United States: IRS Applies New Qualified Liability Rule In Letter Ruling

In a recently released private letter ruling (PLR 201714028), the IRS Office of Chief Counsel determined that liabilities transferred by a taxpayer to a partnership constituted qualified liabilities under Treas. Reg. Sec. 1.707-5(a)(6)(i)(E), the newest addition to the list of liabilities that are treated as a qualified liability. The PLR dealt with a joint venture (referred to subsequently as "Company") which held operating assets as well as the general partnership interests and various classes of limited partnership interests in a publicly traded limited partnership (referred to subsequently as "Partnership").

Under the facts of the PLR, Company planned to contribute substantially all of its assets to Partnership in exchange for new limited partnership interests in Partnership. Partnership, through a wholly owned entity, would also assume Company's liabilities. Some of these liabilities were previously incurred to finance a distribution to Company's owners. The remaining liabilities had been incurred to fund Company's business or to refinance earlier liabilities. Company requested a ruling that the transferred liabilities were "qualified liabilities" under Treas. Reg. Sec. 1.707-5(a)(6)(i)(E).

Company represented that (1) the liabilities were not in default; (2) the liabilities were not incurred in anticipation of the transfer to Partnership; (3) the transfer was not being considered when the liabilities were incurred; (4) the Company would have incurred the liabilities regardless of the transfer; and (5) there would not be a shift in the capital of Partnership as a result of the Transfer, nor would there be a reduction in Company's interests in Partnership's inventory and unrealized receivables.

When a partnership assumes debt from a transferring partner or takes property subject to a debt in a transaction, characterizing the debt as a qualified liability can limit the amount treated as consideration in a disguised sale of property by the partner to the partnership and thereby limit the amount of gain recognized by the transferring partner under the disguised sale rules of Section 707(a)(2)(B). If a transfer of property by a partner to a partnership is not otherwise treated as part of a sale, the partnership's assumption of or taking subject to a qualified liability in connection with a transfer of property is not treated as part of a sale. If a transfer of property by a partner to the partnership is treated as part of a sale without regard to the partnership's assumption of or taking subject to a qualified liability in connection with the transfer of property, the partnership's assumption of or taking subject to that liability is treated as a transfer of consideration made pursuant to a sale of such property to the partnership to the extent of an amount determined based on a formula in the regulations.

In October 2016, the IRS issued final regulations creating a new, fifth category of qualified liability. Under Treas. Reg. Sec. 1.707-5(a)(6)(i)(E), a qualified liability now also includes a liability that was not incurred in anticipation of a transfer of property to a partnership, but that was incurred in connection with a trade or business where substantially all of the assets are transferred to a partnership.

Unlike Treas. Reg. Secs. 1.707-5(a)(6)(i)(A) and (B), a liability is not required to "encumber" the transferred assets to be a qualified liability under Treas. Reg. Sec. 1.707-5(a)(6)(i)(E). Also, to be a qualified liability under paragraph (E), a liability needs only to be incurred "in connection with" rather than "in the ordinary course" of a transferred trade or business, as is required under Treas. Reg. Sec. 1.707-5(a)(6)(i)(D).

The IRS granted the ruling and concluded that Company's liabilities were qualified liabilities under Treas. Reg. Sec. 1.707-5(a)(6)(i)(E) because they were incurred in connection with a trade or business and not in anticipation of being transferred to a partnership. Although some of Company's liabilities were incurred to finance a distribution, the liabilities were still sufficiently connected to the transferred business for the IRS to grant the ruling.

PLR 201714028 demonstrates the application of the new category of qualified liabilities under Treas. Reg. Sec. 1.707-5(a)(6)(i)(E). This new category can potentially provide relief under the disguised sale rules to taxpayers with unsecured liabilities or liabilities incurred outside of the ordinary course of business seeking move their business assets into a partnership, provided that the liabilities were not incurred in anticipation of the transfer of property to the partnership.

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.