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1 FOR LIVE PROGRAM ONLY Partnership Debt Allocations and New IRS Regulations: Prepare Now for Sweeping Changes to Minimize Tax Consequences Meeting Challenges of IRS Crackdown on Leveraged Partnerships, Mitigating Liabilities Under the Disguised Sales Rules THURSDAY, DECEMBER 15, 2016, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at x10 (or x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be ed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

2 Tips for Optimal Quality FOR LIVE PROGRAM ONLY Sound Quality When listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory, please immediately so we can address the problem.

3 Partnership Debt Allocations and New IRS Regulations Dec. 15, 2016 Brian Krause, Partner Skadden Arps Slate Meagher & Flom, New York Nickolas Gianou Skadden Arps Slate Meagher & Flom, Chicago David F. Levy, Partner Skadden Arps Slate Meagher & Flom, Chicago

4 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

5 Partnership Debt Allocations and New IRS Regulations David Levy, Brian Krause, Nickolas Gianou December 15, 2016 Beijing / Boston / Brussels / Chicago / Frankfurt / Hong Kong / Houston / London Los Angeles / Moscow / Munich / New York / Palo Alto / Paris / São Paulo / Seoul Shanghai / Singapore / Tokyo / Toronto / Washington, D.C. / Wilmington 5 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

6 Background on Sections 707 and Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

7 Overview of Partnership Provisions Contributions Section 721: Exchange of Assets for an interest in Partnership is generally taxfree both to Partnership and Contributing Partner (but see Section 721(b)). Section 722: Contributing Partner takes a substituted basis in the partnership interest it receives (i.e., its basis in the partnership interest equals its basis in the property contributed). Section 723: Partnership takes a carryover basis in the asset contributed (i.e., the same basis in the asset as Contributing Partner s basis in the asset prior to the contribution). Contributing Partner Partnership Interest Assets w/ basis of $100 and FMV of $1000 Partnership Other Partners 7 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

8 Overview of Partnership Provisions Distributions Section 731: Recipient Partner does not recognize gain on a distribution of cash, except to the extent that the amount of money (or FMV of marketable securities ) distributed exceeds Recipient Partner s basis in his Partnership interest. Section 733: For nonliquidating distributions, Recipient Partner s basis in its interest in Partnership is reduced by the amount of money and the basis of other property distributed to Recipient Partner. Recipient Partner Cash Partnership Other Partners 8 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

9 Disguised Sales Key Exception to Nonrecognition As a consequence of the foregoing rules, absent an exception, a partner would generally be able to contribute appreciated property to a partnership and receive cash distributions from that partnership up to the partner s basis in the property, all without recognizing any gain. E.g.: Partner A contributes Appreciated Property with a basis of $100 and FMV of $1000 to Partnership, and Partner B Contributes $1000 dollars. Under the general rules, Partnership could distribute up to $100 of cash to Partner A (or more if Partnership has liabilities that are allocated to Partner A; see discussion of Section 752 below) before Partner A recognizes any gain. The disguised sale rules of Sections 707(a)(2)(B) and the regulations thereunder are an important exception. These rules treat certain contributions and related distributions as together being part of taxable sale of property. 9 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

10 Disguised Sales Generally Section 707(a)(2)(B) If (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers described in (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property, then the transactions will be treated as occurring between the parties (either the partner and the partnership or two or more partners) acting other than in their capacity as members of the partnership. 10 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

11 Disguised Sales Regulatory Landscape Treas. Reg Disguised payments for services [Reserved] Treas. Reg General rules related to disguised sales of property by partners to partnerships Treas. Reg Rules related to guaranteed payments; preferred returns, operating cash flow distributions, and reimbursements of preformation expenditures Treas. Reg Rules related to liabilities Treas. Reg General rules related to disguised sales of property by partnerships to partners Treas. Reg Disguised sales of partnership interests [Reserved] Treas. Reg Disclosure rules 11 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

