Guidance on disguised sales of property to or by a partnership and the treatment of partnership liabilities issued

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1 from Mergers & Acquisitions Guidance on disguised sales of property to or by a partnership and the treatment of partnership liabilities issued February 3, 2014 In brief On January 29, 2014, the IRS issued proposed regulations (REG ) amending longstanding rules under Sections 752 and 707 of the Internal Revenue Code of 1986, as amended. The proposed regulations: (1) fundamentally change the manner in which economic risk of loss is measured for purposes of allocating recourse partnership liabilities under Section 752; (2) reduce flexibility in the allocation of nonrecourse liabilities among partners; (3) clarify or amend a number of rules in the disguised sale regulations under Section 707; and (4) expand the definition of qualified liabilities under the disguised sale regulations. The proposed regulations represent significant changes to the manner in which partnership liabilities are allocated for purposes of Sections 752 and 707. However, none of the proposed regulations are effective until the regulations are finalized, and the proposed regulations include a liberal transition rule for the allocation of partnership recourse liabilities for a seven-year period after the proposed regulations become final. Still, given the magnitude of the proposed changes, partnerships and their partners may want to consider in advance the prospective impact that the proposed regulations may have on existing partnerships and partnerships to be formed before the proposed regulations are finalized. In detail Background The IRS and the Treasury Department have signalled for some time that they are considering fundamental changes to the manner in which partnership liabilities are allocated for purposes of Sections 752 and 707. An allocation of a partnership liability is beneficial to a partner because it provides tax basis, which enables the partner to deduct losses and receive taxfree cash distributions from the partnership. Specifically, an allocation of partnership liabilities protects and preserves a partner s negative tax capital account which enables a partner to defer the gain inherent in its partnership interest. The allocation of a partnership liability to a partner may also provide relief from the disguised sale rules upon a contribution of property and permit the partner to receive debt-financed distributions from the partnership without resulting in a disguised sale. Accordingly, these proposed regulations, if finalized in their present form, would have a significant impact on partnership transactions in which leveraged distributions are made to partners, transactions in which partners contribute leveraged property to a partnership, and the

2 reallocation of partnership liabilities to partners generally. The existing regulations under Section 752 provide that a partner s share of partnership recourse liabilities equals the portion of the liability for which the partner or related person bears the economic risk of loss. A partner or related person generally bears the economic risk of loss to the extent the partner or related person would be obligated to make a payment if the partnership s assets became worthless and the liability became due and payable. The existing regulations assume that all partners and related persons will actually satisfy their payment obligations, irrespective of their net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. Under this test, the existing regulations generally allocate an otherwise nonrecourse liability of the partnership to a partner that guarantees the liability, even if the lender and the partnership reasonably anticipate that the partnership will be able to satisfy the liability with partnership profits or capital and the partner does not have sufficient net value to satisfy fully the entire obligation. The proposed regulations eliminate the assumption that all partners and related persons will satisfy their payment obligations. The drafters of the proposed regulations articulate a concern that partners and related persons may be entering into payment obligations that are not commercial solely to achieve an allocation of a partnership liability. In place of the assumption, the proposed regulations introduce a multi-factor, objective test intended to respect only payment obligations that exist for commercial reasons and, then, only to the extent of the net value of the obligor, generally determined without regard to any value attributable to the partnership (individuals and decedents estates are exempt from the net value test). The test is an allor-nothing test, resulting in, among other consequences, preventing bottom-dollar guarantees from being recognized for purposes of Section 752. The proposed regulations also revise the manner in which partnership nonrecourse liabilities are allocated, by eliminating two alternatives under which the partnership nonrecourse liabilities can be allocated under the third tier of the existing partnership nonrecourse liability rules by reference to significant items of partnership income or gain or reasonably expected deductions attributable to partnership nonrecourse liabilities. They offer a new alternative that focuses on the partners liquidation value percentage. Finally, the proposed regulations clarify certain aspects of the existing disguised sale regulations under Section 707, including exceptions to disguised sale treatment for distributions relating to preformation expenditures and debt-financed distributions. Proposed regulations highlights Allocations of partnership recourse liabilities As indicated above, the proposed regulations replace the assumption that all partners and related persons will satisfy their payment obligations with objective requirements intended to establish commercial reasonableness. Under the proposed regulations, obligations to make a payment with respect to a partnership liability (excluding those imposed by state law) will not be recognized for purposes of Section 752 unless two general requirements are