Allocation of nonrecourse debt under the three-tier sec. 752 allocation process.

Facts: Lois and Clark are forming The Daily Planner Partnership, which they will own equally. Lois contributes $40,000 cash and Clark contributes depreciable property with a $40,000 tax basis and a $100,000 fair market value (FMV). The property is burdened with a $60,000 nonrecourse liability. * The partnership agreement provides for 50/50 allocations of all partnership items of income, gain, deduction and loss. In addition, the partnership maintains capital accounts in accordance with the Sec. 704(b) safe harbor rules. * Both partners are concerned they will not receive their fair share of basis allocated to them from the $60,000 nonrecourse note and have asked the partnership's tax adviser to provide them with a detailed calculation showing how the nonrecourse note will be allocated between them. Issue: How will the $60,000 basis from the nonrecourse liability be allocated between Lois and Clark under the three-tier Sec. 752 allocation process?

Analysis

To provide for appropriate matching of basis with nonrecourse deduction allocations and with distributions related to nonrecourse liabilities and to prevent inappropriate shifts in the sharing of such liabilities, Regs. Sec. 1.752-3 provides that a partner's share of partnership nonrecourse liabilities equals:

1. the partner's share of partnership "minimum gain" under the Sec. 704(b) regulations, plus

2. the partner's share of any taxable gain allocated to that partner under Sec. 704(c) (or in the same manner of Sec. 704(c) book/tax differences), plus

3. the partner's share of "excess" nonrecourse liabilities.

Tier-One Allocations

A partner's share of minimum gain generally is determined in accordance with the Sec. 704(b) safe harbor regulations that govern the allocation of partnership losses and deductions attributable to nonrecourse liabilities. Under these rules, minimum gain is defined as the sum of the hypothetical gains a partnership would recognize if, in a taxable transaction, it disposed of all partnership assets that secure nonrecourse liabilities in full satisfaction of those liabilities and for no other consideration. The assets' book value, not the adjusted tax basis, is used when calculating minimum gain.

In this case, there is no partnership minimum gain, since the property's "book" basis ($100,000) exceeds the nonrecourse debt ($60,000). Therefore, there is no tier-one Sec. 752 allocation to be made.

Tier-Two Allocations

A partner's share of Sec. 704(c) minimum gain, the tier-two allocation, includes hypothetical taxable gains that would (1) result from a taxable disposition of property that secures nonrecourse liabilities in satisfaction of those nonrecourse liabilities (and for no other consideration) and (2) be allocated to the partner under Sec. 704(b) or (c) to reflect the difference between the basis and FMV of partnership property. The tier-two allocation depends on which of the three methods the partnership uses to deal with the Sec. 704(c) gains--the traditional method, the traditional method with curative allocations, or the remedial method.

In this case, under the traditional method, the results in Table 1, on page 641, occur.

[TABULAR DATA OMITTED]

There is a $40,000 book loss ($60,000 deemed sale proceeds less $100,000 book basis) split 50/50 between the partners. The $20,000 tax gain ($60,000 deemed sale proceeds less $40,000 tax basis) is allocated entirely to Clark (due to the ceiling rule). After allocating the tax gain and the book loss, there are still disparities between the partners' book and tax capital accounts, but they have no impact on the allocation of basis from the nonrecourse debt when the traditional method is used. Accordingly, the tier-two Sec. 752 allocation would be $20,000 to Clark and zero to Lois.

If the traditional method with curative allocations is used, the result is the same as in Table 1. The curative method depends on using allocations from other partnership income items to "cure" disparities between book and tax capital accounts caused by applying the Sec. 704(c) rules. However, such curative allocations are not taken into account in making Sec. 752 allocations of basis from the nonrecourse debt; only the Sec. 704(c) gain allocation resulting from the deemed sale itself can be considered (Regs. Sec. 1.752-3(a)(2)).

