On December 2, 2024, the IRS published final regulations under Code1 Sections 704 and 752 (pursuant to authority set forth in Code Section 7805(a)) relating to a partner's share of recourse partnership liabilities, largely adopting the proposed regulations issued over a decade ago.
Introduction
Code Section 752 provides that an increase (or decrease) in a partner's share of partnership liabilities (including via a change in a partner's individual liabilities due to assumption of a partnership's liabilities or assumption by a partnership of a partner's liabilities) will be considered a contribution (or distribution) of money to (or from) the partnership.2 These rules result in an increase (or decrease) of a partner's outside basis in the partner's interest in the partnership (but not such partner's capital account). A partner's share of liabilities (i.e., allocation of the debt) is determined first by concluding whether the liability is recourse or nonrecourse. A liability is recourse to the extent that a partner or related person bears the economic risk of loss ("EROL"), which generally means such person (1) has a payment obligation, (2) is a lender to the partnership, (3) guarantees payment of a partnership liability (or portion thereof), or (4) pledges property as security for a partnership liability.3 In contrast, nonrecourse liabilities are governed by separate rules under Regulations Section 1.752-3, which in most cases requires allocation of nonrecourse liabilities in accordance with each partner's share of partnership profits.4
The Final Regulations
As noted, the final regulations adopt much of the proposed regulations with changes that generally are merely correctional or clarifying in nature, including:
- Adding language to clarify that when applying the "Proportionality Rule"5 or in connection with tiered partnerships, EROL is determined by taking into account all statutory and contractual obligations relating to the liability.6
- Adding language to clarify that if the liability of a lower tier partnership (a "LTP") is allocated to (and thereby treated as a liability of) an upper tier partnership (a "UTP") under Regulations Section 1.752-4(a) (for example, due to a partner of the UTP bearing EROL for the LTP's liability), then the UTP also is treated as bearing EROL for such LTP's liability.7
- Narrowing application of the related party rules by disregarding the constructive stock ownership rules under (1) Code Section 267(c)(1) for purposes of determining whether a UTP's interest in an LTP is owned proportionately by the UTP's partner when the LTP directly bears the EROL for a liability of the UTP (for example, where the LTP is a lender to the UTP), and (2) Code Section 1563(e)(2) (applied by incorporation into Code Section 267(b)(3), (f)) for purposes of determining if a corporate partner in a partnership and a corporation owned by the partnership are members of the same controlled group when the subsidiary corporation directly bears the EROL for a liability of the owner partnership (for example, by guaranteeing debt of the partnership).8
The final regulations include a set of ordering rules to determine EROL among related party partners with otherwise overlapping EROL. Regulations Section 1.752-4(e)requires that a recourse partnership liability be allocated to a partner by applying the following steps in order:
- If any direct or indirect partner directly bears the EROL for a partnership liability, then any other direct or indirect partners are not treated as related to such partner for purposes of determining their EROL and apply limited exceptions turning off application of 267(c)(1) and Related Partner Exception" to determining relatedness under Regulations Section 1.752-4(b)(1);9
- If a person who bear EROL for a partnership liability is related to more than one partner in the partnership, then such partners are treated as bearing EROL for such liability based on their relative interests in partnership profits[10]; and
- Apply the Proportionality Rule.11
The final regulations may be applied to all liabilities incurred or assumed by a partnership with respect to all returns, including amended returns, filed after the date of publication of the regulations (December 2, 2024) as long as the rules are applied consistently to all partnership liabilities, but the final regulations do not apply to refinanced debts outstanding (but not yet modified) on or prior to such date to the extent of the amount and duration of the pre-modification liability.
How Do These Rules Relate to Tax Credit Finance?
An understanding of the impact of liabilities on a partnership and its partners is a critical component of maximizing the monetization of the value of the tax attributes arising from a renewable energy project, particularly in those projects that rely on partnership allocations to shift the tax credits and/or other tax attribute to the investor (e.g., the "partnership flip").12 Most renewable energy projects with tax equity investment contain some element of debt financing. The allocation of debt basis to a tax equity investor is often critical to permit the investor to take intended depreciation deductions in the taxable year(s) contemplated by the tax models created in connection with the transaction. Understanding these rules, and the impact of common arrangements (such as sponsor guarantees) on such allocation rules, is a critical component of financial and tax modeling for renewable energy projects. These rules also indirectly play a role in other determinations relevant to investors using certain renewable energy tax credit structures, including the determination of whether recapture applies under Regulations Section 1.47-6(a)(2)(i)(b) and (a)(2)(ii) (a/k/a the "66-2/3 Rule") and the application of the "at-risk" rules under Code Section 49.
Footnotes
1 "Code" refers to the Internal Revenue Code of 1986, as amended. "Regulations" refers to Treasury Regulations promulgated under the Code.
2 Code 752(a), (b).
3 See Regulations Section 1.752-2(b)-(e), (h).
4 Regulations Section 1.752-3(a)(3).
5 The Proportionality Rule applies when partners have overlapping EROL regarding a partnership liability and generally requires each partner's share of the EROL to be equal to the amount of such liability multiplied by a fraction, the numerator or which is the amount of such partner's EROL for such liability and the denominator or which is the sum of the amounts of EROL of all partners for such liability. Regulations Section 1.752-2(a)(2).
6 Regulations Section 1.752-2(a)(3), (f)(9).
7 Regulations Section 1.704-2(k)(5).
8 Regulations Section 1.752-4(b)(1)(iv), (v). The IRS commentary to the final regulations notes that in both case, the partner's risk is limited to the partner's equity investment in the partnership.
9 Regulations Section 1.752-4(b)(2)
10 Regulations Section 1.752-4(b)(3).
11 Regulations Section 1.742-2(a)(2).
12 In this context, "partnership flip" refers to the shifting of allocations between an investor and a sponsor upon a triggering event, which is customarily either time based (in the case of an investment tax credit project) or yield based (in the case of a production tax credit project) and generally contains economic features similar to those discussed in Rev. Proc. 2007-65 (wind PTC), Rev. Proc. 2014-12 (historic tax credit) and Rev. Proc. 2020-12 (carbon oxide sequestration).
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