The IRS appears to be trying to advance as many pending regulatory projects as possible before the election. The new partnership audit rules are not out yet but they are expected by year end. In the meantime, following closely on the heels of the final debt/equity regulations, the IRS has issued regulations related to disguised sales and allocation of partnership liabilities. The latter will have a significant impact on the formation, financing and ongoing operations of real estate partnerships.
IRS targets partnership transactions and liabilities with new regulations
The IRS has issued three sets of regulations — final, temporary and proposed — addressing disguised sales of property involving partnerships, the allocation of partnership liabilities and several other issues related to partnerships. The regulations are largely intended to eliminate what the IRS sees as abuses of some of the tax benefits associated with partnerships. As the designations indicate, some of these regulations are already effective, some are in effect but only for a few years unless finalized, and some are subject to change before being finalized.
Disguised sales and leveraged partnership transactions
No tax is generally owed when a partner contributes property to a partnership or a partnership distributes property to its partners. Some parties have viewed partnerships as a way to exchange property — cash or other property exchanged for a partnership interest — without incurring taxes.
Under the disguised sale rules partners’ contributions and partnerships’ distributions can be treated as taxable sales. A facts-and-circumstances test is applied to determine whether a transaction was, in substance, a sale of property to the partnership. The regulations include a rebuttable presumption that a sale has occurred when a partner makes a contribution and receives a distribution of cash within two years of the contribution.
The regulations include an exception for debt-financed distributions. Under the exception, when a partnership borrows money to finance a distribution to a partner after the partner contributes property, the loan proceeds are considered sale proceeds only to the extent that the distribution exceeds the partner’s allocable share of the partnership liability. In other words, the contributing partner’s allocable share of liability determines whether any of the loan proceeds distributed to it represent a disguised sale.
If all of the loan liability is allocated to the contributing partner (based on, for example, the partner’s guarantee of the loan), the partner’s tax basis in its partnership interest increases. This allows the partner to receive the distribution from the partnership tax-free.
According to the IRS, the debt-financed distribution exception has been abused through leveraged partnership transactions. In those transactions, the contributing partners enter into payment obligations which are not regarded as commercial solely to achieve an allocation of the partnership liability, with the goal of avoiding a disguised sale.
Allocation of partnership liabilities
Previously, in determining a partner’s share of a partnership liability for disguised sale purposes, the regulations had separate rules for a partnership’s recourse and nonrecourse liabilities. With a recourse liability, a partner or related party bears the “economic risk of loss” (EROL) if the partnership can’t pay. But partners have no individual liability for nonrecourse debt.
Under prior guidance, a partner’s share of a recourse liability was the portion of the liability for which the partner or a related person bears the EROL. If a partner had no EROL on a liability, no share of that liability could be allocated to it. This rule applied to allocations of a recourse liability for any purpose, not just for the disguised sale rules.
The temporary regulations change the method of allocating partnership liability for purposes of the disguised sale rules. All liabilities are now treated as nonrecourse liabilities. As such, they’re allocated solely according to the partner’s share of partnership profits. In addition, a partner’s share of a liability doesn’t include any amount of the liability for which another partner bears the EROL.
Because liabilities are allocated based on each partner’s share of profits for disguised sale purposes, no partner can ever be allocated 100% of a liability. This largely undermines leveraged partnership transactions, as a contributing partner can’t be assigned all of the loan liability to offset the gain from the distribution of loan proceeds.
Reimbursements of capital expenditures
The existing regulations also include an exception from the disguised sale rules for reimbursements to partners for certain capital expenditures and costs they incur (also known as preformation capital expenditures). The exception generally applies only to the extent that the reimbursed capital expenditures don’t exceed 20% of the fair market value (FMV) of the property the partnership transfers to the partner.
This 20% limitation doesn’t always apply. It’s applicable only if the FMV of the transferred property doesn’t exceed 120% of the partner’s adjusted basis in the property at the time of the transfer. This alternative is known as the “120% test.”
The final regulations allow limited aggregation of property when applying these tests (as opposed to applying the tests on a property-by-property basis). Despite issuing final regulations addressing the preformation capital expenditures exception, the U.S. Treasury and IRS are still considering whether it’s appropriate and studying its potential for abuse.
Qualified liability exception
The existing regulations also address issues related to a partnership’s assumption of partner debt associated with a property contribution. Generally, if the debt was incurred more than two years before the contribution, or was otherwise incurred in the ordinary course of business, it’s considered a “qualified liability” and won’t trigger the disguised sale rules.
Assumed debt that isn’t a qualified liability results in a disguised sale to the extent the liability exceeds the partner’s allocable share of the partnership liability under the general partnership liability allocation rules. This calculation is subject to certain modifications.
The regulations define four types of qualified liabilities, including a capital expenditure qualified liability. To coordinate the exception for preformation capital expenditures and the capital expenditure qualified liability rule, the final regulations provide that, to the extent any qualified liability is used by a partner to fund capital expenditures — and responsibility for that borrowing shifts to another partner — the preformation capital expenditures exception doesn’t apply. Capital expenditures will be treated as funded by the proceeds of a qualified liability to the extent the proceeds are either 1) traceable to the capital expenditures, or 2) actually used to fund the expenditures.
The final regulations provide a “step-in-the-shoes” rule for cases where a partner acquires property, assumes a liability, or takes property subject to a liability from another person. In such circumstances, the partner assumes the status of the other person for purposes of applying the preformation capital expenditures exception and determining whether a liability is qualified for disguised sale purposes.
