United States: Allocation Of Partnership Liabilities And Nonrecourse Deductions - Part Two

Last Updated: April 11 2000

V. Economic Risk of Loss

A. Background.

The 1956 version of the section 752 regulations provided rules for allocation of a partnership liability based upon whether the liability was recourse or nonrecourse, and whether the partner was a limited partner or a general partner. If the liability was nonrecourse, then all partners, including limited partners, shared the liability in the same proportion as they shared the profits of the partnership. The rationale was that a nonrecourse obligation can be satisfied only out of partnership profits, since the partners are not personally liable.

If the liability was recourse, then all partners shared in the liability in the same proportion that they shared partnership losses. However, a limited partner shared in recourse liabilities only to the extent of the difference between his actual contribution to the partnership and the total contribution which he was obligated to make under the partnership agreement. To the extent that a limited partner's share of a recourse liability exceeded such difference, that liability was allocated to the general partners in proportion to their respective loss-sharing ratios.

In Raphan v. United States, 3 Cl. Ct. 457 (1983), rev'd on this issue, 759 F.2d 879 (Fed. Cir. 1985), the Claims Court held that a liability that was nonrecourse to the partnership but guaranteed by the general partner would still be treated as nonrecourse for purposes of the sharing rules under the 1956 regulations. In response, Congress directed the Service to write new regulations under section 752 to address the basis effects of "guarantees, assumptions, indemnity agreements and similar arrangements." Congress also stated that the new regulations should be based "largely on the manner in which the partners, and persons related to the partners, share the economic risk of loss with respect to partnership debt (other than bona fide nonrecourse debt). H.R. Rep. No. 861, 98th Cong., 2d Sess. 869 (1984), reprinted in 1984 U.S.C.C.A.N. 1445, 1557 and 1984-3 C.B. Vol. 2, at 123.

In 1988, the Service issued temporary regulations to add an "economic risk of loss" analysis to determine which partners are allocated liabilities. Under those regulations, a partner bears the economic risk of loss with respect to a liability to the extent that the partner (or a related person) would be legally obligated to make the payments, or contributions to the partnership to satisfy the liability, if the partnership's liabilities were due and payable in full, and the partner would not be entitled to reimbursement. To simplify the regulations, they were rewritten, reproposed and then finalized in 1991.

B. Elements of the Regulations.

1. Economic Risk of Loss.

In general, a partner's share of a recourse liability equals the portion of the debt for which the partner "bears the economic risk of loss." Reg. 1.752-1(a)(1); 1.752-2(a). A partner bears the economic risk of loss for what he would have to pay if the partnership's assets become worthless and its liabilities are immediately payable. A partner may also have the economic risk of loss for her obligation to make an additional contribution to cover a partnership liability or from an obligation to pay the creditor directly in the event of a partnership default. Economic risk of loss arises in cases such as:

    • a general partner's liability for partnership debts under partnership law;
    • a partner's obligation under the partnership agreement to make a contribution on liquidation to cover any deficit in the partner's capital account;
    • a partner's personal guarantee of a nonrecourse liability of the partnership assuming no rights of subrogation against another partner or person related to a partner; and
    • a partner's agreement to reimburse another partner if the other partner is required to pay the partnership debt.

2. Effect of Other Agreements.

The amount of a partner's economic risk of loss takes into account all rights of contribution and reimbursement.

a. Limited Partners.

A limited partner generally does not bear the economic risk of loss for any partnership liability unless the partner is obligated to make further contributions to the partnership or has made a special agreement to pay a creditor or another partner directly in the event of a partnership default.

b. General Partners.

While a general partner is responsible for all partnership debts, he bears the economic risk of loss only for the net amount he would be required to pay after all rights of contribution among partners are satisfied. The economic risk test assumes that the obligations of persons related to a partner are generally treated as an obligation of that partner.

Illustration:

Each partner in the ABCD Partnership has a 25% interest in profits and losses. A bears the economic risk of loss on 25% of partnership recourse liabilities.

Illustration:

A, the general partner, is a corporation that is a subsidiary of X Corporation. ABC limited partnership obtains a loan without recourse, but the loan is guaranteed by A's parent, X Corporation. A is deemed to bear the economic risk of loss on the loan; the partnership's liability for the loan is allocated to A alone.

An interesting question raised by this second illustration is whether, if X Corporation were called upon to make a payment on the guarantee, the payment would constitute a capital contribution to A or a cancellation of indebtedness. The Service addressed this issue in Field Service Advisory 199921008. This ruling involved a limited partnership between Q, an S corporation, and the Q shareholders, where Q was the general partner. The limited partners, acting in their capacity as Q shareholders, guaranteed recourse financing obtained by the limited partnership. The Service stated that any payments made by the limited partners as a result of the guarantee would be made in their capacity as Q shareholders. The payments would constitute a contribution of capital to Q and would not result in cancellation of indebtedness income.

In a 1996 Private Letter Ruling (PLR 9622014), the Service ruled that a partner must include its proportionate share of a partnership liability which it continued to personally guarantee in the amount realized on the sale of its partnership interest. The purchaser of the interest had agreed to indemnify the seller for any losses suffered on account of the liability. Because of the indemnification agreement between the selling partner and the purchaser, the Service determined that the partnerís guarantee had no economic effect and that the selling partner was effectively relieved from the partnership liability upon the sale of the partnership interest.

C. Allocation of Recourse Liabilities among the Partners.

1. Constructive Liquidation of Partnership.

Recourse liabilities are allocated among the partners based on who bears the economic risk of loss on a constructive liquidation. Reg. 1.752-2(b)(1) expresses the concept that economic risk of loss is to be determined by engaging in the fiction that the partnership is constructively liquidated, and all of the following events are deemed to occur simultaneously:

    • All partnership liabilities are payable in full;
    • Except for property contributed to secure a partnership liability, all partnership assets including cash, have a value of zero;
    • All partnership property is disposed of in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor's right to repayment is limited solely to specified partnership assets);
    • All items of income, gain loss and deduction are allocated among the partners; and
    • The partnership liquidates.

2. Assumption of Worthlessness.

The assumption of worthlessness extends to all partnership assets, including cash, contractual rights and insurance policies. Reg. 1.752-2(b)(i)(ii). For the purpose of making the calculations for the constructive liquidation,

(a) if the creditor's right to repayment is limited solely to specified partnership assets (nonrecourse debt), gain or loss is recognized to the extent of the difference between the amount of liability that is extinguished by the deemed disposition and the tax basis (or book value if section 704(c) or its regulation applies) of those assets;

(b) a loss is recognized equal to the remaining tax basis (or book value if section 704(c) applies) of all partnership assets not taken into account in paragraph (b)(2)(i) of this section. Reg. 1.752-2(b)(2).

Illustration:

A and B form a partnership with A contributing $100,000 and B contributing $0. They agree to share losses: A-10%, B-90%. AB Partnership purchases a building for $1 million, paying $100,000 in cash and borrowing $900,000. The lender takes a mortgage on the building and partner B guarantees the loan. The guarantee is deemed to be an obligation to make a contribution to the partnership in satisfaction of the mortgage. For constructive liquidation purposes, the building is treated as being sold for $0, resulting in a loss of $1 million to the partnership.