12 Disguised Sales Tests for Identifying a Sale Facts and circumstances test Treas. Reg (b) Must show» (1) that the transfer of money or other consideration would not have been made but for the transfer of property; and» (2) In cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations. Regulations outline ten facts and circumstances that may tend to prove the existence of a sale Two-year presumption Treas. Reg (c) Transfers made within two years are presumed to be a sale unless the facts and circumstances clearly establish otherwise» Triggers disclosure requirement under Treas. Reg Transfers outside of two years are presumed not to be part of a sale unless the facts and circumstances clearly establish otherwise 12 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

13 Disguised Sales Key Safe Harbors ( ) Certain distributions are exempt from disguisedsale treatment even if made within the two-year presumption period A distribution will generally not be treated as disguised sale proceeds for a related contribution to the extent the distribution: Represents a reasonable guaranteed payment or preferred return; Consists of operating cash flow; or Represents reimbursement for preformation capital expenditures (capex made on the contributed property in the two years preceding the contribution) 13 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

14 Disguised Sales General Rules for Liabilities ( ) Assumption of qualified liabilities generally does not give rise to disguised sale proceeds. Assumption of nonqualified liabilities does give rise to disguised sale proceeds in the amount of the liability that is allocable to other partners under Section 752 (discussed below) If the partner receives even a dollar of disguised sale consideration (either actual consideration, e.g., cash or property, or through an assumption and shift of non-qualified liabilities), a portion of any assumed and shifted qualified liabilities are tainted and treated as disguised sale proceeds 14 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

15 Disguised Sales Debt-Financed Distributions ( (b)) Treas. Reg (b): One of the provisions that makes (or made) leveraged partnership transactions possible. Under the rule, cash proceeds traceable to a liability incurred by the partnership and distributed to a partner within 90 days of the incurrence can be treated as disguised sale proceeds only to the extent they exceed the partner s share of the liability Prior to the 2016 Final Treasury Regulations: a partner s share of a recourse liability of the partnership was determined in accordance with the allocation of recourse liabilities under Section 752 (discussed below), and a partner s share of a nonrecourse liability of the partnership was determined in accordance with the allocation of excess nonrecourse deductions (i.e., the third tier of allocations of nonrecourse deductions under Section 752). 15 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

16 Overview of Partnership Provisions Liabilities Section 752: A partner whose allocable share of partnership liabilities increases is treated as having contributed money to the partnership, and a partner whose allocable share of partnership liabilities decreases is treated as receiving a distribution from the partnership. Treas. Reg , 2: Where a single partner or a related person bears the economic risk of loss for a partnership liability, the partner s allocable share of that liability (for purposes of Section 752) is 100%. Sections 722 and 733: A partner s basis in its partnership interest is increased by any money contributed (including money deemed contributed pursuant to Section 752), and its basis is reduced by any money distributed (including money deemed distributed under Section 752). Guarantor Partner guarantees* Partnership s loan from Bank Guarantor Partner Bank Deemed Contribution of Cash Existing Loan of $1500, otherwise non-recourse to all partners. Partnership *Subject to various anti-abuse rules that will be discussed Other Partners Deemed Distribution of Cash 16 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

17 Allocation of Partnership Liabilities Section 752 As noted above, the allocation of liabilities can be relevant both to: determining whether there is a disguised sale in connection with a contribution of property, and even if there is no disguised sale issue (e.g., no contribution or no distribution that is treated as part of a sale), determining the consequences of the deemed contributions and distributions that result from liability shifts. The allocation of a partnership liability among the partners depends on whether the liability is a recourse or nonrecourse liability under Section 752. A liability is a recourse liability to the extent that any partner (or a related person) bears the economic risk of loss for such liability. A liability is a nonrecourse liability to the extent that NO partner (or related person) bears the economic risk of loss. 17 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

18 Allocation of Partnership Liabilities Section 752 (cont d) Economic risk of loss is a term of art: Generally, a partner bears the economic risk of loss for a partnership liability if the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership), and would not be entitled to reimbursement from another partner or person related to another partner, assuming a deemed liquidation of the partnership in which the assets of the partnership become worthless and all debt of the partnership was required to be repaid in full Risk of loss can be created by, among other things, deficit restoration obligations, guarantees, and pledges of the partner s assets, and also exists where the partner is the lender 18 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