met. First, the payment obligation of the partner or the related person must meet six specific requirements. Second, the partner or related person must satisfy a minimum net value requirement. Six requirements for generally recognizing payment obligations A payment obligation will not be a recourse obligation of a partner or related person unless it fully meets six requirements (or it is imposed by state law). These requirements are: (1) the partner or related person must maintain a commercially reasonable net worth for the entire term of the payment obligation or must be subject to commercially reasonable restrictions on transfers of assets for nominal consideration; (2) the partner or related person must periodically document its financial condition; (3) the term of the payment obligation must not end before the term of the partnership liability; (4) the payment obligation must not require that the partnership or any other obligor hold liquid assets that exceed the obligor s reasonable needs; (5) the partner or related person must receive arm s-length consideration in exchange for assuming the payment obligation; and (6) in the case of a guarantee, the partner or related person must be liable up to the full amount of the payment obligation if any amount of the partnership liability is not satisfied, and in the case of an indemnity, the partner or related person must be liable up to the full amount of the payment obligation if any payment is made by the indemnitee or other benefited party. The all-or-nothing approach reflected in the sixth requirement effectively prevents bottom-dollar guarantees from being recognized as payment obligations. Net value requirement Even if a payment obligation of a partner of related person satisfies the six specific requirements in the proposed regulations outlined above (or is imposed by state law), the partner or related person is presumed to satisfy its payment obligation only 2 pwc

3 to the extent of the net value of the partner or related person as of the allocation date generally determined without regard to any value attributable to the partnership under the rules of Treas. Reg. Section (k) presently applicable to partnership interests held by disregarded entities. The net value requirement, however, does not apply with respect to payment obligations relating to trade payables of a partnership or to any payment obligations of individuals or decedents estates under the proposed regulations. Anti-abuse rule A payment obligation will not be recognized under the proposed regulations if the facts and circumstances indicate that the partnership liability is part of a plan or arrangement involving the use of tiered partnerships, intermediaries, or similar arrangements to convert a single liability into more than one liability, with a principal purpose of circumventing rules in the proposed regulations intended to prevent the recognition of bottom-dollar guarantees. Allocations of partnership nonrecourse liabilities The proposed regulations modify the manner in which excess nonrecourse liabilities will be allocated among partners by eliminating two longstanding alternatives and by proposing a liquidation value percentage alternative. In general, Treas. Reg. Section allocates partnership nonrecourse liabilities by reference to, and in the order of three tiers -- partnership minimum gain, so called partnership Section 704(c) minimum gain, and excess nonrecourse liabilities (i.e., those partnership nonrecourse liabilities remaining unallocated after the first two tiers). In general, excess nonrecourse liabilities are allocated to partners in accordance with partners interests in partnership profits, determined by reference to all the facts and circumstances. The existing rules permit the partnership agreement to specify the partner s share of partnership profits for this purpose, provided that share is reasonably consistent with allocations having substantial economic effect of some other significant item of partnership income or gain ( significant item method ). The existing rules also permit the excess nonrecourse liabilities to be allocated among the partners in the manner that deductions attributable to those liabilities are reasonably expected to be allocated ( expected deductions method ). The proposed regulations replace the significant item method and the expected deductions method with an alternative that is focused on partners relative interests in the liquidation value of the partnership. Under the proposed regulations, a partnership agreement could specify the partners interest in partnership profits, provided they are in accordance with the partners liquidation value percentages. In general, a partner s liquidation value percentage is generally determined by reference to the amount of cash (expressed as a percentage) that the partner would receive if the partnership sold all of its assets for fair market value (generally determined as of the date of the last revaluation event under Treas. Reg. Section (b)(2)(iv)(f)), paid off its debts, and liquidated. Any shift in the partner s share of excess nonrecourse liabilities resulting from disproportionate contributions and distributions and other events resulting in optional revaluation events (within the scope of Treas. Reg. Section (b)(2)(iv)(f)(5)) is taken into account in determining the tax consequences of such event. Disguised sales rules The disguised sale regulations under Section 707 provide that 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 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 the property and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership. The regulations under Section 707 provide a number of exceptions to disguised sale treatment. The proposed regulations under Section 707 (1) amend or clarify certain widely used exceptions to disguised sale treatment, (2) add an additional qualified liability, and (3) address certain technical aspects that can give rise to ambiguities under the existing regulations. Exception for preformation capital expenditures Under the existing regulations, transfers from a partnership to a partner to reimburse the partner for certain capital expenditures and costs incurred with respect to contributed property generally are not treated as part of a sale of the property, provided that the capital expenditures are incurred within two years preceding the contribution of the property and do not exceed 20 percent of the fair market value of the contributed property. The 20% limit does not apply if the fair market value of the property does not exceed 120% of the tax basis of the property. The proposed regulations address three ambiguities relating to preformation expenditures. First, the fair market value limitation and tax 3 pwc

