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Allocation of partnership liabilities.

Although the Final Sec. 752 Regulations Have Been Streamlined, They Require a Complex Analysis of Related Rules and State Law Sec. 752 provides the mechanism under which a partner may include his share of partnership liabilities in computing his tax basis in his partnership interest. Partnership basis is important in determining a partner's limitation on the deduction of losses as well as on the amount of money that can be received through a partnership distribution without gain recognition under Sec. 731.

The general statutory rules of Sec. 752(a) and (b) can be divided into a share rule and an assumption rule. Under the share rule, (1) any increase in a partner's share of partnership liabilities is considered to be a contribution of money to the partnership by the partner, and (2) any decrease in a partner's share of partnership liabilities is considered to be a distribution of money to the partner by the partnership. The assumption rule likewise has two mirror components: (1)The assumption of a partnership liability by a partner is deemed to be a contribution of cash by the partner, and (2) the assumption of a partner's liability by the partnership is deemed to be a cash distribution to the partner. The statute does not address the rules for determining a partner's share of partnership liabilities. These rules are left to the regulations.

On Dec. 20, 1991, the IRS issued final regulations under Sec. 752 dealing with the allocation of partnership liabilities. With the issuance of these final regulations, partnerships are potentially subject to three different sets of liability sharing rules: (1) the "old" regulations (Regs. Sec. 1.752-1(e),2 as amended); (2) the "temporary" regulations (Temp. Regs. Sees. 1.752-0T through -4T,3 as amended); and (3)the "final" regulations (Regs. Sees. 1.752-0 through 1.752-5).

Effective Dates

In general, the Sec. 752 regulations are effective based on the date that the liability is incurred, unless there is a material modification of the liability or the partnership elects to apply a subsequent version of the regulations. Assuming that no material modification of the liability occurs and that no election to apply a different set of regulations is made, the general effective date rules are as follows.

The final regulations generally apply to liabilities incurred or assumed by the partnership on or after Dec. 28, 1991 (subject to a fairly standard binding contract exceptional? The temporary regulations generally apply to liabilities incurred or assumed by the partnership on or after Jan. 30, 1989 and before Dec. 29, 1991, except for certain "direct" partner loans and guarantees, which are subject to the temporary regulations as of the later of Mar. 1, 1984 or the date of the loan or guarantee subject to a fairly standard binding contract exception).5 The old regulations govern allocations of liabilities incurred or assumed by the partnership prior to the effective dates of the temporary regulations.6

A nonrecourse liability incurred or assumed by a partnership prior to Mar. 1, 1984 is subject to the old regulations. A subsequent guarantee by a partner or a related person does not change this result. Thus, such nonrecourse liabilities are to be allocated in accordance with partnership "profits," The generally accepted theory for allocating nonrecourse liabilities in accordance with profits is that the nonrecourse debt will be paid off with partnership profits, or the income will be allocated in accordance with profits interests if the nonrecourse debt is forgiven or if the property is sold. The determination of a partner's interest in profits, however, is often uncertain in complex partnership agreements involving special allocations of various items of income, gain, etc.

A third-party nonrecourse liability incurred or assumed by a partnership before Jan. 30, 1989 is governed by the old regulations. The liability is treated as a nonrecourse liability subject to the old regulations even if the liability is subsequently guaranteed by a related person. Thus, the same uncertainty in determining a partner's interest in profits exists. If the liability was incurred or assumed by the partnership after Feb. 29, 1984 and before Jan. 30, 1989, a partner guarantee of the liability would subject the liability to the temporary regulations.

* Elections

A partnership may elect to apply the final regulations to all of its liabilities as of the beginning of the first tax year of the partnership ending on or after Dec. -28, 1991.7 Regs. Sec. 1.752-5(b)(2) provides that the election is made by attaching a written statement (containing certain specified information) to the partnership return for the first tax year ending on or after Dec. 28, 1991. A second election exists under Temp. Regs. Sec. 1.7524T(d)(3), which allows a partnership to apply the temporary regulations to previously incurred liabilities by filing an amended return for the first tax year of the partnership ending after Dec. 9.9, 1988. For its first tax year ending after Dec. 9.7, 1991, a partnership is also permitted to elect to apply the temporary regulations to liabilities incurred or assumed by the partnership after Dec. 27, 1991 and before Jan. 1, 1992.8 These elections allow the partnership to simplify its tax records that track liabilities incurred in transitional years, as well as attempt to take advantage of liability allocation methods prescribed by later issued regulations. Any election should be carefully evaluated under both the Sec. 704(b)and Sec. 752 regulations. In addition, an election to apply the temporary or final regulations may provide an opportunity for a partnership with special allocations to determine liability allocations with greater certainty than existed under the old regulations.