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20 Allocation of Recourse and Nonrecourse Liabilities Generally, recourse liabilities are allocated to the partner or partners that bear the economic risk of loss for such liability, to the extent the partner or partners bear the economic risk of loss. Nonrecourse liabilities, for general liability allocation purposes (but, as described below, not for disguised sale purposes), are allocated according to a 3-tier waterfall: First tier: an amount equal to a partner s share of the partnership minimum gain attributable to that liability is allocated to the partner (very generally, the amount by which a nonrecourse liability exceeds the book basis of an encumbered property). Second tier: then, an amount equal to the partner s share of the pre-contribution built in gain that would be allocated to such partner under Section 704(c) if the property subject to the nonrecourse liability were sold in full satisfaction of the liability and for no other consideration. Third tier: any remaining excess nonrecourse liabilities are allocated in accordance with the partner s share of partnership profits. As an alternative to allocating in accordance with share of partnership profits, the Section 752 regulations permit alternative (and generally more flexible ) methods of allocation. For example, allocations can be made in accordance with the partner s share of a significant item. As described below, however, the new temporary Section 707 regulations do not permit the use of the alternative methods for disguised sale purposes. 20 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

21 Guarantees Generally As the rules described above suggest, a partner will ordinarily be incentivized to cause itself be allocated as much partnership debt as possible, which both: minimizes the likelihood of having (or minimizes the consequences of having) a disguised sale; and minimizes the likelihood of otherwise receiving taxable deemed or actual distributions. Traditionally, the most common way for a partner to maximize its debt allocation was to guarantee the debt The rules generally assume that the partner will make good on its guarantee Pre-Existing Anti-Abuse Rules Treas. Reg (j)(1)): An obligation of a partner or related person to make a payment may be disregarded or treated as an obligation of another person for purposes of this section if facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner s economic risk of loss with respect to that obligation or create the appearance of the partner or related person bearing the economic risk of loss when, in fact, the substance of the arrangement is otherwise. Treasury Reg (j)(3): An obligation of a partner to make a payment is not recognized if the facts and circumstances evidence a plan to circumvent or avoid the obligation. The IRS has sought to apply this anti-abuse rule with some success.» See, e.g., Canal Corp. v. Comm r. 21 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

22 Generic Leveraged Partnership Structure 1. Owner contributes appreciated property and Investor contributes other property to Partnership in exchange for interests in Partnership. 2. Partnership borrows cash from unrelated Bank. Owner guarantees Partnership s borrowing. 3. Partnership distributes $1800 of loan proceeds to Owner. Result under prior law: Owner does not recognize any gain. Owner Guarantees Loan 2 Owner Loan of $ $1800 of loan proceeds 2 Assets w/ basis of $0 and FMV $ Partnership Investor Asset w/ basis of $1500 and FMV of $2000 Bank 22 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

23 Brief Introduction to the Bottom Dollar Guarantee A Bottom Dollar Guarantee is a guarantee of debt only to the extent that a certain minimum amount is not received from the primary obligor. Consider the following example: Guarantor executes a Bottom Dollar Guarantee of $200 of an Obligor s $2000 loan. If the Obligor repays $200 or more of the $2000 it owes, the Guarantor has no liability. If the Obligor repays $150 of the $2000 it owes, the Guarantor has an obligation to pay $50. If the Obligor repays $0 of the $2000 it owes, the Guarantor has an obligation to pay $200. Bottom Dollar Guarantees were commonly used to make a partner bear the economic risk of loss for a partnership liability under the Section 752 rules, while limiting the partner s actual economic risk with respect to the guarantee. Contrast the Bottom Dollar Guarantee with: First dollar guarantees: lender may go after guarantor if any amount of the liability is unrecovered from the obligor Vertical slice guarantees: a percentage of each unrecovered dollar is guaranteed 23 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

