Recent Regulations Issued On The Treatment of Partnership Liabilities Under the Disguised Sales Rules Still Meeting With Much Criticism

By: Jerald David August

On October 5, 2016 the Internal Revenue Service and the Treasury issued Final and Temporary Regulations (T.D. 9788) pertaining to how liabilities are to be allocated and treated for purposes of applying the disguised sales rules under section 707 and when certain obligations will be as a recourse liability under section 752. Shortly thereafter, new proposed regulations (REG-122855-15) withdrew a portion of the recent rule-making to the extent not adopted in the final regulations and contain new proposed regulations on: (i) whether certain obligations to restore a deficit balance in a partner's capital account are to be regarded (versus disregarded) for purposes of section 704; and (ii) when partnership liabilities are to be treated as recourse liabilities under section 752. These are important regulations obviously and, as reported in a prior blog post, will affect many if not most partnerships and their partners, including members of limited liability companies and limited liability limited partners. The regulations were to be effective on date of issuance with an important deferred date on the application of revisions to the disguised sales rules and liabilities until early next month. [1]

The Preamble to the new Final and Temporary Regulations note that based on a comment it had received on the 2014 Proposed Regulations, reconsideration was given to Treas. Reg. §1.707-5(a)(2) of the 2014 Proposed Regulations in determining a partner's share of partnership liabilities under section 707. The Temporary Regulations (the 752 Temporary Regulations) require a partner to generally apply the same percentage used to determine the partner's share of excess nonrecourse liabilities under Treas. Reg. § 1.752-3(a)(3) in determining the partner's share of partnership liabilities for disguised sale purposes. The new 752 Temporary Regulations also provide guidance on the treatment of "bottom dollar payment obligations", a subject which has long been viewed as problematic to the Service on leveraged partnership transactions designed to withdraw funds from a partnership as a tax-free recovery of basis. In T.D. 9787 the 752 Final Regulations address the allocation of a partnership's excess nonrecourse liabilities.  

This post addresses the rule-making's prescription for treating recourse debt in the same manner as nonrecourse debt for applying the disguised sales rules. Other aspects of this important rule-making, such as determining whether a liability is a recourse liability, including "bottom-dollar guarantees" are not addressed..  

General Treatment of Partnership Liabilities for Disguised Sales Purposes

In accordance with section 707(a)(2)(B), when a partner contributes, directly or indirectly, money or appreciated property to a partnership as part of an exchange purported to be non-taxable under section 721 and, where as part of an exchange, the contributing partner receives, again directly or indirectly, an actual or deemed distribution of cash or other property, the transactions, when viewed together, will be recharacterized as a disguised sale for purposes of section 707(a)(1).  See H.R. Rep. No. 861, 98th Cong., 2d Sess. 862 (1984).  The regulations previously issued under the disguised sales rules are complex and contain various operating rules and exceptions. See Treas. Reg. §1.707-3(a)(2). Particularly troublesome for the Service was the way in which the disguised sale regulations should address non-simultaneous contributions and distributions, particularly for distributions that do not occur in fact until after the statute of limitations has expired for the year of the contribution. As mentioned, his issue was present with working with the debt-financed distribution rule.  

While the disguised sales rules under section 707 are implicated in various contexts, one important area concerns the proper treatment of contributions of encumbered property, such as property with a liability in excess of the contributed property's adjusted basis in the hands of the transferor where there is a simultaneous and/or non-simultaneous distribution of money or other property received by the transferor. Treas. Reg. §1.707-5(a)(1). It should be noted that certain liabilities are allocated to contributed property even if not a direct encumbrance on the contributed property. The disguised sale regulations set forth different rules depending on whether the underlying assumed encumbrance is a "qualified liability". Thus, for example, where a partnership assumes or takes property subject to a liability of the contributing partner which is not a "qualified liability", the partnership is treated as transferring "money" or consideration to the partner to the extent the amount of the liability exceeds the partner's share of that liability immediately after the partnership assumes or takes subject to the liability, etc [2]. The terms "recourse liability" and "nonrecourse liability" have had the same meaning for the disguised sales rules as they do under section 752. See Treas. Regs. §§1.752-1(a)(1), 1.752-1(a)(2). Under the disguised sales regulations, all nonrecourse liabilities are treated as "excess" nonrecourse liabilities and are allocated under Treas. Reg. §1.752-3(a)(3).

