Final, Temporary and Proposed Regulations Issued on Partnership Disguised Sales and Allocations of Excess Nonrecourse Liabilities (T.D. 9787, T.D. 9788, NPRM REG-122855-15)

CCH Tax Day Report

The IRS has issued final regulations under Code Sec. 707 regarding disguised sales and the allocation of excess partnership nonrecourse liabilities to a partner under Code Sec. 752; temporary regulations concerning a partner’s share of partnership liabilities for purposes of Code Sec. 707 and the treatment of certain payment obligations under Code Sec. 752; and proposed regulations addressing when certain obligations to restore a deficit balance in a partner’s capital account are disregarded under Code Sec. 704 and when a partnership’s liabilities are treated as recourse liabilities under Code Sec. 752. The final and temporary regulations are effective on October 4, 2016. The proposed regulations provided in NPRM REG-119305-11 (2014 proposed regulations) are withdrawn in part.

Final Regulations

Preformation capital contributions. The disguised sales rules under Code Sec. 707 generally provide that related transfers to and by a partnership that, when viewed together, are more properly characterized as a sale or exchange of property, are treated either as a transaction between the partnership and one who is not a partner or between two or more partners acting other than in their capacity as partners. A transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner will be treated as a sale of property by the partner to the partnership (a disguised sale), if based on all the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of property and, for nonsimultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership. An exception to this rule is provided under Reg. §1.707-4(d) for reimbursements of capital expenditures, which generally applies only to the extent that reimbursed capital expenditures do not exceed 20 percent of the fair market value of the property transferred; the 20-percent limitation, in turn, does not apply if the fair market value does not exceed 120 percent of the partner’s basis in the property at the time of the transfer. The 2014 proposed regulations required that these tests be applied separately for each property that qualifies for the exception. The final regulations provide for limited aggregation of property, subject to certain limitations and provided that such aggregation is not part of a plan a principal purpose of which is to avoid the disguised sale rules.

The final regulations also clarify the rules for capital expenditure qualified liabilities under Reg. §1.707-5. A liability that is allocable to a capital expenditure with respect to property transferred by a partner to a partnership may be assumed by the partnership without triggering the disguised sale rules (capital expenditure qualified liability). To coordinate the exception for preformation capital expenditures and the capital expenditure qualified liability rule, the 2014 proposed regulations provided that to the extent a partner funded a capital expenditure through a capital expenditure qualified liability, and economic responsibility for that borrowing shifts to another partner, the preformation capital expenditure exception would not apply because there is no outlay by the partner to reimburse. Under the final regulations, to the extent any qualified liability under Reg. §1.707-5(a)(6) is used by a partner to fund capital expenditures and economic responsibility for that borrowing shifts to another partner, the exception for preformation capital expenditures does not apply. Capital expenditures are treated under the final regulations as funded by the proceeds of a qualified liability to the extent the proceeds are either traceable to the capital expenditures under Reg. §1.163-8T or are actually used to fund the capital expenditures, irrespective of the tracing requirements under Reg. §1.163-8T. However, under an anti-abuse provision, if capital expenditures and a qualified liability are incurred under a plan a principal purpose of which is to avoid the requirements of this coordinating rule, the capital expenditures are deemed funded by the qualified liability.

Partner’s share of partnership liabilities. The temporary regulations under Code Sec. 707, as discussed below, provide that a partner’s share of any partnership liability for disguised sale purposes is determined using the same percentage used to determine the partner’s share of the partnership’s excess nonrecourse liabilities under Reg. §1.752-3(a)(3) based on the partner’s share of partnership profits; thus, all partnership liabilities are treated as nonrecourse liabilities solely for disguised sale purposes under Code Sec. 707. The final regulations provide limitations on the available allocation methods under Reg. §1.752-3(a)(3), applicable solely for disguised sale purposes under Code Sec. 707 for determining a partner’s share of excess nonrecourse liabilities. For these purposes, the 2014 proposed regulations removed the significant item method and the alternative method, but provided a new approach based on a partner’s liquidation value percentage. The final regulations under Reg. §1.752-3 retain the significant item method and the alternative method, but do not adopt the liquidation value percentage approach for determining partners’ interests in partnership profits. However, because the allocation of excess nonrecourse liabilities in accordance with the significant item method and the alternative method has been abused by partnerships and their partners for disguised sale purposes, the final regulations provide that, along with the additional method, the significant item method and the alternative method do not apply for purposes of determining a partner’s share of a partnership liability for disguised sale purposes. Also, to mitigate the effect of the allocation method for disguised sales, the final regulations include a rule under Reg. §1.707-5(a)(5) that does not take into account qualified liabilities as consideration in transfers of property treated as a sale when the total amount of all liabilities other than qualified liabilities that the partnership assumes or takes subject to is the lesser of 10 percent of the total amount of all qualified liabilities the partnership assumes or takes subject to, or $1,000,000.

