Final regs. on treatment of disregarded entities under Sec. 752.

Treasury and the Service issued final regulations (TD 9289, 10/11/06) under Sec. 752, on taking into account certain obligations of a business entity disregarded as separate from its owner under Sec. 856(i) (a qualified real estate investment trust subsidiary), Sec. 1361(b)(3) (a qualified subchapter S subsidiary) or the check-the-box rules (collectively, a disregarded entity). The rules help determine the extent to which a partner is deemed to bear the economic risk of loss for a partnership liability when it holds a partnership interest through a disregarded entity.

The regulations are generally effective for liabilities incurred or assumed by a partnership after Oct. 10, 2006.

Background

Sec. 752 provides that a partner's basis in its partnership interest includes its share of partnership liabilities. In general, a partner is allocated a share of a partnership liability under Sec. 752 to the extent it bears the "economic risk of loss" for repayment.

Treasury and the Service had issued proposed regulations (REG-128767-04, 8/12/04) under Sec. 752 for taking into account certain obligations of disregarded entities. The final rules adopted the proposed regulations in substantially the same form.

Final Regs.

Net value approach: The proposed regulations provide that a disregarded entity's payment obligation for which a partner is treated as bearing the economic risk of loss is taken into account only to the extent of the disregarded entity's net value. Some commentators disagreed with this approach, arguing that it would result in the inconsistent treatment of similar economic situations and unwarranted complexity. Treasury and the Service, however, believe that applying the presumption of deemed satisfaction to a disregarded entity that shields a Federal tax partner from liability for the entity's obligation would, in many cases, cause partnership liabilities economically indistinguishable from nonrecourse liabilities to be classified as recourse under Sec. 752. Thus, the final regulations retain the proposed regulations' rule.

Not extended to other entities: Treasury and the IRS requested comments on whether the proposed regulations should extend to the Regs. Sec. 1.752-2(b) (1) payment obligations of other entities (i.e., entities not disregarded, but nominally capitalized). Some commentators suggested that the Regs. Sec. 1.752-2(j) anti-abuse rule could be expanded to cover certain situations involving thinly capitalized entities. Although Treasury and the Service received comments on this issue, the final regulations do not modify the anti-abuse rule of Regs. Sec. 1.752-2(j) and do not extend the net value approach to nominally capitalized entities. However, they stated that they may continue to study such issues in conjunction with future guidance projects.

Calculating net value: In the preamble to the final regulations, Treasury and the IRS noted that the comments received on a disregarded entity's net value illustrate the difficulty of taking into account priorities among obligations of disregarded entities in determining their net value, as well as the differing views on the best approach to measure a partner's economic risk of loss.

The final regulations provide that a disregarded entity's net value equals the fair market value (FMV) of all its assets that may be subject to creditors' claims under local law, including enforceable rights to contributions from its owner, but excluding its interest in the partnership for which the net value is being determined (if any) and the FMV of property pledged to secure a partnership liability (already taken into account under Regs. Sec. 1.752-2(h)(1)), less obligations that are not, and that are senior or of equal priority to, its Regs. Sec. 1.752-2(b)(1) payment obligations. That net value is then reported by each owner to each partnership for which the disregarded entity may have one or more Regs. Sec. 1.752-2(b)(1) payment obligations. If the disregarded entity has a payment obligation for more than one partnership liability, the partnership must allocate net value among the partnership's liabilities in a reasonable and consistent manner, taking into account their relative priorities.

Further, a disregarded entity's interest in another partnership (other than the one for which the net value is being determined) is included as an asset to be valued for the purpose of the net value calculation.

Valuation events: In the proposed regulations, Treasury and the Service requested comments on the type of events that should give rise to a re-determination of a disregarded entity's value once net value is initially determined. The final regulations generally provide for the following valuation events: (1) a more-than-de minimis contribution to a disregarded entity of property, other than property pledged to secure a partnership liability; (2) a more-than-de minimis distribution from a disregarded entity of property, other than property pledged to secure a partnership liability; (3) a change in the legally enforceable obligation of the disregarded entity's owner to make contributions to the disregarded entity; (4) the incurrence, refinancing or assumption of an obligation of the disregarded entity that does not constitute its payment obligation under the regulations; and (5) the sale or exchange of a non-de minimis asset of the disregarded entity in a transaction outside of the normal course of business.

Finally, Treasury and the IRS agreed with comments that certain transfers to a disregarded entity that remain there only briefly should not be valuation events. The final regulations reflect this comment.

Timing issues: The final rules clarify when the net value of a disregarded entity must be determined. It is generally determined as of the earlier of the (1) first date occurring on or after the date on which the requirement to determine a disregarded entity's net value arises for which the partnership otherwise determines a partner's share of partnership liabilities under Regs. Secs. 1.705-1(a) and 1.752-4(d); or (2) end of the partnership's tax year in which the requirements to determine a disregarded entity's net value arise. For example, if a valuation event occurs during the partnership's tax year, and subsequently (but before the end of the tax year), the partnership makes a distribution that requires a determination of the distributee partner's basis in the partnership, the disregarded entity's net value must be redetermined as of the distribution date.

Value of pledged property: The final regulations provide that, if additional property is made subject to a pledge, it is treated as a new pledge and the net FMV of all of the pledged property must be determined at that time. In addition, Treasury and the Service stated that they may continue to study whether further modifications to the pledge rule are needed.

Implications

These regulations implement another restriction in the treatment of an entity disregarded for Federal tax purposes. Unlike most of the other areas that are procedural in nature (e.g., determining the tax matters partner), this acknowledgement of a disregarded entity's existence applies to a technical rule under the regulations.

Moreover, these regulations differentiate between disregarded-entity partners and regarded-entity partners with regard to the satisfaction presumption. As in the proposed regulations, the satisfaction presumption is not available to a disregarded entity, but may be available to a thinly capitalized entity regarded as a partner for Federal tax purposes. For example, the satisfaction presumption provides that such an entity that is a partner is generally presumed to be able to satisfy its obligations under local law in determining how partnership liabilities are allocated, notwithstanding its actual net value. The satisfaction presumption does not apply when, under local hw, the tax partner holds its interest in the partnership through a disregarded entity. In finalizing the regulations, the Service and Treasury declined to adopt the net value approach of partners that are regarded entities.

Finally, these rules impose an additional administrative requirement on partnerships with certain passthrough partners. The partnership must ascertain whether any of its legal partners are disregarded entities. If any are, it then must obtain information about that entity's net asset value. The Treasury and Service rejected taxpayer comments requesting that a partnership be allowed to make certain assumptions about its partners in complying with these rules. In response, they stated that partnerships are responsible for obtaining the required information in order to allocate partnership liabilities correctly among the partners, and that partnership agreements should require that partners comply with the reporting requirements.

FROM BARKSDALE HORTENSTINE, J.D., WASHINGTON, DC