Deemed sale

 

Amount realized

$ -0-

Basis

1,000,000

Loss

(1,000,000)

 

A

B

Initial contribution

$ 100,000

$ -0-

Loss allocation

(100,000)

(900,000)

Deemed contribution

-

900,000

 

$ -0-

$ -0-

D. Obligations Recognized.

All facts and circumstances determine whether a partner is obligated to make a payment. Obligations include those by contract outside the partnership such as guarantees, indemnities, and other reimbursement arrangements; obligations imposed by the partnership agreement, including contribution to and restoration of capital accounts; and payment obligation imposed by state law. Contingent obligations are disregarded if it is unlikely that they will be discharged, or if occurrence of contingent event is not determinable, the obligation is ignored until the event occurs. Reg. 1.752-2(b)(3),(4).

1. Reimbursement Rights.

The obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner or related person is entitled to reimbursement from another partner or person related to that partner. Reg. 1.752-2(b)(5).

2. Partner as a Lender.

A partner bears the economic risk of loss for that partner's nonrecourse loan to the partnership, if the economic risk of loss is not borne by another partner. If what the partnership owes to that partner includes wrapped debt, that is, a nonrecourse obligation owed to another person, encumbering partnership property, the partnership debt is bifurcated, the amount corresponding to the wrapped debt is treated as a liability owed to a nonpartner. Reg. 1.752-2(c).

a. Exception.

An exception to this rule exists when the partner's interest in each item of partnership income, gain, loss, deduction or credit for every taxable year of being a partner is 10% or less, and the loan constitutes qualified nonrecourse financing under section 465(b)(6).

b. Debt vs. Equity.

At times, the IRS has contended that loans from partners are not really debts, but equity. Hanbuechen v. Commissioner, 43 T.C. 90, 98 (1964) held that each case must be determined on the applicable facts and circumstances, and the question is whether, looking at all of them, a valid debtor-creditor relationship was established. In Butler v. Commissioner, 36 T.C. 1097 (1961), acq., 1962-2 C.B. 4, the Tax Court allowed an attorney, who advanced $50,000 to a limited partnership of which he was a member, to claim his losses as fully deductible business bad debts. At times, the Service has taken the position that a "loan" is equity instead of debt, when there is thin capitalization. See PLR 8140017 (1981).

c. Loans by Related Persons.

Except for some de minimis transactions, Reg. 1.752-2(c) provides that a partner bears the economic risk of loss to the extent that the partner or a related person makes a nonrecourse loan to the partnership, and the economic risk of loss is not borne by another partner. As with direct partner loans for the de minimis exceptions to apply, the interest of a partner or related party must be 10% or less in each item of partnership income, gain, loss, deduction or credit and the loan must constitute qualified nonrecourse financing under section 465(b)(6).

3. Obligation to Restore Capital Account.

Reg. 1.752-2(b)(3)(ii) includes, as one of the obligations which is taken into account for determining the extent to which a partner has a payment obligation, the existence of a deficit capital account restoration obligation upon liquidation of the partnership.

Illustration:

A&B form equal general partnership AB.

 

 

Capital Accounts

A

B

Initial

$10,000

$10,000

AB borrows $80,000 on a recourse note;

 

 

AB buys property for $100,000. In a

 

 

constructive liquidation:

 

 

Partnership loss of $100,000 on

 

 

hypothetical sale of property

(50,000)

(50,000)

Deficits in capital accounts

(40,000)

(40,000)

If the partnership agreement or partnership law requires each partner on liquidation to cover any capital account deficit, each partner would be required to make a $40,000 contribution in the constructive liquidation and, therefore, share the economic risk of loss for the debt equally. Reg. 1.752-2(g)(4).

The obligation to contribute additional capital is an important factor in determining economic risk of loss. See Reg. 1.752-2(b). When a limited partner is obligated to make an additional capital contribution to satisfy recourse partnership liabilities, the limited partner is entitled to an allocation of the liability to the extent of the obligation.

Illustration:

ABC limited partnership incurs a $300,000 recourse liability. Limited partners B and C obligate themselves to contribute no more than $250,000 to ABC partnership in the future. A, B and C share profits and losses equally. Accordingly, each is entitled to allocation of 1/3 of the recourse liability ($100,000). If B and C were obligated to contribute only $50,000 each, the $300,000 liability would be allocated $50,000 each to B and C and $200,000 to A, the general partner.

If a partner has a contingent obligation to contribute to the partnership, for example, to cover an overage in construction costs, the obligation is not deemed a liability under Reg. 1.752-2(b)(4). The obligation is disregarded if taking into account all facts and circumstances, the contingencies make it unlikely that it will ever be discharged. If payment is contingent upon an event which is not determinable with reasonable certainty, the obligation is ignored until the event occurs.

In Revenue Ruling 97-38, 1997-38 I.R.B. 14, the Service ruled that if an allocation to a partner creates a deficit in that partnerís capital account in excess of the partnerís restoration obligation, then the partner has no repayment obligation to the extent of the excess. As a result, the allocation does not have economic effect because the partner does not bear the economic risk of loss.

Illustration

A and B each contribute $100 to a limited partnership. A and B share profits and loses equally, but A, as the general partner, is allocated all depreciation deductions. The partnership purchases depreciable property for $1,000, paying $200 cash and borrowing $800 on a recourse basis. The loan is secured by the depreciable property. The building depreciates $200 per year, and the partnership recognizes no other items of income or loss in the first year. At the end of the first year, Aís capital account has a deficit of $100. Reg. 704-1(b)(2) presumes the value of the property to be equal to its basis, $800. At that value, the partnershipís obligation to the lender could be satisfied by transferring the property to the lender. Therefore, A will have no obligation to contribute any amount to cover the partnershipís shortfall. Since A has no contribution obligation at the end of year one, the allocation creating the $100 capital account deficit will have no economic effect because A does not bear the economic risk of loss for that amount.

4. Related Persons.

A person is related to a partner if the relationship between them is as specified in section 267(b) or section 707(b)(1), except (i) 80% or more replaces more than 50%; and (ii) brothers and sisters are excluded. Reg. 1.752-4(b).