Step-in-the-shoes rule for preformation capital expenditures and liabilities incurred by another person. The final regulations provide a “step-in-the-shoes” rule for applying the exception for preformation capital expenditures and for determining whether a liability is a qualified liability under Reg. §1.707-5(a)(6) when a partner acquires property, assumes a liability, or takes property subject to a liability from another person in connection with a nonrecognition transaction under Code Secs. 351, 381(a), 721, or 731. Thus, Rev. Rul. 2000-44, 2000-2 CB 336, relating to preformation capital expenditures and qualified liabilities involved in a Code Sec. 381(a) transaction, is superceded by the final regulations.

Anticipated reduction. Under the existing regulations, for purposes of Code Sec. 707, a partner’s share of a liability assumed or taken subject to by a partnership is determined by taking into account certain subsequent reductions in the partner’s share of the liability. The 2014 proposed regulations provided that if, within two years of the partnership assuming, taking property subject to, or incurring a liability, a partner’s share of the liability is reduced due to a decrease in the partner’s or a related person’s net value, then the reduction is presumed to be anticipated and must be disclosed unless the facts and circumstances clearly establish that the decrease in the net value was not anticipated. Because the temporary regulations under Code Sec. 707 provide that a partner’s share of any liability for disguised sale purposes is determined in accordance with the partner’s interest in partnership profits under Reg. §1.752-3(a)(3), net value is not relevant in determining a partner’s share of partnership liabilities for disguised sale purposes. Accordingly, the final regulations do not retain the net value component of the anticipated reduction of share of liabilities rule.

Tiered partnerships. The 2014 proposed regulations provided additional rules regarding tiered partnerships for cases in which a partnership succeeds to a liability of another partnership. Under that proposed rule, a contributing partner’s share of a liability from a lower-tier partnership is treated as a qualified liability to the extent the liability would be a qualified liability had the liability been assumed or taken subject to by the upper-tier partnership in connection with a transfer of all of the lower-tier partnership’s property to the upper-tier partnership by the lower-tier partnership. The final regulations retain this proposed rule but also provide that in determining whether a liability would be a qualified liability under Reg. §1.707-5, the determination of whether the liability was incurred in anticipation of the transfer of property to the upper-tier partnership is based on whether the partner in the lower-tier partnership anticipated transferring the partner’s interest in the lower-tier partnership to the upper-tier partnership at the time the liability was incurred by the lower-tier partnership. The final regulations also allow for the application of the exception for preformation capital expenditures when a person incurs capital expenditures with respect to property, transfers the property to a partnership (lower-tier partnership), and then transfers an interest in the lower-tier partnership to another partnership (upper-tier partnership) within the two-year period in which the person incurred the capital expenditures. Under the final rules, the upper-tier partnership “steps in the shoes” of the person with respect to the property for which the capital expenditures were incurred and may be reimbursed for the capital expenditures by the lower-tier partnership to the same extent that the person could have been reimbursed by the lower-tier partnership. In addition, the person is deemed to have transferred the property, rather than the partnership interest, to the upper-tier partnership for purposes of the exception for preformation capital expenditures and, accordingly, may be reimbursed by the upper-tier partnership to the extent the person could have been previously reimbursed by the lower-tier partnership. The aggregate reimbursements for capital expenditures under this rule cannot exceed the amount that the person could have been reimbursed for such capital expenditures under Reg. §1.707-4(d)(1).

Treatment of liabilities in assets-over merger. The 2014 proposed regulations extended the netting principles of Reg. §1.752-1(f) in a provision for determining the effect of an assets-over merger or consolidation under the disguised sale rules. The final regulations do not retain the proposed rule for partnership assets-over mergers or consolidations. In many instances, liabilities involved in such a merger will constitute qualified liabilities, especially given that the final regulations adopt a “step-in-the-shoes” rule for liabilities acquired by a partner from another person in certain nonrecognition transactions. Further, in cases in which liabilities involved in an assets-over merger do not constitute qualified liabilities, the facts and circumstances test in Reg. §1.707-3 should reach the proper result.