24 (Over) Simplified Bottom-Dollar Guarantee Structure PRIOR LAW Historic Owners have held real estate for several years. The real estate has a zero basis and is subject to an $1,800 nonrecourse qualified liability. 1. Historic Owners contribute property to UP-REIT Partnership, a large partnership with a diversified real-estate portfolio in exchange for a small interest in UP-REIT Partnership and UP-REIT Partnership pays off the liability. 2. To prevent gain on the liability shift, under prior law, Historic Owners enter into a Bottom- Dollar Guarantee of UP-REIT Partnership s other liabilities. Historic Owners Guarantee Bank Loan to UP-REIT Partnership, to the extent Bank collects less than $1,800 on the loan. Historic Owners 2 Real Estate with $0 basis, FMV of $2000 subject to nonrecourse liability of $1,800 Bank 1 REIT UP-REIT Partnership Outstanding unsecured loan of $50,000. *Bottom Dollar Guarantees or the opportunity to enter into such guarantees in the future may also be desirable when property is contributed but remains subject to a pre-contribution liability, if there is a later liability shift because of changes in the contributing partner s 704(c) amount 24 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

25 Brief Overview of the 2014 Proposed Regulations Payment Obligation Standards of Proposed Treasury Reg (b)(3): In order for a liability to be treated as a recourse liability of a partner, all of the following must be true: The partner s obligation to repay must require partner to maintain commercially reasonable net worth throughout period of payment obligation. The obligation must subject the partner to commercially reasonable restrictions on transfers for low or no consideration. The obligor partner must provide commercially reasonable documentation regarding financial condition on a periodic basis. The term of payment obligation must not end prior to the term of the partnership liability. The partner s payment obligation must not require any other primary obligor or other obligor with respect to partnership liability to hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor. AND The partner must receive arm s length consideration for entering into the payment obligation. Importantly, the Payment Obligation Standards would have applied for all purposes, not just for purposes of exceptions to disguised sale treatment. Each Payment Obligation Standard was a necessary prerequisite for qualification as a recourse liability. In other words, if any one of the Payment Obligation Standards was not met to any extent, then a liability would be treated as fully nonrecourse. In contrast, although the Tax Court in Canal Corp. referenced many facts similar to the Payment Obligation Standards, it was the sum total of these facts that the Tax Court found dispositive under the -2(j) anti-abuse regulation. 25 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

26 Brief Overview of the 2014 Proposed Regulations (cont d) In addition to the Payment Obligation Standards, the Proposed Regulations specifically targeted Bottom Dollar Guarantees. Prop. Reg (b)(3)(ii)(F) would have required that a partner must be liable up to the full amount of the partner s payment obligation, if and to the extent that any partnership liability is not satisfied in order for the obligation to be respected. In addition, a Net Value Requirement would have recognized payment obligations of a partner or related person only to the extent of the net value of the partner or related person as of the allocation date. Former Prop. Reg (k). Certain changes were made to permissible methods of allocating excess nonrecourse liabilities, including the removal of allocation in accordance with a significant item of income. These portions of the 2014 Proposed Regulations received a relatively negative reception from many tax practitioners. 26 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

27 Brief Overview of New Regulations On October 4, 2016, the Treasury released a sweeping package of proposed, temporary, and final regulations that drastically change the rules described above. Key Provisions of the Regulations: Final Regulations:» Section 707: > Capex amendments (20% imitation applied property-by-property; contributions of partnership interests; overlap with qualified liabilities) > De minimis exception to taint of qualified liabilities > Step-into-shoes rules for capex and qualified liabilities > New category of qualified liability > Alternative methods of allocating nonrecourse liabilities not available for disguised sale purposes Temporary Regulations:» Section 707: > All liabilities allocated as tier 3 nonrecourse» Section 752: > Bottom Dollar Guarantees disregarded Proposed Regulations:» Section 752: New anti-abuse rule for disregarded guarantees and other payment obligations 27 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

28 Overview of New Section 752 Regulations 28 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

29 New Temporary 752 Regs Bottom Dollar Guarantees For all purposes of Section 752 (not just for disguised sale purposes), bottom dollar payment obligations ( BDPOs ) will not taken into account for determining whether a liability is recourse to a partner, subject to certain exceptions. Reasoning: IRS generally views such arrangements as lacking significant non-tax commercial business purpose BDPO defined: [A]ny payment obligation other than one in which the partner or related person is or would be liable up to the full amount of such partner s or related person s payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied. Includes tiered partnerships, intermediaries, senior and subordinate liabilities and other obligations involving multiple liabilities if the liabilities were incurred as part of a common plan to avoid having at least one of the liabilities be treated as a bottomdollar payment obligation Disclosure is required of all BDPOs that are incurred or modified (including obligations that are recognized under the 90% rule on the following slide) 29 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

