner will still receive a sufficient liability allocation to avoid recognizing taxable income from a liability shift. However, performing additional analysis to confirm this is generally recommended, to the extent the general partner requires a liability allocation to avoid recognizing taxable income and the amount at stake is material.

The regulations apply to partnership liabilities incurred on or after October 9, 2019 (other than any liabilities assumed or incurred under a written binding contract in effect before that date), so there may be some flexibility for the 2019 tax year.

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