The exceptions are more favorable to taxpayers than the general rules of sections 267(b) and 707(b)(1).

a. Shareholders, partners and beneficiaries are treated as owning proportionately the stock and partnership owned (directly or indirectly) by or for their corporations, partnerships, estates or trusts. I.R.C. 267(c)(1) and 707(b)(3).

b. An individual is treated as owning the stock and partnership interest owned (directly or indirectly) by or for his or her spouse, ancestors and lineal descendants. Brothers and sisters are excluded. I.R.C. 267(c)(2), (4), (5); 707(b)(3).

c. An individual who owns stock in a corporation (disregarding what would be attributed through his or her spouse, ancestors or lineal descendants), shall also be treated as owning the stock in the corporation owned (directly or indirectly) by or for his or her partner. I.R.C. 267(c)(3),(5).

d. The following persons are related to the partner:

(i) Spouse, ancestors and lineal descendants;

(ii) Any corporation if 80% or more, in value, of the outstanding stock of which is owned (directly or indirectly) by or for the partner. Value, and not voting power, is the test. If there are several classes of stock, value is still the test;

(iii) Any partnership of which 80% or more of the capital interest or profits interest is owned by the partner;

(iv) If the partner is a corporation:

(a) the individual owning 80% or more in value of the outstanding stock;

(b) other members of the controlled group of which the corporate partner is a member;

(c) If an S corporation, any other S or C corporation of which 80% or more in value of the outstanding stock is owned by the same persons who own 80% or more in value of the outstanding stock of the corporate partner. If a C corporation, any S corporations of which 80% or more in value of the outstanding stock is owned by the same persons who own 80% or more in value of the outstanding stock of the corporate partner;

(d) Any partnership of which 80% or more of the capital interest or profits interest is owned by the same persons who 80% or more in value of the outstanding stock of the corporate partner;

(e) Any trust, or grantor of a trust, which or who owns (directly or indirectly) 80% or more in value of the outstanding stock of the corporate partner which is the fiduciary of the trust.

(v) If the partner is another partnership:

(a) Any person owning (directly or indirectly) 80% or more in value of the capital interest or the profits interest in the other partnership;

(b) Any corporation of which 80% or more in value of the outstanding stock is owned by the same persons who own 80% or more of the capital interest or profits interest in the other partnership;

(c) Any partnership of which 80% or more of the capital interest or profits interest is owned by the other partnership.

(vi) If the partner is the grantor of a trust, all fiduciaries of that trust.

(vii) If the partner is a fiduciary of a trust:

(a) The grantor and all beneficiaries of the trust;

(b) If the grantor of the trust is also the grantor of another trust, the fiduciaries and all beneficiaries of the other trust;

(c) Any corporation of which the trust or the grantor of the trust owns (directly or indirectly) 80% or more in value of the outstanding stock of a corporation.

(viii) If the partner is the beneficiary of a trust:

(a) The fiduciary of the trust;

(b) The fiduciary of any other trust having the same grantor.

(ix) Any organizations, exempt under section 501, controlled (directly or indirectly) by the partner or the partner's spouse, ancestors and lineal descendants.

(x) If the partner is an organization exempt under section 501, any person who controls the exempt organization (directly or indirectly) or whose spouse, ancestors or lineal descendants control such organization (directly or indirectly).

e. Persons related to more than one partner.

(i) General rule. When a person is related to more than one partner, as a general rule, the related partner determination of Reg. 1.752-4(b)(1) is applied by treating the person as related only to the partner with whom there is the highest percentage of related ownership. If two or more partners have the same percentage of related ownership and no other partner has a greater percentage, the liability is allocated among all partners having the equal percentages of related ownership. Reg. 1.752-4(b)(2)(i).

(ii) Natural persons who are members of the same family are treated as having a percentage relationship of 100 percent with respect to each other. Reg. 1.752-4(b)(2)(ii).

(iii) An exception is made for persons owning interests directly or indirectly in the same partnership; they are not treated as related persons for purposes of determining the economic risk of loss. This exception does not apply when determining a partner's interest under the de minimis rules in Reg. 1.752-2(d), (e). 1.752-4(b)(2)(iii).

(iv) A special rule disregards any entity structured to avoid related partner status, when:

(a) A partnership liability is owed to or guaranteed by another partnership, or an S corporation, a C corporation or a trust;

(b) A partner or related person owns directly or indirectly 20% or more ownership interest in the other entity; and

(c) A principal purpose of the other entity acting as a lender or guarantor of the liability is to avoid the determination that the partner that owns the interest bears the economic risk of loss for federal income tax purposes for all or part of the liability; then the partner is treated as holding the other entity's interest as a creditor or guarantor to the extent of the partner's or related person's ownership interest in the entity.

"Ownership interest" in (1) a partnership equals the partner's highest percentage interest in any item of partnership loss or deduction for any taxable year; (2) an S corporation equals the stockholder's percentage of the outstanding stock; (3) a C corporation equals the stockholder's percentage of the fair market value of the issued and outstanding stock; and (4) a trust equals the percentage of the actuarial interests owned by the beneficial owner of the trust. Reg. 1.752-4(b)(2)(iv).

Illustration:

A, B and C form a general partnership. A, B and C each contribute $1,000 to ABC partnership; they are equal partners.

A and B form second partnership - each contributes $50,000. They share losses equally. The purpose is to have the loan to ABC treated as nonrecourse under section 752.

AB loans ABC $100,000 on nonrecourse basis secured by property which ABC purchases.

A and B bear equally the economic risk of loss for the ABC partnership liability based on their percentage interests in losses of AB. Reg. 1.752-4(c).

E0 Time-Value-of-Money Considerations.

The regulations provide that the extent to which a partner or related person bears the economic risk of loss takes into account any time delay when a payment or contribution obligation is to be satisfied. Reg. 1.752-2(g)(1). If payment is not required to be made within a reasonable time, or if the contribution obligation does not have to be satisfied before the later of (i) the end of the year, or (ii) 90 days after liquidation, the obligation is recognized only to the extent of the value of the obligation.

The value of the delayed payment or contribution obligation equals face value only if it bears interest at a rate at least equal to the applicable federal rate under section 1274(d) at, the time of valuation. If the interest rate is less (or none), the face value is discounted to present value of all payments due (i.e., the imputed principal amount computed under section 1274(b). Reg. 1.752-2(g)(2).

A partner's promissory note does not constitute a payment obligation unless the note is readily tradeable on an established securities market. Reg. 1.752-2(g)(3).

Illustration:

AB limited partnership -- A is general partner; B is limited partner; profits and losses shared equally. Each required to make up deficits in capital accounts: A has 90 days grace, while B has 2 years after liquidation without interest:

 

A

B

Contribution

10,000

10,000

AB buys property for $20,000 in cash plus a $70,000 recourse purchase money note. In a constructive liquidation, with all assets deemed worthless and all liabilities due and payable, Loss on hypothetical sale

(45,000)

(45,000)

 

(35,000)

(35,000)

Each partner's capital accounts would have a deficit of $35,000. However, B's obligation is recognized only to extent of present fair market value. Since B's obligation does not have to be satisfied within 90 days after liquidation, and it does not bear interest, the fair market is the imputed principal amount computed under 1274(b). If the applicable federal rate is 6%, compounded semiannually, the present value is $31,100. To the extent B's deficit restoration obligation is not recognized, A, the general partner, is deemed to bear that obligation ($3,900). Accordingly, A bears the economic risk of loss of $38,900, and B's economic risk of loss is $31,100. Reg. 1.752-2(g)(4).

F0 Partner Providing Security for Partnership Liability.

A partner bears the economic risk of loss for a partnership liability to the extent that property of the partner or a related person is pledged as security for a partnership liability. Contributed property is not deemed to be pledged as security unless all items of income, gain, loss and deduction attributable to that property are allocated to the contributing partner; and this allocation is greater than the partner's share of other such items. The amount of economic risk of loss is limited to the fair market value of all the property at the time of pledge or contribution. Reg. 1.752-2(h).