* Terminations and admissions

A partnership termination under Sec. 708(b)(1)(B) will not change the general effective date rules, i.e., the newly constituted partnership will not be treated as incurring or assuming partnership liabilities on the termination date.9 Although not specifically stated in the regulations, the admission of new partners also should not change the general effective date rules of the regulations.

* Material modifications

The preamble to the final regulations indicates that a grandfathered partnership liability will lose its grandlathering if it is materially modified. Such materially modified liability becomes subject to a different set of regulations depending on when the material modification occurs. In recent times, obligations have frequently been modified in various restructuring and work-out arrangements. The final regulations, however, do not help clarify when such modifications are material.[10]

Assumption of Liability

Regs. Sec. 1.752-1(d) provides that "a person is considered to assume a liability only to the extent that: (1) [t]he assuming person is personally obligated to pay the liability; and (2)[i]f a partner or related person assumes a partnership liability, the person to whom the liability is owed knows of the assumption and can directly enforce the partner's or related person's obligation . . . , and no other partner or person that is a related person to another partner would bear the economic risk of loss for the liability immediately after the assumption." When a partnership assumes a liability from a partner, it appears that the partnership needs only to be personally obligated, i.e., the second part of subsection (d) does not apply.

Curiously, the requirements for an assumption under the final regulations differ from the requirements under the Sec. 704(b)regulations. Under Regs. Sec. 1.704-1(b)(2){iv)(c) a liability is assumed "only to the extent the assuming party is thereby subjected to personal liability with respect to such obligation, ... and, as between the assuming party and the party from whom the liability is assumed, the assuming party is ultimately liable." The final regulations do not contain the "ultimately liable" language, nor do the Sec. 704(b) regulations elaborate on its meaning.

Subject to a Liability

Sec. 752 (c) provides that a liability to which property is subject will, to the extent of the fair market value (FMV) of the property, be considered as a liability of the owner of the property. Sec. 752(c) seeks to treat unassumed liabilities in the same manner as those expressly assumed by the owner of the encumbered property.

Regs. Sec. 1,752-1(e} clarifies that Sec. 752(c)applies to contributions and distributions of property subject to a liability of the transfer or, and not to the sale or exchange of a partnership interest. [11] While it is clear that Sec. 752(c)applies to contributions and distributions, it is not clearly established that Sec. 752(c)does not apply to transactions other than contributions and distributions of encumbered property. [12] In addition, the transferee (the partnership in a contribution and the partner in a distribution} is treated as assuming the liability to the extent that the amount of the liability does not exceed the FMV Of the property at the time of contribution or distribution. Although not expressly stated, the FMV limitation of Sec. 752(c) arguably affects only liabilities not expressly assumed by the owner of the property.

There is very little guidance available in applying the FMV limitation and, therefore, many uncertainties exist.[13] For example, does the FMV limitation apply only at the time of contribution or distribution or must FMV fluctuations be accounted for? How are the "excess liability" and subsequent payments treated? Unfortunately, the final regulations do not fill this guidance void.

Liability Defined

Temp. Regs. Sec. 1.752-IT(g)provides that "an obligation is a liability of the obligor for purposes of section 752 and the regulations thereunder to the extent, but only to the extent, that incurring or holding such obligation gives rise to--( l)It]he creation of, or an increase in, the basis of any property owned by the obligor {including cash attributable to borrowings); (2)[a] deduction that is taken into account in computing the taxable income of the obligor; or {3] [a]n expenditure that is not deductible in computing the obligor's taxable income and is not properly chargeable to capital." For unexplained reasons, the final regulations do not provide guidance on the definition of a liability. Thus, the relevance of this definition is uncertain.

In drafting a set of regulations explaining the treatment of liabilities, it would seem that a very basic starting point would be to define liabilities.[14] Since it would seem possible for liabilities to exist for state law purposes that may not be liabilities for Sec. 752 purposes, it remains to be seen whether this lack of clear guidance will have to be clarified (or possibly confused) in the courts.

Recourse Liability Sharing

A partnership liability is a recourse liability to the extent that any partner or a related person bears the economic risk of loss for that liability.[15] Regs. Sec. 1.752-2(a)provides that "[a] partner's share of a recourse partnership liability equals the portion of that liability, if any, for which the partner or related person bears the economic risk of loss." In general, a partner or a related person bears the economic risk of loss for a partnership liability, to the extent that the partner or related person would be obligated (without any right of reimbursement) to bear the economic burden of extinguishing the liability if the partnership were not able to satisfy the liability. To determine who bears the economic risk of loss, Regs. Sec. 1.7522(b)(1) adopts a constructive liquidation analysis, which provides that on a constructive liquidation, all of the following are deemed to occur simultaneously.

