The Treasury Department and the IRS this week released a package of partnership tax regulations regarding Section 707 disguised sales and Section 752 debt allocations1 that include significant changes to previously proposed regulations published in early 2014 (the "2014 proposed regulations").
The new regulations effectively put an end to tax-deferred leveraged partnership transactions in which a partner could contribute appreciated property to a partnership in exchange for cash proceeds from partnership borrowings that remain "recourse" to the contributing partner that is responsible for payment of the debt under state law, a guarantee or other similar arrangement. Although a distribution of cash to a partner upon contribution would generally be treated as "disguised sale" proceeds, an exception provides that a distribution won't be treated as such if the distribution is traceable to partnership debt and the amount of the distribution does not exceed the partner's allocable share of the debt incurred to fund the distribution.
The temporary Section 707 regulations now treat all partnership debt as "nonrecourse" for purposes of the disguised sale rules by generally requiring that partnership debt be allocated to a contributing partner for these purposes in accordance with the partner's share of partnership profits, rather than the full amount of the debt, effectively ending the advantage of the leveraged partnership transaction. This change will apply to any transaction in which all transfers occur on or after January 3, 2017.
In addition to this fundamental change to the disguised sale rules, the remaining final and proposed regulations address several technical aspects of the disguised sale rules, target "bottom-dollar" guarantees, and make several other notable changes, including with respect to capital expenditure reimbursements. These new rules are complex, voluminous and in some cases will be difficult to apply.
Temporary Section 707 Regulations Impact Debt-Financed Distributions
A contribution of property to a partnership in exchange for a partnership interest is generally a tax-deferred transaction. However, if a partner contributes property to a partnership that distributes cash or other property to the partner within two years, the disguised sale rules under Section 707 presume that the transaction was really part of a taxable sale. One (of many) exceptions to disguised sale treatment generally provides that a distribution of money to a partner is not treated as disguised sale proceeds if the distribution is traceable to a partnership borrowing and the amount of the distribution does not exceed the partner's allocable share of the debt incurred to fund the distribution (the "debt-financed distribution exception").
The underlying reason for the changes in the disguised sale regulations appears to stem from IRS concerns that leveraged partnership transactions often involved taxpayers that entered into non-commercial terms to guarantee debt solely to treat the debt as recourse to the contributor for tax purposes, thereby avoiding disguised sale treatment on debt-financed distributions.
Thus, in the temporary Section 707 regulations, the IRS now treats all partnership debt as nonrecourse for purposes of the disguised sale rules and generally requires that partnership debt be allocated to partners in accordance with their share of partnership profits. The temporary Section 707 regulations accomplish this by requiring partners to determine their share of any liability in the manner in which excess nonrecourse liabilities are allocated under Treas. Reg. §1.752-3(a)(3) based on the partner's share of partnership profits. Furthermore, a partner's share of the partnership debt will not take into account any amount of the partnership's debt for which another partner bears the economic risk of loss. Now, in a leveraged partnership transaction, a contributing partner may receive a partnership debt-financed cash distribution, but it will be tax-deferred only to the extent of the contributor's share of profits in the partnership, effectively ending the advantage of the leveraged partnership transaction. This change will apply to any transaction in which all transfers occur on or after January 3, 2017.
Allocations of Nonrecourse Liabilities for Purposes of the Disguised Sale Rules
As discussed above, the temporary Section 707 regulations treat all partnership debt as nonrecourse for purposes of the disguised sale rules and instead generally require that partnership debt be allocated in the manner in which "excess nonrecourse liabilities" are allocated under Treas. Reg. §1.752-3(a)(3) based on the partner's share of partnership profits.
Treas. Reg. §1.752-3(a)(3) generally provides that a partner's share of "excess nonrecourse liabilities" is determined in accordance with the partner's share of partnership profits taking into account all the facts and circumstances relating to the economic arrangement of the partners. Treas. Reg. §1.752-3(a)(3) also provides various specific methods that can be used to determine a partner's share of "excess nonrecourse liabilities." Under one method, the partnership agreement may specify the partners' interests in partnership profits so long as the interests so specified are reasonably consistent with allocations (that have substantial economic effect under the Section 704(b) regulations) of some other significant item of partnership income or gain (the "significant item method"). Alternatively, excess nonrecourse liabilities may be allocated among partners in a manner that deductions attributable to those liabilities are reasonably expected to be allocated (the "alternative method"). Treas. Reg. §1.752-3(a)(3) also provides for a third "additional method," that already explicitly provides that it is inapplicable for disguised sale purposes.
