The IRS has issued three sets of regulations — final, temporary and proposed — addressing disguised sales of property involving partnerships, the allocation of partnership liabilities and several other issues related to partnerships. The regulations are largely intended to eliminate what the IRS sees as abuses of some of the tax benefits associated with partnerships.
Disguised sales and leveraged partnership transactions
No income is usually generated when a partner contributes property to a partnership or a partnership distributes property to its partners. Some parties have viewed partnerships as a way to exchange property — cash or other property exchanged for a partnership interest — without incurring taxes.
Under the disguised sale rules, though, transfers of money or other property between a partnership and one or more of its partners can be treated as a sale or exchange of property. A facts-and-circumstances test is applied to determine whether a transaction was, in substance, a sale of property to the partnership. The regulations include a rebuttable presumption that a sale has occurred when a partner makes a contribution and receives a distribution of cash within two years of the contribution.
The regulations include an exception for debt-financed distributions. Under the exception, when a partnership borrows money to finance a distribution to a partner after the partner contributes property, the loan proceeds are considered sale proceeds only to the extent that the distribution exceeds the partner’s tax basis, which includes the allocable share of the partnership liabilities. In other words, the contributing partner’s allocable share of liability determines whether any of the loan proceeds distributed to it represents a disguised sale.
If all of the loan liability is allocated to the contributing partner (based on, for example, the partner’s guarantee of the loan), the partner’s tax basis in its partnership interest increases. This allows the partner to receive the distribution from the partnership tax-free.
According to the IRS, the debt-financed distribution exception has been abused through leveraged partnership transactions. In those transactions, it says, the contributing partners enter into payment obligations that aren’t commercial, solely to achieve an allocation of the partnership liability, with the goal of avoiding a disguised sale.
Allocation of partnership liabilities
Previously, in determining a partner’s share of a partnership liability for disguised sale purposes, the regulations had separate rules for a partnership’s recourse and nonrecourse liabilities. With a recourse liability, a partner or related party bears the “economic risk of loss” (EROL) if the partnership can’t pay. But partners have no individual liability for nonrecourse debt.
Under prior guidance, a partner’s share of a recourse liability was the portion of the liability for which the partner or a related person bears the EROL. If a partner had no EROL on a liability, no share of that liability could be allocated to it. This rule applied to allocations of a recourse liability for any purpose, not just the disguised sale rules.
However the temporary regulations change the method of allocating partnership liability for purposes of the disguised sale rules. Now, all liabilities assumed by (or taken subject to) a partnership in connection with a transfer of property by a partner to a partnership will now be treated as nonrecourse liabilities, only to the extent the liability are not allocated to another partner as a recourse liability, and then only in proportion to the transferring partner’s share of partnership profits
Because liabilities are allocated based on each partner’s share of profits for disguised sale purposes, no partner can ever be allocated 100% of a liability. This largely undermines leveraged partnership transactions, as a contributing partner can’t be assigned all of the loan liability to offset the gain from the distribution of loan proceeds.
Reimbursements of capital expenditures
The existing regulations also include an exception from the disguised sale rules for reimbursements to partners for certain capital expenditures and costs they incur (also known as preformation capital expenditures). The exception generally applies only to the extent that the reimbursed capital expenditures don’t exceed 20% of the fair market value (FMV) of the property the partnership transfers to the partner.
This 20% limitation doesn’t always apply. It’s applicable only if the FMV of the transferred property doesn’t exceed 120% of the partner’s adjusted basis in the property at the time of the transfer. This alternative is known as the “120% test.”
The final regulations allow limited aggregation of property when applying these tests (as opposed to applying the tests on a property-by-property basis). Despite issuing final regulations addressing the preformation capital expenditures exception, the U.S. Treasury and IRS are still considering whether it’s appropriate and studying its potential for abuse.
Qualified liability exception
The existing regulations also address issues related to a partnership’s assumption of partner debt associated with a property contribution. Generally, if the debt was incurred more than two years before the contribution, or was otherwise incurred in the ordinary course of business, it’s considered a “qualified liability” and won’t trigger the disguised sale rules.
