Recently Proposed Treasury Regulations Regarding The Allocation Of Partnership Recourse And Nonrecourse Liabilities Contain Significant Changes For Many Routine Partnership Transactions

On January 29, 2014, the Internal Revenue Service ("IRS") and the Treasury Department issued proposed regulations1 (the "Proposed Regulations") modifying the rules under Section2 752 regarding the allocation of recourse and nonrecourse partnership liabilities and clarifying some aspects of the disguised sale rules of Section 707. The Proposed Regulations would make significant changes to the rules for allocating partnership liabilities among partners, including imposing a "net value" requirement on partners to whom liabilities are allocated and ignoring "bottom-dollar" guarantees in determining whether debt is recourse to the guarantor. In addition, the proposed regulations eliminate two of the alternative methods of allocating certain nonrecourse liabilities and replace those with a new method focusing on the partners' relative liquidation values in the partnership. Although some aspects of the Proposed Regulations are helpful, the provisions regarding bottom-dollar guarantees and allocations of recourse and nonrecourse liabilities, if enacted as proposed, represent a significant change from current law and could create significant challenges for many common partnership structures.

Overview of Allocations of Recourse and Nonrecourse Liabilities under Current Law

General Rules

Section 752(a) treats any increase in a partner's share of partnership liabilities as a contribution of money by such partner to the partnership. Conversely, a decrease in a partner's share of partnership liabilities is treated as a distribution of money to the partner by the partnership. Partnership liabilities are subject to different allocation rules depending on whether they are treated as recourse or nonrecourse liabilities. In general, recourse liabilities are allocated to the partner(s) that bear the risk of loss while nonrecourse liabilities are allocated among all partners based on how they share profits.

Treasury Regulations Section 1.752-1 generally defines a recourse liability as any partnership liability to the extent that any partner bears the economic risk of loss for that liability. A partnership liability is generally treated as nonrecourse liability to the extent that no party bears the economic risk of loss for that liability.

Under Treasury Regulations Section 1.752-2, a partner's share of recourse partnership liability is generally an amount equal to the portion of the liability for which the partner bears the economic risk of loss. A partner generally bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment to any person (or a contribution to the partnership) and would not be entitled to reimbursement from another partner. For purposes of determining whether a partner has a payment obligation and the economic risk of loss, Treasury Regulation Section 1.752-2 assumes that all partners who have obligations to make payments will actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate otherwise.

Nonrecourse liabilities on the other hand are allocated among partners based on a three-tier structure under Treasury Regulations Section 1.752-3. First, each partner is allocated nonrecourse liability in an amount equal to his share of partnership minimum gain. Second, each partner is allocated nonrecourse liabilities in an amount equal to the taxable gain (if any) that would be allocated to the partner under Section 704(c) if the partnership were to dispose of all partnership property that is subject to nonrecourse liability in full satisfaction of the nonrecourse liabilities and for no other consideration. Third, any excess amount of nonrecourse liability is allocated among the partners in accordance with their shares of partnership profits. Under the current rule, an allocation of nonrecourse liabilities generally is treated as consistent with a partner's share of partnership profits if it is in accordance with allocations of some other significant item of partnership income (the so-called "significant item method") or in accordance with the allocation of deductions with respect to the nonrecourse liabilities. Accordingly, if the allocation conforms to the allocation of another single significant item, it should be respected.

Certain IRS Concerns In Connection with Current Debt Allocation Rules

One motivation for the proposed changes in the allocation of recourse and nonrecourse liabilities has been the perceived abuses of certain leveraged partnership transactions which involve guarantees of partnership debt by undercapitalized taxpayers.3 Taxpayers owning real estate and other property with large built-in gains have used leveraged partnership transactions to get some liquidity with respect to their investments. In these transactions, a newly-formed partnership to which the taxpayer contributes property will borrow against the equity in the appreciated property and then distribute all or a portion of the amount borrowed to the contributing partner. If properly structured, these transactions may permit the taxpayer to monetize its investment in the property without the recognition of the built-in gain. For the leveraged partnership structure to be respected, the loan must be properly allocable to the partner benefiting from the debt so that it is treated as a debt financed transfer under Treasury Regulations Section 1.707-5(b)(1). Under the current Treasury Regulations, if the contributor guarantees the debt, the debt will be treated as recourse to the contributor, the...