United States: New IRS Partnership Regulations Shut Down Bottom Guarantees And Significantly Limit Use Of Leveraged Partnerships


On October 5th, 2016, the Internal Revenue Service and Treasury Department published final, temporary and reproposed regulations1 under Sections 707 and 752 of the Internal Revenue Code of 1986, as amended.2 These regulations, which substantially modify Proposed Regulations from 2014 (the "2014 Proposed Regulations"), effect significant changes to the partnership disguised sale and debt allocation rules.

Notably, the new Final and Temporary Regulations restrict the ability to enter into "leveraged" partnership transactions by modifying the disguised sale rules so as to take into account all liabilities for disguised sale purposes as if such liabilities were nonrecourse, thereby preventing partners from guaranteeing debt in order to avoid recognition of gain. The regulations also preclude the use of "bottom-dollar" guarantees to allocate debt for basis purposes, even outside the context of a disguised sale. These changes, as well as certain other provisions in the Final and Temporary Regulations, are discussed in further detail below.

This Stroock Special Bulletin examines these changes, which are particularly important for those entering into real estate deals involving partnerships or joint ventures, as real estate often has significant debt and built-in gain, which would be recognized on a deemed sale.


The debt allocation rules, under Section 752 and the regulations thereunder, provide methods under which partners determine their share of the partnership's debt, which in turn affects their basis in the partnership. In general, a recourse liability (for which a partner is personally liable, such as by having guaranteed the debt of the partnership) is allocated to that partner under Treas. Reg. Section 1.752-2. Non-recourse liabilities are allocated under three separate tiers pursuant to Treas. Reg. Section 1.752-3:

  • the first tier based on a partner's share of partnership minimum gain (that is gain that would be recognized if the property subject to nonrecourse debt were sold for that nonrecourse debt);
  • the second tier based on a partner's share of built-in Section 704(c) gain (up to the amount of gain on a deemed sale for the amount of the debt); and
  • under the third tier, any excess not allocated under the first two tiers, based on a partner's allocable share of partnership profits, or pursuant to any of several additional methods should the partnership so choose.

It is important for partners to have basis allocated to them because it permits them, to the extent of such basis, to receive distributions of cash, or potentially sell interests in the partnership, without incurring tax.

The disguised sale rules, under Section 707 and the regulations thereunder, relate to certain transactions that otherwise would be cast in the form of a contribution of assets to a partnership, and recharacterize those transactions as a partial or complete sale of the assets by the partner to the partnership, by the partnership to the partner, or by one partner to another. The general rule provides that a transfer or transfers of property to a partnership and a transfer or transfers of cash to the contributing partner (or vice versa) are presumed part of a deemed sale transaction if engaged in within two years of each other.

In addition, if "non-qualified" liabilities are assumed by the partnership and allocated to partners other than the contributing partner, the relief from these non-qualified liabilities is treated as part of a disguised sale. Significant tax planning in the partnership area revolves around avoiding disguised sales on contributions to partnerships, often by permitting partners to guarantee partnership debt in order to avoid the shifting of liabilities or to otherwise increase their basis in the partnership.

Leveraged Partnerships Restricted

The Temporary Regulations under Section 707 restrict, to the point of potentially eliminating, one common method previously utilized to avoid a disguised sale: leveraged partnership transactions, in which the contributing partner guarantees all or a portion of the debt on the contributed property. This guarantee results in the guaranteed liabilities being allocated only to the contributing partner, thereby preventing a deemed cash distribution to the contributing partner – which, as discussed above, could trigger a disguised sale. The Temporary Regulations, however, provide that, for disguised sale purposes, a partner's share of any partnership liability, whether recourse or nonrecourse, is determined using the same percentage (based on partnership profits only) used to determine the partner's share of the partnership's excess nonrecourse liabilities under Section 1.752- 3(a)(3).3 That is, the contributing partner's guarantee would be disregarded for disguised sale purposes, and, because such partner cannot have a 100 percent interest in partnership profits, some portion of the liabilities would shift to another partner.

It should be noted that, per the above, some amount of both qualified and non-qualified liabilities4 may shift, and that even a de minimis amount of non-qualified liability shifting could trigger taxable consideration treatment for a portion of the qualified liabilities. To mitigate this result, the Final Regulations include a rule under 1.707-5(a)(5) that does not take into account qualified liabilities as consideration in transfers of property treated as a sale (if such sale treatment is due solely to the partnership's assumption of non-qualified liabilities) when the total amount of all non-qualified liabilities that the partnership assumes is the lesser of (a) 10 percent of the amount of qualified liabilities assumed, or (b) $1,000,000. Nevertheless, in the majority of circumstances under which partners would previously have been able to benefit from a leveraged partnership transaction, such benefit may no longer be achieved due to disguised sale treatment.