Disguised sales of property by a partnership to a partner. The final regulations do not make any substantive changes to the rules under Reg. §1.707-6. The preamble to the 2014 proposed regulations requested comments on whether it is inappropriate to take into account a transferee partner’s share of a partnership liability immediately prior to a distribution if the transferee partner did not have economic exposure with respect to the partnership liability for a meaningful period of time before appreciated property is distributed to that partner subject to the liability. Because under the Code Sec. 707 temporary regulations a partner’s share of all liabilities is determined for disguised sale purposes in accordance with the partner’s interest in partnership profits under Reg. §1.752-3(a)(3), the transitory nature of a partner’s share of nonqualified liabilities is no longer an issue. Under that allocation method, an allocation of a 100 percent share of a liability to a partner immediately before a transfer of property by the partnership to the partner in which the transferee partner assumes the liability will not be taken into account.

Temporary Regulations

Partner’s share of partnership liabilities for purposes of Code Sec. 707.

The temporary regulations under Code Sec. 707 provide that a partner’s share of any partnership liability for disguised sale purposes is the same percentage used to determine the partner’s share of the partnership’s excess nonrecourse liabilities under Reg. §1.752-3(a)(3), as limited for disguised sale purposes under the final regulations under Code Sec. 752. The temporary rules also provide that a partner’s share of a partnership liability for disguised sale purposes does not include any amount of the liability for which another partner bears the economic risk of loss (EROL) for the partnership liability under Reg. §1.752-2. However, the temporary regulations reserve with respect to the treatment of Reg. §1.752-7 contingent liabilities for disguised sale purposes. The Treasury Department and the IRS will continue to study the effect of contingent liabilities with respect to Code Sec. 707, as well as other Code sections.

Bottom dollar payment obligations. Based on continuing concerns that partners and related persons are entering into payment obligations that are not commercial solely to achieve an allocation of partnership liability, temporary regulations under Code Sec. 752 provide that certain obligations, identified in the temporary regulations as “bottom dollar payment obligations”, should not be recognized as payment obligations because they lack a significant nontax commercial business purpose. A bottom dollar payment obligation includes, with certain exceptions, (1) any payment obligation other than one in which the partner or related person is or would be liable for the full amount of the obligation if (A) in the case of a guarantee or other similar arrangement, less than the full amount is otherwise satisfied, or (B) in the case of an indemnity or similar arrangement any amount of the indemnitee’s or benefited party’s payment obligation is satisfied, and (2) an arrangement with respect to a partnership liability involving tiered partnerships, intermediaries, or similar arrangements to convert an otherwise-single liability into multiple liabilities if the facts and circumstances indicate that the liabilities were incurred (A) pursuant to a common plan or as part of a single transaction, and (B) with a principal purpose of avoiding having at least one of such liabilities or payment obligations being treated as a bottom dollar payment obligation. Any payment obligation under Reg. §1.752-2, including an obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership, may be a bottom dollar payment obligation if it meets these requirements. The temporary regulations provide an exception where the partners have allocated risk among themselves and the person making the bottom dollar payment obligation is liable for at least 90 percent of the person’s payment obligation (because the person is not entitled to indemnification or reimbursement for more than 10 percent of the person’s payment obligation). Such an obligation, like any other payment obligation, must otherwise be recognized under Reg. §1.752-2, including under the anti-abuse rules in Reg. §1.752-2(j). The temporary regulations also provide an anti-abuse rule to ensure that if a partner bears the EROL for a partnership liability, partners may not agree among themselves to create a bottom dollar payment obligation in order to treat the liability as nonrecourse. A disclosure requirement also applies to all bottom dollar payment obligations, which must be reported on Form 8275 and attached to the partnership return for the tax year in which the obligation is undertaken or modified.

Proposed Regulations

Rights of reimbursement. Reg. §1.752-2(b)(1) provides that, except as otherwise provided in Reg. §1.752-2, a partner bears the EROL for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or a person that is a related person to another partner. The 2014 proposed regulations provided that a partner would not bear the EROL under Reg. §1.752-2(b)(1) if the partner or a related person is entitled to reimbursement from “any person”. This language would include a reimbursement from the partnership, which is contrary to the intent of the regulations under Code Sec. 752. The new proposed regulations therefore do not include the changes to Reg. §1.752-2(b)(1) that were in the 2014 proposed regulations.