* All of the partnership liabilities become payable in full.

* With the exception of property contributed to secure a partnership liability (see Regs. Sec. 1.7522(h)(2)) all of the partnership's assets, including cash, have a value of zero.

* The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor's right to repayment is limited solely to one or more partnership assets).

* All items of income, gain, loss or deduction are allocated among the partners.

* The partnership liquidates.

Regs. Sec. 1.752-2(b)(2)clarifies the treatment of the deemed disposition of property under the constructive liquidation analysis:(1) If the creditor's right to repayment of a partnership liability is limited solely to one or more assets of the partnership, the assets are deemed to be sold for the amount of the liability extinguished; and (2)a loss is recognized for any remaining basis of all partnership assets not taken into account in (1). The final regulations clarify that "book value," rather than tax basis, should be used in the calculations to the extent Sec. 704(c)(relating to property contributions with a tax basis different than FMV) or Regs. Sec. 1.704-1(b)(4)(i)(relating to capital account adjustments)applies.

Obligations Recognized

The final regulations provide that all statutory and contractual obligations relating to the partnership liability are taken into account for purposes of determining economic risk of loss.[16] Certain obligations are disregarded if, under the facts and circumstances, the obligations are subject to contingencies that make it unlikely that the obligations will ever be discharged.[17]

Regs. Sec. i.752-2{b)(6) contains a very important assumption, i.e., that all obligations will be satisfied, irrespective of the net worth of the relevant partners or related persons. This assumption is coupled with a subjective anti-abuse provision for plans to circumvent or avoid the obligation.

* Partner or related person as lender As a general rule, if a partner or a related person makes (or acquires an interest in) a nonrecourse loan to .a partnership, such partner bears the economic risk of loss for the partnership liability, unless the economic risk of loss for that liability is borne by another partner.[18] A special rule divides certain wrapped debt into two separate liabilities: (1) the wrapped portion (treated as a liability owed to another person) and (2) the remaining portion (treated as owed to the partner).[19]

The general rule does not apply to a partner or related person creditor if that partner or related person has a 10%-or-less interest in each item of partnership income, gain, loss, deduction or credit for every tax year that the partner is a partner in the partnership. To qualify for this de minimis exception, the loan to the partnership must constitute qualified nonrecourse financing within the meaning of Sec. 465(b)(6), determined without regard to the type of activity financed. A similar de minimis exception applies to the guarantee of an otherwise nonrecourse partnership loan?

Regs. Sec. 1.752-2(e) contains a rule that can cause an otherwise nonrecourse liability to be characterized as recourse when a partner (or related person) guarantees the interest payments of the liability. The recharacterization rule applies when (1) the guarantee is for a period that exceeds the lesser of five years or one-third of the term of the liability ("term requirement"); (2) the partners or related persons have guaranteed the payment of more than 25% of the total interest that will accrue on the nonrecourse liability over its remaining term ("amount requirement"J; and (3) it is reasonable to expect that the guarantor will be required to pay substantially all of the guaranteed future interest if the partnership fails to do so. If the rule applies, the liability is divided into (1) a recourse portion, i.e., the partner or related person is treated as bearing the economic risk of loss to the extent of the present value (using a discount rate equal to either the interest rate stated in the loan documents, or if interest is imputed under Sec. 483 or 1274, the applicable Federal rate (AFR) (compounded semiannually))of the guaranteed future interest payments, and (2) a nonrecourse portion, i.e., the remainder of the stated principal amount of the partnership liability. In general, if a guarantee provides that the lender can enforce the interest guaranty without foreclosing on the property and thereby extinguishing the underlying debt, it will be subject to this recharacterization rule (assuming the guarantee otherwise meets the term and amount requirements).

Regs. Sec. 1.752-2(e)(1) clarifies that once the more-than-25% criteria are met, the interest guarantee rule continues to apply even after the point at which the amount of guaranteed interest that will accrue is less than 25% of the total interest that will accrue on the liability.

Regs. Sec. 1.752-2(e)(4) also contains a de minimis exception to the interest guarantee rules that is very similar to the exception in which a partner or related person makes or guarantees an otherwise nonrecourse loan. However, to be eligible for the interest guarantee de minimis exception, the guarantor does not have to be in the lending business.