30 New Temporary 752 Regs Exceptions Exceptions: An obligation is not treated as a BDPO merely because: Capped Obligations: a maximum amount is placed on the obligation Vertical Slice Guarantees: the obligation is stated as a fixed percentage of every dollar of the partnership liability to which such obligation relates Certain Rights of Contribution: there is a right of proportionate contribution running between co-obligors with respect to a payment obligation for which each of them is jointly and severally liable 90% risk retention exception: Additionally, a BDPO is nevertheless recognized if: The payment obligation would otherwise be recognized, but for the effect of an indemnity, reimbursement agreement, or similar arrangement, AND Taking into account the indemnity or reimbursement agreement, the partner or related person remains liable for at least 90% of the partner s or a related person s initial payment obligation (i.e., the amount of the payment obligation determined without regard to the indemnity or reimbursement obligation). Anti-Abuse Rule: Finally, an anti-abuse rule allows the IRS to respect certain payment obligations that otherwise would be disregarded under the new rules, if the obligation was structured purposefully to allow the related liability to be treated as nonrecourse (e.g., where a principal purpose to have other partners include the debt in their basis) 30 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

31 New Temporary 752 Regs Effective Dates and Expiration Immediate effectiveness for new obligations: The new bottom dollar guarantee rules became effective immediately for all liabilities incurred/assumed by a partnership, and payment obligations undertaken by partner, after Oct. 4, 2016 Grandfathering of preexisting liabilities/obligations and those under contract: The new rules do not apply to liabilities incurred/assumed and payment obligations undertaken prior to Oct. 5, 2016, nor do they apply to liabilities/obligations incurred pursuant to a written binding contract in effect prior to Oct. 5, 2016» Note, however, that post-oct. 4 modifications or refinancings of existing debts/payment obligations are generally not grandfathered Seven-year transitional relief: The regulations contain a seven-year transition rule for partners with negative tax capital accounts: To the extent a partner s negative tax capital account (i.e., the excess of its allocable share of partnership liabilities over its adjusted basis in its partnership interest) as of Oct. 5, 2016, a partner may continue to apply prior law to debts and payment obligations incurred even after Oct. 4, 2016, but only for seven years thereafter The amount for which this transitional rule is available is reduced as a partner s negative tax capital is reduced following Oct. 4, 2016 Expiration if not finalized sooner: Oct. 4, Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

32 New Proposed 752 Regs General Anti-Abuse Rule Under the proposed regulations, even if an obligation passes muster under the BDPO rules, it must also be tested under a more general anti-abuse rule The new proposed regulations differ from the 2014 proposed regulations Abandon the all-or-nothing approach and instead create a non-exclusive list of 10 factors in a new anti-abuse rule indicating plan or intention to avoid payment obligation, including:» Lack of commercially reasonable restrictions to protect likelihood of payment» Unilateral right to terminate payment obligation (unless objective factors)» Obligor holds excess assets» Inability of creditor to pursue remedies» Credit support did not modify borrowing terms» Beneficiary of credit support did not receive relevant documents within reasonable time Net-value requirement replaced with a presumption: evidence of a plan to circumvent or avoid an obligation is deemed to exist no reasonable expectation that obligor will have the ability to satisfy the obligation Effective: when published in final form 32 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

33 Overview of New Section 707 Regulations 33 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

34 New Temporary 707 Regs All Liabilities Nonrecourse The most significant change in the new Section 707 regulations (contained in the temporary portion of the reg package) is that for disguised sale purposes, all liabilities are treated as nonrecourse Guarantees, even guarantees fully recognized under the new final and proposed 752 regulations, no longer can prevent a shift in liabilities for disguised sale purposes This means that an assumption of any nonqualified liability will always cause the related contribution to be treated in part as a taxable disguised sale Similarly, a debt-financed distribution in excess of the partner s pro rata share of the liability (based on share of profits) will trigger a partial sale if not otherwise exempt under the disguised sale rules 34 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

