2013-Issue 44—Did you know that Treasury and IRS officials appear close to issuing newly proposed Treasury regulations that could significantly impact the way partnership debt is characterized and allocated? The Tax Court’s decision in Canal Corporation and Subsidiaries v. Commissioner (135 T.C. 9) has seemingly prompted this decision by the government to re-evaluate the rules for allocating debt among partners of a partnership.
In the Canal Corporation case, the Tax Court held that the anti-abuse rules in Reg. Section 1.752-2(j) applied to a leveraged partnership transaction and, as a result, the Court disregarded certain contractual obligations of a partner to a make a payment that would otherwise have resulted in debt basis to the partner in question under IRC Section 752. As a result, the partner lacked sufficient debt basis and was the recipient of taxable disguised sale proceeds. The importance of this decision and the resulting re-examination of the guidance for partnership liability allocations should not be lost on taxpayers, who should consider bracing for the impact of new regulations immediately. If new rules are enacted and a partner’s share of recourse liabilities is subsequently decreased, then a deemed distribution under IRC Section 752(b) may result in current taxable income to the partner.
Current Test for Recourse Liabilities
As currently enacted, the Internal Revenue Code and the accompanying Treasury regulations provide that a partner’s share of a recourse partnership liability equals the portion for which that partner bears the economic risk of loss. A partner is deemed to bear the economic risk of loss to the extent that the partner would be obligated to make a payment if the partnership constructively liquidated and such partner was not entitled to reimbursement from another partner or person related to another partner. This is often referred to as the “payor of last resort” analysis.
At issue in Canal Corporation (among others) were two specific provisions of the 1.752-2 regulations that the taxpayer incorrectly relied on in reaching the conclusion that it had sufficient recourse debt basis to avoid a taxable disguised sale of property to a partnership:
- First, the taxpayer relied on a provision that states that “all statutory and contractual obligations relating to the partnership liability are taken into account.”
- Second, the taxpayer relied on the presumption that “all partners and related persons who have obligations to make payments actually perform those obligations, irrespective of their actual net worth.”
It is important to note that the deemed payment presumption is disregarded by the Treasury regulations when “the facts and circumstances indicate a plan to circumvent or avoid the obligation.” Furthermore, Treasury Regulation Section 1.752-2(j) promulgates an anti-abuse rule, which provides that an obligation to make a payment may be disregarded if the facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner’s economic risk of loss with respect to an obligation or to create the appearance of a partner’s economic risk of loss when in fact the substance is otherwise.
"Canal Corporation" Revisited
In Canal Corporation, a partner in a joint venture agreed to guarantee certain partnership debt that was used to fund a debt financed distribution to the other partner. The recipient partner provided a limited indemnification to the guarantor partner with the ultimate goal of obtaining a valid allocation of recourse partnership debt sufficient to make the debt financed distribution tax deferred. The recipient partner was a thinly capitalized corporate subsidiary of a larger consolidated group.
The Tax Court held that the terms of the indemnification provision attempted to limit the circumstances under which the partner would or could actually be called upon to make a payment. Notably, the indemnification provision only covered principal payments on the loan in the event of a default (and not interest). It did not mandate that the corporate subsidiary maintain a reasonable level of net worth, and it did not prohibit the subsidiary from further encumbering any of its assets, which were limited to begin with. Furthermore, neither the ultimate lender nor the guarantor partner actually requested the indemnification (i.e., it was not required in order to obtain the loan), which was devised in the opinion of the Tax Court solely to secure the allocation of the liability for tax purposes.
Potential Changes to Debt Allocation Rules
In response to the Tax Court’s ruling in Canal Corporation, the Treasury and IRS officials have indicated that proposed regulations may be issued that will drastically alter the rules for characterizing and allocating partnership liabilities. Based on informal comments made by government officials, these proposed regulations, if and when issued, are believed to contain at least two key provisions that will impact many existing partnership arrangements: 1) they would impose a “commercial” requirement for purposes of assessing the validity of contractual obligations to make a payment and 2) they would extend the net-worth requirement (which currently applies solely to disregarded entity partners) to all entities and possibly individuals. The inclusion of these types of provisions would seem to result in a fundamental change from the payor of last resort standard that taxpayers have historically based tax planning and reporting decisions upon.
As noted, the proposed regulations may only recognize an obligation to make a payment if it is deemed to be commercial. The definition of what constitutes a commercial obligation for this purpose is unclear at this time. Chief Counsel Advice 201324013 may provide some useful insight into the government’s requirement for recourse obligations to be commercial. The CCA lays out two relevant factors that, when present, may result in the application of the anti-abuse provision of Treasury Regulation 1.752-2(j) to a contractual obligation: 1) the obligation lacks important features typical of a similar obligation resulting from a commercially-driven transaction and 2) there is no practical or commercial risk of the obligation being enforced. Ultimately, the commercial requirement may simply boil down to whether or not an unrelated third-party lender would require the specific legal protections in question irrespective of any tax-motivated considerations.
Treasury Regulation 1.752-2(k) currently imposes a net-worth requirement on all disregarded entity partners of a partnership for purposes of allocating recourse debt. The language of the existing regulations may shed some light on the potential structure of a proposed regulation that would extend the net-worth requirement to all regarded entities and possibly individuals. The existing disregarded entity regulations specifically limit the amount of a recourse liability allocation to a disregarded entity partner to the “net value” of the disregarded entity. Net value for this purpose is generally defined as the fair market value of all assets of the entity that would be subject to creditor’s claims under local law, reduced by the disregarded entity’s other obligations (i.e., other than the indirect obligation to make a payment with respect to the partnership’s liabilities being allocated). Net value does not include the value of the interest in the partnership whose liabilities are being allocated, but it does include the value of other partnership interests held by the disregarded entity and the entity’s enforceable rights to receive contributions from its owner. Net value determinations are generally made as of the date that the partnership determines its shares of liabilities.
Alvarez & Marsal Taxand Says:
Now is the time to evaluate whether your partnership liability allocations would be subject to reduction in light of recent case law and/or upon the issuance of newly proposed 752 regulations. To the extent that a liability reduction occurs, then a deemed cash distribution under IRC Section 752(b) or, worse yet, ordinary income recapture under the at-risk rules may result.
Taxpayers should be aware of certain types of contractual obligations (i.e., deficit restoration obligations, limited indemnification provisions, bottom side guarantees, etc.) that they believe give rise to 752 liability allocations under current law, but that could be at risk as a result of the potential new requirement that they be “commercial.” To assess the potential risk, it may be prudent to compare the current legal terms of your contractual obligations to other unrelated third-party transaction terms. If your legal terms/protections are lacking, it may be possible to amend them prior to the issuance of a Treasury regulation that contains an effective date.
However, any meaningful amendments would likely result in additional business risk that would need to be weighed against the benefit of your debt basis allocation. Furthermore, it is not clear how the IRS would view these types of modifications to the extent that they were not present when the transaction giving rise to the liability was entered into. Similarly, taxpayers should be able to assess the risk of a potential net-worth issue now; however, addressing this issue would likely also result in the acceptance of additional business risk (i.e., by subjecting more assets to potential creditor claims). Don’t wait until Treasury regulations are issued, because your partnership debt basis may already be at risk.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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