VI. Nonrecourse Deductions

A. Effective Dates. There are three separate sets of nonrecourse debt regulations applicable to partnerships depending on the date of their formation:

1. The original final regulations ("Original Regulations" or "Orig. Reg.") found at Reg. 1.704-1(b)(4)(iv) (before December 28, 1991) continue to apply indefinitely to partnerships entered into on or before December 29, 1988 which complied with the provisions thereof until a subsequent material modification of the partnership agreement, unless either:

(a) The partnership elected to apply the temporary regulations ("Temporary Regulations" or "Temp. Reg.") (referred to in 2 below) pursuant to Temp. Reg.

1.704-1T(b)(4)(iv)(m)(l) commencing with its first taxable year ending after December 28, 1988, e.g., usually calendar year 1988; or,

(b) The partnership elects to apply the new final regulations ("Final Regulations" or "Reg.") (referred to in 3 below) to it commencing with the first taxable year ending on or after December 28, 1991. This election is made by attaching a written statement to the partnership return for its first taxable year ending on or after December 28, 1991, with the statement including the name, address and identification number of the partnership and that it makes an election under Reg.1.704-2(l)(4).

2. The Temporary Regulations (1.704-1T(b)(4) December 29, 1988) apply to any partnership formed on or before December 29, 1988, which has elected to apply them (see 1(a) above) and to any partnership entered into after December 29, 1988 and before December 28, 1991 which complied with the Temporary Regulations unless it elects to be governed by the Final Regulations under Reg.1.704-2(l)(4).

3. The Final Regulations (Reg. 1.704-2(l)(4), December 27, 1991) apply to partnerships which elect them for their first year ending after December 28, 1991 and to partnerships formed on or after December 28, 1991 and to taxable years beginning on or after that date.

B. General Rules.

1. The Original, Temporary and Final Regulations take the position that deductions attributable to the portion of the adjusted basis of an asset or of an expenditure financed with nonrecourse debt cannot have substantial economic effect because the nonrecourse creditor bears the economic risk of loss. Orig. Reg.1.704-1(b)(4)(iv); Temp. Reg. 1.704-1T(b)(4)(iv)(a)(1); Reg. 1.704-2(b)(1). However, because nonrecourse creditors cannot be allocated with any deductions or losses, those financed with nonrecourse debt must be allocated among the partners in accordance with their interests in the partnership.

2. The regulations provide that the portion of a deduction attributable to nonrecourse debt ("nonrecourse deduction") is an amount which results in an increase in the "minimum gain" which the partnership would realize on a foreclosure or sale of the applicable property for the nonrecourse mortgage balance. Orig. Reg. 1.704-1(b)(4)(iv)(b) and (c); Temp. Reg. 1.704-1T(b)(4)(iv)(a)(2) and (c); Reg. 1.704-2(c). Any deduction funded with nonrecourse debt, which did not result in a depreciable, depletable or amortizable asset, is determined for characterization purposes as a pro rata share of all partnership deductions, losses and Section 705(a)(2)(B) expenditures for the applicable year. Orig. Reg.1.704-1(b)(4)(iv)(b); Temp. Reg. 1.704-1T(b)(4)(iv)(b); Reg. 1.704-2(c).

3. An allocation of a deduction attributable to nonrecourse debt will be treated as made in accordance with a partner's interest in the partnership if:

(1) Capital accounts are properly maintained and liquidating distributions are to be made in accordance with positive capital account balances in accordance with the rules of Reg. 1.704-1(b)(2)(ii)(b)(1) and (2) and, under the Final Regulations the partner either has a deficit make up obligation or there is a qualified income offset (Reg. 1.704-1(b)(2)(ii)(b)(3), 1.704-1(b)(2) (ii)(d)(3));

(2) The allocations of deductions attributable to nonrecourse debt throughout the term of the partnership are "reasonably consistent" with allocations of some other significant partnership item (which have substantial economic effect) attributable to the property securing the nonrecourse debt (other than allocations of minimum gain). Some "other significant" partnership item apparently includes other taxable income or loss (other than attributable to nonrecourse debt) and, presumably, significant specially allocated items of deduction (other than attributable to nonrecourse debt) and significant gain on sale other than the minimum gain, and "reasonably consistent" apparently means that the nonrecourse deduction allocation must be virtually identical to the allocation of the relevant "other significant" item. Orig. Reg. 1.704-1(b)(5) Ex. 20 (ii) and (iii); Reg. 1.704-2(m), Ex. 1(ii);

(3) (a) Under the Original Regulations, either the partner has an obligation to eliminate the deficit balance in his capital account on liquidation of the partnership or of his interest or the partnership agreement contains a "minimum gain chargeback";

(b) Under the Final and Temporary Regulations: In the first taxable year of the partnership in which it has nonrecourse deductions or makes a distribution of proceeds of a nonrecourse liability that are allocable to an increase in minimum gain and thereafter throughout the full term of the partnership, the partnership agreement contains a "minimum gain chargeback"; and

(4) All other material allocations and capital account adjustments are recognized.

Orig. Reg.1.704-1(b)(4)(iv)(d);Temp.Reg.1.704-1(b)(4)(iv)(d); Reg. 1.704-2(e). The stated rationale of the change made to the Original Regulations by the Temporary Regulations was that it was necessary to require a minimum gain chargeback since an allocation of minimum gain has no substantial economic effect.

4. If the above requirements are satisfied, a partner not having an obligation to eliminate the deficit in his capital account on liquidation may be allocated deductions attributable to nonrecourse debt even if they cause a deficit in his capital account balance, provided that deficit is not in excess of his share of partnership minimum gain. Orig. Reg. 1.704-1(b)(5) Ex.22; Reg. 1.704-2(m) Ex. 1(ii). Does the partnership agreement itself have to limit allocations of deductions and losses so that the deficit of limited partners will not exceed the sum of their shares of minimum gain and their negative capital account contribution obligation (if any)?

C. Minimum Gain Chargeback and Nonrecourse Debt.

1. (a) Under the Original Regulations, a "minimum gain chargeback" is a provision in the partnership agreement which requires that if there is a net decrease in partnership minimum gain for a taxable year any partner having a deficit capital account balance (computed net of his obligation to eliminate any portion of his deficit balance and his share of remaining minimum gain) will be allocated gross income and gain thereafter in the amount and proportions needed to eliminate such deficits as quickly as possible. The deficit balance is computed net of the items which have to be considered as distributed or charged under the qualified income offset provision (Reg. 1.704-1(b)(2)(ii)(d)(4), (5) and (6)) and the amount of minimum gain chargeback in any year is deemed to consist first of gains realized on the disposition of items of partnership property subject to one or more nonrecourse liabilities to the extent of the decrease in minimum gain attributable to the disposition of such items with the remainder made up of a pro rata portion of other items of income and gain. Orig. Reg. 1.704-1(b)(4)(iv)(e); Reg.1.704-2(f)(6).