The final Section 752 regulations provide that, in addition to the additional method, the significant item method and the alternative method do not apply for purposes of determining a partner's share of a partnership liability for disguised sale purposes.
Because these specific methods do not apply, the preamble to the reproposed Section 752 regulations specifically discusses that the Treasury Department and the IRS recognize that taxpayers may require further guidance regarding reasonable methods for determining a partner's share of partnership profits under Treas. Reg. §1.752–3(a)(3) for disguised sale purposes and request comments regarding possible safe harbors and reasonable methods that can be used.
For a partnership that has one sharing ratio for allocating partnership profits during the life of the partnership, the application of the new rule will be relatively straight-forward. However, for partnerships with preferred returns, so-called guaranteed payments under Section 707(c), and shifting or "flipping" allocations, the new rule will be difficult to apply in the absence of bright-line safe harbors that clearly apply to that partnership.
Final Section 707 Regulations Clarify Disguised Sale Exceptions and other Ambiguities
Debt-Financed Distribution Exception Ordering Rule
Prior to the final regulations, it was unclear whether the applicability of other disguised sale exceptions would reduce the amount of the distribution traceable to a partnership borrowing for purposes of the debt-financed distribution exception discussed above. Thus, the final Section 707 regulations added an ordering rule, in which the debt-financed distribution exception is applied first, before applying the other exceptions contained in Treas. Reg. §1.707-4.
Reimbursement of Preformation Capital Expenditures
Another exception to disguised sale treatment is for reimbursement of preformation capital expenditures. The underlying rationale of this exception is that if partners incur partnership organization and syndication costs or if partners acquire or improve a property before contributing it to the partnership, those partners should be allowed to be reimbursed for those expenditures without reimbursement distributions being treated as disguised sale proceeds. Thus, transfers to reimburse a partner for certain organization, syndication, and capital expenditures incurred within two years prior to contributing the property to the partnership are not treated as a disguised sale. However, a contributing partner is limited to a reimbursement of 20% of the fair market value of contributed property. This 20% limitation does not apply if the fair market value of the property does not exceed 120% of the property's tax basis.
The final Section 707 regulations address ambiguities regarding the preformation capital expenditures exception. First, they provide that the 20% limitation is applied on a property-by-property basis, to the particular property for which the expenditures were made, and thus the values of all property contributed to the partnership are not aggregated for purposes of determining the amount of this limitation. The IRS and the Treasury Department were concerned that taxpayers were aggregating numerous property contributions for purposes of the 20% limitation when separate property contributions would not qualify for the exception if they were analyzed on a property-by-property basis. However, unlike the 2014 proposed regulations, the final Section 707 regulations recognize the burden of calculating on a property-by-property basis and permit aggregation in certain limited circumstances if: (i) the total fair market value ("FMV") of the aggregated property (of which no single property's FMV exceeds 1% of the total FMV of such aggregated property) is no greater than the lesser of either 10% of the total FMV of all property transferred (excluding money and marketable securities) or $1,000,000; (ii) the partner uses a reasonable aggregation method that is consistently applied; and (iii) the aggregation of property is not part of a plan a principal purpose of which is to avoid the disguised sale rules of Treas. Reg. §§1.707-3 through 1.707-5. Additionally, the final Section 707 regulations add an example to illustrate the application of the property-by-property rule when a partner transfers both tangible and intangible property to a partnership.
The final Section 707 regulations also add a rule coordinating the reimbursement for preformation capital expenditures exception with the qualified liability exception (discussed below). In the past, some taxpayers had argued that under existing regulations they could receive a cash distribution from a partnership in reimbursement of preformation capital expenditures, even though those same preformation expenditures were made using the proceeds of a "qualified liability" that is assumed by the partnership, essentially getting a double benefit. The final Section 707 regulations responded by providing that if any "qualified liability" is used by a partner to fund preformation capital expenditures, and economic responsibility for that borrowing shifts to another partner, the exception for preformation capital expenditures does not apply. In the final Section 707 regulations, capital expenditures are generally treated as funded by the proceeds of a "qualified liability" to the extent the proceeds are either traceable to the capital expenditures or are actually used to fund the capital expenditures.
