16 December 2024 Final regulations address allocation of partnership recourse liabilities
The Treasury Department and IRS on November 29, 2024 issued final regulations (TD 10004) on allocating recourse liabilities of a partnership under IRC Section 752. The final regulations adopt the proposed regulations from December 2013 with some modifications. IRC Section 752(a) treats an increase in a partner's share of a partnership's liabilities (or an increase in a partner's individual liabilities by reason of assuming partnership liabilities) as a deemed contribution of money by the partner to the partnership. IRC Section 752(b), conversely, treats a decrease in a partner's share of a partnership's liabilities (or a decrease in a partner's individual liabilities by reason of the partnership assuming the partner's individual liabilities) as a deemed distribution of money by the partnership to the partner. Existing Treas. Reg. Sections 1.752-1 through 1.752-3 distinguish between recourse and nonrecourse liabilities when determining a partner's share of partnership liabilities and require an analysis of which partners, if any, bear the economic risk of loss (EROL) for these liabilities. If a partner or person related to the partner bears EROL for a partnership liability, that liability is generally considered a recourse liability that is allocated to such partner. On December 16, 2013, Treasury and the IRS issued proposed regulations that would amend the then existing regulations to provide (1) rules for allocating partnership liabilities when multiple partners bear the EROL for the same liability (i.e., overlapping EROL), (2) allocation of liabilities involving tiered partnerships, (3) general guidelines on EROL and (4) related-party rules, among other things. The final regulations largely adopt those proposed regulations with some modifications. The final regulations adopt the proportionality rule from the proposed regulations for purposes of determining each partner's share of a recourse liability in the event multiple partners bear the EROL for the same liability. If the partners' aggregate EROL exceeds the total partnership liability, the rule requires each partner's share of the liability to be determined by multiplying the partnership's liability by a fraction that equals each partner's respective EROL over the total EROL of all the partners combined. The final regulations clarify how to allocate recourse liabilities of a lower-tier partnership (LTP) to an upper-tier partnership (UTP) in fact patterns in which a partner of the UTP has EROL for such liability. The regulations generally require the LTP to allocate the UTP's share of such liability to the UTP and the UTP to allocate its share of the liability directly to any of its partners that have EROL for the LTP liability. However, if any UTP partners bearing EROL for the LTP's liabilities also own an interest in LTP, the final regulations require the LTP to allocate the appropriate portion of its liabilities directly to that partner to the extent that the partner bears the EROL for those liabilities. The final regulations also clarify that a UTP bears the EROL for LTP liabilities that are treated as UTP liabilities under the tiered partnership rule in Treas. Reg. Section 1.752-4(a). This ensures that LTP's partner nonrecourse deductions are allocated to UTP under Treas. Reg. Section 1.704-2(i). The final regulations provide an example (found in Treas. Reg. Section 1.752-2(i)(3)) illustrating the tiered partnership rule. The facts of the example provide that A and B (unrelated) are partners in UTP, a limited liability company treated as a partnership for federal tax purposes. A owns a 90% interest in UTP, and B owns a 10% interest in UTP. UTP has a 90% interest in LTP, a partnership for federal tax purposes, along with A, who owns the remaining 10% interest. The partners of UTP and LTP have zero basis in their partnership interests due to losses generated before any borrowings. LTP then borrows $10 million from a third-party lender. The lender required A and B to provide a personal guaranty up to the amount of the liability. The example explains that A and B each have $10 million of EROL for LTP's liability. Applying the overlapping EROL rule under Treas. Reg. Section 1.752-2(a)(2), A is considered to bear $5 million of EROL for LTP's liability, and B is also considered to bear $5 million of EROL for LTP's liability. LTP first allocates $5 million of the $10 liability to A (a direct partner), and then allocates the remaining liability under Treas. Reg. Section 1.752-2(i)(1) to UTP. Under Treas. Reg. Section 1.752-2(i)(1)(ii), UTP allocates its share of LTP's liability entirely to B (because UTP's share of liability from LTP only includes the amount for which B bears EROL, and that amount does not include any liability allocated to A, a direct partner of LTP). Under Treas. Reg. Section 1.752-4(b)(1), persons are related to a partner if they have a relationship with a partner as specified in IRC Sections 267(b) or 707(b)(1). A person's family is determined by excluding siblings and disregarding IRC Section 267(e)(1) and (f)(1)(A). The determination is generally made taking into account the constructive ownership rules of IRC Section 267(c)(1). The final regulations provide for certain modifications to the constructive ownership rules for purposes of determining whether persons are related to each other for purposes of Treas. Reg. Section 1.752-4(b)(1). For example, the final regulations disregard the IRC Section 267(c)(1) constructive ownership rules in determining whether to treat stock of a corporation directly or indirectly owned by a partnership as proportionately owned by its partners if the corporation directly bears EROL for a partnership liability. In determining relatedness under Treas. Reg. Section 1.752-4(b)(1), the final regulations also disregard:
In these situations, a partner should not be treated as bearing the EROL due to potential relatedness between the partner and a corporation or a partnership owned by the partnership, when the partner's risk is limited to its equity investment in the partnership. The final regulations provide an exception to the related-party rules when a person owns an interest, directly or indirectly through one or more partnerships, in a partnership and is a direct lender or has direct payment obligations with respect to a partnership liability. In that case, other persons owning interests, directly or indirectly through one or more partnerships, in that partnership would not be treated as related to that person for purposes of determining the EROL borne by each of them for the partnership liability. According to the Preamble of the final regulations, this rule is intended to align the regulations with the U.S. Tax Court's holding in IPO II v. Commissioner, 122 T.C. 295 (2004). If a person is a lender or has a payment obligation for a partnership liability and is related to more than one partner, the final regulations treat each partner that is related to such person as bearing the EROL for the partnership liability in proportion to that partner's interest in partnership profits (as compared with only the related partners, and not the unrelated partners share of partnership profits). It is unclear if the partnership may apply the flexible rules under Treas. Reg. Section 1.752-3(a)(3) when determining a partner's share of profits for purposes of this rule as well. The final regulations adopt an ordering rule for allocations of partnership recourse liabilities. The ordering rule is as follows:
The final regulations provide the following example illustrating the ordering rule (found in Treas. Reg. Section 1.752-4(f)): A, an individual, owns 100 percent of two corporations, X and Y. X, Y, and Z, a corporation, are members of P, a limited liability company treated as a partnership for Federal tax purposes. The partnership agreement provides that the partners share equally in all items of income, gain, loss, deduction, and credit of P. Z is not related to A, X, or Y. P borrows $1,000 from Bank. Each of A, X, and Z guarantees payment for the entire amount of P's $1,000 liability. Each of A, X, and Z has a payment obligation of $1,000 under § 1.752-2(b) for P's $1,000 liability. The ordering rule first requires a determination of whether any partner directly bears the EROL for a partnership liability under the related-partner exception. X is a direct partner in P and guarantees the payment of $1,000 liability. Therefore, under the related-partner exception, X and Y are not treated as related to each other with respect to X's guarantee. Thus, X is treated as bearing EROL for $1,000 of P's liabilities. Next, the example analyzes A's $1,000 guarantee. The example concludes that the related-partner exception does not apply to A's guarantee, because A is not a direct partner in P nor does A own an interest in P through one or more partnerships. The EROL associated with A's $1,000 payment obligation is then allocated equally among X and Y in proportion to their interests in partnership profits under the rule for persons related to more than one partner, because X and Y each owns one-third of the profits interest in P. As a result, X and Y are each treated as bearing $500 EROL for A's $1,000 payment obligation of P's liabilities. While not articulated by the example, it is worth noting that the related-partner exception could be relevant if X and Y were partnerships instead of corporations. Lastly, the example analyzes Z's $1,000 guarantee. Given that Z has a payment obligation and is not related to any other person, Z bears EROL for $1,000 of P's liabilities. The proportionality rule must be applied given that the aggregate amount of X, Y, and Z's EROL exceeds P's total liabilities: X bears EROL for $1,500 of P's liabilities ($1000 related to its direct guarantee, and $500 related to A's guarantee), Y bears EROL for $500 of P's liabilities (relating to A's guarantee), and Z bears EROL for $1,000 of P's liabilities. Under the proportionality rule, the example concludes that X is allocated $500 of P's liabilities ($1,500 / $3,000 * $1000); Y is allocated $167 of P's liabilities ($500 / $3,000 * 1,000); and Z is allocated $333 of P's liabilities ($1,000 / $3,000 * $1,000). The final regulations are generally effective for any liability incurred or assumed by a partnership on or after December 2, 2024, other than a liability incurred or assumed by a partnership under a written binding contract in effect before that date. Special effective dates apply for partnership refinancing transactions. A partnership may apply the rules described previously to all of its liabilities (including those assumed before December 2, 2024) for any return filed on or after December 2, 2024, provided the partnership consistently applies the final regulations. The final regulations largely adopted the proposed regulations issued 11 years ago, without breaking major new ground. The final regulations resolve uncertainty that has existed since the U.S. Tax Court decided IPO II v. Commissioner as to how taxpayers must apply the related-partner exception. The final regulations align the related partner-exception with the holding in IPO II v. Commissioner. The final regulations also clarify that a partner is considered to have direct EROL when the partner guarantees payment of interest on a partnership nonrecourse liability under Treas. Reg. Section 1.752-2(e) or pledges property as security for that liability under Treas. Reg. Section 1.752-2(h). The proposed regulations inadvertently failed to include these situations, and only described direct EROL as a partner or related person with a payment obligation under Treas. Reg. Section 1.752-2(b) or as a lender described in Treas. Reg. Section 1.752-2(c). All four categories of direct EROL determination are now clearly listed in the final regulations. The final regulations only apply to liabilities of a partnership incurred or assumed on or after December 2, 2024, but a partnership can choose to consistently apply these rules to all of its recourse liabilities on filings made after the date the final regulations were issued.
Document ID: 2024-2308 | ||||||