Arrangements part of a plan to circumvent or avoid an obligation. The 2014 proposed regulations provided a list of factors used to determine whether a partner’s or related person’s payment obligation with respect to a partnership liability will be recognized for purposes of Code Sec. 752 (recognition factors). The new proposed regulations would move the list of factors to an anti-abuse rule in Reg. §1.752-2(j) (not including the factors concerning bottom dollar payment obligations, which are addressed in the Code Sec. 752 temporary regulations) and make certain other changes to the factors in response to the comments received.

Deficit restoration obligations. the proposed regulations refine the list of factors applicable to deficit restoration obligations (DROs) and clarify the interaction of Code Sec. 752 with Code Sec. 704 regarding DROs. The existing regulations under Code Sec. 704 provide that a partner’s DRO is not respected if the facts and circumstances indicate a plan to circumvent or avoid the partner’s DRO. The proposed regulations would add a list of factors, similar to the factors in the proposed anti-abuse rule under Reg. §1.752-2(j), but specific to DROs, to indicate when a plan to circumvent or avoid an obligation exists.

Exculpatory liabilities. A comment was received suggesting that the 2014 proposed regulations would result in “exculpatory liabilities” being treated as nonrecourse liabilities. An exculpatory liability is one that is recourse to an entity under state law and Code Sec. 1001. However, no partner bears the EROL within the meaning of Code Sec. 752, and the liability is therefore treated as nonrecourse for purposes of Code Sec. 752. The new proposed regulations do not address exculpatory liabilities; the Treasury Department and the IRS seek additional comments regarding the proper treatment of these liabilities.

Net value. Under Reg. §1.752-2(b)(6), for purposes of determining the extent to which a partner or related person has a payment obligation and the EROL, all partners and related persons who have obligations to make payments are assumed to actually perform those obligations, regardless of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. Reg. §1.752-2(k)(1) provides that a payment obligation of a disregarded entity is taken into account only to the extent of the entity’s net value. The 2014 proposed regulations provided that in determining the extent to which a partner or related person other than an individual or a decedent’s estate bears the EROL for a partnership liability other than a trade payable, a payment obligation is recognized only to the extent of the net value of the partner or related person that, as of the allocation date, is allocated to the liability, as determined under Reg. §1.752-2(k). The new proposed regulations would remove the net value rules under Reg. §1.752-2(k) and instead provide a new presumption under the anti-abuse rule in Reg. §1.752-2(j). Under this presumption, evidence of a plan to circumvent or avoid an obligation would be deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation that the payment obligor (including a disregarded entity) will have the ability to make the required payments if the payment obligation becomes due and payable. Under the new proposed regulations, Reg. §1.752-2(b)(6) continues to presume that payment obligations with respect to a partnership liability will be satisfied unless evidence of a plan to circumvent or avoid the obligation exists as determined under Reg. §1.752-2(j). If evidence of a plan to circumvent or avoid the obligation exists or is deemed to exist, the obligation is not recognized under Reg. §1.752-2(b) and, therefore, the partnership liability is treated as a nonrecourse liability under Reg. §1.752-1(a)(2).

Rev. Rul. 2000-44, 2000-2 CB 336, is superseded.

T.D 9787, 2016FED ¶47,047

T.D. 9788, 2016FED ¶47,048

Proposed Regulations and Partial Withdrawal of Notice of Proposed Regulations, NPRM REG-122855-15, 2016FED ¶49,714

Other References:

Code Sec. 704

CCH Reference – 2016FED ¶25,122P

CCH Reference – 2016FED ¶25,130

Code Sec. 707

CCH Reference – 2016FED ¶25,180A

CCH Reference – 2016FED ¶25,181C

CCH Reference – 2016FED ¶25,181D

CCH Reference – 2016FED ¶25,180DB

CCH Reference – 2016FED ¶25,181DK

CCH Reference – 2016FED ¶25,181E

CCH Reference – 2016FED ¶25,181H

CCH Reference – 2016FED ¶25,181HE

Code Sec. 752

CCH Reference – 2016FED ¶25,521D

CCH Reference – 2016FED ¶25,523

CCH Reference – 2016FED ¶25,523DA

CCH Reference – 2016FED ¶25,523DB

CCH Reference – 2016FED ¶25,524

Tax Research Consultant

CCH Reference – TRC LLC: 9,254

CCH Reference – TRC PART: 15,254.05

CCH Reference – TRC PART: 15,254.15

CCH Reference – TRC PART: 21,358

CCH Reference – TRC PART: 27,058.10

CCH Reference – TRC PART: 27,058.15

AUTHOR

CCHTaxGroup

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