35 New Temporary 707 Regs Allocation of Liabilities All liabilities are generally treated as Section 752 excess nonrecourse liabilities i.e., allocated under tier 3 Under new final regulations, Treas. Reg has been amended so that the alternative methods for allocating excess nonrecourse liabilities in tier 3 (e.g., significant item method) do not apply for disguised sale purposes A contributing partner s share of liabilities is reduced, however, by any amount with respect to which any other partner has the risk of loss In other words, a contributing partner s guarantee cannot help, but guarantees by other partners can hurt 35 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

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37 Result of attempted leveraged partnership structure (same example as above) under new Temporary 707 Regulations 1. Notwithstanding Owner s guarantee of the loan, for purposes of applying the disguised sale rules, the $1800 liability is treated as nonrecourse. 2. The nonrecourse liability, for disguised sale purposes is allocated according to tier 3 of the nonrecourse liability allocation under Section Assuming Owner owns 1/11 of the Partnership, Owner is allocated $163 of the Bank Loan. 4. Owner is treated as receiving a distribution of $1637 ($ $163) that is part of a disguised sale. Owner recognizes gain as if it sold 81.85% (1637/2000) of the property. Owner Guarantees Loan Owner Bank $1800 of loan proceeds Assets w/ basis of $0 and FMV $2000 Loan of $1800 Partnership Investor Asset w/ basis of $1500 and FMV of $ Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

38 New Temporary 707 Regs Effective Dates and Expiration The new temporary regulations have a 90-day delayed effective date The regulations are effective for any transaction with respect to which all transfers occur on or after January 3, 2017 Because all transfers are required to occur on or after January 3, 2017 in order to be subject to the new regulations, partners looking to engage in leveraged partnership transactions may have opportunities to grandfather themselves E.g., contribution made before Jan. 3, but debt-financed distribution and related guarantee not made until after Jan. 3. But because the 752 temporary regulations are immediately effective, any guarantee would need to pass muster under those regulations even if the transaction can be grandfathered for 707 purposes Expiration if not finalized sooner: Oct. 4, Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

39 Final 707 Regulations Ancillary Disguised Sale Issues In addition to the significant changes in the temporary regulations, Treasury issued final Section 707 regulations that address a number of ancillary issues, many (but not all) of which were resolved in a taxpayer-favorable manner: Capex amendments (20% imitation applied property-byproperty; contributions of partnership interests; overlap with qualified liabilities) De minimis exception to taint of qualified liabilities Step-into-shoes rules for capex and qualified liabilities New category of qualified liability 39 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

40 Final 707 Regulations Capex Rules (Background) An important exception to the disguised sale rules is the preformation capital expenditure exception This exception permits a contributing partner to receive distributions from the partnership as reimbursement for capital expenditures made by the partner within two years of the contribution In general, the exception is available for expenditures only up to 20% of the value of the contributed property However, the 20% limitation does not apply if the property s FMV is less than 120% of its basis The final regulations address a number of issues with the capex exception 40 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

41 Final 707 Regulations Capex Rules (20% Limitation) 20% Limitation Tested Property-by-Property Under the final regulations, when multiple properties are contributed in a single transaction, the 20% capex limitation is generally tested on a property-by-property basis, not in the aggregate Depending on the facts, this rule may be taxpayerfavorable or taxpayer-unfavorable (see examples below) No guidance as to what constitutes a property 41 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

42 Final 707 Regulations Capex Rules (20% Limitation Examples) EXAMPLE 1 Facts: X owns two assets. Asset 1 (FMV $200, basis $170) and Asset 2 (FMV $200, basis $150). X bought each asset for $200 each within the last two years. Property-by-Property Result: Asset 1 is not substantially appreciated (120% of $170 = $204).» Result: Entire $200 may be reimbursed. Asset 2 is substantially appreciated (120% of $150 = $180).» Result: Only 20% of $200 or $40 may be reimbursed. Total amount qualifying under Treas. Reg (d): $240 Aggregation Result: Total FMV would be $400 and total basis would be $320. The properties, in the aggregate, are substantially appreciated (120% of $320 = $384). Result: Only 20% of $400 or $80 would qualify under Treas. Reg (d). 42 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