Under Treas. Reg. §1.707-5(a)(2)(i), a partner's share of a partnership's recourse liability equals the partner's share of the liability as determined under section 752. See Treas. Reg. § 1.752-1(a)(1). Under Treas. Reg. § 1.707-5(a)(2)(ii), a partner's share of a partnership's nonrecourse liability is the same percentage used to determine the partner's share of the excess nonrecourse liability under Treas. Reg. § 1.752-3(a)(3), which is generally determined in accordance with the partner's share of partnership profits. A partnership liability is a nonrecourse liability under section 707 to the extent that the obligation is a nonrecourse liability under  Treas. Reg. § 1.752-1(a)(2).

Treas. Reg. § 1.752-1(a)(1) treats a partnership liability as recourse to the extent that a partner or related person bears the economic risk of loss (EROL) for repayment of the liability. See Treas. Reg. §1.752-2(b). Treas. Reg. §1.752-1(a)(2) provides that a partnership liability is a nonrecourse liability to the extent that no partner or related person bears the EROL for that liability.  As previously mentioned, this determination is made by use of a constructive liquidation model further assuming that the partnership’s assets are worthless.   More specifically, a partner generally will be treated as having an obligation to make a payment to the extent that the partner or related person would be legally obligated to repay part or all of an indebtedness of the partnership, if, upon a constructive liquidation of the partnership, the partnership's assets were worthless and the liability became due and payable (constructive liquidation test). Treas. Reg. § 1.752-2(b)(6) assumes that partners and related persons will satisfy their (recourse) payment obligations irrespective of their net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation.

Prior to the issuance of the new regulations, it was possible for a partner to have received a tax-deferred distribution of cash sourced from a debt-financing and treat such amount as a recovery of basis and not the proceeds from a disguised sale.  See Treas. Reg. §1.707-5(b).

Partner's Share of Partnership Liabilities for Purposes of Section 707

The Preamble to the recently issued Final and Temporary regulations noted that among the comments it received to the 2014 Proposed Regulations, many of which were unfavorable, one commentator lauded the Service in its effort to attack leveraged partnership structures. As stated by the Treasury, such commenter argued that the clear effect of the 2014 Proposed Regulations under section 752 was to make it more likely that liabilities would be treated as nonrecourse liabilities, and thus allocable under the EROL rule under Treas. Reg. § 1.752-3. This would result in realization of gain under the disguised sales rules which gain could otherwise have been avoided under the debt-financed rule or by application of the general allocation of liabilities under the section 752 regulations. Such commenter noted that gain recognition as part of a leveraged distributions seems appropriate as an economic matter, because, contrary to the constructive liquidation test in  Treas. Reg. § 1.752-2(b)(1), lenders, borrowers, and credit support providers generally do not expect that the assets of the partnership will become worthless [3]. Rather, lenders, borrowers and credit support providers generally expect borrowers (including partnerships) to satisfy their obligations out of profits. So that guarantors of partnership debt, for example,  will not be called upon to honor their guaranty.  

This was the abuse the Treasury wanted to address in the rule-making is the debt-financed distribution exception contained in Treas. Reg. §1.707-5(b). Under this rule, a distribution of money to a partner by a partnership is not taken into account to the extent that the distribution is traceable to a partnership borrowing and the amount of the distribution does not exceed the partner's allocable share of the liability incurred to fund the distribution. See H.R. Rep. No. 861, 98th Cong., 2d Sess. 859 (1984).  The Treasury then pivots around the legislative history of the disguised sales rules to leveraged partnership transaction. It notes that  the debt financed exception has been abused through leveraged partnership transactions in which the contributing partners or related persons enter into payment obligations that are not driven by business necessity but instead are effectuated solely to achieve an allocation of the partnership liability to the partner, with the objective of avoiding a disguised sale. The Office of Chief Counsel, in CCA 201324013, had gone on the record for the reasons it planned to attack a "leveraged partnership" transaction that was sourced from the Chicago Tribune's disposition of Newsday to Cablevision in 2010 [4]. The IRS went after the transaction based on the Tax Court's decision and supporting analysis in Canal Corp. v. Commissioner, 135 T.C. 199, 216 (2010)("We have carefully considered the facts and circumstances and find that the indemnity agreement should be disregarded because it created no more than a remote possibility that [the indemnitor] would actually be liable for payment."). [5]

