IRS Issues New Regs on Allocating Debt to Partners and LLC Members
On October 5, 2016, the IRS released new temporary and final Section 752 regulations. Sec. 752 of the Internal Revenue Code and related regulations explain how to allocate partnership debt among partners for purposes of calculating the basis of their partnership interests. This calculation determines what’s often referred to as the partners’ “outside basis” in the partnership (their basis for deducting losses and receiving tax-free distributions). In some situations, the new regulations make it more difficult for partnerships to manipulate the rules to increase the outside basis of certain partners for tax planning purposes. In most situations, however, the effects of the new regulations are neutral.
Here are the most important changes included in the new Sec. 752 regulations — and how they may affect your investments in partnerships and limited liability companies (LLCs).
Why Sec. 752 Matters
A partner’s share of partnership liabilities, as determined under the Sec. 752 rules, is added to the partner’s outside basis. That gives the partner more room to deduct partnership losses and/or receive tax-free partnership distributions.
However, a reduction in a partner’s share of partnership liabilities, as determined under the Sec. 752 rules, is treated as a deemed cash distribution that reduces the partner’s outside basis. A reduction can trigger a taxable gain to the extent the deemed distribution — along with actual cash distributions and actual distributions of certain marketable securities — exceeds the partner’s outside basis.
For these reasons, the Sec. 752 rules are important. In general, these rules apply equally to LLCs that are treated as partnerships for federal tax purposes. For simplicity, this article uses the terms 1) “partnership” to refer more generally to both partnerships and LLCs that are treated as partnerships for tax purposes, and 2) “partner” to refer more generally to the owners of those entities (partners and LLC members).
How to Define a “Payment Obligation”
IRS temporary regulations typically have the same authority as final regulations. As such, they are in force as of the specified effective date. However, temporary regulations may be amended before being reissued as final regulations, with a new effective date for any changes.
A new temporary regulation issued in October clarifies when a partner is considered to have a payment obligation with respect to a partnership recourse debt for purposes of allocating that debt among the partners under the Sec. 752 rules. (Recourse debt is debt for which the borrower is personally liable — the lender can collect what is owed beyond any collateral.)
Without having a payment obligation with respect to a recourse liability, a partner generally can’t be allocated any basis from that liability under the Sec. 752 rules. However, in some cases, a partner can be allocated basis from a recourse liability when a taxpayer related to the partner has a payment obligation with respect to that liability.
The new guidance stipulates that the determination of the extent to which a partner or related person has a payment obligation with respect to a recourse liability is based on the facts and circumstances at the time of the determination. It also lists some specific factors that should be considered.
To the extent that the obligation of a partner or related person to make a payment with respect to a partnership recourse liability is not recognized under this rule, the payment obligation is ignored for purposes of allocating that debt to that partner under the Sec. 752 rules. All statutory and contractual obligations relating to the payment obligation are considered in applying this rule.
Example 1: Payment Obligations
If a partner guarantees a partnership recourse debt, but the guarantee isn’t legally binding under applicable state law, the purported guarantee won’t be recognized as a payment obligation. Therefore, the guarantee will have no impact on how that debt was allocated to that partner under the Sec. 752 rules.
The new clarification of payment obligations with respect to partnership recourse debts generally applies to liabilities incurred or assumed by a partnership on or after October 5, 2016. It also applies to payment obligations imposed or undertaken with respect to a partnership liability, other than liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken pursuant to a written binding contract in effect prior to that date.
A partnership can, however, elect to apply all the new rules to all of its liabilities as of the beginning of the first taxable year of the partnership that ends on or after October 5, 2016 (calendar year 2016 for a calendar year partnership). A special transitional rule allows the impact of the new rules to be postponed for up to seven years in some situations when the new rules would be harmful to a partner.
Important note: This temporary regulation is basically neutral in its effect on partners.
How to Handle Guarantees of Recourse Debt and Exculpatory Liabilities
Another new temporary regulation creates a new term called “bottom-dollar payment obligation.” For purposes of allocating recourse liabilities among partners under the Sec. 752 rules, a bottom-dollar payment obligation isn’t recognized. That means it’s ignored for purposes of allocating the entity’s recourse liabilities under the Sec. 752 rules.