(b) The Temporary Regulations (Temp. Reg. 1.704-1T(b)(4)(iv)(e)(2)) modified the above formulation by requiring, in the event of a required minimum gain chargeback, that each partner be allocated items of income and gain (for the years of the decrease and subsequent years, if necessary) in proportion to, and to the extent of, an amount equal to the greater of:

(1) The portion of such partner's share of the net decrease in partnership minimum gain during such year which is allocable to the disposition of partnership property subject to one or more nonrecourse liabilities of the partnership; or

(2) The deficit balance in such partner's capital account at the end of such year (before allocations of income, gains, deductions and losses, but net of his deficit restoration obligation, share of partnership minimum gain, share of minimum gain with respect to partner nonrecourse debt and the adjustments in 1.704-1(b)(2)(ii)(d)(4),(5) and (6)).

(c) The Final Regulations merely require that each partner (whether or not he has a deficit in his capital account balance) must be allocated items of partnership gross income and gain for the year in which minimum gain is reduced equal to that partner's share of the net decrease in partnership minimum gain. Reg. 1.704-2(f)(1). Note that the amount of minimum gain chargeback is only the "net" decrease in minimum gain so that refinancings in which the amount of total nonrecourse debt remains the same do not trigger a minimum gain chargeback. Reg. 1.704-2(m), Ex. 2. Exceptions are provided, however:

(1) If the net decrease in partnership minimum gain is caused by a guarantee, refinancing or other change in the debt instrument causing it to become partially or wholly recourse debt or partner nonrecourse debt and the partner bears the economic risk of loss (under Reg. 1.752-2) for the changed liability. Reg.1.704-2(f)(2);

(2) To the extent the partner actually contributes capital to the partnership that is used to repay the nonrecourse debt or is used to increase the basis of property subject to the nonrecourse liability and the partner's share of the net decrease in partnership minimum gain results from the repayment or the increase in the property's basis. Reg. 1.704-2(f)(3); Reg. 1.704-2(m), Ex.1(iv).

(3) If the minimum gain chargeback would cause a distortion in the economic arrangement among the partners, it is not expected that the partnership will have other income to correct the distortion and a waiver by the Commissioner of the minimum gain chargeback is obtained. The following facts must be demonstrated for a waiver request to be considered:

(i) The partners have made capital contributions or received net income allocations that have restored the previous nonrecourse deductions and distributions attributable to the proceeds of a nonrecourse liability; and

(ii) The minimum chargeback requirement would distort the partners' economic arrangement as reflected in the partnership agreement and as evidenced over the term of the partnership by the partnership's allocations and distributions and the partners' contributions. Reg. 1.704-2(f)(4.

It appears that if a partner does not have a deficit in his capital account at the time minimum gain is recognized, it is unnecessary to require a minimum gain chargeback, provided a waiver is obtained from the Internal Revenue Service. See Reg. 1.704-2(f)(7), Ex.1.

(4) The Commissioner may provide additional exceptions by ruling. Reg. 1.704-2(f)(5).

(5) The reason for the change in the Final Regulations was to prevent distortions from the economic business arrangement the parties undertook.

2. A "nonrecourse" liability is one with respect to which none of the partners bears the economic risk of loss. Consequently, a purported nonrecourse loan made by a partner to a partnership, or a nonrecourse loan guaranteed by a partner, is not a nonrecourse loan for this purpose and allocations of losses and deductions attributable thereto will be made in accordance with the partners' interests in the partnership. Reg. 1.704-2(b)(3); Orig. Reg. 1.704-1(b)(4)(iv)(g); Temp. Reg. 1.704-1T(b)(4)(iv)(h)(1). The regulations allocate the entire loss attributable thereto to the creditor partner. Reg. 1.704-2(m) Ex.1(viii); Orig. Reg.1.704-1(b)(5) Ex. 20 (vii); Temp. Reg. 1.704-1T(b)(4)(iv)(h)(2). Also, Orig. Reg. 1.704-1(b)(l)(iii) indicates the Service will look at debt/equity characterization issues with respect to third party purported nonrecourse debts and could characterize them as equity. However, the de minimis 752 exception, i.e., 10% interest or less of Reg. 1.752-2(d), is incorporated.

3. (a) (i) The Temporary and Final Regulations provide that if a partner bears the economic risk of loss of a partnership nonrecourse debt, it is recharacterized as a "partner nonrecourse debt" and any nonrecourse deductions attributable to that debt must be allocated to the partner who bears its economic risk of loss, or among all partners who bear the economic risk of loss in the ratio in which they bear that risk of loss. Reg. 1.704-2(b)(4), 1.704-2(i); Temp. Reg. 1.704-1T(b)(4)(iv)(h)(2). This effectuates a special allocation of the deduction to the lender so that the other partners may have taxable income without any cash flow.

(ii) Note that the Temporary Regulations define "partner nonrecourse debt" as any nonrecourse debt for purposes of 752 for which a partner bears the economic risk of loss, thus including unsecured advances by a partner with respect to which no partner is personally liable. Reg. 1.704-2(b)(4) defines this term by reference to the definition of nonrecourse debt used in Reg. 1001-2, i.e., apparently limiting partner nonrecourse debt only to secured debts.

(b) For this purpose a more-than 10% partner is deemed to bear the economic risk of loss if the nonrecourse loan is made by a person related to that partner under the rules applicable for purposes of determining basis in partnership interests under Section 752. Reg. 1.752-4(b); Temp. Reg. 1.752-1T(h) (Sections 267(b) and 707(b)(1), with modifications, related to over 10% partners); Temp. Reg. 1.704-1T(b)(4)(iv)(k)(1); Reg. 1.704-2(b)(4). The Temporary 752 and Final 752 regulations grandfathered pre-January 30, 1989 related party loans and guarantees and do not require a shift from unaffiliated partners to related ones, although nonrecourse deductions funded by such loans for 1989 and thereafter will not be allowed to the unaffiliated persons. Temp. Reg. 1.752-4T(a), 1.752-4T(d); Reg.1.752-5; See also, Levine, Loffman and Presant, A Practical Guide to the New Section 752 Regulations, Part II, 70 Journal of Taxation 260 (May,1989). These debts will be treated for 704(b) purposes as partnership non-recourse debts if incurred or assumed by the partnership prior to January 30, 1989 or pursuant to a contract which was binding prior to January 30, 1989. Temp. Reg.1.704-1T(b)(4)(iv)(m)(2). Also, partnership nonrecourse debts which were treated as such under the prior 752 regulations before the effective date of the Tax Reform Act of 1984 (March 1, 1984) and which had been incurred or assumed by the partnership prior to March 1, 1984, will continue to be treated as partnership nonrecourse debt for 704 purposes, but without permitting increases in the amount thereof after December 31, 1986 to be taken into account. Temp. Reg.1.704-1T(b)(4)(iv)(m)(3).

