The New Partnership Disguised Sale and Liability Allocation Regulations

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1 The New Partnership Disguised Sale and Liability Allocation Regulations Tax Executives Institute Houston Chapter Amy L. Sutton Deloitte Tax LLP May 2, 2017

2 Sections 707 and 752: Final, Temporary, and Proposed Regulations

3 Example 1 Leveraged Partnership Is X s guarantee of the Bank loan effective? Impact on disguised sale X Y Impact on debt allocations guarantee 10% common + $90 Assets FMV 100 A/B 0 $90 complementary assets 90% common Bank $90 loan note LLC 4

4 Introduction 2014 Proposed Regulations and 2016 Regulation Package On January 30, 2014, the Treasury Department and the IRS published proposed regulations under section 707 relating to disguised sales of property to or by a partnership and under section 752 concerning the treatment of partnership liabilities (the 2014 Proposed Regulations ). On October 5, 2016, the Treasury Department and the IRS published the following: T.D. 9787, which consists of final regulations that: substantially adopt the 2014 Proposed Regulations under section 707 with revisions to certain proposed rules in response to comments; adopt provisions of the 2014 Proposed Regulations that amend Treas. Reg , revised in response to the comments received; and adopt provisions of the 2014 Proposed Regulations revising Treas. Reg (d)(2)(ii) and (m) Example 1, to comport with the provisions in the 752 Proposed Regulations and the 752 Temporary Regulations relating to bottom dollar payment obligations. T.D. 9788, which includes 707 Temporary Regulations that require a partner to apply the same percentage used to determine the partner s share of excess nonrecourse liabilities under Treas. Reg (a)(3) (with certain limitations) in determining the partner s share of partnership liabilities for disguised sale purposes; and 752 Temporary Regulations providing guidance on the treatment of bottom dollar payment obligations. Withdrawal of Treas. Reg of the 2014 Proposed Regulations and addition of new 752 Proposed Regulations. 5

5 Sections 707 and 752 Comparison of Proposed, Temporary, and Final Regulations Topic 2014 Proposed Regulations 2016 Temporary Regulations 2016 Final Regulations 2016 Proposed Regulations Partner s share of nonrecourse liabilities Would have removed significant item and alternative method under Treas. Reg (a)(3), but would have added liquidation value percentage approach Partner s share of partnership liability for disguised sale purposes only treated as nonrecourse but not in excess of partner s share of the partnership liability under section 752 and applicable regulations Determined under (a)(3) (but not applying significant item method, alternative method, and additional method) Retain significant item method and alternative method but methods do not apply for disguised sale purposes; do not adopt liquidation value percentage approach Preformation capital expenditures Property-by-property rule for determining 20% limitation and 120% test Adopt rule and added rule to permit limited aggregation of property in certain cases Would have eliminated reimbursement of preformation capex funded by capital expenditure qualified liability to extent exceeds share of liability ( double dip ) Broaden proposed rule to include any qualified liability used to fund capital expenditures Treatment of transferees for purposes of preformation capex and qualified liability rules Step-in-the-shoes rule when partner acquires property, assumes a liability, or takes property subject to a liability in certain nonrecognition transactions (sections 351, 381(a), 721, and 731; Rev. Rul superseded) Qualified liabilities Added a fifth category of qualified liabilities, which are liabilities not incurred in anticipation of the transfer of property to a partnership, but incurred in connection with a trade or business in which the property transferred was used Adopt rule 6

6 Sections 707 and 752 Comparison of Proposed, Temporary, and Final Regulations (cont.) Topic 2014 Proposed Regulations 2016 Temporary Regulations 2016 Final Regulations 2016 Proposed Regulations Deficit restoration obligations Would have applied list of recognition factors to DROs Would add a list of factors similar to factors in proposed anti-abuse rule, but specific to DROs Tiered partnerships Contributing partner s share of a liability from lower-tier partnership (LTP) is qualified to the extent the liability would be qualified had it been assumed or taken subject to by upper-tier partnership (UTP) in connection with a transfer of all of the LTP s property to the UTP by LTP Adopts rule and adds that it is the partner's intent (not LTP's intent) that is relevant when determining whether a liability of LTP is a qualified liability when applying the anticipated transfer of property rules UTP steps in the shoes of a person with respect to the property for which capital expenditures were incurred and may be reimbursed for the capital expenditures by the LTP to the same extent that the person could have been reimbursed by LTP Rights of reimbursement Partner would not bear EROL if entitled to reimbursement from any person Would not include 2014 proposed changes Contingent liabilities Would have provided that contingent liabilities are not taken into account for disguised sales The language in the 2014 proposed regulation was not adopted; Treasury and IRS agree to continue to study the issue 7