4 basis test are applied on a propertyby-property basis. Second, the term capital expenditures is defined to include capital expenditures that the taxpayer previously elected to deduct but to exclude deductible expenses the taxpayer elected to capitalize. Third, under the proposed regulations, the exception for preformation expenditures does not apply to the reimbursement by the partnership to the extent a partner funds a capital expenditure through borrowing and economic responsibility for the borrowing is shifted to another partner upon the assumption of that liability by the partnership. The drafters of the proposed regulations explain there was no economic outlay by the partner to reimburse. Exception for debt-financed distributions Under the debt-financed distribution exception to disguised sale treatment, a distribution of money to a partner generally is not treated as consideration to the extent the distribution is traceable to a partnership liability (incurred within 90 days of the distribution) and the amount of the distribution does not exceed the partner s allocable share of the liability incurred to fund the distribution. The proposed regulations add a helpful ordering rule that apply the debt-financed distribution exception before other exceptions from disguised sale treatment. The drafters of the proposed regulations wanted to ensure that any of the other exceptions to the disguised sale treatment do not reduce the impact of the debt-financed distribution exception. The proposed regulations also add an example illustrating the technical application of the debtfinanced distribution exception in the context of multiple partnership liabilities treated as a single partnership liability in certain cases. Qualified liabilities Under existing regulations, assumptions of qualified liabilities generally are excluded from disguised sale treatment. The current regulations include four types of qualified liabilities, including, among others, liabilities incurred more than two years before the transfer, or within two years of the transfer but not in anticipation thereof, that encumber the transferred property throughout that period. The existing regulations provide no guidance on the meaning of encumbrance for this purpose. The proposed regulations relax the encumbrance requirement by adding as a new qualified liability any liability incurred in connection with the conduct of a trade or business provided the liability was not incurred in anticipation of the transfer and all of the assets material to the that trade or business are transferred to the partnership. The anticipated reduction rule Under the existing regulations, for purposes of the rules under section 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. A subsequent reduction in a partner s share of a liability is taken into account if: (1) at the time that the partnership incurs, assumes, or takes property subject to the liability, it is anticipated that the partner s share of the liability will be subsequently reduced; and (2) the reduction is part of a plan that has as one of its principal purposes minimizing the extent to which the distribution or assumption of, or taking property subject to, the liability is treated as part of a sale (the anticipated reduction rule ). The proposed regulations clarify that a reduction that is subject to the entrepreneurial risks of partnership operations is not an anticipated reduction. The proposed regulations also provide that if the a partner s share of the liability is reduced within two years of the partnership incurring, assuming, or taking project subject to the liability due to a decrease in the partner s or related person s net value, then the reduction is presumed to be anticipated unless the facts and circumstances clearly establish otherwise. Any such reduction must be disclosed to the IRS. Tiered-partnership rules The existing regulations provide only a limited tiered-partnership rule for cases in which a partnership succeeds to a liability of another partnership. The proposed regulations add rules indicating that (1) the debt-financed distribution exception applies in a tiered partnership setting, and (2) liabilities attributable to a contributed partnership interest are treated as qualified liabilities in the hands of the upper-tier partnership to the extent the liabilities would be qualified liabilities had the liabilities 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 uppertier partnership. Netting liabilities for purposes of disguised sales rules Under existing regulations under Treas. Reg. Section , increases and decreases in a partner s share of liabilities resulting from a single transaction (e.g., a merger or consolidation) are netted by each of the partners to determine the effect of the overall transaction under Section 752. The proposed regulations under Section 707 explicitly extend these netting principles to the disguised sale rules. 4 pwc