(c) If there is a decrease in the minimum gain attributable to partner nonrecourse debt, a minimum gain chargeback must be provided in the partnership agreement, i.e.:

(1) Under the Temporary Regulations, all partners with a share of that minimum gain attributable to the partner nonrecourse debt at the beginning of the year must be allocated items of partnership income and gain thereafter in proportion to, and the extent of, an amount equal to the greater of:

(i) The portion of such partner's share of the net decrease in the minimum gain attributable to such partner nonrecourse debt that is allocable to the disposition of partnership property subject to the debt; or

(ii) The deficit balance of such partner's capital account at the end of such year (determined before allocations of income, gains, deductions and losses for such year but net of his deficit restoration obligation, his remaining share of partnership minimum gain, share of minimum gain attributable to partner nonrecourse debt and the adjustments in Reg. 1.704-1(b)(2)(ii)(d)(4), (5) and (6)). Temp. Reg.1.704-1(b)(4)(iv)(h)(4).

(2) Under the Final Regulations:

(i) Any partner with a share of that partner nonrecourse debt minimum gain as of the beginning of the year must be allocated items of income and gain for the year (and, if necessary, for succeeding years) equal to that partner's share of the net decrease in partner nonrecourse debt minimum gain (determined in the same manner as a partner's share of decreases in partnership minimum gain is determined).

(ii) If, however, the reduction is caused by a conversion of the debt into partnership nonrecourse debt the lender partner's decrease in partner minimum gain is added to the partner's share of partnership minimum gain. This defers the chargeback until the debt is discharged or the property is sold. Reg. 1.704-2(i)(4).

(d) A partner's share of minimum gain attributable to partner nonrecourse debt at the end of any year and his share of net increases in minimum gain are determined under rules identical to the determination of the shares of partnership minimum gain. Temp. Reg. 1.704-1T(b)(4)(iv)(h)(5) and (6); Reg. 1.704-2(i)(5).

(e) Rules consistent with those pertaining to the distribution of partnership nonrecourse debt proceeds apply also to distributions of the proceeds of partner nonrecourse debts. Reg. 1.704-2(i)(6).

4. In computing the amount of minimum gain, if a property is subject to more than one liability of equal priority, the book value is allocated among all liabilities in proportion to their outstanding balances. If it is subjected to two or more liabilities of unequal priority, book value is allocated among the liabilities in the order of their priority up to the balance of each. Orig. Reg. 1.704-1(b)(4)(iv)(c); Temp. Reg. 1.704-1T(b)(4)(iv)(c); Reg. 1.704-2(d)(2).

5. (a) Under the Original Regulations, a partner's "share of minimum gain" at the end of each year is defined as the aggregate "nonrecourse deductions" allocated to that partner up to that time less his share of decreases in minimum gain allocated to him up to that time, under the final regulations. Orig. Reg. 1.704-1(b)(4)(iv)(f).

(b) (1) The Temporary and Final Regulations define "partnership minimum gain" to be equivalent to the excess of the nonrecourse liabilities encumbering a partnership asset over the adjusted tax basis of the asset (or book value if different from adjusted basis). This definition is much better in that it permits minimum gain to be created or increased as a result of a refinancing. Temp. Reg. 1.704-1T(b)(4)(iv)(a)(2); 1.704-1T(b)(4)(iv)(f); Reg. 1.704-2(d)(3), 1.704-2(h); see, Reg. 1.704-2(m), Ex. 1(vi).

(2) The precise definition of a partner's "share of minimum gain" which appears in the Final Regulations is an amount which equals:

(i) The sum of nonrecourse deductions allocated to that partner (and to that partner's predecessors in interest) up to that time and the distributions made to that partner (and to that partner's predecessors in interest) up to that time of proceeds of a nonrecourse liability allocable to an increase in partnership minimum gain; minus

(ii) The sum of that partner's (and that partner's predecessors' in interests) aggregate share of the net decreases in partnership minimum gain plus their aggregate share of decreases resulting from revaluations of partnership property subject to one or more partnership nonrecourse liabilities. Reg. 1.704-2(g)(1).

(3) However,

(i) The capital account maintenance requirements and requirement that assets be distributed at liquidation in accordance with positive capital accounts of Reg. 1.704-1(b)(2)(ii)(b)(1) and (2) must be satisfied throughout the partnership's term, and

(ii) All other material allocations and capital account adjustments under the partnership agreement must be recognized under Reg. 1.704-1(b) and 1.704-1T (without regard to whether allocations of adjusted tax basis and amount realized under Section 613A(c)(7)(D) are recognized). Temp. Reg. 1.704-1T(b)(4)(iv)(g)(1); Reg. 1.704-2(e).

(4) Although the usual rule is that a distribution of loan proceeds will be treated as a distribution which is allocable to an increase in partnership minimum gain to the extent of the net increase therein, the Final and Temporary Regulations permit a partnership to treat such a distribution as not being allocable to an increase in partnership minimum gain provided the distribution does not cause or increase the deficit balance in the distributee's capital account above his deficit restoration obligation and deemed deficit restoration obligation (without regard to the effect thereon of the distribution itself) as of the end of the partnership taxable year in which the distribution occurs. Reg. 1.704-2(h)(3); Temp. Reg. 1.704-1T(b)(4)(iv)(g)(1). Apparently no formal election need be filed for a partnership to opt for this different treatment. The effect of this election, as indicated below, would be to enable the distributee and non-distributee partners to utilize the increase in minimum gain against partnership deductions.

(c) (1) The Final and Temporary Regulations provide that a net increase in minimum gain is allocated to a nonrecourse liability to the extent of the increase in minimum gain which arose as a result of incurring the liability. If the net increase for a partnership year is allocated to more than one nonrecourse liability and the sum of the amounts so allocated exceeds the total amount of such net increase,

(i) Under the Temporary Regulations the amount of the net increase in minimum gain allocated to each such liability equals the amount determined by multiplying the net increase by a fraction the numerator of which is the amount of net increase which would be allocated to the liability over the sum of the net increases which would be allocated to all such liabilities. Temp. Reg. 1.704-1T(b)(4)(iv)(g)(2);

(ii) Under the Final Regulations, the net increase is allocated among the liabilities on a pro rata basis based on the outstanding balance of each liability. Reg. 1.704-2(h)(1).

(2) If the aggregate increases in the minimum gain for all nonrecourse liabilities exceed the sum of distributions and losses for the year,

(i) The excess ("excess allocable amount") is carried over to the next succeeding year and is absorbed to the extent of the sum of distributions and losses for that year in generating a net increase in total partnership minimum gain, and

(ii) If there is not a 100% absorption in the next year, the absorption is prorated among all nonrecourse liabilities in proportion to the amount each liability contributed to the increase in minimum gain. Reg. 1.704-2(h)(4); Temp. Reg. 1.704-1T(b)(4)(iv)(g)(3).

(d) The determination of to whom excess financing proceeds are distributed can be done under any reasonable method. The regulations state that the interest allocation rules of Reg. 1.163-8T (tracing the loan proceeds) is a reasonable method. Reg. 1.704-2(h)(2); Temp. Reg. 1.704-1T(b)(4)(iv)(g)(4). This method determines to which partner the minimum gain generated by the excess financing must be allocated.

