Allocation Of Partnership Liabilities And Nonrecourse Deductions - Part Two

1. Reimbursement Rights.

The obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner or related person is entitled to reimbursement from another partner or person related to that partner. Reg. 1.752-2(b)(5).

2. Partner as a Lender.

A partner bears the economic risk of loss for that partner's nonrecourse loan to the partnership, if the economic risk of loss is not borne by another partner. If what the partnership owes to that partner includes wrapped debt, that is, a nonrecourse obligation owed to another person, encumbering partnership property, the partnership debt is bifurcated, the amount corresponding to the wrapped debt is treated as a liability owed to a nonpartner. Reg. 1.752-2(c).

3. Obligation to Restore Capital Account.

Reg. 1.752-2(b)(3)(ii) includes, as one of the obligations which is taken into account for determining the extent to which a partner has a payment obligation, the existence of a deficit capital account restoration obligation upon liquidation of the partnership.

Illustration:

ABC limited partnership incurs a $300,000 recourse liability. Limited partners B and C obligate themselves to contribute no more than $250,000 to ABC partnership in the future. A, B and C share profits and losses equally. Accordingly, each is entitled to allocation of 1/3 of the recourse liability ($100,000). If B and C were obligated to contribute only $50,000 each, the $300,000 liability would be allocated $50,000 each to B and C and $200,000 to A, the general partner.

If a partner has a contingent obligation to contribute to the partnership, for example, to cover an overage in construction costs, the obligation is not deemed a liability under Reg. 1.752-2(b)(4). The obligation is disregarded if taking into account all facts and circumstances, the contingencies make it unlikely that it will ever be discharged. If payment is contingent upon an event which is not determinable with reasonable certainty, the obligation is ignored until the event occurs.

In Revenue Ruling 97-38, 1997-38 I.R.B. 14, the Service ruled that if an allocation to a partner creates a deficit in that partner’s capital account in excess of the partner’s restoration obligation, then the partner has no repayment obligation to the extent of the excess. As a result, the allocation does not have economic effect because the partner does not bear the economic risk of loss.

A and B each contribute $100 to a limited partnership. A and B share profits and loses equally, but A, as the general partner, is allocated all depreciation deductions. The partnership purchases depreciable property for $1,000, paying $200 cash and borrowing $800 on a recourse basis. The loan is secured by the depreciable property. The building depreciates $200 per year, and the partnership recognizes no other items of income or loss in the first year. At the end of the first year, A’s capital account has a deficit of $100. Reg. 704-1(b)(2) presumes the value of the property to be equal to its basis, $800. At that value, the partnership’s obligation to the lender could be satisfied by transferring the property to the lender. Therefore, A will have no obligation to contribute any amount to cover the partnership’s shortfall. Since A has no contribution obligation at the end of year one, the allocation creating the $100 capital account deficit will have no economic effect because A does not bear the economic risk of loss for that amount.

4. Related Persons.

A person is related to a partner if the relationship between them is as specified in section 267(b) or section 707(b)(1), except (i) 80% or more replaces more than 50%; and (ii) brothers and sisters are excluded. Reg. 1.752-4(b).

The exceptions are more favorable to taxpayers than the general rules of sections 267(b) and 707(b)(1).

A, B and C form a general partnership. A, B and C each contribute $1,000 to ABC partnership; they are equal partners.

A and B form second partnership - each contributes $50,000. They share losses equally. The purpose is to have the loan to ABC treated as nonrecourse under section 752.

AB loans ABC $100,000 on nonrecourse basis secured by property which ABC purchases.

A and B bear equally the economic risk of loss for the ABC partnership liability based on their percentage interests in losses of AB. Reg. 1.752-4(c).

AB limited partnership -- A is general partner; B is limited partner; profits and losses shared equally. Each required to make up deficits in capital accounts: A has 90 days grace, while B has 2 years after liquidation without interest:

1. The original final regulations ("Original Regulations" or "Orig. Reg.") found at Reg. 1.704-1(b)(4)(iv) (before December 28, 1991) continue to apply indefinitely to partnerships entered into on or before December 29, 1988 which complied with the provisions thereof until a subsequent material modification of the partnership agreement, unless either:

(a) The partnership elected to apply the temporary regulations ("Temporary Regulations" or "Temp. Reg.") (referred to in 2 below) pursuant to Temp. Reg.

