Bottom dollar. It conjures up images of orphans dancing across the stage in “Annie” or characters from a Damon Runyon novel. And also of bottom dollar guarantees – perhaps the last way to obtain basis in real estate and partnerships without real exposure to economic loss. The IRS believes that bottom dollar guarantees generally shouldn’t be recognized as payment obligations when allocating recourse liabilities among partners since these guarantees allow a partner to enhance their tax basis and defer taxes. To eliminate what the IRS sees as abuses of some of the tax benefits associated with partnerships, in October 2016, the IRS issued a proposed set of temporary regulations relating to the allocation of liabilities and other partnership tax issues, including the commonly used bottom-dollar guarantees.
What is a Bottom Dollar Guarantee?
Bottom dollar guarantees assure a lender that they will collect something on a given debt. For example, a partner could guarantee up to $100 of a $1,000 loan. If the lender collected less than $100, the partner would make up the difference. If, however, the lender collected $100, the partner would have no payment obligation. Clearly, the economic risk of loss is minimal, especially in real estate transactions. After all, who expects land and buildings to become totally worthless without some cataclysmic event?
This is why the IRS is changing the rules, so that the essentially free basis aspect of the guarantees is eliminated. This is not to say all is lost. Partners who are willing to assume some real economic risk of loss – which may be otherwise manageable – can still maintain or increase their basis in the partnership.
The Basics of Basis
First, let’s discuss some basics. A partner’s basis in their partnership interest is computed by adding to their contributed capital (or the purchase price of the interest) any allocable income (ordinary, capital or nontaxable) less any losses (ordinary, capital or nontaxable) and distributions. Also included in basis is the partner’s allocable share of liabilities. Real estate is usually financed with non-recourse debt which, subject to certain special restrictions, is allocated among the partners based on how they share the partnership’s profits. If a partner or a related party is the lender or has guaranteed all or part of a loan, that portion of the loan is considered recourse and included in the basis of the partner who bears the economic risk of loss.
So, to recap, basis is contributions (or purchase price) plus income less losses less distributions plus allocable share of recourse and nonrecourse liabilities. The end result is that an investor may be able to deduct losses in excess of contributed capital, or refinance and receive distributions in excess of contributed capital and be able to defer the tax liability.
The New 2016 Temporary Regulations
Under the new rules, bottom dollar guarantees (and the economically similar limited Deficit Restoration Obligation or “limited DRO”) will not convert otherwise nonrecourse debt into recourse debt. First dollar guarantees (the lender can seek payment of the guaranteed amount if it does not fully collect on the debt) or vertical-slice guarantees (where the partner guarantees a percentage of each dollar of the debt) are generally still respected for partnership liability allocation purposes.
The Seven Factors Determining Payment Obligation
That being said, there is an anti-abuse provision in the proposed regulations which could prevent any guarantee from being effective in converting debt from recourse to nonrecourse. The seven factors which are weighed to determine whether a guarantee will be respected are as follows:
- the guarantee is commercially reasonable;
- the partner is required to provide commercially reasonable documentation regarding its financial condition;
- the term of the payment obligation ends prior to the term of the partnership liability;
- the partnership holds money or liquid assets that exceed reasonably foreseeable needs;
- creditors are permitted to promptly pursue payment following default;
- the terms of the partnership liability would be substantially similar without the guarantee;
- the creditor received executed documents from the partner with respect to the payment obligation within a commercially reasonable period of time after the creation of the obligation.
The Temporary Regulations, which replaced the originally proposed regulations regarding allocation of nonrecourse debt in 2014, have the effect of law but expire in three years (October 4, 2019). They apply to liabilities incurred or assumed and guarantees imposed or undertaken on or after October 5, 2016. With respect to liabilities allocated under the prior rules, there is a seven-year transition period.
One fly in the ointment is President Trump’s freeze on new regulations. Technically, since the liability allocation rules were issued as published temporary regulations, they are in effect now, but how will they fare under the President’s regulatory review process? Stay tuned for further developments.