In this context, so-called exculpatory liabilities are treated as recourse debts. Exculpatory liabilities are debts that are secured by all partnership property. Therefore, they’re effectively recourse to the partnership, even though no partner is personally liable.
The new guidance also requires partnerships to disclose to the IRS all bottom-dollar payment obligations for the tax year in which the bottom-dollar payment obligation is undertaken or modified.
Important note: The new rules for bottom-dollar payment obligations are primarily aimed at LLCs treated as partnerships for tax purposes that use member guarantees of exculpatory liabilities. Guarantees of LLC exculpatory liabilities have been used “creatively” to increase the basis of certain LLC members in their membership interests (outside basis). The IRS doesn’t look kindly on these types of arrangements, and the new rules make it more difficult to use them for tax planning purposes. As such, the new rules are unfavorable to taxpayers.
Limited liability partnerships (LLPs) can also have exculpatory liabilities. But LLPs are unlikely to have bottom-dollar payment obligation arrangements, because LLPs are most often used simply to operate professional practices. In contrast, some LLCs have been used as “creative” tax-planning vehicles.
Exculpatory liabilities aren’t relevant in the context of garden-variety general or limited partnerships, because one or more of their general partners will always be personally liable for partnership recourse debts.
Example 2: Guarantee of First and Last Dollars of LLC Exculpatory Liability
Individual taxpayers A, B and C are equal members (owners) of ABC LLC, which is treated as a partnership for federal tax purposes. ABC borrows $1 million from the bank. The $1 million liability is an exculpatory liability of ABC, because all of ABC’s assets are potentially exposed to the debt, but none of the three members have any personal liability for the debt.
Member A guarantees payment of up to $300,000 of the debt if any part of the $1 million isn’t recovered by the bank. Member B guarantees payment of up to $200,000, but only if the bank otherwise recovers less than $200,000.
Member A is obligated to pay up to $300,000 if, and to the extent that, any part of the $1 million liability isn’t recovered by the bank. So, Member A’s guarantee is not a bottom-dollar payment obligation, and his or her payment obligation is recognized for Sec. 752 purposes. Therefore, Member A is allocated $300,000 of basis from the $1 million debt, because he or she has an economic risk of loss to that extent.
On the flip side, Member B is obligated to pay up to $200,000 only if, and to the extent that, the bank otherwise recovers less than $200,000 of the $1 million loan. So, Member B’s guarantee is a bottom-dollar payment obligation, which is not recognized under the new guidance, because Member B isn’t considered to bear any economic risk of loss for the $1 million liability.
In summary, the first $300,000 of ABC’s $1 million liability is allocated to Member A. The remaining $700,000 is allocated to Members A, B and C under the rules for nonrecourse liabilities, because none of ABC’s members have any personal liability for the $700,000.
The same effective date and transitional relief rules that apply to the updated definition of payment obligations with respect to recourse debts also apply to the new rules regarding bottom-dollar payment obligations.
How to Allocate Excess Nonrecourse Liabilities
Under the Sec. 752 rules, partnerships must allocate nonrecourse liabilities among the partners using a three-tiered procedure. The last tier applies to so-called excess nonrecourse liabilities, which are allocated according to the partners’ percentage shares of partnership profits.
Effective for partnership liabilities incurred or assumed on or after October 5, 2016 — subject to an exception for pre-existing binding contracts — a new final regulation stipulates that the partnership agreement can specify the partners’ percentage interests in partnership profits for purposes of allocating excess nonrecourse liabilities.
But the specified percentages must be reasonably consistent with valid allocations of some other significant item of partnership income or gain. This is often referred to as the “significant item method” of allocating excess nonrecourse liabilities.
The new regulation also allows two other alternative methods of allocating excess nonrecourse liabilities. Moreover, excess nonrecourse liabilities aren’t required to be allocated under the same method each year.
Important note: This new final regulation is basically neutral in its effect on determining the outside basis of partners.
Where to Find Additional Information
This is only a brief summary of the key changes under the new temporary and final Sec. 752 regulations. Consult your tax professional for full details on how the new rules might affect your partnership (or LLC) and its partners (or members).