A tiered partnership arises when a partnership (the upper-tier partnership) has an interest in another partnership (the lower-tier partnership). The final regulations provide that a contributing partner’s share of a liability from a lower-tier partnership is a qualified liability if the liability would be qualified as if it had been assumed by the upper-tier partnership in connection with a transfer of all of the lower tier’s property to the upper-tier partnership.
The final regulations also permit an exception for preformation capital expenditures when a person incurs capital expenditures related to property, transfers the property to a lower-tier partnership, and subsequently transfers an interest in the lower-tier partnership to the upper-tier partnership within two years of incurring the capital expenditures. The upper-tier partnership can be reimbursed for the capital expenditures by the lower-tier partnership to the same extent the contributing partner could be reimbursed and also can reimburse that partner.
“Bottom dollar” payment obligations
In addition to some disguised sale issues, the temporary regulations address when certain payment obligations (which represent EROL) are recognized for purposes of determining whether a liability is a recourse partnership liability that will be allocated according to EROL (for nondisguised sale purposes). Similar to its concerns regarding disguised sales, the IRS worries that partners and related persons enter into noncommercial payment obligations simply to achieve an allocation of a partnership liability that will increase their basis and reduce taxes on future distributions.
Specifically, the IRS believes that “bottom dollar” guarantees generally shouldn’t be recognized as payment obligations when allocating recourse liabilities among partners. A bottom dollar guarantee gives the guarantor a real risk on debt, but a risk that’s unlikely to occur and could be a fraction of the full liability. For example, a partner might guarantee up to $250 of a $1,000 liability that’s secured by $1,500 of assets, with the guarantee kicking in only if the lender can’t collect at least $250 from the partnership in case of a default.
Until now, a partner was generally allocated the full guaranteed amount of the liability, regardless of the likelihood of the economic risk coming to fruition. But the temporary regulations provide that “bottom dollar payment obligations,” including guarantees and indemnities, generally aren’t recognized when allocating recourse liabilities.
One point to note – if a partner actually bears the EROL for a partnership liability and the partners can’t agree among themselves to create a bottom dollar payment obligation, the liability will be treated as nonrecourse.
Vertical Slice Guarantees
The temporary regulations provide an exception for so-called “vertical slice guarantees” – where the payment obligation is stated as a percentage of every dollar of the partnership liability to which the obligation relates. The exception also applies to situations calling for a proportionate contribution running between partners where each has joint and several liability.
The final regulations generally took effect on October 5, 2016. The regulation allocating partnership liabilities for disguised sales purposes according to profit share applies only to transactions where all transfers occur on or after January 3, 2017.
The temporary regulations concerning allocation of partnership liabilities apply to liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken with respect to a partnership liability on or after October 5, 2016. There is, however, a transition rule. A partner whose allocable share of partnership liabilities exceeds its adjusted basis in its partnership interest as of October 5, 2016 can continue to apply the existing regulations with respect to such partnership liability for a seven-year period, subject to certain adjustments and limitations.
The IRS also issued new proposed regulations addressing 1) when partnership liabilities are treated as recourse liabilities, and 2) when certain obligations to restore a deficit balance in a partner’s capital account (“Deficit Restoration Obligation” or “DRO”) are disregarded.
The new proposed regulations include an anti-abuse rule based on facts and circumstances to determine if a payment obligation should be respected, with a non-exclusive list of the factors that may indicate such a plan including whether:
- there are contractual restrictions protecting the likelihood of payment,
- the partner or related person is required to disclose its financial condition,
- the term of the payment obligation ends prior to the term of the partnership liability, or the partner or related person has a right to terminate its payment obligation,
- the obligor holds money or other liquid assets exceeding the relevant liabilities,
- the payment obligation permits the creditor to pursue payment promptly following a default,
- in the case of a guarantee, the terms of the liability would be substantially the same had the partner or related person not agreed to provide the guarantee, and
- creditors receive executed documents with respect to the payment obligation.
Also, the new proposed regulations add a presumption that evidence of a plan to circumvent or avoid an obligation is deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation that the obligor has the ability to pay if ever required to do so.
The proposed regulations also distinguish DROs under the section 704(b) capital account rules from other payment obligations, such as guarantees and indemnities and include a revised list of factors to determine whether DROs will be respected for purposes of section 704(b) allocations and allocations of liabilities under section 752. The factors are whether:
- the partner is subject to commercially reasonable provisions for enforcement and collection of the obligation
- the partner is required to provide (either at the time the obligation is made or periodically) commercially reasonable documentation regarding the partner’s financial condition to the partnership
- the obligation ends or could, by its terms, be terminated before the liquidation of the partner’s interest in the partnership or when the partner’s capital account as provided in Reg. section 1.704-1(b)(2)(iv) is negative
- the terms of the obligation are provided to all the partners in the partnership in a timely manner
The proposed regulations will not be effective until finalized although they may be relied on before then.
So, what’s the bottom line for partnerships? Under the new guidance, more property transactions between partners and partnerships are likely to be classified as disguised sales — and, therefore, subject to taxes — than under the previous IRS guidance. The guidance also curbs the use of so-called leveraged partnership transactions to avoid paying taxes.
As always, your Friedman LLP tax professional can help you navigate these changes and their impact on you and your partnership.