6. (a) In the case of tiered partnerships, the Final and Temporary Regulations provide that an upper tier partnership's increase or decrease in its share of a lower tier partnership's minimum gain is an increase or decease, respectively, in the minimum gain of the upper tier partnership. Reg. 1.704-2(k)(1) and (2); Temp. Reg. 1.704-1T(b)(4)(iv)(j).

(b) Also, proceeds of nonrecourse debts of the lower tier partnership distributed to the upper tier partnership are treated as proceeds of a nonrecourse liability of the upper tier partnership. Reg. 1.704-2(k)(3).

(c) All nonrecourse deductions of the lower tier partnership allocated to the upper tier partnership are treated as depreciation or cost recovery deductions with respect to property owned by the upper tier partnership subject to a nonrecourse liability.

7. (a) A special rule has been added by the Final Regulations to reflect a revaluation of partnership property subject to a nonrecourse debt occasioned by the admission of a new partner, contribution of property by an existing partner, withdrawal of an old partner or as of calendar year 1987. (Reg. 1.704-1(b)(2)(iv)(d), (f) and (r)). Reg. 1.704-2(d)(4), 1.704-2(m) Ex. 3(iii).

(b) If the capital accounts are so increased or decreased:

(i) The net decrease or increase in partnership minimum gain using the current year's book values and the prior year's partnership minimum gain amount is first determined.

(ii) Any decrease attributable solely to the revaluation is added back so that the revaluation will not trigger a minimum gain chargeback.

Restated book values thereafter are used to determine net increases and decreases in minimum gain. However, the revaluation is based on the fair market value of the partnership's assets which, as to property subject to nonrecourse debt, is not less than the nonrecourse mortgage balance. Reg. 1.704-1(b)(2)(iv)(f)(1); I.R.C. 7701(g). Consequently, all revaluations eliminate all minimum gain, but because of the above special rule no minimum gain chargeback is triggered.

D. Example.

To illustrate, assume that on January 15, 1992 G and L form a limited partnership (L being the limited partner) with G contributing $10,000 cash and L contributing $90,000 cash for interests in operating profits, losses and cash flow of 10% and 90% throughout the partnership's term, respectively, and in gains on sale of 10% and 90%, respectively, until L's positive capital account balance equals $90,000 less refinancing cash flow distributed to L during the partnership's term, and thereafter gains would be allocated 50%-50%.

The agreement provides that capital accounts will be maintained and liquidating distributions will be made in accordance with positive capital account balances pursuant to Reg. 1.704-1(b)(2)(ii)(b)(l) and (2), that G is required to eliminate the deficit in his capital account within 90 days after the final liquidating distribution as to his interest but L is not so required (nor is he required to make any other capital contributions) and the agreement contains a qualified income offset.

The agreement also provides that if there is a net decrease in either G's or L's share of partnership "minimum gain", he will be allocated items of gross income and gain on sale equal to his share of the reduction in minimum gain. The agreement provides further that L will not be distributed any cash if the effect thereof is to cause the deficit in his capital account to exceed his share of minimum gain nor will L be allocated any losses if the effect thereof is to cause his deficit capital account balance to exceed his share of minimum gain.

The Partnership enters into a 99 year ground lease of vacant property at a rent of $10,000 per year (with rent commencing on completion of improvements) and constructs an office building on it at a cost of $500,000, $450,000 of which is financed with a nonrecourse loan from a qualified lender, interest-only at 10% per annum for the first 5 years with principal amortized in equal, annual principal payments over 15 years ($30,000/year) plus 10% per annum interest on the unpaid principal balance. The building is completed on January 1, 1993 and no income or loss is sustained for 1992.

The operating results for the first five years are as follows:

Calendar

Year:

1993

1994

1995

1996

1997

Rent

$20,000

$25,000

$30,000

$40,000

$45,000

Operating Expense

10,000

15,000

20,000

25,000

30,000

Interest

45,000

45,000

45,000

45,000

45,000

Depreciation (S/L)

15,873

15,873

15,873

15,873

15,873

Total Expenses

$70,873

$75,873

$80,873

$85,873

$90,873

Loss

$(50,873)

$(50,873)

$(50,873)

$(45,873)

$(45,873)

Cash flow deficits are covered by recourse loans from the General Partner repayable commencing in the 6th year with interest of 10% per annum. Under Sections 267(a)(1) and (e)(1)(B)(i), however, the interest thereon is not deductible until paid, absent the possible application of Section 7872(b). See, Prop. Reg. 1.7872-4(f). No cash distributions are made to G or L during the first 5 years.

(a) Does this partnership satisfy the requirements of Reg. 1.704-2(e)?

(1) Paragraphs (1) and (4) appear to be satisfied since capital accounts will be maintained and liquidating distributions will be made in accordance with them and there is a qualified income offset.

(2) Paragraph (2) seems to be satisfied since the allocation of deductions and gain on disposition attributable to nonrecourse debt is the same as the general profit-loss sharing allocation.

(3) Paragraph (3) ("minimum gain chargeback") is satisfied by allocating all items of gross income and gain to L and G equal to their shares of any reduction in minimum gain.

(b) The capital accounts would apparently be maintained.

(c)(i) If before the end of 1997 the partnership had refinanced its nonrecourse mortgage with a new nonrecourse mortgage having a principal balance of $550,000 and it retained the excess $100,000 refinancing proceeds for working capital needs, the increase in minimum gain attributable to the refinancing and operations would be $115,873 ($550,000 -$420,635 = $129,365 - $13,492 = $115,873). Reg. 1.704-2(d)(3), 1.704-2(h). However, because no part of excess refinancing proceeds were distributed to the partners in 1997, that increase is treated as nonrecourse deductions which can then be taken into account in 1997 up to the partnership's 1997 loss of $45,873, i.e., the entire 1997 loss would be deemed attributable to nonrecourse deductions, and the allocations of the 1997.

(ii) If the $100,000 of excess financing proceeds had been distributed in 1997 entirely to G, the extra $30,000 of operating losses (apart from depreciation) would generally not be treated as nonrecourse deductions since conceptually they would have been deemed funded with the recourse debt from G to the partnership. Thus, L would not have borne this loss. However, as noted above, the partnership could elect not to treat this distribution as attributable to nonrecourse debt so as to permit L the same level of deductions he would have had if the loan proceeds were not distributed.

(iii) If the excess financing proceeds had been distributed $10,000 to G and $90,000 to L, the increase in minimum gain of $115,872 would have been fully taken into account in 1997, unless the partnership elected not to treat the $10,000 distributed to G as allocable to nonrecourse debt. However, because L's capital account, immediately after the distribution but before his allocation of the 1997 loss, would be ($102,143) and his share of total minimum gain at that point would be $116,428 [$90% x $129,365], his share of 1997 loss would nevertheless be limited to only ($14,285) as was the case absent a refinancing. The election not to treat the $10,000 distributed to G as derived from nonrecourse refinancing would apparently permit L an additional $9,000 of loss (90% x $10,000 undistributed loan proceeds).

