United States: IRS Issues Final, Temporary And Reproposed Regulations On Disguised Sales And Liability Allocations

The IRS has issued much anticipated guidance concerning disguised sales of property involving partnerships under Section 707 and the determination of whether an obligation is a recourse liability under Section 752.

The guidance package includes final, temporary and proposed regulations and comes nearly three years after the IRS initially proposed regulations in January 2014 that were widely perceived as having the potential to fundamentally change whether certain obligations result in a partner's economic risk of loss (EROL) for a partnership liability under Section 752, which in turn affects a partner's ability to deduct losses and receive tax-free cash distributions from the partnership.

The final regulations (T.D. 9787) address certain rules concerning disguised sales of property to and by a partnership and allocations of excess nonrecourse liabilities to partners for purposes of the disguised sale rules. The temporary regulations (T.D. 9788) address how liabilities are allocated for purposes of Section 707 and when certain obligations are recognized for purposes of determining whether a liability is a recourse partnership liability under Section 752. The proposed regulations (REG-122855-15) incorporate by reference the text of the temporary regulations and offer new reproposed regulations concerning when certain obligations to restore a deficit in a partner's capital account are disregarded under Section 704 and when partnership liabilities are treated as recourse liabilities under Section 752.

Disguised sale provisions

The regulations on disguised sales are intended to address certain deficiencies and ambiguities under Section 707. The existing disguised sale regulations provide several exceptions, such as reimbursements for preformation capital expenditures and debt-financed distributions, as well as the exclusion of certain liabilities (qualified liabilities), or portions thereof, from disguised sale treatment. The final regulations provide modifications to certain of these exceptions.

Under the existing disguised sale rules, transfers of money or other consideration from a partnership to reimburse a partner for certain capital expenditures and costs incurred by the partner are excluded from being treated as part of a disguised sale, subject to certain limitations based on the fair market value (FMV) of property (fair market value limitation) that also involves looking at the partner's adjusted basis in the contributed property (tax basis test). The final regulations provide the following modifications:

  • The FMV limitation and tax basis test would apply on a property-by-property basis. However, the final regulations permit aggregation for small amounts, and where the partner uses a reasonable aggregation method that is consistently applied, and the aggregation of property is not part of a plan of which a principal purpose is to avoid the disguised sale rules.
  • 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.
  • The taxpayers would be precluded from "double-dipping" when a preformation capital expenditure is funded with any qualified liability, and economic responsibility for the qualified liability is shifted to another partner upon the assumption of the liability by the partnership.

Another area the temporary and final regulations are intended to address involves leveraged partnership transactions in which the contributing partners or related persons enter into payment obligations that are not genuinely commercial solely to achieve an allocation of the partnership liability to the partner with the objective of avoiding a disguised sale.

The existing disguised sale rules also provide an exception for debt-financed distributions. The existing rules provide that if a partner transferred property to a partnership, and the partnership incurred a liability, the proceeds of which are traceable to that partner, the partner's consideration for disguised sale proceeds would be only to the extent that the money exceeded the partner's allocable share of liabilities. Thus, if the liability were recourse for purposes of Section 752 to the contributing partner, the contributing partner would be effectively shielded from the disguised sale rules.

The temporary regulations now provide that all liabilities are to be treated as nonrecourse under Section 752 for purposes of the disguised sale rules, and they are allocated in the manner in which excess nonrecourse liabilities are allocated under Treas. Reg. Sec. 1.752-3(a)(3), solely in accordance with the partners' allocable share of partnership profits. This represents a major change to the tax impact of liabilities in disguised sale analyses, which will limit significantly the tax usefulness of leveraged distributions in connection with the contribution of property. That is, a distributee partner's guarantee or other similar obligation will no longer cause the debt related to the debt-financed distribution to be allocated solely to such partner, and the cash proceeds in excess of the partner's allocable share of such debt will be treated as received as part of a taxable sale of a portion of the property to the partnership. An exception in the final regulations is provided for small shifts in nonqualified liabilities to prevent pitfalls. Qualified liabilities are not taken into account as consideration in transfers of property treated as a sale when the total amount of all liabilities other than qualified liabilities that the partnership assumes is the lesser of 10% of the total amount of all qualified liabilities the partnership assumes, or $1 million. Additionally, a partner's share of a partnership liability for purposes of the disguised sale rules does not include any amount of the liability for which another partner bears the EROL for the partnership liability.

Another notable change in the final regulations is a "step-in-the-shoes" rule for applying the exception for preformation capital expenditures 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 transfer under Sections 351, 381(a), 721 or 731.

Recourse liabilities under Section 752 and bottom dollar payment obligations

The temporary regulations restrict "bottom dollar payment obligations" from being recognized as a recourse liability under Treas. Reg. Sec. 1.752-2(b)(3). A bottom dollar payment obligation is a payment obligation other than one in which the partner or related person would be liable for up to the full amount of such partner's payment obligation if any amount of the partnership liability were not satisfied. The temporary regulations provide a few exceptions for certain arrangements:

  • If the partner or related person is liable for at least 90% of the partner's initial payment obligation after taking into account the indemnity, reimbursement agreement or similar arrangement
  • If a maximum amount is placed on the partner's payment obligation
  • If a partner's payment obligation is stated as a fixed percentage of every dollar of the partnership liability to which such obligation relates
  • If there is a right of proportionate contribution running between partners or related persons who are co-obligors with respect to a payment obligation for which each of them is jointly and severally liable

Anti-abuse rule

In response to concerns expressed by commentators with the 2014 proposed regulations, the new proposed regulations replace the seven specific requirements for a partner's payment obligation to be respected with an anti-abuse rule in Treas. Reg. Section 1.752-2(j). The factors in the anti-abuse rule of the new proposed regulations are weighed to determine whether a payment obligation should be respected under Section 752. The list of factors is non-exclusive, and the weight to be given to any particular factor depends on the particular case. The presence or absence of a particular factor is not necessarily indicative of whether or not a payment obligation is recognized for purposes of Section 752.

This departure from the 2014 proposed regulations was made to address concerns that a partner could manipulate contractual arrangements to achieve a federal income tax result that is inconsistent with the economics of the arrangement (e.g., deliberately failing one of the requirements under the 2014 proposed regulations, causing a partnership liability to be treated as nonrecourse under Section 752 even though one partner has true EROL). To combat this, the temporary regulations grant the IRS the authority in an anti-abuse rule to ensure that a liability will be treated as recourse under Section 752 if a partner truly has EROL.

Effective date

The final regulations under Section 707 apply to any transaction with respect to all transfers that occur on or after Oct. 5, 2016. The final regulations under Section 752 apply to liabilities that are incurred by a partnership, that a partnership takes property subject to or that are assumed by a partnership on or after Oct. 5, 2016, unless pursuant to a written binding contract in effect prior to that date.

The temporary regulations under Section 707 apply to any transaction with respect to all transfers that occur on or after Jan. 3, 2017. The temporary regulations under Section 752 apply to liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken with respect to a partnership liability on or after Oct. 5, 2016, unless pursuant to a written binding contract in effect prior to that date. Partnerships may elect to apply all the provisions contained in the Section 752 temporary regulations to all their liabilities as of the first taxable year of the partnership ending on or after Oct. 5, 2016. The temporary regulations provide a seven-year transition relief for any partner whose allocable share of partnership recourse liabilities exceeds its adjusted basis in its partnership interest on the date the temporary regulations are finalized.

The proposed regulations would be effective on the date the final regulations are published and would be applicable to any liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability.

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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