One major implication of this change is that alternative structures to transfer interests in assets to or from a partnership will need to be relied on (and will likely see an increase in popularity). For example, holding property in a partnership for a period of years gains additional value: if there is an existing partnership – with all contributions made at least two years ago5 – a new partner can contribute cash into such a partnership and cash distributions can be made to the existing partners, to the extent of their basis, generally without triggering disguised sale tax consequences.

The Temporary Regulations under Section 707, described above, are effective for any transaction occurring on or after January 3, 2017 (90 days after the publication in the Federal Register).

Bottom Guarantees Not Respected

The Temporary Regulations provide, under Section 752, that so-called "bottom-dollar guarantees," under which an obligation is guaranteed only to the extent that the lender recoups a total less than the guaranteed amount, are not recognized for purposes of 1.752-2(b)(3), and thus do not permit such liabilities to be allocated to the guarantor under the "recourse" rules of 1.752-2. The Treasury Department and the IRS believe that these obligations generally lack a significant non-tax business purpose.

Consistent with the 2014 Proposed Regulations, "vertical slice" guarantees (under which a percentage of each dollar of debt is guaranteed) and obligations that would otherwise be full guarantees but for a cap on the maximum obligation to the guarantor are not treated as bottom-dollar guarantees under the Temporary Regulations. Additionally, the Temporary Regulations provide an exception for situations in which a bottom-dollar guarantee is created due to an indemnity or reimbursement arrangement that relieves the guarantor of 100 percent of the liability.

In such cases, if the partner is liable for at least 90 percent of the initial payment obligation, and the obligation is otherwise recognized as recourse under 1.752-2, the Temporary Regulations provide that the guarantee will not be disqualified as a bottom-dollar guarantee. For example, if Partner A guarantees 100 percent of a partnership liability and Partner B indemnifies Partner A for the first 1 percent, Partner A's guarantee technically becomes a guarantee of the bottom 99 percent, but the rules do not treat it as a disqualified bottom guarantee, but rather respect it under the logic that the amount for which Partner A is not responsible is sufficiently de minimis. Note, however, that if Partner A engaged in a direct guarantee of the bottom 99 percent, without any cross-indemnity to create it, such guarantee would not be respected under these rules.6

The non-disqualified types of guarantees discussed above may become more common, as may other guarantees not precluded by the new regulations such as credit line guarantees – since at least in theory these types of non-disqualified guarantees involve real risk to the guarantor (unlike a bottom guarantee, where the risk to the guarantor is relatively low).

Although the 2014 Proposed Regulations contained certain provisions pertaining to contingent liabilities, the Temporary Regulations reserve comment on the treatment of contingent liabilities. The Treasury Department and IRS note that guidance is warranted and should be forthcoming after further study.

The Temporary Regulations under Section 752, described above, apply to any liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken with respect to a partnership liability on or after October 5, 2016, other than those pursuant to a written binding contract in effect prior to that date.

The Temporary Regulations under 1.752-2 also provide transitional relief for any partner whose allocable share of partnership liabilities under §1.752-2 exceeds that partner's adjusted basis in its partnership interest on October 5, 2016. Under this transitional relief, the partner can continue to apply the existing regulations under §1.752-2 with respect to a partnership liability for a seven-year period to the extent that the partner's allocable share of partnership liabilities exceeded its adjusted basis in its partnership interest on such date.7

Some commenters have noted that there is confusion as to what the transitional rules are intended to address, given that the Temporary Regulations only apply to liabilities and obligations after the effective date (thus pre-existing liabilities would already continue to operate under the old rules). We believe one possible set of circumstances is a refinancing or modification of a loan, wherein the terms of the loan are altered or the debt refinanced with a different lender. In such a scenario, there would be a "new" loan, even though such loan would be substantially similar to the pre-existing loan. If not for the transitional rule, the new Temporary Regulations would apply to such loan and preclude a bottom guarantee on the indebtedness where one might have existed before, so that a partner who previously was a bottom guarantor would have a lower share of the debt after the refinancing and would be treated as receiving a constructive cash distribution, which would be recognized as income to the extent it exceeded his/her basis.

The Treasury, in the preamble to the Temporary Regulations, specifically declined to extend the pre-existing regulations to such a situation, as that would involve determinations as to precisely which terms changed and whether that affected the recourse nature of certain portions of the liability. Thus, the transitional rules may be the Treasury's solution, providing relief for a partner with debt in excess of basis in circumstances involving a refinancing or modification, by continuing to permit a bottom guarantee to be recognized for the seven-year transition period and thereby preventing a taxable constructive cash distribution to the guarantor partner.