43 Final 707 Regulations Capex Rules (20% Limitation Examples) EXAMPLE 2 Facts: Same facts as Example 1 except basis of Asset 2 is $165, not $150. Property-by-Property Results: Asset 1 is not substantially appreciated (120% of $170 = $204).» Result: Entire $200 may be reimbursed. Asset 2 is substantially appreciated (120% of $165 = $198).» Result: Only 20% of $200 or $40 may be reimbursed. Total amount qualifying under Treas. Reg (d): $240 Aggregation Results: Total FMV would be $400 and total basis would be $335. The properties, in the aggregate, are not substantially appreciated (120% of $335 = $402). Result: Entire $400 would qualify under Treas. Reg (d). 43 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

44 Final 707 Regulations Other Capex Rules New Tiered Partnership Rules: If Partner contributes property on which he s made capex to a lower-tier partnership (LTP) and then contributes the LTP interests to an upper-tier partnership (UTP):» UTP steps into the shoes of Partner with respect to capex (and so can be reimbursed by LTP even though UTP did not incur the capex), and» Partner can look-through UTP with respect to the capex (and so can be reimbursed by UTP even though UTP does not own the contributed property) Overlap with Qualified Liabilities: One category of qualified liability is a liability incurred to make capital expenditures on the contributed property Prior to the issuance of the new regulations, there was an open question as to the extent to which a partner could both (i) avoid gain on a shift in such a liability under the qualified liability rules, and (ii) receive cash reimbursements of the expenditures. If so, this could represent a double-counting of the expenditures. The new regulations clarify in this case that the capex exception applies to distributions only to the extent of the contributing partner s share of the qualified liability 44 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

45 Final 707 Regulations De Minimis Exception to Qualified Liability Taint As noted above, if a contributing partner receives even a dollar of disguised sale consideration (including through a shift in nonqualified liabilities), a portion of any assumed qualified liabilities are tainted The new regulations contain a de minimis exception to this rule: Qualified liabilities will not be tainted if the total amount of nonqualified liabilities assumed by the partnership is the lesser of 10% of all qualified liabilities assumed by the partnership or $1 million. Because of the $1 million threshold, many transactions will not benefit from this rule 45 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

46 Final 707 Regulations Step-into-Shoes Rule Prior to the new regulations, it was generally unclear when and to what extent a transferee of property would step into the transferor s shoes with respect to preformation capex made by the transferor Similarly unclear was whether a qualified liability retained its status as qualified when assumed by a transferee Previous guidance on both points was generally limited to 381 transactions (e.g., 368 reorganizations, 332 liquidations) and certain other limited situations addressed in the prior regulations For example, unclear what happened in other nonrecognition transactions, such as a 721 or 351 contribution or a 731 partnership distribution The new regulations clarify that a transferee steps into the transferor s shoes, both with respect to preform capex and qualified liabilities, to the extent the property/liability was acquired/assumed in a nonrecognition transaction under 721, 731, 351, and Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

47 Final 707 Regulations New Qualified Liability The regulations create a new class of qualified liabilities: A liability that was not incurred in anticipation of the transfer of the property to a partnership, but that was incurred in connection with a trade or business in which property transferred to the partnership was used or held but only if all the assets related to that trade or business are transferred other than assets that are not material to a continuation of the trade or business Key requirements not in anticipation of the transfer of the property to a partnership in connection with 47 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

48 Practical Implications and Planning Techniques 48 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

49 Immediate To-Dos for Existing Partnerships Partners and partnerships that have debt in their structures should undertake an evaluation of the effects of the new Section 752 rules on those structures This is especially true for partnerships, including many UPREITs, that have debtmaintenance guarantee-opportunity obligations with their partners. For these partnerships, the stakes may be covenant breaches. Given that currently outstanding debt and payment obligations are grandfathered, the main pressure points for existing partnerships will be modifications and refinancings; these are not grandfathered and could trigger immediate application of the new rules (or application at the end of the seven-year transition period; see next slide). Example: Partner X owns 10% of Partnership and has a basis in his partnership interest of $40. Partnership has one nonrecourse liability of $1000, $200 of which is allocated to Partner X because Partner X has undertaken a BDPO. Assume Partnership refinances the debt with $1000 of new debt (to which same BDPO applies), and assume that the seven-year transition rule discussed above does not apply (e.g., because the refinancing took place more than seven years after the promulgation of the regulations). Result: Partner X s BDPO is disregarded, meaning that Partner X s share of the new liability is only $100 (10% of $100). This causes Partner X to receive a $100 deemed distribution, triggering $60 of gain. 49 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