Under existing regulations, the partnership's assumption of four types of "qualified liabilities" or a partnership's taking property subject to such qualified liabilities in connection with a transfer of property by a partner to the partnership is generally excluded from disguised sale treatment. The final regulations add a new type of qualified liability that will apply if it was "not incurred in anticipation of the transfer of the property to a partnership, but that was incurred in connection with a trade or business in which property transferred to the partnership was used or held but only if all the assets related to that trade or business are transferred other than assets that are not material to a continuation of the trade or business..." Two of the existing "qualified liabilities" had similar language, but also required that the liability encumber the transferred property. The IRS and the Treasury Department believed the requirement that the liability encumber the transferred property was not necessary to carry out the purposes of the disguised sale rules when a liability was incurred in connection with the conduct of a trade or business.
"Step-in-the-Shoes" Rule for Preformation Capital Expenditures and Qualified Liabilities
After the 2014 proposed regulations were released, commentators requested that the final Section 707 regulations clarify how the rules for qualified liabilities and the preformation capital expenditure exception apply if the transferor partner acquired the transferred property in a nonrecognition transaction, assumed a liability in a nonrecognition transaction, or took property subject to a liability in a nonrecognition transaction from another person who incurred the preformation capital expenditures or the liability. Thus, the final Section 707 regulations provide a "step-in-the-shoes" rule for applying the preformation capital expenditures exception and for determining whether a liability is a "qualified liability" when a partner acquires property, assumes a liability, or takes property subject to a liability from another person in connection with a nonrecognition transaction under Section 351, 381(a), 721, or 731.
Current regulations provide that if a lower-tier partnership succeeds to a liability of an upper-tier partnership, the liability in the lower-tier partnership retains the same characterization as either a qualified liability (discussed above) or a nonqualified liability that it had as a liability of the upper-tier partnership. Likewise, if an upper-tier partnership succeeds to a liability of a lower-tier partnership, the liability in the upper-tier partnership retains the same characterization that it had as a liability of the lower-tier partnership.
The final Section 707 regulations add to the tiered-partnership rules by providing that the debt-financed distribution exception (discussed earlier) applies in a tiered partnership setting. The upper-tier partnership's share of the lower-tier partnership's liabilities will be treated as direct liabilities of the upper-tier partnership, and the liabilities will be treated as incurred on the same day as the liabilities were incurred by the lower-tier partnership. The final Section 707 regulations also add that if a partner contributes a lower-tier partnership interest to an upper-tier partnership, a liability of the lower-tier partnership would be a qualified liability to the extent that it would be a qualified liability if the lower-tier partnership had directly contributed its assets and liabilities to the upper-tier partnership.
In response to comments, the final Section 707 regulations also address whose intent (the partner's or the lower-tier partnership's) is relevant for applying the anticipated transfer of property rule when determining whether a liability constitutes a qualified liability in Treas. Reg. §1.707-5(a)(6)(i)(B) or (E). Thus, the final Section 707 regulations provide that in determining whether a liability would be a qualified liability under those provisions, the determination of whether the liability was incurred in anticipation of the transfer of property to the upper-tier partnership is based on whether the partner in the lower-tier partnership (not the partnership) anticipated transferring the partner's interest in the lower-tier partnership to the upper-tier partnership at the time the liability was incurred by the lower-tier partnership.
Also in response to comments, the final Section 707 regulations allow for a "step-in-the-shoes" application of the preformation capital expenditure exception when a person incurs capital expenditures for property, transfers the property to a partnership (lower-tier partnership), and then transfers an interest in the lower-tier partnership to another partnership (upper-tier partnership) within two years of incurring the capital expenditures. The final Section 707 regulations provide that in such a scenario, the person is deemed to have transferred the property (rather than the partnership interest) to the upper-tier partnership for purposes of the preformation capital expenditure exception and, thus, may be reimbursed by the upper-tier partnership to the extent the person could have been previously reimbursed by the lower-tier partnership.
Changes to Section 752 Allocations of Recourse Liabilities
Unless the disguised sale rules apply, cash distributions from a partnership to a partner are only taxable to the extent they exceed the partner's basis in its partnership interest, including the partner's share of the partnership's liabilities. Thus, partners who are allocated a share of a partnership's recourse debt benefit from increased basis in their partnership interest. Under existing rules, a partnership liability is treated as recourse and is allocated to a specific partner if that partner would bear the "economic risk of loss" of that liability if the partnership's assets became worthless and the debt were required to be repaid in full. To meet this economic risk of loss test, partners enter into contractual payment obligations such as guarantees, indemnifications, etc. Existing rules presume that partners and related persons who have payment obligations actually perform those obligations, irrespective of their net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation.