5 Liability assumption by partner from partnership The drafters of the proposed regulations indicated they are studying the existing regulations addressing the disguised sale of property by a partnership to a partner. Under the existing regulations, if a partner assumes or takes property subject to a liability that is not a qualified liability from the partnership, the amount treated as consideration transferred to the partnership is the amount of the liability assumed or taken subject to by the partner that exceeds the partner s share of that liability immediately before the transfer. It is possible that the IRS may require a partner to bear some economic exposure or other consequence for a meaningful time period before respecting such allocations of partnership liabilities. Effective dates The regulations under Section 707 are proposed to apply to transactions with respect to which all transfers occur on or after the date the proposed regulations become final. The regulations under Treas. Reg. Section are proposed to apply to liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after the date the proposed regulations become final. The regulations under Treas. Reg. Section are proposed to apply to liabilities incurred or assumed by a partnership on or after the date the proposed regulations become final. The IRS and the Treasury Department anticipate that the final regulations under Section 752 will permit a partnership to apply the provisions in the final regulations to all of its liabilities as of the beginning of the first taxable year of the partnership ending on or after the date the regulations become final. The proposed regulations also provide transitional relief for any partner to the extent that such partner s allocable share of partnership liabilities under Treas. Reg. Section exceeds such partner s adjusted basis in such partner s partnership interest on the date the proposed regulations are finalized. The transitional rule permits a partnership to continue to apply the existing regulations under Treas. Reg. Section for the grandfathered liabilities for a seven-year period from the date the proposed regulations are made final. The partner s grandfathered amount of liabilities is reduced under the transitional rules by any decrease in the partner s share of the grandfathered liabilities that result from anything other than a sale of partnership property. In the case of a sale of partnership property, the amount of the grandfathered liability is decreased by any excess of any tax gain allocated to the partner less the partner s share of the amount realized by the partnership on the sale. Request for comments The IRS and the Treasury Department request comments on all aspects of the proposed regulations and have indicated that they do not expect to finalize the regulations until all comments have been considered. The takeaway If finalized in their current form, the proposed regulations under Section 752 will change fundamentally the manner in which partnership liabilities are allocated to partners. Many partnership liabilities that are treated as recourse liabilities under the existing rules will become nonrecourse liabilities allocated by reference to partnership profits rather than by reference to a refined concept of economic risk of loss. Any partnership liability structure relying on bottom-dollar guarantees or other economic risk of loss principles that are effective under current law will have to be revisited and possibly restructured. The proposed changes present an unquestionable trap for the unwary (or unprepared), but they also may present opportunities that do not exist under current law. A shift towards nonrecourse liabilities permits, in appropriate situations, a partnership to shift tax basis from partners who bear some direct economic connection to the repayment of the partnership liabilities to partners who bear no direct economic connection to the repayment. The proposed regulations limit the flexibility partnerships currently have in allocating partnership nonrecourse liabilities by dropping the significant item method and expected deductions method for allocating tier 3 excess nonrecourse liabilities. The proposed alternative liquidation percentage method takes into account partners interests in profits and capital and, consequently, may introduce its own distortions and complexity. Partnerships and partners will have to weigh the benefit of embracing this bright line alternative with any unexpected repercussions that it may have, including, for example, a potential inconsistency between the proposed method and the manner in which nonrecourse deductions are allocated under Treas. Reg. Section (e). The proposed changes under Section 752 are dramatically different than longstanding rules that have influenced existing forms of partnership transactions and partnership documents involving partnership liabilities. At a minimum, partnerships and their partners may want to review currently viable structures and transaction documents to assess the potential impact of the proposed regulations and to identify any necessary or desired changes. 5 pwc

6 The proposed disguised sale regulations are more evolutionary than revolutionary. The IRS and the Treasury Department address various technical applications of exceptions to disguised sale treatment and apply the concept of entrepreneurial risk that is a foundation of the disguised sale rules to anticipatory changes in allocations of partnership liabilities. Fortunately, the proposed regulations are not effective until finalized and contain a liberal transition rule with respect to the allocation of partnership recourse liabilities. The IRS and the Treasury Department are encouraging comments on the proposed regulations. Therefore, there is time to plan and comment before having to live with a fundamentally new approach to allocating partnership liabilities. Please do not hesitate to reach out to us if you are interested in providing comments or discussing the potential effects the proposed regulations may have in your particular context. Let s talk For a deeper discussion of how this might affect your business, please contact: Mergers & Acquisitions Karen Lohnes, Washington, D.C. (202) karen.lohnes@us.pwc.com Todd McArthur, Washington D.C. (202) todd.y.mcarthur@us.pwc.com Megan Stoner, Washington, D.C. (202) megan.stoner@us.pwc.com Brian Meighan, Washington, D.C. (202) brian.meighan@us.pwc.com John Schmalz, Washington, D.C. (202) john.schmalz@us.pwc.com Susana Noles, San Francisco (415) susana.e.noles@us.pwc.com Elizabeth Amoni, Washington, D.C. (202) elizabeth.amoni@us.pwc.com 2014 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. Solicitation This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 6 pwc