1.704-1T(b)(4)(iv)(m)(l) commencing with its first taxable year ending after December 28, 1988, e.g., usually calendar year 1988; or,

(b) The partnership elects to apply the new final regulations ("Final Regulations" or "Reg.") (referred to in 3 below) to it commencing with the first taxable year ending on or after December 28, 1991. This election is made by attaching a written statement to the partnership return for its first taxable year ending on or after December 28, 1991, with the statement including the name, address and identification number of the partnership and that it makes an election under Reg.1.704-2(l)(4).

2. The Temporary Regulations (1.704-1T(b)(4) December 29, 1988) apply to any partnership formed on or before December 29, 1988, which has elected to apply them (see 1(a) above) and to any partnership entered into after December 29, 1988 and before December 28, 1991 which complied with the Temporary Regulations unless it elects to be governed by the Final Regulations under Reg.1.704-2(l)(4).

3. The Final Regulations (Reg. 1.704-2(l)(4), December 27, 1991) apply to partnerships which elect them for their first year ending after December 28, 1991 and to partnerships formed on or after December 28, 1991 and to taxable years beginning on or after that date.

1. The Original, Temporary and Final Regulations take the position that deductions attributable to the portion of the adjusted basis of an asset or of an expenditure financed with nonrecourse debt cannot have substantial economic effect because the nonrecourse creditor bears the economic risk of loss. Orig. Reg.1.704-1(b)(4)(iv); Temp. Reg. 1.704-1T(b)(4)(iv)(a)(1); Reg. 1.704-2(b)(1). However, because nonrecourse creditors cannot be allocated with any deductions or losses, those financed with nonrecourse debt must be allocated among the partners in accordance with their interests in the partnership.

2. The regulations provide that the portion of a deduction attributable to nonrecourse debt ("nonrecourse deduction") is an amount which results in an increase in the "minimum gain" which the partnership would realize on a foreclosure or sale of the applicable property for the nonrecourse mortgage balance. Orig. Reg. 1.704-1(b)(4)(iv)(b) and (c); Temp. Reg. 1.704-1T(b)(4)(iv)(a)(2) and (c); Reg. 1.704-2(c). Any deduction funded with nonrecourse debt, which did not result in a depreciable, depletable or amortizable asset, is determined for characterization purposes as a pro rata share of all partnership deductions, losses and Section 705(a)(2)(B) expenditures for the applicable year. Orig. Reg.1.704-1(b)(4)(iv)(b); Temp. Reg. 1.704-1T(b)(4)(iv)(b); Reg. 1.704-2(c).

3. An allocation of a deduction attributable to nonrecourse debt will be treated as made in accordance with a partner's interest in the partnership if:

4. If the above requirements are satisfied, a partner not having an obligation to eliminate the deficit in his capital account on liquidation may be allocated deductions attributable to nonrecourse debt even if they cause a deficit in his capital account balance, provided that deficit is not in excess of his share of partnership minimum gain. Orig. Reg. 1.704-1(b)(5) Ex.22; Reg. 1.704-2(m) Ex. 1(ii). Does the partnership agreement itself have to limit allocations of deductions and losses so that the deficit of limited partners will not exceed the sum of their shares of minimum gain and their negative capital account contribution obligation (if any)?

1. (a) Under the Original Regulations, a "minimum gain chargeback" is a provision in the partnership agreement which requires that if there is a net decrease in partnership minimum gain for a taxable year any partner having a deficit capital account balance (computed net of his obligation to eliminate any portion of his deficit balance and his share of remaining minimum gain) will be allocated gross income and gain thereafter in the amount and proportions needed to eliminate such deficits as quickly as possible. The deficit balance is computed net of the items which have to be considered as distributed or charged under the qualified income offset provision (Reg. 1.704-1(b)(2)(ii)(d)(4), (5) and (6)) and the amount of minimum gain chargeback in any year is deemed to consist first of gains realized on the disposition of items of partnership property subject to one or more nonrecourse liabilities to the extent of the decrease in minimum gain attributable to the disposition of such items with the remainder made up of a pro rata portion of other items of income and gain. Orig. Reg. 1.704-1(b)(4)(iv)(e); Reg.1.704-2(f)(6).

