IRS Issues Partnership Disguised Sales Guidance

Posted by Todd Keator, Todd Lowther, and Jessica Kirk               The IRS has issued guidance on disguised sales of property within partnerships.  Generally, partners may contribute property to, and receive distributions from, a partnership without recognizing a gain or loss.  But in certain circumstances, the Sections 707 and 752 regulations will characterize a contribution and related distribution as a disguised sale or exchange requiring the “selling” partner to recognize a gain or loss.In 2014, the IRS issued proposed regulations to address deficiencies and ambiguities in the existing disguised sales rules.  After considering written comments, the IRS has now replaced those proposed regulations with three new forms of guidance:Sections 707 and 752 Final Regulations – Addressing disguised sales of property to or by a partnership and allocations of partnership excess nonrecourse liabilities for disguised sale purposes (T.D. 9787).Sections 707 and 752 Temporary Regulations – Addressing how liabilities are allocated and when certain obligations are recognized for purposes of determining whether a liability is recourse (T.D. 9788).Section 752 Proposed Regulations – Addressing deficit restoration obligations and when partnership liabilities are treated as recourse (REG-122855-15). The final regulations substantially adopt the 2014 proposed regulations, with some modifications. The proposed regulations incorporate the text of the temporary regulations and withdraw a portion of the 2014 proposed regulations.Summary of Key ChangesDebt financed distributions exception largely eliminated.  Under existing interpretations, partners have been able to avoid a disguised sale by receiving partnership distributions related to partnership level debt allocated to the partner receiving the distribution, but the new guidance largely eliminates that exception. The new temporary regulations under Section 707 treat all debt as nonrecourse for purposes of applying the disguised sales rules.  Thus, all liabilities must be allocated under the excess nonrecourse liability rule (tier 3) in accordance with the partners’ allocable share of partnership profits (i.e., the significant item method, alternative method, and additional method do not apply for disguised sales purposes).  Further, the contributing partner’s share of debt is now determined based on the partner’s share of the partnership profits, without regard to any guarantees or indemnities.  In effect, this rule prevents a partner from guaranteeing debt and receiving a tax-free distribution of such debt from the partnership because a significant portion of that type of distribution will be caught by the disguised sales rules.  Notably, the preamble acknowledges that it may be difficult to determine a partner’s share of partnership profits and requests comments regarding possible safe harbors and reasonable methods.  This new allocation rule is effective for any transaction in which all transfers occur on or after January 3, 2017.Capital expenditures reimbursement exception clarified.  Under existing regulations, partners have been able to avoid disguised sale treatment for distributions that reimburse the partners for pre-formation capital expenditures, and the new guidance clarifies certain aspects of that exception.  The proposed regulations define a capital expenditure for such purpose to include capital expenditures that the partner previously elected to deduct, but to not include deducible expenditures that the partner elected to capitalize.  The proposed regulations also prevent partners from “double dipping” by funding capital expenditures with a qualified liability, contributing the property subject to the qualified liability, and receiving a cash reimbursement from the partnership of those same capital expenditures.  Further, a step-in-the-shoes rule is now applied to property transferred to the contributing partner in a previous nonrecognition transaction (under Sections 351, 381(a), 721, or 731).  Likewise, a step-in-the-shoes rule is to be applied when a capital expenditure reimbursement is made with respect to a property that is contributed to a partnership and, within 2 years of the initial expenditure, is then contributed to an upper tier partnership.  Notably, the preamble explains that the IRS is reconsidering the capital expenditure reimbursement exception in its entirety, and requests comments on whether to retain it. Bottom dollar guarantees will not be respected.  Under existing regulations, some partners have taken the position that a portion of a partnership debt should be allocated to them because they have provided a “bottom dollar” guarantee of that debt.  A bottom dollar guarantee is an obligation to pay a portion of such debt, but only if the creditor does not recover any funds from the debtor up to the amount of the bottom guarantee (for example, the partner guarantees that the creditor will be repaid at least $100 on a $1,000 debt).  With limited exceptions, the temporary regulations state that when allocating partnership liabilities, bottom dollar guarantees will not be recognized as a payment obligation of the partner making the guarantee because they lack a significant non-tax commercial business purpose.  The regulations provide a seven-year transition rule allowing for the temporary continued application of existing rules to existing debts.Multi-factor test to determine whether debt is recourse or nonrecourse. In the partnership setting, whether a debt is recourse or nonrecourse continues to hinge on whether a partner bears the economic risk of loss. But the proposed regulations now require the terms of payment obligations (such as guarantees and indemnitees) to be commercially reasonable and not designed solely to achieve an allocation of a partnership liability merely to obtain tax benefits.  Thus, the proposed regulations add a new non-exclusive multi-factor test to the anti-abuse rule. Under this facts and circumstances test, a payment obligation will be disregarded if there is a plan to circumvent or avoid a payment obligation.  The seven factors are:Whether the partner (or related person) is subject to commercially reasonable contractual restrictions that protect the likelihood of payment;Whether the partner (or related person) is required to provide commercially reasonable documentation regarding the party’s financial condition to the benefited party;Whether the term of the payment obligation ends prior to the term of the partnership liability, or the partner (or related person) has a right to terminate its payment obligation, if the purpose of limiting the duration of the payment obligation is to terminate such payment obligation prior to the occurrence of an event or events that increase the risk of economic loss to the guarantor or benefited party;Whether there exists a plan or arrangement in which the primary obligor or any other obligor (or a person related to the obligor) with respect to the partnership liability directly or indirectly holds money or other liquid assets in an amount that exceeds the reasonable foreseeable needs of such obligor;Whether the payment obligation does not permit the creditor to promptly pursue payment following a payment default on the partnership liability, or other arrangements with respect to the partnership liability or payment obligation otherwise indicate a plan to delay collection;Whether, in the case of a guarantee or similar arrangement, the terms of the partnership liability would be substantially the same had the partner (or related person) not agreed to provide the guarantee;Whether the creditor or other party benefiting from the obligation received executed documents with respect to the payment obligation from the partner (or related person) before, or within a commercially reasonable period of time after, the creation of the obligation.Effective DateExcept as noted above, the final and temporary regulations apply to transactions in which all transfers have occurred on or after October 5, 2016, and to liabilities that are incurred, taken subject to, or assumed by the partnership (unless pursuant to a written contract already in effect) on or after October 5, 2016.  The proposed regulations will be effective once their final version is published in the Federal Register.If you have any questions about the partnership disguised sales regulations, please contact one of us or any other Tax Lawyer at Thompson & Knight.