So, in order to once and for all take much of the bite out of the leveraged partnership strategy, the Treasury Department and the IRS have concluded that, for disguised sale purposes only, it is appropriate for partners to determine their share of any partnership liability, whether recourse or nonrecourse under section 752, in the manner in which excess nonrecourse liabilities are allocated under § 1.752-3(a)(3). This is the rule announced in the new Temporary Regulations. The rationale for ignoring the recourse status of the debt, as previously stated, is that in "most cases" a partnership will satisfy its liabilities with partnership profits, the partnership's assets do not become worthless, and the payment obligations of partners or related persons are not called upon.  The new regulations require this treatment of recourse debt to be viewed as non-recourse debt to apply: (i) where a partner's liability is assumed by a partnership in connection with a transfer of property to the partnership or by a partner in connection with a transfer of property by the partnership to the partner; (ii) where a partnership takes property subject to a liability in connection with a transfer of property to the partnership or a partner takes property subject to a liability in connection with a transfer of property by the partnership to the partner; or (iii) where a liability is incurred by the partnership to make a distribution to a partner under the debt-financed distribution exception in  Treas. Reg. § 1.707-5(b). Accordingly, under the 707 Temporary Regulations, a partner's share of any partnership liability for disguised sale purposes is the same percentage used to determine the partner's share of the partnership's excess nonrecourse liabilities under § 1.752-3(a)(3), as limited for disguised sale purposes under the 752 Final Regulations.

There was an exception provided that a partner's share of a partnership liability for disguised sale purposes should not include any portion of the liability for which another partner bears the EROL, as these liabilities would not be allocated to a partner without EROL under general principles of subchapter K.  Ok, don't tax the person who didn't get the actual money or deemed distribution, right?  That's right, as the Preamble to the 707 Temporary Regulations provides that a partner's share of a partnership liability for disguised sale purposes does not include any amount of the liability for which another partner bears the EROL for the partnership liability under  Treas. Reg. § 1.752-2.  The bottom line is the 707 Temporary Regulations treat all partnership liabilities, whether recourse or nonrecourse, as nonrecourse liabilities solely for purposes of section 707.

Well, this may “sound nice” that profits are what pays the bills, including bills traceable to recourse debt for which one or more partners bear personal liability, but the regulations have long applied a "constructive liquidation" model for allocating partnership recourse debt. The policy rationales for respecting and then ignoring recourse debt are mutually inconsistent. Can the Service have it both ways? Perhaps a court in review will say “no”.

Finally, in addition to the rule for determining a partner's share of a § 1.752-1(a) partnership liability for disguised sale purposes, the 707 Temporary Regulations reserve with respect to the treatment of Treas. Reg. § 1.752-7 contingent liabilities for disguised sale purposes. In many cases,  Treas. Reg. § 1.752-7 contingent liabilities may constitute qualified liabilities that would not be taken into account for purposes of determining a disguised sale.  Yes, but some commenters on the 2014 Proposed Regulations noted that such contingent liabilities albeit meeting the definition of “qualified liabilities” "may be abusive".  As a result, the Preamble notes the Treasury Department and the IRS will continue to study the issue of the effect of contingent liabilities with respect to section 707, as well as other sections of the Code, in connection with future guidance projects.

The disguised sale liability regulations are to go into effect for any transaction for which all transfers occur on or after January 3, 2017.

Treasury and Service Engaged in a Do-Over?

The revisions to the disguised sales rules in the  2014 Temporary Regulations (T.D. 9788) were met with much concern and criticism from various professional groups and experts in this area. One well known commentator who is a former Chair of the ABA Tax Section, Richard M. Lipton of the Baker & McKenzie law firm, expressed concerns that the regulations were not only poorly drafted, as well as "flawed," but should have been issued in proposed form. Another noted expert in the field commented that the regulations were capable of various inconsistent interpretations. That's a nice way of confirming Mr. Lipton's thought that they were poorly drafted indeed. Well, the criticisms hit a "nerve" and the Treasury and IRS responded with a "correction" on November 16, 2016.

In particular, the way the regulations were drafted, another partner's guarantee of partnership debt for which such partner was EROL, could increase the amount of a distribution that was part of disguised sale to the partner contributing the property. That is because the debt would be allocated based on partnership profits (tier three rule) but without including any amount that another partner guaranteed even though, as mentioned, such guarantor can not benefit from the guaranteed for purposes the disguised sales rule.

The Treasury issued two corrections to its October 5, 2016 rule-making on November 16, 2016.(F.R. 80993-80994).  One correction changes the wording of the Preamble with respect to a partner's share of liability for disguised sales rules. So, previously the language in the Preamble describing the rule treating all liabilities as third-tier nonrecourse debt for disguised sales purposes was as follows:

" Therefore, the 707 Temporary Regulations provide that a partner's share of a partnership liability for disguised sale purposes does not include any amount of the liability for which another partner bears the EROL for the partnership liability under [Treas. Reg.] § 1.752-2."

Now, the Treasury corrected the statement as follows:

""Therefore, the 707 Temporary Regulations provide that for purposes of § 1.707-5, a partner's share of a liability of a partnership, as defined in § 1.752-1(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 § 1.752-3(a)(3) (as limited in its application to § 1.707-5T(a)(2)), but such share shall not exceed the partner's share of the partnership liability under section 752 and applicable regulations (as limited in the application of § 1.752-3(a)(3) to § 1.707-5T(a)(2))."

