United States: IRS Proposes Regulations On Disguised Sales And Allocations Of Partnership Liabilities

The IRS has issued long-awaited proposed regulations (REG-119305-11) addressing allocations of partnership liabilities under Section 752 and certain rules concerning disguised sales of property to and from a partnership under Section 707. The Section 752 piece of the proposed regulations could have the effect of changing fundamentally the manner in which some partnership liabilities have been allocated to partners, and in turn could affect a partner's ability to deduct losses and receive tax-free cash distributions from the partnership.

Allocations of partnership recourse liabilities

The proposed regulations replace the presumption that all partners and related persons will satisfy their payment obligations with requirements intended to establish commercial reasonableness. Under the proposed regulations, two main requirements must be met for the payment obligation of a partner or related person to be recognized for purposes of Section 752: (1) The payment obligation must satisfy a minimum net value requirement, and (2) the payment obligation of the partner or the related person must meet six specific requirements, which are as follows:

1. The partner or related person must maintain a commercially reasonable net worth for the entire term of the payment obligation or must be subject to commercially reasonable restrictions on transfers of assets for nominal consideration.

2. The partner or related person must periodically document the financial condition.

3. The term of the payment obligation must not end before the term of the partnership liability.

4. The payment obligation must not require that the partnership or any other obligor hold liquid assets that exceed the obligor's reasonable needs.

5. The partner or related person must receive arm's-length consideration in exchange for assuming the payment.

6. In the case of a guarantee, the partner or related person must be liable up to the full amount of the payment obligation if any amount of the partnership liability is not satisfied, and in the case of an indemnity, the partner or related person must be liable up to the full amount of the payment obligation if any payment is made by the indemnitee or other benefited party.

The sixth requirement concerning guarantees essentially makes bottom-dollar guarantees ineffective for purposes of partnership liability allocations. The net value requirement would operate to turn off the general presumption that all partners and related persons will actually satisfy their payment obligations, irrespective of their net worth (unless the facts and circumstances indicate a plan to circumvent or avoid the obligation). Under the proposed regulations, the net value requirement would apply to all taxpayers other than individuals and estates of individuals, and would not apply with respect to payment obligations relating to trade payables of a partnership. Previously, the net value requirement applied only with regard to partnership interests held by disregarded entities.

The proposed regulations include an anti-abuse rule under which a payment obligation would not be recognized if the partnership liability is part of a plan involving the use of "tiered partnerships, intermediaries, or similar arrangements" to convert a single liability into more than one liability with a principal purpose of circumventing the rules concerning guarantees and indemnities (the sixth requirement listed above).

Allocations of partnership nonrecourse liabilities:

The proposed regulations would modify how nonrecourse liabilities are allocated in the third tier (Treas. Reg. Sec. 1.752-3) by replacing two optional approaches for determining a partner's share of partnership profits with an alternative method focused on partners' relative interests in the liquidation value of the partnership. This alternative method would look to a partner's liquidation value measured at formation or at a revaluation event.

Disguised sale rules

The proposed regulations would (1) add amendments or clarifying changes to certain widely used exceptions to a disguised sale treatment, (2) add an additional type of qualified liability and (3) address certain technical aspects that can give rise to ambiguities under the existing regulations. Notably, the proposed regulations would make three changes to the preformation capital expenditure reimbursement exception to a disguised sale:

1. The fair market value limitation and tax basis test would apply on a property-by-property basis.

2. The term "capital expenditures" would be defined to include capital expenditures that the taxpayer previously elected to deduct but to exclude deductible expenses the taxpayer elected to capitalize.

3. The taxpayers would be precluded from "double-dipping" when a preformation capital expenditure is funded with borrowing and economic responsibility for the borrowing is shifted to another partner upon the assumption of the liability by the partnership.

Effective dates

Generally, the provisions are proposed to be prospective (tied to the date final regulations are published). However, the IRS anticipate that the final regulations under Section 752 will permit a partnership to apply the provisions in the final regulations to all of its liabilities as of the beginning of the first taxable year of the partnership ending on or after the date the regulations become final. Additionally, the proposed regulations provide transitional relief for any partner whose allocable share of partnership liabilities under Treas. Reg. Section 1.752-2 (recourse liability sharing) exceeds its adjusted basis in its partnership interest on the date the final regulations are issued. Under the transitional rule, the partner generally would be permitted to continue to apply the existing regulations for seven years from the date the proposed regulations are made final.


The proposed regulations would tighten the ability of taxpayers to be viewed as having economic risk of loss under the Section 752 regulations. In some respects, the proposed provisions under Section 752 may present challenges to taxpayers who relied on guarantees and indemnities to obtain basis in their partnership interests. On the other hand, if a liability becomes a nonrecourse liability under the Section 752 regulations because of the application of these proposed regulations, then some taxpayers may have opportunities to make use of the additional tax basis afforded by the shift in liability allocations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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