(b) The Temporary Regulations (Temp. Reg. 1.704-1T(b)(4)(iv)(e)(2)) modified the above formulation by requiring, in the event of a required minimum gain chargeback, that each partner be allocated items of income and gain (for the years of the decrease and subsequent years, if necessary) in proportion to, and to the extent of, an amount equal to the greater of:

(c) The Final Regulations merely require that each partner (whether or not he has a deficit in his capital account balance) must be allocated items of partnership gross income and gain for the year in which minimum gain is reduced equal to that partner's share of the net decrease in partnership minimum gain. Reg. 1.704-2(f)(1). Note that the amount of minimum gain chargeback is only the "net" decrease in minimum gain so that refinancings in which the amount of total nonrecourse debt remains the same do not trigger a minimum gain chargeback. Reg. 1.704-2(m), Ex. 2. Exceptions are provided, however:

2. A "nonrecourse" liability is one with respect to which none of the partners bears the economic risk of loss. Consequently, a purported nonrecourse loan made by a partner to a partnership, or a nonrecourse loan guaranteed by a partner, is not a nonrecourse loan for this purpose and allocations of losses and deductions attributable thereto will be made in accordance with the partners' interests in the partnership. Reg. 1.704-2(b)(3); Orig. Reg. 1.704-1(b)(4)(iv)(g); Temp. Reg. 1.704-1T(b)(4)(iv)(h)(1). The regulations allocate the entire loss attributable thereto to the creditor partner. Reg. 1.704-2(m) Ex.1(viii); Orig. Reg.1.704-1(b)(5) Ex. 20 (vii); Temp. Reg. 1.704-1T(b)(4)(iv)(h)(2). Also, Orig. Reg. 1.704-1(b)(l)(iii) indicates the Service will look at debt/equity characterization issues with respect to third party purported nonrecourse debts and could characterize them as equity. However, the de minimis 752 exception, i.e., 10% interest or less of Reg. 1.752-2(d), is incorporated.

3. (a) (i) The Temporary and Final Regulations provide that if a partner bears the economic risk of loss of a partnership nonrecourse debt, it is recharacterized as a "partner nonrecourse debt" and any nonrecourse deductions attributable to that debt must be allocated to the partner who bears its economic risk of loss, or among all partners who bear the economic risk of loss in the ratio in which they bear that risk of loss. Reg. 1.704-2(b)(4), 1.704-2(i); Temp. Reg. 1.704-1T(b)(4)(iv)(h)(2). This effectuates a special allocation of the deduction to the lender so that the other partners may have taxable income without any cash flow.

(ii) Note that the Temporary Regulations define "partner nonrecourse debt" as any nonrecourse debt for purposes of 752 for which a partner bears the economic risk of loss, thus including unsecured advances by a partner with respect to which no partner is personally liable. Reg. 1.704-2(b)(4) defines this term by reference to the definition of nonrecourse debt used in Reg. 1001-2, i.e., apparently limiting partner nonrecourse debt only to secured debts.

(b) For this purpose a more-than 10% partner is deemed to bear the economic risk of loss if the nonrecourse loan is made by a person related to that partner under the rules applicable for purposes of determining basis in partnership interests under Section 752. Reg. 1.752-4(b); Temp. Reg. 1.752-1T(h) (Sections 267(b) and 707(b)(1), with modifications, related to over 10% partners); Temp. Reg. 1.704-1T(b)(4)(iv)(k)(1); Reg. 1.704-2(b)(4). The Temporary 752 and Final 752 regulations grandfathered pre-January 30, 1989 related party loans and guarantees and do not require a shift from unaffiliated partners to related ones, although nonrecourse deductions funded by such loans for 1989 and thereafter will not be allowed to the unaffiliated persons. Temp. Reg. 1.752-4T(a), 1.752-4T(d); Reg.1.752-5; See also, Levine, Loffman and Presant, A Practical Guide to the New Section 752 Regulations, Part II, 70 Journal of Taxation 260 (May,1989). These debts will be treated for 704(b) purposes as partnership non-recourse debts if incurred or assumed by the partnership prior to January 30, 1989 or pursuant to a contract which was binding prior to January 30, 1989. Temp. Reg.1.704-1T(b)(4)(iv)(m)(2). Also, partnership nonrecourse debts which were treated as such under the prior 752 regulations before the effective date of the Tax Reform Act of 1984 (March 1, 1984) and which had been incurred or assumed by the partnership prior to March 1, 1984, will continue to be treated as partnership nonrecourse debt for 704 purposes, but without permitting increases in the amount thereof after December 31, 1986 to be taken into account. Temp. Reg.1.704-1T(b)(4)(iv)(m)(3).

(c) If there is a decrease in the minimum gain attributable to partner nonrecourse debt, a minimum gain chargeback must be provided in the partnership agreement, i.e.:

(1) Under the Temporary Regulations, all partners with a share of that minimum gain attributable to the partner nonrecourse debt at the beginning of the year must be allocated items of partnership income and gain thereafter in proportion to, and the extent of, an amount equal to the greater of:

(2) Under the Final Regulations:

(d) A partner's share of minimum gain attributable to partner nonrecourse debt at the end of any year and his share of net increases in minimum gain are determined under rules identical to the determination of the shares of partnership minimum gain. Temp. Reg. 1.704-1T(b)(4)(iv)(h)(5) and (6); Reg. 1.704-2(i)(5).

(e) Rules consistent with those pertaining to the distribution of partnership nonrecourse debt proceeds apply also to distributions of the proceeds of partner nonrecourse debts. Reg. 1.704-2(i)(6).

4. In computing the amount of minimum gain, if a property is subject to more than one liability of equal priority, the book value is allocated among all liabilities in proportion to their outstanding balances. If it is subjected to two or more liabilities of unequal priority, book value is allocated among the liabilities in the order of their priority up to the balance of each. Orig. Reg. 1.704-1(b)(4)(iv)(c); Temp. Reg. 1.704-1T(b)(4)(iv)(c); Reg. 1.704-2(d)(2).

5. (a) Under the Original Regulations, a partner's "share of minimum gain" at the end of each year is defined as the aggregate "nonrecourse deductions" allocated to that partner up to that time less his share of decreases in minimum gain allocated to him up to that time, under the final regulations. Orig. Reg. 1.704-1(b)(4)(iv)(f).

(b) (1) The Temporary and Final Regulations define "partnership minimum gain" to be equivalent to the excess of the nonrecourse liabilities encumbering a partnership asset over the adjusted tax basis of the asset (or book value if different from adjusted basis). This definition is much better in that it permits minimum gain to be created or increased as a result of a refinancing. Temp. Reg. 1.704-1T(b)(4)(iv)(a)(2); 1.704-1T(b)(4)(iv)(f); Reg. 1.704-2(d)(3), 1.704-2(h); see, Reg. 1.704-2(m), Ex. 1(vi).

(2) The precise definition of a partner's "share of minimum gain" which appears in the Final Regulations is an amount which equals:

(3) However,

(4) Although the usual rule is that a distribution of loan proceeds will be treated as a distribution which is allocable to an increase in partnership minimum gain to the extent of the net increase therein, the Final and Temporary Regulations permit a partnership to treat such a distribution as not being allocable to an increase in partnership minimum gain provided the distribution does not cause or increase the deficit balance in the distributee's capital account above his deficit restoration obligation and deemed deficit restoration obligation (without regard to the effect thereon of the distribution itself) as of the end of the partnership taxable year in which the distribution occurs. Reg. 1.704-2(h)(3); Temp. Reg. 1.704-1T(b)(4)(iv)(g)(1). Apparently no formal election need be filed for a partnership to opt for this different treatment. The effect of this election, as indicated below, would be to enable the distributee and non-distributee partners to utilize the increase in minimum gain against partnership deductions.

(c) (1) The Final and Temporary Regulations provide that a net increase in minimum gain is allocated to a nonrecourse liability to the extent of the increase in minimum gain which arose as a result of incurring the liability. If the net increase for a partnership year is allocated to more than one nonrecourse liability and the sum of the amounts so allocated exceeds the total amount of such net increase,

(2) If the aggregate increases in the minimum gain for all nonrecourse liabilities exceed the sum of distributions and losses for the year,

(d) The determination of to whom excess financing proceeds are distributed can be done under any reasonable method. The regulations state that the interest allocation rules of Reg. 1.163-8T (tracing the loan proceeds) is a reasonable method. Reg. 1.704-2(h)(2); Temp. Reg. 1.704-1T(b)(4)(iv)(g)(4). This method determines to which partner the minimum gain generated by the excess financing must be allocated.