Ok, so the Treasury admitted it was "wrong" and corrected. But what about the recourse borrower or guarantor where no other partner is liable for repayment or if two (or more) general partners in a limited partnership who are not "Bowery Bums" so to speak have personal liability for repayment of partnership debt but are to still get taxed under the disguised sales rules on their actual share of liabilities based solely as if the debts were nonrecourse? The result is illogical and perhaps could be argued is arbitrary. Expect a challenge in this area to work its way up through the courts at a later date.

Moreover, the new language generates its own confusion and uncertainty by interjecting the parenthetical "(as limited in the application of §1.752-3(a)(3)...)". Perhaps what the new wording means is that each partner should be allocated the lesser of their nonrecourse liability share or their normal section 752 share for disguised sale purposes. There is some irony involved here in the sense that the new rules may allow partners who are not liable on partnership debt to receive allocation of debt for disguised sale purposes for which another partner is EROL.  

What the Treasury and Service seemed to ignore, perhaps completely, is that rather straight forward examples of debt-financed distributions by partnerships for which the partners have guaranteed part or all of the debt become taxable under this new bizarre construct of ignoring the stark difference between recourse and nonrecourse debt in applying the disguised sales rules under Treas. Reg. §1.707-5. The regulation seems to be flawed not only because of its confusing verbiage but because it does ignore economic reality as well as the aggregate-entity principles of partnership taxation.

It seems like the recent race engaged in by the Treasury and the IRS  to get out important regulations projects have picked up several forms of “technical viruses” that not only will result in challenges to the validity of such regulations under Mead/Chevron type principles, but may go beyond the permitted boundary of merely interpreting the law to making it. [6]


 [1] On January 30, 2014, the Treasury Department and the IRS published a notice of proposed rulemaking in the Federal Register (REG-119305-11, 79 FR 4826) to amend existing regulations under section 707 relating to disguised sales of property to or by a partnership and section 752 concerning the treatment of partnership liabilities (the 2014 Proposed Regulations). The 2014 Proposed Regulations provided certain technical rules intended to clarify the application of the disguised sale rules under section 707 and also contained rules regarding the sharing of partnership recourse and nonrecourse liabilities under section 752.

[2] Where the liability in question is “qualified” and the contribution of property to the partnership is not otherwise treated as a sale, the partnership’s assumption of or taking subject to the liability is not treated as part of a sale. Where the contribution is otherwise treated as a “sale”, however, the partnership’s assumption of or taking subject to a qualified liability is treated as the payment of cash to the transferor in an amount equal to the lesser of: (i) the consideration the partnership would have been treated as transferring to the partner were the liability a nonqualified liability; or (ii) an amount equal to the amount of the (qualified) liability multiplied by the partner’s net equity percentage of the contributed property. Treas. Reg. §1.707-5(a)(5)(ii); Treas. Reg. §1.707-5(f), Ex. 6.

Under Treas. Reg. §1.707-5(a)(6), a qualified liability of a partner with respect to a transfer of property to the partnership where the property is encumbered by a liability exists only to the extent that (i) the liability is: (a) a liability that was incurred by the partner more than two years prior to the earlier of the date the partner agrees in writing to transfer the property or the date the partner transfers the property to the partnership and that has encumbered the transferred property throughout that two-year period; (b) a liability that was not incurred in anticipation of the transfer of the property to a partnership, but that was incurred by the partner within the two-year period prior to the earlier of the date the partner agrees in writing to transfer the property or the date the partner transfers the property to the partnership and that has encumbered the transferred property since it was incurred; (c) a liability incurred in the ordinary course of business in which property was transferred to the partnership but only if all assets related to that trade or business are transferred; (d) a liability allocable to capital expenditures under Treas. Reg. §1.163-8T; or (v) if the liability is recourse, the amount of the liability that does not exceed the FMV of the transferred property (less the amount of any other liabilities that are senior in priority, etc.

[3] See New York State Bar Members Report on Proposed Partnership Disguised Sale Regulations, May  30, 2014, reprinted in Tax Notes Today, 6/02/2014.

[4] See McManus, "Tribune's Cubs, Newsday Transactions Are Taxable as Disguised Sales, IRS Says," BNA Daily Tax Report, 6/24/13, page K-5.

[5] See, Lipton "Leveraged Partnerships Under Fire? IRS Attacks the Tribune's Transactions", J.Tax'n (Aug. 2013).

[6] Different methodologies were recently used by the Service in issuing regulations under §385 (T.D. 9790)(anticipated allocation of partnership interest expense) and §956 (T.D. 9792)(based on partner's liquidation value percentage".

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