The regulations continue the recent trend to recognize time value of money concepts. Regs. Sec. 1.752-2(g)requires present value discounting of a liability if a payment obligation with respect to such partnership liability is not required to be satisfied within a reasonable time after the liability becomes due and payable. Discounting is also required if the payment obligation is not required to be satisfied before the later of(l)the end of the year in which the partner's interest is liquidated or {2)90 days after the liquidation. If such delayed obligations bear interest (at least equal to the AFR under Sec. 1274(d))beginning on (1)the date the partnership liability to a creditor or other person to whom the obligation relates becomes due and payable (for payment obligations) or (2) the date of the liquidation of the partner's interest in the partnership (for contribution obligations), no discounting is required. Otherwise, the value of the obligation is discounted to the present value of all payments due from the partner or related person using Sec. 1274 principles.

* Pledged property

If a partner or related person pledges separate property as security for a partnership liability, the partner is considered to bear the economic risk of loss for the liability, limited to the FMV of the pledged property at the time of the pledge? Regs. Sec. 1,752-2(h)(2) provides a similar rule for what are called "indirect pledges." An indirect pledge occurs when a partner contributes property to a partnership solely for the purpose of securing a partnership liability and substantially all the items of income, gain, loss and deduction attributable to the contributed property are allocated to the contributing partner, and this allocation is generally greater than the partner's share of other significant items of partnership income, gain, loss or deduction. In this case, the partner is considered to bear the economic risk of loss for the liability, limited to the FMV of the property at the time of contribution?

* Tiered partnership

As partnerships become a more prevalent form of doing business, many partnerships own interests in other partnerships. The final regulations give very little guidance in this tiered partnership realm. The regulations provide that "[ill a partnership [upper-tier partnership] owns . . . an interest in another partnership ]lower-tier partnership], the liabilities of the lower-tier partnership are allocated to the upper-tier partnership in an amount equal to the sum of . . . (l)The amount of the economic risk of loss that the upper-tier partnership bears with respect to the liabilities; and (2)Any other amount of the liabilities with respect to which partners of the upper-tier partnership bear the economic risk of lOSS.''23 In addition, under Regs. Sec. 1.752-4(a), an upper-tier partnership's share of a lower-tier partnership's liabilities is treated as a liability of the upper-tier partnership for purposes of allocating liabilities to the partners in the upper-tier partnership.

The final regulations do not give guidance in situations in which the total amount of the economic risk of loss that all the partners are determined to bear for a partnership liability exceeds the aggregate amount of the liability. Temp. Regs. Sec. 1.752-iT(d)(3)(i)provides for a formula apportionment of the economic risk of loss in such a situation. For example, a person may be a partner in two separate upper-tier partnerships. If he guarantees (without any reimbursement rights) a nonrecourse loan of the lower-tier partnership, no guidance is provided as to how the resulting economic risk of loss is shared. Arguably, the guaranteeing partner bears the full economic risk of loss through each partnership. Thus, it appears that the partner bears the economic risk of loss (and therefore should receive basis) equal to 50% of the liability in each upper-tier partnership. It does not appear that the answer would change even if the indirect interest the partner has in each upper-tier partnership was different.

* No double counting Regs. Sec. 1,752-4(c)provides that "[t]he amount of an indebtedness is taken into account only once, even though a partner (in addition to the partner's liability for the indebtedness as a partner) may be separately liable therefore in a capacity other than as a partner." Thus, a liability can give rise to basis only equal to the amount of the liability. As discussed above, the final regulations fail to provide guidance when the total amount of the economic risk of loss borne by the partners exceeds the aggregate amount of the liability.24

* Anti-abuse rules

Regs. Sec. 1.752-2(i) adds anti-abuse rules that give the IRS the right to disregard an obligation, or treat the obligation as an obligation of another person if the facts and circumstances indicate that "a principal purpose of the arrangement between the parties is to eliminate the partner's economic risk of loss with respect to that obligation or create the appearance of the partner or related person bearing the economic risk of loss when, in fact, the substance of the arrangement is otherwise." The regulations list arrangements tantamount to a guarantee and situations in which the facts show that plans exist to circumvent or avoid the obligation, as illustrations of when payment obligations might be disregarded.

Nonrecourse Debt

A partnership liability is nonrecourse to the extent that no partner or related person bears the economic risk of loss for that liability.25 This definition of nonrecourse liabilities is not necessarily the same as the definition of a nonrecourse liability under Sec. 1001. For example, a liability that is recourse to the partnership and nonrecourse to the partners may be recourse under Sec. 1001 but nonrecourse under Sec. 752. In addition, a nonrecourse loan from a partner to a partnership is arguably treated as nonrecourse under Sec. 1001 and a partner nonrecourse debt under the Sec. 704(b) rules. The Sec. 752 regulations would classify this loan as a recourse debt since a partner (the lender)bears the economic risk of loss.