The reproposed Section 752 regulations are intended to establish that the terms of payment obligations (such as guarantees) that are relied on by taxpayers to meet this test are commercially reasonable and are not designed solely to achieve an allocation of a partnership liability to obtain tax benefits. Thus, they added a facts and circumstances test to the anti-abuse rule under which a payment obligation is disregarded if there is a plan to circumvent or avoid such obligations. The reproposed Section 752 regulations provide a non-exclusive list of factors that may indicate a plan to circumvent or avoid the payment obligation, as summarized below:
- The partner or related person is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment
- The partner or related person is not required to provide commercially reasonable documentation regarding the partner's or related person's financial condition
- The term of the payment obligation ends prior to the term of the partnership liability, or the partner or related person has a right to terminate its payment obligation (if the purpose of limiting the duration of the payment obligation is to terminate such payment obligation prior to the occurrence of an event or events that increase the risk of economic loss to the guarantor or benefited party)
- There exists a plan in which the primary obligor or any other obligor (or a person related to the obligor) with respect to the partnership liability holds money or other liquid assets in an amount that exceeds the reasonable foreseeable needs of such obligor
- The payment obligation does not permit the creditor to promptly pursue payment following a payment default, or there are indications of plans to delay collection
- In the case of a guarantee or similar arrangement, the terms of the partnership liability would be substantially the same had the partner or related person not agreed to provide the guarantee
- The creditor or other party benefiting from the obligation did not receive executed documents with respect to the payment obligation from the partner or related person before, or within a commercially reasonable period of time after, the creation of the obligation
Additionally, the Treasury Department and the IRS remain concerned with ensuring that a partner or related person only be presumed to satisfy its payment obligation to the extent that such partner or related person would actually be able to pay the obligation. Thus, the reproposed Section 752 regulations create a new presumption under the anti-abuse rule, whereby evidence of a plan to circumvent or avoid an obligation is deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation that the obligor will have the ability to make the required payments if the obligation becomes due and payable. If evidence of a plan to circumvent or avoid the obligation exists or is deemed to exist, the obligation is disregarded and therefore the partnership liability is treated as a nonrecourse liability.
Temporary Section 752 Regulations Restrict "Bottom-Dollar" Guarantees
As discussed above, under existing Section 752 rules, a partnership liability is treated as recourse and is allocated to a specific partner if that partner would bear the "economic risk of loss" of that liability if the partnership's assets became worthless and the debt were required to be repaid in full. To meet this economic risk of loss test, partners enter into contractual payment obligations such as guarantees, indemnifications, reimbursements, etc. One such payment obligation used by taxpayers was so called "bottom-dollar" guarantees. "Bottom-dollar" guarantees are generally those in which a partner guarantor is not liable for the full amount of the liability and is instead only liable to the extent the lender cannot first collect at least a certain guaranteed amount from the partnership. The Treasury Department and the IRS believe that "bottom-dollar" guarantees should generally not be recognized as payment obligations for these purposes because they lack a significant non-tax commercial business purpose. Thus, the temporary Section 752 regulations retain the restriction on certain guarantees and indemnities from the 2014 proposed regulations and provide that these payment obligations are not recognized under Treas. Reg. §1.752-2(b)(3).
However, in response to comments, the temporary Section 752 regulations clarified the meaning of "bottom-dollar payment obligations," adding a broader factor-based definition. Additionally, the 2014 proposed regulations had an example that would have also treated "vertical slice guarantees" as nonrecourse. A vertical slice guarantee is a promise to pay on some percentage of every dollar borrowed. For example, the 2014 proposed regulations gave an example where a partnership borrowed $1,000, and a partner guaranteed 25% of every dollar of the loan. If the bank did not recover $250 of the $1,000 partnership liability, the partner would only be obligated to pay $62.50 (25% of $250) pursuant to the terms of the guarantee. Commentators noted that such vertical slice guarantees differ from a pure bottom-dollar guarantee in that the partner is on the hook for paying at least something for even the first dollar the bank loses. Thus, the temporary Section 752 regulations provide for an exception for vertical slice guarantees if they meet the other requirements. The temporary Section 752 regulations also provide an exception if, taking into account the indemnity, reimbursement agreement, or similar arrangement, the partner or related person is liable for at least 90% of the initial payment obligation.