6. (a) In the case of tiered partnerships, the Final and Temporary Regulations provide that an upper tier partnership's increase or decrease in its share of a lower tier partnership's minimum gain is an increase or decease, respectively, in the minimum gain of the upper tier partnership. Reg. 1.704-2(k)(1) and (2); Temp. Reg. 1.704-1T(b)(4)(iv)(j).

(b) Also, proceeds of nonrecourse debts of the lower tier partnership distributed to the upper tier partnership are treated as proceeds of a nonrecourse liability of the upper tier partnership. Reg. 1.704-2(k)(3).

(c) All nonrecourse deductions of the lower tier partnership allocated to the upper tier partnership are treated as depreciation or cost recovery deductions with respect to property owned by the upper tier partnership subject to a nonrecourse liability.

7. (a) A special rule has been added by the Final Regulations to reflect a revaluation of partnership property subject to a nonrecourse debt occasioned by the admission of a new partner, contribution of property by an existing partner, withdrawal of an old partner or as of calendar year 1987. (Reg. 1.704-1(b)(2)(iv)(d), (f) and (r)). Reg. 1.704-2(d)(4), 1.704-2(m) Ex. 3(iii).

(b) If the capital accounts are so increased or decreased:

Restated book values thereafter are used to determine net increases and decreases in minimum gain. However, the revaluation is based on the fair market value of the partnership's assets which, as to property subject to nonrecourse debt, is not less than the nonrecourse mortgage balance. Reg. 1.704-1(b)(2)(iv)(f)(1); I.R.C. 7701(g). Consequently, all revaluations eliminate all minimum gain, but because of the above special rule no minimum gain chargeback is triggered.

(a) Does this partnership satisfy the requirements of Reg. 1.704-2(e)?

(b) The capital accounts would apparently be maintained.

(c)(i) If before the end of 1997 the partnership had refinanced its nonrecourse mortgage with a new nonrecourse mortgage having a principal balance of $550,000 and it retained the excess $100,000 refinancing proceeds for working capital needs, the increase in minimum gain attributable to the refinancing and operations would be $115,873 ($550,000 -$420,635 = $129,365 - $13,492 = $115,873). Reg. 1.704-2(d)(3), 1.704-2(h). However, because no part of excess refinancing proceeds were distributed to the partners in 1997, that increase is treated as nonrecourse deductions which can then be taken into account in 1997 up to the partnership's 1997 loss of $45,873, i.e., the entire 1997 loss would be deemed attributable to nonrecourse deductions, and the allocations of the 1997.

(ii) If the $100,000 of excess financing proceeds had been distributed in 1997 entirely to G, the extra $30,000 of operating losses (apart from depreciation) would generally not be treated as nonrecourse deductions since conceptually they would have been deemed funded with the recourse debt from G to the partnership. Thus, L would not have borne this loss. However, as noted above, the partnership could elect not to treat this distribution as attributable to nonrecourse debt so as to permit L the same level of deductions he would have had if the loan proceeds were not distributed.

(iii) If the excess financing proceeds had been distributed $10,000 to G and $90,000 to L, the increase in minimum gain of $115,872 would have been fully taken into account in 1997, unless the partnership elected not to treat the $10,000 distributed to G as allocable to nonrecourse debt. However, because L's capital account, immediately after the distribution but before his allocation of the 1997 loss, would be ($102,143) and his share of total minimum gain at that point would be $116,428 [$90% x $129,365], his share of 1997 loss would nevertheless be limited to only ($14,285) as was the case absent a refinancing. The election not to treat the $10,000 distributed to G as derived from nonrecourse refinancing would apparently permit L an additional $9,000 of loss (90% x $10,000 undistributed loan proceeds).

(iv) Consequently, an excess refinancing of nonrecourse debt helps limited partners if the proceeds thereof are not distributed.