If the remedial method is used, the "initial" $20,000 Sec. 704(c) gain would be allocated to Clark (the difference between the debt and the property's tax basis). Lois would then be given a $20,000 remedial tax loss allocation t o reflect her share of the book loss. Clark would receive a remedial tax gain allocation of an additional $20,000 to offset the "created" tax loss allocated to Lois. Thus, the total Sec. 704(c) gain allocated to Clark would be $40,000. Accordingly, the tier-two Sec. 752 allocation would be $40,000 to Clark and zero to Lois (as shown in Table 2).

[TABULAR DATA OMITTED]

Clark, the contributing partner, will probably prefer to use the remedial method, since he receives a larger allocation of nonrecourse liabilities. This is generally true for contributing partners, especially if the contributed property has a low basis. Lois, the noncontributing partner, will prefer using one of the other two methods, which results in a larger allocation of nonrecourse liabilities to her.

Tier-Three Allocations

To the extent a partnership's nonrecourse liabilities exceed any amounts allocated under the general minimum gain and Sec. 704(c) minimum gain rules, they constitute "excess" nonrecourse liabilities. Excess nonrecourse liabilities are allocated among the partners in proportion to their percentage interests in partnership profits (Regs. Sec. 1.752-3(a)(3)). The partners' interests in partnership profits generally are determined based on all relevant facts and circumstances. However, they can, by agreement, specify the partners' interests in partnership profits for purposes of allocating excess nonrecourse liabilities. The allocation also can be made in proportion to how the partnership expects to allocate nonrecourse deductions attributable to the property. The specified interests will be honored as long as they are consistent with allocations of some other significant item of partnership income or gain that has substantial economic effect.

A factor to consider in making the tier-three allocation is the partner's share of the Sec. 704(c) built-in gain, to the extent the gain was not taken into account in making an allocation of nonrecourse liabilities under the tier-two allocation. The Sec. 704(c) built-in gain not taken into account in the tier-two allocation is one factor (but not the only one) to be considered in determining a partner's interest in partnership profits. In this situation, the Sec. 704(c) allocation has no impact because it does not have substantial economic effect.

The excess nonrecourse liabilities to be allocated between Lois and Clark is either $40,000 or $20,000. The amount depends on the method used for dealing with the Sec. 704(c) gains. If the traditional method or traditional method with curative allocations is used, the excess nonrecourse liability amount is $40,000 ($60,000 total liability less the tier-two allocation of $20,000). If the remedial method is used, the excess amount is $20,000 ($60,000 total liability less the tier-two allocation of $40,000)

In this case, the overall profit-sharing arrangement between Lois and Clark is 50/50. This 50/50 split could be used to make the tier-three allocation. If the partnership uses either the traditional method or the traditional method with curative allocations, the tier-three allocation would be $20,000 to Lois and $20,000 to Clark. If the remedial method is used, the tier-three allocation would be $10,000 to Lois and $10,000 to Clark.

Alternatively, the partnership could make the tier-three allocation in proportion to the expected allocation of nonrecourse deductions from the property. If this is done, the result would be an allocation of 100% of the excess nonrecourse liability amount to Clark, since all nonrecourse deductions from the property are required to be allocated to him. Therefore, if the partnership uses either the traditional method or the traditional method with curative allocations, the tier-three allocation would be $40,000 to Clark and zero to Lois. If the remedial method is used, the tier-three allocation would be $20,000 to Clark and zero to Lois.

Conclusion

There is more than one way to allocate basis from a nonrecourse liability. There are decisions to be made when making the tier-two and tier-three allocations that will affect the amount of basis allocated to each partner. While a particular method may prove beneficial to one partner, it may be disadvantageous to another partner. A lot of thought should be given to selecting the method of allocating both of these tiers. The partners should address the method of allocation for nonrecourse liabilities in the partnership agreement. If the agreed on method proves to be detrimental to a partner, perhaps this can be used as a bargaining tool when structuring another area of the partnership agreement.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 10th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard D. Thorsen, published by Practitioners Publishing Company Fort Worth, Tex., 1996.