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Prop. regs. on allocation of partnership debt.

On Jan. 19, 2000, the IRS issued proposed regulations on the allocation of nonrecourse liabilities by a partnership. The proposed regulations would revise Regs. Secs. 1.752-3 and -5. In particular, the revisions will (1) affect the third tier of the three-tiered allocation structure contained in the current nonrecourse liability regulations and (2) provide guidance on the allocation of a single nonrecourse liability secured by multiple properties.

Regs. Sec. 1.752-3 currently provides a three-tiered system for allocating nonrecourse liabilities, which applies sequentially. Once an allocation is made under the first tier, that amount is not available for allocation under the second or third tier.

Currently, an allocation to a partner under the first tier represents a liability equal to his share of partnership minimum gain under Sec. 704(b) (Regs. Sec. 1.752-3(a)(1)). Under the second tier, a partner will be allocated a liability equal to the gain he would be allocated under Sec. 704(c) if the partnership disposed of all partnership property (subject to one or more nonrecourse liabilities) in full satisfaction of the liabilities and for no other consideration (Regs. Sec. 1.7523(a)(2)). Finally, under current Regs. Sec. 1.752-3(a)(3), the third tier allocates excess nonrecourse liabilities, using one of several methods. Generally, a partner is allocated any excess nonrecourse liabilities in accordance with his share of partnership profits. The partnership may specify in its agreement the partners' interests in partnership profits for purposes of allocating excess nonrecourse liabilities, provided the specified interests are reasonably consistent with allocations of some other significant item of partnership income or gain. Alternatively, the partnership may choose to allocate excess nonrecourse liabilities in accordance with the manner in which it is reasonably expected that the deductions attributable to such liabilities will be allocated. The partnership is not bound to the same allocation method under the third tier from year to year and may choose to change its allocation method annually.

The three tiers of Regs. Sec. 1.7523 are structured to allocate liabilities to partners who generally would be allocated income or gain on the relief of such liabilities. Under Sec. 752(b), any decrease in a partner's share of partnership liabilities will be considered a distribution of money to him by the partnership. Under Sec. 731(a), a partner will recognize gain on the distribution of money by the partnership to the extent the distribution exceeds his adjusted basis in his partnership interest. Sec. 704(c) generally ensures that, on disposition of the contributed property, the contributing partner will recognize any built-in gain or loss that the partnership realizes. Arguably, the partnership liability allocation rules should not accelerate the contributing partner's gain recognition when the partnership's liabilities attributable to such property are sufficient, if allocated to the contributing partner, to prevent such partner from recognizing gain.

Prop. Regs. Sec. 1.752-3(b) would modify the third-tier rules to allow a partnership to allocate a portion of the nonrecourse liability, based on the excess Sec. 704(c) gain attributable to the property securing the liability. Sec. 704(c) is generally applied on a property-by-property basis. In determining the excess Sec. 704(c) gain, the built-in gains and losses on items of contributed property cannot be aggregated.

To determine if a partnership has Sec. 704(c) property, the book value of contributed property equals its fair market value (FMV) at the time of contribution and is subsequently adjusted for cost recovery and other events that affect the property's basis. The Sec. 704(c) built-in gains are the excess of the property's book value over the contributing partner's adjusted tax basis in the property at the time of contribution. The built-in gain is thereafter reduced by decreases in the difference between the property's book value and adjusted tax basis. Similarly, the excess Sec. 704(c) gain will decline as the difference between the property's FMV and tax basis declines.

If a partnership holds Sec. 704(c) property subject to the ceiling rule of Regs. Sec. 1.704-3(b)(1), in certain situations, the first tier of Regs. Sec. 1.752-3(a) can gradually shift the allocation of liabilities from the partner that contributed the property to a noncontributing partner who does not necessarily need (for tax purposes) the entire allocated liability. This can give rise to deemed distributions for the contributing partner, resulting in gain recognition under Sec. 731(a)(1) at a time arguably earlier than appropriate.

The Service has considered other alternatives for amending Regs. Sec. 1.752-3 that would address the liability shifts caused by the ceiling rule, but rejected them because of complexity. The proposed alternative was adopted because it is simple and seems to address the predominant concerns raised by practitioners regarding the contribution of Sec. 704(c) property.

The proposed regulations also address the allocation of a single nonrecourse liability among multiple properties. Prop. Regs. Sec. 1.752-3(b) was added to provide guidance for a partnership that holds multiple properties subject to a single liability. The liability may be allocated among the properties based on any reasonable method. Under the proposed regulations, a method is not reasonable if it allocates to any property an amount that exceeds its FMV.

The portion of the nonrecourse liability allocated to each item of partnership property is treated as a separate loan under Regs. Sec. 1.752-3(a)(2). Prop. Regs. Sec. 1.752-3(b) provides that once a liability is allocated among the properties, a partnership may not change the method for allocating the liability. If one of the properties is no longer subject to the liability, the partnership must reallocate that portion of the liability to the properties still subject to the liability, so that the amount allocated to any property does not exceed its FMV at the time of the reallocation.

If the outstanding principal of a liability is reduced, the reduction will affect the amount of Sec. 704(c) minimum gain under the second tier. Regs. Sec. 1.752-3(b) provides that, as the outstanding principal of a liability is reduced, the reduction is allocated among the properties in the same proportion that the principal originally was allocated to the properties.


Editor: Anthony Bakale, CPA, MT Cohen & Company, CPAs Summit International Associates, Inc. Cleveland, OH
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Author:Bakale, Anthony
Publication:The Tax Adviser
Geographic Code:1USA
Date:Aug 1, 2000
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