(d) (1) If the income and operating expense figures for 1998 were identical to those for 1997, as shown in Paragraph (b) above, but at the beginning of 1998 principal of $30,000 is paid on the nonrecourse mortgage, the taxable income of the partnership would be computed.

(2) If in (d)(1) above the $30,000 of principal reduction came from a capital contribution from G, pursuant to the exception set forth in Reg. 1.704-2(f)(3), 1.704-2(m) Ex. 1(iv), the allocations for 1998.

(e) Assume the above agreement had been modified at inception so that there were no limitations in the agreement on cash distributions or loss allocations to L, even if they caused a deficit in his capital account to exceed his share of minimum gain. You are asked to prepare the partnership's 1994, 1995, 1996 and 1997 returns. Assuming the fair market value of the property at December 31, 1994, 1995, 1996 and 1997 were as follows:

(1) Could you ethically prepare those returns allocating to L the full amount of losses he would be allocated under the partnership agreement? What if fair market values equaled adjusted basis?

(2) If so, what type of disclosure on the return should you provide?

Reg. 1.752-3 which governs the allocation of nonrecourse liabilities utilizes the section 704 concepts of "minimum gain" and "built-in gain." A partner's share of nonrecourse liabilities equals the sum of:

(1) The partner's share of minimum gain determined in accordance with the rule of section 704(b) and its regulations. Minimum gain is the excess of nonrecourse liability secured by any property over the property's adjusted basis. The "partnership minimum gain" for a nonrecourse liability is the gain the partnership would realize if the property was sold for an amount equal to the liability. Reg.  1.704-2(d). If the partnership has more than one nonrecourse liability, partnership minimum gain is the sum of the minimum gain computed for all nonrecourse liabilities;

(2) The amount of any taxable gain that would be allocated to the partner under section 704(c) if the partnership disposed of all partnership property (in a taxable transaction) subject to nonrecourse liabilities, in full satisfaction of the liabilities and for no other consideration; and

(3) The partner's share of the excess nonrecourse liabilities (those not allocated above) in accordance with the partner's share of partnership profits.

Accordingly, each partner's share of nonrecourse liabilities is the sum of (1) his or her share of minimum gain, (2) his or her section 704(c) taxable gain, and (3) his or her share of the partnership's excess nonrecourse liabilities.

On January 13, 2000, the Treasury Department issued proposed regulations revising the allocation of nonrecourse liabilities under the three tier system. Prop. Reg. 1.752-3. The proposed regulations do not alter the allocation of nonrecourse liabilities under tier-1 or tier-2. However, under tier-3, the proposed regulations provide that, to the extent allocable to property subject to the nonrecourse liability, the partnership may first allocate the excess nonrecourse liabilities to any partner to the extent that the partner has section 704(c) built-in gain in excess of the section 704(c) taxable gain allocated to that partner under tier-2. Any remaining excess nonrecourse liabilities would then be allocated to each partner in accordance with the partner’s share of partnership profits.

Section 704(c)(1)(A) provides that income, gain, loss, and deduction with respect to property contributed to a partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. Under the implementing regulations, a partnership, subject to general anti-abuse rules, has an option of three methods to accomplish the section 704(c) requirement -- the traditional method, the traditional method with curative allocation, and the remedial method.

In Revenue Ruling 95-41, 1995-23 IRB. 5, the Service provided guidance concerning the allocation of nonrecourse liabilities when property subject to a liability is contributed to a partnership. The Ruling points out that generally there will be no tier-1 allocation on formation because the partnership has no minimum gain. As to tier-2 -- section 704(c) minimum gain - the amount allocated will depend upon the section 704(c) method utilized by the partnership. If the remedial method is elected, the contributing partner is allocated nonrecourse liabilities in tier-2 equal to the fair market value of the contributed property in excess of its tax basis. In contrast, if the traditional or the traditional with curative allocation are elected, the amount allocated to the contributing partner under tier-2 is merely the excess of the non-recourse liability over tax basis.

As to tier-3, the Ruling states that the partners’ agreement to share the profits of the partnership is one fact to be considered in making the determination. Another fact to be considered is a partner’s share of section 704(c) built-in gain to the extent that the gain was not taken into account in making an allocation of liabilities under tier-2. However, the Ruling makes clear that the amount of section 704(c) built-in gain is not determinative for purposes of allocation of tier-3 liabilities.