(iv) Consequently, an excess refinancing of nonrecourse debt helps limited partners if the proceeds thereof are not distributed.

(d) (1) If the income and operating expense figures for 1998 were identical to those for 1997, as shown in Paragraph (b) above, but at the beginning of 1998 principal of $30,000 is paid on the nonrecourse mortgage, the taxable income of the partnership would be computed.

(2) If in (d)(1) above the $30,000 of principal reduction came from a capital contribution from G, pursuant to the exception set forth in Reg. 1.704-2(f)(3), 1.704-2(m) Ex. 1(iv), the allocations for 1998.

(e) Assume the above agreement had been modified at inception so that there were no limitations in the agreement on cash distributions or loss allocations to L, even if they caused a deficit in his capital account to exceed his share of minimum gain. You are asked to prepare the partnership's 1994, 1995, 1996 and 1997 returns. Assuming the fair market value of the property at December 31, 1994, 1995, 1996 and 1997 were as follows:

   Date:     Fair

December 31st Market Values

1994   $600,000

1995   $700,000

1996   $800,000

1997   $900,000

(1) Could you ethically prepare those returns allocating to L the full amount of losses he would be allocated under the partnership agreement? What if fair market values equaled adjusted basis?

(2) If so, what type of disclosure on the return should you provide?

In Young v. Commissioner, T.C. Memo. 1987-397, 54 T.C.M. (CCH) 119 (1987), aff'd, 923 F.2d 719 (9th Cir. 1991), the Tax Court and Ninth Circuit refused to apply a book up of capital accounts because no authority for that was cited. However, the pre-1976 Act regulations in defining "substantial economic effect" provided:

"[W]hether the allocation has substantial economic effect, that is, whether the allocation may actually affect the dollar amount of the partners' shares of the total partnership income or loss independently of tax consequences." Reg. 1.704-1(b)(2) (1964). (Emphasis Added.)

However, the court in this case determined that liquidating distributions were not to be made in accordance with positive capital account balances so even if the capital accounts could be marked to fair market value, the allocations would still have lacked economic effect.

(f) If the partnership agreement contained a special allocation of depreciation 1% to G and 99% to L with first gains on sale (up to the aggregate amount of depreciation deducted by the partnership) allocated 1% to G and 99% to L, with the next amount of gains until L's positive capital account balance equals $90,000 (less refinancing cash flow distributed to L during the partnership's term) allocated 10% to G and 90% to L and with remaining gains allocated 50% to G and 50% to L, is the consistency requirement of Reg. 1.704-2(e)(2) satisfied?

Here 10% of the building cost ($50,000) was funded with the capital contributions of the partners. Although depreciation is a "significant item" with respect to the property securing nonrecourse liabilities, is 10% of total depreciation (attributable to the partners' equity interests in the building) significant? Note that Orig. Reg. 1.704-1(b)(5) Ex. 20(ii) indicates that a 20% equity and recourse investment would be significant. Temp Reg. 1.704-1(b)(5) Ex. 20 (iii) and Reg. 1.704-2(m), Ex. 1(iii) provides that a 99% share of nonrecourse deductions is not reasonably consistent with a 90% interest in other items of income gain, loss and deduction.

VII. Allocating Nonrecourse Liabilities

A. Allocation Rules.

Reg. 1.752-3 which governs the allocation of nonrecourse liabilities utilizes the section 704 concepts of "minimum gain" and "built-in gain." A partner's share of nonrecourse liabilities equals the sum of:

(1) The partner's share of minimum gain determined in accordance with the rule of section 704(b) and its regulations. Minimum gain is the excess of nonrecourse liability secured by any property over the property's adjusted basis. The "partnership minimum gain" for a nonrecourse liability is the gain the partnership would realize if the property was sold for an amount equal to the liability. Reg.  1.704-2(d). If the partnership has more than one nonrecourse liability, partnership minimum gain is the sum of the minimum gain computed for all nonrecourse liabilities;

(2) The amount of any taxable gain that would be allocated to the partner under section 704(c) if the partnership disposed of all partnership property (in a taxable transaction) subject to nonrecourse liabilities, in full satisfaction of the liabilities and for no other consideration; and

(3) The partner's share of the excess nonrecourse liabilities (those not allocated above) in accordance with the partner's share of partnership profits.

Accordingly, each partner's share of nonrecourse liabilities is the sum of (1) his or her share of minimum gain, (2) his or her section 704(c) taxable gain, and (3) his or her share of the partnership's excess nonrecourse liabilities.

On January 13, 2000, the Treasury Department issued proposed regulations revising the allocation of nonrecourse liabilities under the three tier system. Prop. Reg. 1.752-3. The proposed regulations do not alter the allocation of nonrecourse liabilities under tier-1 or tier-2. However, under tier-3, the proposed regulations provide that, to the extent allocable to property subject to the nonrecourse liability, the partnership may first allocate the excess nonrecourse liabilities to any partner to the extent that the partner has section 704(c) built-in gain in excess of the section 704(c) taxable gain allocated to that partner under tier-2. Any remaining excess nonrecourse liabilities would then be allocated to each partner in accordance with the partnerís share of partnership profits.

B. Allocations of Debt When There is Contributed Property.

Section 704(c)(1)(A) provides that income, gain, loss, and deduction with respect to property contributed to a partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. Under the implementing regulations, a partnership, subject to general anti-abuse rules, has an option of three methods to accomplish the section 704(c) requirement -- the traditional method, the traditional method with curative allocation, and the remedial method.

In Revenue Ruling 95-41, 1995-23 IRB. 5, the Service provided guidance concerning the allocation of nonrecourse liabilities when property subject to a liability is contributed to a partnership. The Ruling points out that generally there will be no tier-1 allocation on formation because the partnership has no minimum gain. As to tier-2 -- section 704(c) minimum gain - the amount allocated will depend upon the section 704(c) method utilized by the partnership. If the remedial method is elected, the contributing partner is allocated nonrecourse liabilities in tier-2 equal to the fair market value of the contributed property in excess of its tax basis. In contrast, if the traditional or the traditional with curative allocation are elected, the amount allocated to the contributing partner under tier-2 is merely the excess of the non-recourse liability over tax basis.

As to tier-3, the Ruling states that the partnersí agreement to share the profits of the partnership is one fact to be considered in making the determination. Another fact to be considered is a partnerís share of section 704(c) built-in gain to the extent that the gain was not taken into account in making an allocation of liabilities under tier-2. However, the Ruling makes clear that the amount of section 704(c) built-in gain is not determinative for purposes of allocation of tier-3 liabilities.

This article is intended to provide the reader with general information and should not be considered a substitute for legal advice or opinion. Readers are advised not to act upon this information without seeking professional counsel.

For more information, please call M. Celeste Pickron, Sutherland Asbill & Brennan LLP, 999 Peachtree Street, NE, Atlanta, GA 30309, Phone: 404.853.8222, mcpickron@sablaw.com

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Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) Ė meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with ďno disclosureĒ in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a userís hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friendís name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our usersí information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a userís personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that userís personal data provided to us. This can usually be done at the ďYour ProfileĒ page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.