7 Sections 707 and 752 Comparison of Proposed, Temporary, and Final Regulations (cont.) Topic 2014 Proposed Regulations 2016 Temporary Regulations 2016 Final Regulations 2016 Proposed Regulations Recognition of payment obligations Payment obligation would not have been recognized unless it met each factor in list of recognition factors; bottom dollar payment obligations and vertical slices not allowed (disclosure required) Recognition based on all facts and circumstances, special rules for bottom dollar payment obligations (disclosure required on Form 8275), reimbursement agreements, and indemnities; vertical slice is permitted Would modify and move list of factors to anti-abuse rule in Prop. Treas. Reg (j) Would not include commercially reasonable net worth factor or arm s length consideration factor but would add restrictions that might delay collection by creditor Net value Payment obligation would have been recognized only to the extent of net value as determined under Treas. Reg (k); Would have extended to all taxpayers other than an individual/ estate Would remove Treas. Reg (k) and create new presumption under anti-abuse rule regarding ability to make required payments Anticipated reduction rule Liabilities in assets-over merger Would have modified rule, including presumption related to reduction in net value Would have applied netting principles for determining effect of assets-over merger Adopt modified rule but do not retain net value component Rule not adopted Effective dates For purposes of determining disguised sale gain, for transfers occurring on or after Jan. 3, 2017 For purposes of section 752 in general, for debt incurred or assumed on or after Oct. 5, 2016 Also has a 7-year transition rule for recourse debt if allocable share of debt exceeds basis on Oct. 5, 2016 Generally for transactions occurring on or after October 5, 2016 Date published in Federal Register in final form However, taxpayers may rely on various parts of the Proposed Regulation beginning on or after Oct. 5,

8 Sections 707 and 752: Final and Temporary Regulations

9 Sections 707/752 Temporary Regulations Partner s Share of Partnership Liabilities Temp. Treas. Reg T(a)(2) In determining a partner s share of a partnership liability for disguised sale purposes, the previously existing regulations under section 707 prescribed separate rules for a partnership s recourse liability and a partnership s nonrecourse liability. The withdrawn portions of the 2014 Proposed Regulations included proposed changes to Treas. Reg that were intended to ensure that only genuine commercial payment obligations, including guarantees and indemnities, affected the allocation of partnership liabilities. Temp. Treas. Reg T(a)(2) provides: For purposes of , a partner s share of a liability of a partnership, as defined in (a) (whether a recourse liability or a nonrecourse liability) is determined by applying the same percentage used to determine the partner s share of the excess nonrecourse liability under (a)(3) (but not applying significant item method, alternative method, and additional method), but such share shall not exceed the partner s share of the partnership liability under section 752 and applicable regulations (not applying significant item method, alternative method, and additional method under (a)(3)). 10

10 Sections 707/752 Final Regulations Partner s Share of Nonrecourse Liabilities Treas. Reg (a)(3) Under Treas. Reg (a)(3), a partner s share of excess nonrecourse liabilities ( Tier 3 ) is determined in accordance with that partner's share of partnership profits. The existing regulation provided various methods to determine a partner s share of excess nonrecourse liabilities. The 2014 Proposed Regulations would have removed the significant item method and the alternative method, but provided a new approach based on a partner s liquidation value percentage. The Final Regulations under Treas. Reg retain the significant item method and the alternative method, but do not adopt the liquidation value percentage approach for determining partners interests in partnership profits. However, the final regulations under Treas. Reg provide that, along with the additional method, the significant item method and the alternative method do not apply for purposes of determining a partner s share of a partnership liability for disguised sale purposes. 11

11 Example 1 Revisited Leveraged Partnership X Y guarantee 10% common + $90 Assets FMV 100 A/B 0 $90 complementary assets 90% common Bank $90 loan note LLC Under the Temporary and Final Regulations, only $9 of the bank loan is allocated to Partner X Partner X treated as receiving a $81 distribution that is part of a disguised sale, resulting in $81 of gain 12

12 Sections 707/752 Final Regulations Definition of a Qualified Liability Treas. Reg (a)(6) The Final Regulations add an additional definition of qualified liability. Specifically, a qualified liability includes 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. 13

13 Sections 707/752 Final Regulations (cont.) Qualified Liability $90 cash X Y guarantee 10% common Asset FMV $100 & A/B $0 + $90 liability to Bank $90 assets 90% common Bank LLC 14

14 Sections 707/752 Final Regulations (cont.) Preformation Capital Expenditures Treas. Reg (d)(1) Z Z Limited to $110,000 Partners Other Business Tangible Asset LLC LLC Tax Basis $100,000 FMV $100,000 Tax Basis $450,000 FMV $550,000 Capital Expenditure $130,000 The Final Regulations clarify that the 20 Percent Limitation and the 120 Percent Test apply on a property-by-property basis subject to a limited aggregation rule. Other Business Tangible Asset Cash 15

15 Sections 707/752 Final Regulations (cont.) Preformation Capital Expenditures Treas. Reg (d)(4) Under the Final Regulations, Treas. Reg (d)(4) treats only $10 of the reimbursement as a qualified reimbursement. Thus, the economic benefit to X is limited to $100 (net decrease in debt of $90, and reimbursement of $10). The remaining $90 of reimbursement, would not qualify under Treas. Reg (d). Bank X Asset 1 Tax Basis $600 FMV $1,000 Subject to loan of $100 Contribution of Asset 1 subject to loan in exchange for a 10 percent interest and $100 in cash LLC 16

16 Sections 707/752 Final Regulations (cont.) Treatment of Transferees for Purposes of Preformation Expenditures and Qualified Liabilities Treas. Reg (d)(2) & Treas. Reg (a)(8) Preformation Expenditures For purposes of applying the exception for reimbursements of preformation expenditures under Treas. Reg (d), a partner steps in the shoes of a person (to the extent the person was not previously reimbursed for preformation expenditures) with respect to capital expenditures the person incurred with respect to property transferred to the partnership by the partner to the extent the partner acquired the property from the person in a nonrecognition transaction described in sections 351, 381(a), 721, or 731. Qualified Liabilities Except in certain tiered partnership situations (described below), in determining whether a liability is a qualified liability under Treas. Reg (a)(6), a partner steps in the shoes of a person with respect to a liability the person incurred or assumed to the extent the partner assumed or took property subject to the liability from the person in an nonrecognition transaction described in sections 351, 381(a), 721, or 731. Revenue Ruling is superseded by the Final Regulations. 17

17 Sections 707/752 Final Regulations (cont.) Treatment of Transferees for Purposes of Preformation Expenditures and Qualified Liabilities Treas. Reg (d)(2) & Treas. Reg (a)(8) Example: X X Y $100 Loan Asset Subject to Liability Y Bank Asset Subject to Liability LLC X borrows $100 from Bank, and the borrowing is secured by Asset. X uses the proceeds of the loan to make substantial capital improvements to Asset. X then contributes Asset, subject to the liability, to Y in a section 351 transaction. Later, Y contributes Asset, subject to the liability, to LLC in exchange for an interest in LLC and $100 in cash. Y steps into the shoes of X for purposes of applying the exception for reimbursements of preformation expenditures and determining whether the liability is a qualified liability. 18

18 Sections 707/752 Final Regulations (cont.) Tiered Partnerships and Qualified Liability Determination Treas. Reg (e)(2) If an interest in a partnership that has one or more liabilities (the lower-tier partnership) is transferred to another partnership (the upper-tier partnership), the upper-tier partnership s share of any liability of the lower-tier partnership that is treated as a liability of the uppertier partnership under Treas. Reg (a) is treated as a qualified liability under Treas. Reg (a)(6)(i) to the extent the liability would be a qualified liability under Treas. Reg (a)(6)(i) had the liability 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 upper-tier partnership by the lower-tier partnership. A determination that the liability was not incurred in anticipation of the transfer of property to the upper-tier partnership (for purposes of Treas. Reg (a)(6)(i)(B) and (E)) is based on whether the partner in the lower-tier partnership anticipated transferring its interest in the lower-tier partnership to the upper-tier partnership at the time the liability was incurred by the lower-tier partnership. Therefore, the intent of the lower-tier partnership is irrelevant. 19

19 Sections 707/752 Final Regulations (cont.) Tiered Partnerships and Qualified Liability Determination Treas. Reg (e)(2) Example: Partners X Partners X Partners Bank $100 loan LLC $10 distribution to X Bank $100 loan LLC LLC 2 X is a 10 percent member in LLC. LLC borrows $100 from an unrelated bank (giving the bank a security interest in its assets), allocates the liability under Treas. Reg (a)(3) to its members in proportion to their interests, and distributes the debt proceeds in the same proportions. At the time of the borrowing, X does not anticipate transferring its LLC interest. One month later, X contributes its interest in LLC to LLC 2 in exchange for an interest in LLC 2. To determine the extent to which LLC 2 s taking the LLC interest subject to X s share of the liability is treated as part of a disguised sale, the liability would be characterized in the same manner as if LLC had transferred its assets, subject to the liability, to LLC 2. 20

20 Sections 707/752 Temporary Regulations Contingent Liabilities Temp. Treas. Reg T(a)(2)(ii) Unlike the 2014 Proposed Regulations, which would have provided that Treas. Reg contingent liabilities ( -7 Liabilities ) are not taken into account for disguised sale purposes, the Temporary Regulations do not address the treatment of -7 Liabilities for disguised sale purposes. The preamble to the these Temporary Regulations states that in many cases, -7 Liabilities may constitute qualified liabilities that would not be taken into account for purposes of determining a disguised sale. The preamble further notes that there may be some circumstances in which certain transfers of -7 Liabilities to a partnership may be abusive. Therefore, the Treasury Department and the IRS will continue to study the issue of the effect of -7 Liabilities with respect to disguised sales. 21

21 Sections 707/752 Final Regulations Anticipated Reduction Rule Treas. Reg (a)(3) Under the existing regulations 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. The Final Regulations modify the anticipated reduction rule by adding that a subsequent reduction is taken into account only if it is not subject to the entrepreneurial risks of partnership operations. This could arise, for example, where the partnership has a predictable income stream and where the partnership agreement provides for a future change in the partners profit allocations (and a corresponding change in nonrecourse debt allocations) based solely on the passage of time. The Final Regulations do not include the net value component from the 2014 Proposed Regulations. 22

22 Section 752 Temporary and Proposed Regulations Recognition of Payment Obligations The 2014 Proposed Regulations would have provided that a partner s or related person s obligation 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 each of six recognition factors was met. The IRS and Treasury have abandoned the all-or-nothing approach of the 2014 Proposed Regulations. In its place, they have: Proposed Creating a list of factors in an anti-abuse rule in Prop. Treas. Reg (j) in the 752 Proposed Regulations and Addressed recognition factors concerning bottom dollar guarantees and indemnities in the 752 Temporary Regulations. 23

23 The End of Bottom Dollar Guarantees

24 $20 bottom dollar guarantee Guarantor liable only if lender recovers less than $20 25

25 Bottom Dollar Guarantees Temporary Regulations Bottom Dollar Payment Obligation Not Recognized Temp. Treas. Reg T(b)(3) The Temporary Regulations provide that a bottom dollar payment obligation will not be respected for purposes of allocating liabilities under section 752 A bottom dollar payment obligation includes, among other arrangements, any payment obligation other than one in which the partner or a related person 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 26

26 Bottom Dollar Guarantees Temporary Regulations Bottom Dollar Payment Obligation Not Recognized (cont.) Exceptions 90% Exception Bottom dollar payment obligation under which the partner or related person is liable for at least 90% of the liability Caps A payment obligation that is subject to a cap Vertical Slice A payment obligation that is stated as a fixed percentage of every dollar of the partnership s liability Disclosure: Partnership must disclose bottom dollar payment obligations, including those qualifying under the 90% exception 27

27 Section 752: Proposed Regulations

28 Section 752 Proposed Regulations Recognition of Payment Obligations Anti-Abuse Factors The list of anti-abuse factors in Prop. Treas. Reg (j)(3)(ii) is non-exclusive, and the weight given to any one factor depends on the particular case. The factors are: (A) The partner or related person is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment, including, for example, restrictions on transfers for inadequate consideration or distributions by the partner or related person to equity owners in the partner or related person (B) The partner or related person is not required to provide (either at the time the payment obligation is made or periodically) commercially reasonable documentation regarding the partner s or related person s financial condition to the benefited party (C) 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 (for example, termination prior to the due date of a balloon payment or a right to terminate that can be exercised because the value of loan collateral decreases) 29

29 Section 752 Proposed Regulations (cont.) Recognition of Payment Obligations Anti-Abuse Factors (cont.) (D) 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 (E) 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 (F) 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 (G) The creditor or other party benefiting from the obligation did not receive 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 30

30 Section 752 Proposed Regulations (cont.) Deficit Restoration Obligations (DROs) The 2014 Proposed Regulations applied the list of recognition factors to all payment obligations under Treas. Reg (b), including a DRO, as provided under the section 704(b) regulations. The 752 Proposed Regulations refine the list of factors applicable to DROs and clarify the interaction of section 752 with section 704 regarding DROs. 31

31 Section 752 Proposed Regulations (cont.) Deficit Restoration Obligations (DROs) (cont.) Under Treas. Reg (b)(2)(ii)(c)(2) of the existing regulations, a partner s DRO is not respected if the facts and circumstances indicate a plan to circumvent or avoid the partner s DRO. The 752 Proposed Regulations add a list of factors to Treas. Reg (b)(2)(ii)(c) that are similar to the factors in the proposed anti-abuse rule under Prop. Treas. Reg (j), but specific to DROs, to indicate when a plan to circumvent or avoid an obligation exists. 1) the partner is not subject to commercially reasonable provisions for enforcement and collection of the obligation; 2) the partner is not required to provide (either at the time the obligation is made or periodically) commercially reasonable documentation regarding the partner s financial condition to the partnership; 3) the obligation ends or could, by its terms, be terminated before the liquidation of the partner s interest in the partnership or when the partner s capital account as provided in (b)(2)(iv) is negative; and 4) the terms of the obligation are not provided to all the partners in the partnership in a timely manner. 32

32 Section 752 Proposed Regulations (cont.) Net Value Rule Treas. Reg (k)(1) provides that, when determining the extent to which a partner bears the EROL for a partnership liability, a payment obligation of a DRE is taken into account only to the extent of the net value of the DRE as of the allocation date that is allocated to the partnership liability. The 2014 Proposed Regulations would have provided that, in determining the extent to which a partner or related person other than an individual or a decedent s estate bears the EROL for a partnership liability other than a trade payable, a payment obligation is recognized only to the extent of the net value of the partner or related person that, as of the allocation date, is allocated to the liability, as determined under Treas. Reg (k). Treasury and the IRS have decided not to expand the application of the net value rules under Treas. Reg (k). Instead, they propose to remove Treas. Reg (k) and add a new presumption under the anti-abuse rule in (j). Prop. Treas. Reg (j)(3)(iii) provides: Evidence of a plan to circumvent or avoid an obligation is deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation that the payment obligor will have the ability to make the required payments if the payment obligation becomes due and payable. 33

33 Changes Not Adopted in Final or Temporary Regulations

34 Changes Not Adopted in Final or Temporary Regulations Treatment of liabilities in assets-over merger under section 707 The 2014 Proposed Regulations extended the netting principles of Treas. Reg (f) in a provision for determining the effect of an assets-over merger or consolidation under the disguised sale rules. Treasury Department and the IRS have determined that no rule on the treatment of liabilities in an assets-over merger is needed in Treas. Reg , so the proposed change was not adopted. Rights to reimbursement Under the 2014 Proposed Regulations, a partner would not bear the EROL under Treas. Reg (b)(1) if the partner or related person is entitled to a reimbursement from any person. This proposal was not adopted. 35

35 Questions?

36 Contacts Amy L. Sutton Partner Washington National Tax, Passthroughs Deloitte Tax LLP Houston (713) ;

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