Allocation of Excess Nonrecourse Liabilities

The regulations under §1.752-3(a)(3) provide for four methods under which excess nonrecourse liabilities can be allocated. Notably, the Final Regulations under Section 752 reject a proposed change from the 2014 Proposed Regulations, which would have introduced a "net value" methodology, and instead retain the following four methods:

  1. Partnership profits generally ("partnership profits method");
  2. Partnership profits wherein the partnership agreement specifies the partners' interests in profits if reasonably consistent with allocations of some other significant item of partnership income or gain ("significant item method");
  3. Allocation in a manner that deductions attributable to such liability would be reasonably expected to be allocated ("alternative method"); and
  4. Based on built-in gain on 704(c) or reverse 704(c) property to the extent such gain is not allocated under 1.752-3(a)(2) ("additional method").

Consistent with the leveraged partnership discussion above, the Final Regulations provide that the significant item method, alternative method, and additional method do not apply for purposes of determining a partner's share of a partnership liability for disguised sale purposes. Apart from this addition, the 1.752-3 regulations remain as they were prior to the 2014 Proposed Regulations.

The Final Regulations for Section 752, described above, are effective for any transaction on or after October 5, 2016.

Disguised Sale – Preformation Expenditures and Qualified Liabilities

The Final Regulations under Section 707 provide for an exception under which amounts distributed to a partner that contributed property are not treated as disguised sale consideration to the extent such amounts reimburse a partner for certain capital expenditures and costs incurred up to two years prior to the contribution ("preformation expenditures"). This exception generally applies only to the extent that the reimbursed expenditures do not exceed 20 percent of the fair market value of the property contributed, but this 20-percent limitation does not apply unless the property's fair market value exceeds 120 percent of the partner's basis in such property. The Final Regulations now provide for a property-by-property rule in applying this test, subject to limited aggregation.

To eliminate a potential abuse, the Final Regulations provide that a cash distribution received by a partner is only excludable as a preformation expenditure to the extent that it was not funded with the proceeds of debt assumed by the partnership in excess of the contributing partner's allocable share of such debt. That is, a contributing partner cannot exclude both its preformation expenditures and its share of the debt if the latter funded the former. In that case, the two are treated as effectively the same and only a single exclusion is permitted.

The Final Regulations additionally provide a helpful "step-in-the-shoes" rule for both preformation expenditures and for determining whether a liability is a qualified liability for disguised sale purposes, wherein a partner acquiring property or assuming a liability from another person in certain non-recognition transactions may make use of that person's holding period towards the requisite two-year period.

The Final Regulations under Section 707 relating to preformation expenditures and step-in-the-shoes rules, are effective for any transaction on or after October 5, 2016.


1 Respectively, the "Final Regulations," "Temporary Regulations," and "Reproposed Regulations." The Reproposed Regulations, as a general matter, set forth a facts-and-circumstances test for anti-abuse rules as to when a partner truly bears the obligation for debt purported to be recourse, and modify certain presumptions.

2 TD 9787, TD 9788, and REG-122855-15, respectively. All section references herein, unless otherwise noted, are to the Internal Revenue Code of 1986, as amended (the "Code").

3 The regulations as first released provided that if a partner other than the contributing partner guaranteed a portion of the debt or otherwise bore the economic risk of loss for such debt, that portion of the debt would not be included in the contributing partner's share. That is, the rules operated only to deny a guarantee by the contributing partner, as that was the perceived abuse.

However, this inconsistent treatment would have led to inequitable results, where, for example, the proceeds of a recourse borrowing are distributed pro rata to each of two contributing partners in a 50-50 partnership, yet each contributing partner cannot receive full credit for his/her share of liabilities (because half of the borrowing would have been allocated to the other partner and only the remaining half divided pro rata) and would accordingly be treated as receiving disguised sale consideration. Accordingly, on November 17, 2016, the Treasury Department and Internal Revenue Service issued a correction to the regulations that eliminates this issue. The regulations now provide that, for disguised sale purposes, partnership debt is allocated under the third tier of 1.752-3 (using partnership profits), provided that the amount allocated to a contributing partner cannot exceed what the partner would be allocated under the entirety of the regulations under Section 752. Other partners' guarantees are taken into account in this alternative calculation, but so too would be the contributing partner's guarantees.

4 Qualified liabilities, in general, are those incurred more than two years before the contribution of property, or otherwise incurred not in anticipation of such transfer. Qualified liabilities are subject to special favorable treatment in determining disguised sale consideration.

5 Where non-cash property is distributed to the contributing partner, a seven-year waiting period (rather than the two-year period referenced above) may be needed to avoid recognition of gain due to "mixing bowl" considerations under Section 737.

6 The provision is likely a "fairness" point to taxpayers who provide full guarantees (at the time of such guarantee), and are later relieved of small amounts by other partners.

7 The amount of partnership liabilities subject to transitional relief will be reduced for certain reductions in the amount of liabilities allocated to that partner under the transition rules and, upon the sale of any partnership property, for any tax gain (including section 704(c) gain) allocated to the partner less that partner's share of the amount realized.

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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