Overview
Today, Treasury and the IRS issued a long-awaited regulation package relating to disguised sales under section 707(a)(2)(B) and the characterization of partnership liabilities as recourse or non-recourse under section 752.
Aaron Nocjar, partner in Steptoe’s Washington office, commented that: “these rules further narrow the circumstances under which a partnership liability can be treated as a recourse liability for both a disguised sale of property analysis (including within a leveraged partnership context) and a general partnership liability sharing analysis (for purposes of determining, among other things, whether a partner can receive a tax-free distribution of cash or an allocation of partnership loss). Further, Treasury’s use in the form of an anti-abuse rule of ‘commercially reasonable’ standards and contemporaneous documentation requirements regarding partnership liabilities parallel somewhat Treasury's approach in the debt-equity section 385 proposed regulations, which makes it somewhat surprising that the relevant preamble omits any reference to such regulatory project and its potential application in the sub-K space.”
Today’s regulatory package contains sets of final regulations, temporary regulations, proposed regulations, and re-proposed regulations.
With respect to disguised sales, the headline change is a rule (in temporary and proposed regulatory form) that requires the allocation of a partnership liability to be made in accordance with the manner in which the partners share profits of the partnership, regardless of whether such liability otherwise meets the definition of a recourse liability that is allocable in any other manner. A related regulatory change (in final form) eliminates, only for purposes of allocating liabilities for disguised sale purposes, the various safe harbor methods to determine a partner’s interest in partnership profits (the so-called “significant item method,” the “alternative method,” and “the additional method”). It also eliminates the prior proposed approach of determining a partner’s interest in partnership profits via its relative rights to liquidation proceeds (the so-called “liquidation value percentage method”). The preamble to the related proposed regulations then asks for comments on whether replacement safe-harbor methods to determine a partner’s interest in partnership profits should be issued for disguised sale purposes.
In addition, the regulatory package (in final form) makes several expected changes to the disguised sale rules, including, among others: (i) clarifying that the exception for preformation capital expenditures in multiple property contributions is to be applied on a property-by-property basis; (ii) adding a new definition of a qualified liability; (iii) clarifying how various disguised sale rules should be applied in a tiered partnership context; and (iv) providing for certain “step-in-the-shoes” rules.
With respect to the general partnership liability allocation rules under section 752, the prior proposed regulations introduced a set of contractual and net worth factors that needed to be satisfied in order for a partnership liability to be classified a recourse liability and allocable to any particular partner under the pre-existing “atom bomb” economic risk of loss test. Those proposed regulations are withdrawn and re-proposed with such factors being converted into a new facts and circumstances anti-abuse rule (rather than serving as bright-line factors themselves). Further, the pre-existing net worth final regulations applicable to disregarded entities are proposed to be withdrawn as well. However, the net worth factor of the prior proposed and final regulations appears to have been converted into a so-called “super-factor” within such re-proposed regulations in that, if such factor is not met, the new anti-abuse rule appears to apply regardless of the existence of other positive factors.
Finally, the regulatory package (in temporary form) further limits the use of so-called bottom-dollar guarantees, indemnities, and similar arrangements (including capital contribution obligations, tranched debt, and deficit restoration obligations) to characterize a partnership liability as a recourse liability allocable to any particular partner. Such rules, however, permit certain de minimis exceptions and analogous arrangements regarding “vertical slices” of partnership liabilities to be recognized for recourse liability purposes.