Assumed debt that isn’t a qualified liability results in a disguised sale to the extent the liability exceeds the partner’s allocable share of the partnership liability under the general partnership liability allocation rules. This calculation is subject to certain modifications.
The regulations define four types of qualified liabilities, including a capital expenditure qualified liability. To coordinate the exception for preformation capital expenditures and the capital expenditure qualified liability rule, the final regulations provide that, to the extent any qualified liability is used by a partner to fund capital expenditures — and responsibility for that borrowing shifts to another partner — the preformation capital expenditures exception doesn’t apply. Capital expenditures will be treated as funded by the proceeds of a qualified liability to the extent the proceeds are either 1) traceable to the capital expenditures, or 2) actually used to fund the expenditures.
The final regulations provide a “step-in-the-shoes” rule for cases where a partner acquires property, assumes a liability, or takes property subject to a liability from another person. In such circumstances, the partner assumes the status of the other person for purposes of applying the preformation capital expenditures exception and determining whether a liability is qualified for disguised sale purposes.
A tiered partnership arises when a partnership (the upper-tier partnership) has an interest in another partnership (the lower-tier partnership). The final regulations provide that a contributing partner’s share of a liability from a lower-tier partnership is a qualified liability if the liability would be qualified if it had been assumed by the upper-tier partnership in connection with a transfer of all of the lower tier’s property to the upper-tier partnership.
The final regulations also permit an exception for preformation capital expenditures when a person incurs capital expenditures related to property, transfers the property to a lower-tier partnership, and subsequently transfers an interest in the lower-tier partnership to the upper-tier partnership within two years of incurring the capital expenditures. The upper-tier partnership can be reimbursed for the capital expenditures by the lower-tier partnership to the same extent the contributing partner could be reimbursed and also can reimburse that partner.
“Bottom dollar” payment obligations
In addition to some disguised sale issues, the temporary regulations address when certain payment obligations (which represent EROL) are recognized for purposes of determining whether a liability is a recourse partnership liability that will be allocated according to EROL (for nondisguised sale purposes). Similar to its concerns regarding disguised sales, the IRS worries that partners and related persons enter into noncommercial payment obligations simply to achieve an allocation of a partnership liability that will increase their basis and reduce taxes on future distributions.
Specifically, the IRS believes that “bottom dollar” guarantees generally shouldn’t be recognized as payment obligations when allocating recourse liabilities among partners. A bottom dollar guarantee gives the guarantor a real risk on debt, but a risk that’s unlikely to occur and could be a fraction of the full liability. For example, a partner might guarantee up to $250 of a $1,000 liability that’s secured by $1,500 of assets, with the guarantee kicking in only if the lender can’t collect at least $250 from the partnership in case of a default.
Until now, a partner was generally allocated the full guaranteed amount of the liability, regardless of the likelihood of the economic risk coming to fruition. But the temporary regulations provide that “bottom dollar payment obligations,” including guarantees and indemnities, generally aren’t recognized when allocating recourse liabilities.
Certain exceptions apply. For example, an exception applies to certain obligations that satisfy the definition of a bottom dollar payment obligation but give rise to the EROL that prevents a partnership liability from being nonrecourse (and, therefore, allocated according to profit share). And if a partner actually bears the EROL for a partnership liability, the partners can’t agree among themselves to create a bottom dollar payment obligation so the liability will be treated as nonrecourse.
The IRS also issued new proposed regulations addressing 1) when certain obligations to restore a deficit balance in a partner’s capital account are disregarded, and 2) when partnership liabilities are treated as recourse liabilities. Although it’s not required, the proposed regulations can be relied on before they’re finalized.
So, what’s the bottom line for partnerships? Under the new guidance, more property transactions between partners and partnerships are likely to be classified as disguised sales — and, therefore, subject to taxes — than under the previous IRS guidance. The guidance also curbs the use of so-called leveraged partnership transactions to avoid paying taxes.
The final and temporary regulations generally took effect on October 5, 2016. The regulation allocating partnership liabilities for disguised sales purposes according to profit share applies only to transactions where all transfers occur on or after January 3, 2017.