Since the lender bears the economic risk of loss for a nonrecourse liability, the economic risk of loss principles using a constructive liquidation analysis are not an appropriate method to determine sharing of nonrecourse liabilities. The final regulations continue the theory that it is appropriate to allocate nonrecourse liabilities in accordance with how the partners share profits. Regs. Sec. 1.752-3(a) creates a three-tier sharing structure, similar to the temporary regulations, under which a partner's share of nonrecourse liabilities of a partnership is the sum of the following.

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

2. The amount of any taxable gain that would be allocated to the partner under Sec. 704(c)(or under Sec. 704(c)principles in connection with a revaluation of partnership property) if the partnership disposed of (in a taxable transaction)all of its property subject to nonrecourse liabilities in full satisfaction of the liabilities and for no other consideration (Sec. 704(c)minimum gain). 3. The partner's share of excess nonrecourse liabilities (those not allocated in 1 or 2 above)as determined in accordance with the partner's share of partnership profits (excess nonrecourse liabilities).

* Tier I--minimum gain

Regs. Sec. 1.752-3(a)(1) allocates nonrecourse debt to the partner that is allocated nonrecourse deductions (i.e., the increase in minimum gain). This ties into the nonrecourse deduction allocation rules of Regs. Sec. 1.704-2 and has the effect of giving the partner basis to support the allocated deductions. Minimum gain is the gain the partnership would realize if the property securing the liability were disposed of for no consideration other than relief from the liability. The minimum gain is the "book" gain and, therefore, does not necessarily equal the tax minimum gain if there was a "book-up" of partnership property or a booktax disparity at contribution.

* Tier II--Sec. 704(c) minimum gain This tier has the effect of allocating to the partner a share of nonrecourse liabilities equal to the difference between the tax minimum gain and the book minimum gain. In general, this tier can help a partner avoid Sec. 73 1 gain from a deemed distribution (from a shift in liabilities) on the contribution of encumbered property when the liabilities exceed basis. The amount of "gain" at the time of contribution will be allocated to the contributing partner under Sec. 704(c); however, this gain share may change as a result of depreciation or amortization. Therefore, the partners must be aware of liability shifts that may occur throughout the life of the partnership.

* Tier III--excess nonrecourse liabilities The partnership agreement may designate the partners' interest in partnership profits for purposes of allocating excess nonrecourse liabilities provided the interests so specified are reasonably consistent with allocations (that have substantial economic effect under the Sec. 704(b)regulations) of some other significant item of partnership income or gain. Alternatively, excess nonrecourse liabilities may be allocated among partners in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated. Excess nonrecourse liabilities do not have to be allocated under the same method each year.26

The excess nonrecourse liability sharing rules are an improvement from the temporary regulations and should lessen unintended shifts in liabilities. However, some uncertainties still remain. For example, the term "significant" item of partnership income or gain is not defined. This same problem exists under the Sec. 704(b)nonrecourse regulations. In addition, using the alternative allocation seems to require projections of what is "reasonably expected." It is not clear what happens if deductions attributable to the nonrecourse liabilities are ultimately allocated in a different manner than what was reasonably expected.

Related Persons

A partner and a person are related if they bear a relationship to each other using a modified version of Sees. 267(b)and 707(b)(1).27 For this purpose, Sees. 267(b)and 707(b)(l) are subject to the following modifications.

* "80 percent or more" is substituted for "more than 50 percent" each place it appears in those sections.

* Family does not include brothers and sisters.

* Sec. 267(e)(1)and (f)(l)(A)are disregarded.

If a person happens to be related to more than one partner, the person is generally treated as being related only to the partner with whom there is the highest percentage of related ownership. In addition, Regs. Sec. 1.752-4(b)(2)(iv) contains an anti-abuse rule when a principal purpose of having another entity act as a lender or guarantor of the liability is to avoid the determination that the partner who owns the interest bears the economic risk of loss for all or a part of the liability.


Commentators have praised the final regulations for their simplicity. Nevertheless, the regulations require a complex analysis of state law and agreements among all parties involved (partners, lenders and others) to determine their legal rights. If simplification means eliminating certain definitional provisions and numerous clarifying examples from the regulations, then the final regulations have achieved simplification. In addition, the tax consequences of the allocation rules under Sec. 704(b), in particular the Sec. 704(b) nonrecourse rules, must be analyzed. The authors will deal with the final Sec. 704(b)nonrecourse regulations that were issued shortly after the Sec. 752 final regulations in a future article.
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Author:Dennis, William A., Jr.
Publication:The Tax Adviser
Date:Aug 1, 1992
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