50 Immediate To-Dos for Existing Partnerships (cont d) Any partners that expect that they may want or need to rely on the seven-year transitional relief will need to determine negative tax capital accounts as of Oct. 4, 2016, and will need to diligently track changes in those accounts and partnership allocations that can reduce the maximum amount of guarantee that is available for the benefit of the transitional rule Partners and partnerships should also begin planning for the expiration of the seven-year period what will the effect be for your partners at the end of the period when the new rules immediately take effect, and how can that be mitigated? Example: Same facts as above, except assume the seven-year transition rule initially applies to the refinanced debt and BDPO. If the debt remains outstanding at the end of the seven-year period, the new rules will take effect at that point, triggering the $50 of gain then, unless the BDPO is restructured to comply with the new regulations. Restructuring of the payment obligation to satisfy the new rules, or maintaining more partnership-level debt in order to provide sufficient debt allocations for partners whose payment obligations do not satisfy the new rules, may be required 50 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

51 Strategies for Dealing with the New 707 Rules: Window Before Effectiveness Given that the temporary Section 707 regulations that treating all liabilities as nonrecourse for disguised sale purposes have a delayed effective date that is keyed to all related transfers, taxpayers expecting to engage in leveraged partnership transactions in the foreseeable future have a narrow window to initiate those transactions (without the need to complete them by the delayed effective date) These taxpayers could consider effecting the contribution to the partnership before Jan. 3, 2017, even if any related transactions (such as debt-financed distributions) cannot occur until after Jan. 3, Example: In December 2016, Partner contributes Property to Partnership. In February 2017, Partnership incurs debt that is guarantee in whole or in part by Partner. The guarantee is not a BDPO under the new Section 752 regulations and is otherwise regarded under those regulations. Partnership distributes the proceeds of the guaranteed amount of the debt to Partner. The transaction should not be treated as a disguised sale as a result of the new Section 707 rules. Remember the Section 752 rules on BDPOs are effective immediately, so any guarantee will in any event need to comply with those rules, even if the transaction is able to be grandfathered under delayed effectiveness of the Section 707 rules 51 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

52 Strategies for Dealing with the New 707 Rules Post-Effective Planning For non-grandfathered transactions, the new regulations largely shut down the opportunity for tax-deferral through (i) contributions of property subject to nonqualified liabilities, and (ii) traditional debt-financed distributions occurring in connection with a contribution of property. There are, however, some alternatives that could be considered 52 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

53 Leveraged Partnership Alternatives Delayed Debt- Financed Distribution Steps: Step 1: Partner contributes Property (free of nonqualified liabilities) to Partnership Step 2: More than two years later, Partnership makes a debt-financed distribution. Partner guarantees enough of the debt to give it sufficient basis to absorb the distribution without recognizing gain. Considerations: Guarantee cannot be a BDPO or other guarantee that is disregarded under the new Section 752 regulations. Even though the distribution is presumed not to be part of a sale (because it occurs more than two years after the contribution), this presumption could be rebutted if there is not sufficient entrepreneurial risk with respect to the occurrence of the subsequent distribution.» This means that the parties would have to take material business risk of the later distribution not occurring or occurring on terms not initially anticipated. 53 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates

54 Leveraged Partnership Alternatives Debt Structured as Qualified Liability Steps: Step 1: Partner borrows against property. Borrowing is secured by Property. Step 2: More than two years later, Partner contributes Property to Partnership, subject to the debt. Because the debt was incurred more than two years earlier and secured the contributed Property, the debt is a qualified liability. Considerations: Again, the contribution should not be so certain that there is not significant entrepreneurial risk due to change in circumstances. 54 Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates