ALLOCATION OF PARTNERSHIP RECOURSE LIABILITIES UNDER SECTION 752
LEARNING OBJECTIVES
After completing this chapter, you should be able to do the following:
• Recognize how liabilities affect the calculation of a partner's or member's basis and at-risk amount in his or her partnership or LLC interest.
• Calculate the gain that can result from reallocation of liabilities when a partner joins a partnership.
• Distinguish between recourse and nonrecourse liabilities of a partnership or LLC.
• Calculate a partner's or member's share of recourse liabilities of a partnership or LLC.
How Liabilities Affect Partner Tax Consequences
BASIC CONCEPTS
Because partners are (in theory) ultimately liable for partnership debts, liabilities increase the partners' potential losses in the event of partnership dissolution. Accordingly, they must be included in the partners' bases in their partnership interests, and changes in either the total level of partnership indebtedness or in the way in which partners share in that indebtedness must be accounted for on an ongoing basis.
The partnership is essentially disregarded from a tax standpoint when accounting for partnership debts. The partners' shares of partnership indebtedness flow through to the partners who are then treated as if they had made cash payments to the partnership in a like amount. Of course, since the statute treats partnership debts as indirect cash payments made by the partners, any reduction in partnership indebtedness must also be treated as a cash payment, albeit to the partners, rather than from them. Thus, accounting for partnership liabilities is important for tax purposes, not only in that a partner's share of partnership debt increases the amount of losses he or she can deduct (since deductions are limited to basis) but also because in certain cases, a reduction in partnership indebtedness can trigger unexpected gain recognition for one or more partners. It is also important to understand that because Section 752 treats the assumption by a partner of partnership debt as a cash payment by the partner to the partnership, liabilities attached to properties received as a distribution from the partnership increase the partner's basis in the partnership interest, rather than in the encumbered property.
TRANSACTIONS THAT CHANGE PARTNERS' SHARES OF PARTNERSHIP LIABILITIES
The mechanical application of Section 752 is relatively straightforward. Section 752(a) provides that increases in a partner's share of partnership debt, or the assumption by a partner of a partnership debt, are treated as contributions of money by the partner to the partnership, thus increasing the partner's basis in his or her partnership interest. Section 752(b) provides that decreases in a partner's share of partnership debt, or assumptions by the partnership of a partner's debt, are treated as distributions of money by the partnership to the partner. Deemed distributions under Section 752(b) decrease the partner's basis in his or her partnership interest and, as noted above, may trigger the recognition of gain to the partner under Section 731.
Thus, whenever a partnership obtains additional financing or pays down existing loans, the increased or decreased debt levels will have a flow-through effect on the partners just as if they had made or received cash payments to or from the partnership. Other, less obvious, transactions, however, will also impact the partners' shares of partnership indebtedness. For example, the admission of a new partner, the contribution of additional capital to the partnership by an existing partner, the distribution of encumbered property to an existing partner, and the reduction or termination of an existing partner's interest in the partnership will all have potential consequences for partners that might initially appear to be uninvolved in the transaction. Even if uninvolved in the transaction, partners can be treated as receiving cash distributions or making cash contributions, as the case may be. One final caveat – even if the partnership has not been involved in any of the above transactions during the year, and has neither paid down existing debt nor incurred additional financing, if it makes special allocations of gain, loss, income or deductions among the partners, the partners' shares of debt will generally change. Thus, it is important that the proper allocation of partnership liabilities be recalculated every year.
Contribution of Encumbered Property
The application of Section 752(b) can trigger gain under Section 731(a) when a partner contributes property encumbered by a liability in excess of its basis. Such a gain is not precluded by Section 721 because it arises, not from the contribution of property in exchange for a partnership interest, but rather from a deemed distribution under Section 752(b) resulting from the partner's entry into the partnership.
It should be noted, however, that in computing any such gain under Section 731 (a) upon a partner's entrance into the partnership, the provisions of Section 752(a) and Section 752(b) are applied simultaneously.1 Thus, gain will be triggered under Section 731(a) only to the extent that the amount of liability shifted from the contributing partner to the other partners exceeds the sum of the basis of property contributed and the increase in the contributor's share of partnership debts.
Example 3-1
A and B form the AB partnership with the following contributions of property and cash. A contributes land with a basis of $15,000, and a fair market value of $30,000, but encumbered by a debt of $20,000. B contributes $10,000 cash. A and B are equal partners. Assume that they share liability for the new partnership debt 50:50. Under Section 752(b), A will be treated as if she received a distribution of $20,000 cash when the partnership assumes the $20,000 debt encumbering the land. A will recognize no gain under Section 731(a), however, because she is also treated, under Section 752(a), as if she had contributed $10,000 cash (representing her 50 percent share of the partnership debt) in addition to the land. Thus A will have sufficient basis in her partnership interest to absorb the deemed distribution under Section 752(b). After fully accounting for the debt transfer, A's basis in her partnership interest is reduced to $5,000 [$15,000 Basis of Land – $20,000 Liability Relief + $10,000 (Share of Liabilities)]. B has a $20,000 basis in her partnership interest. ($10,000 cash contributed directly plus $10,000 deemed contribution under Section 752(a)).
KNOWLEDGE CHECK
1. R and Q form RQ partnership with the following contributions of property and cash. R contributes land with a basis of $500 and a fair market value of $1,000, but encumbered by a debt of $800. Q contributes $200 cash. R and Q are equal partners. Assume that they share liability for the new partnership debt 50:50. What will be R's basis in his partnership interest?
a. $0.
b. $100.
c. $200.
d. $500.
Example 3-2
J and D form the JD Partnership. J contributes property with a tax basis of $10,000, and subject to a recourse mortgage of $24,000.
The FMV of the property is $30,000. D contributes $12,000 cash.
Assume the partners share the partnership debt in accordance with their capital interests – one-third to J and two-thirds to D.
Under Section 752(a), J will be deemed to have contributed property with a basis of $10,000 and $8,000 cash (one-third of the liability) to the partnership. She will simultaneously be treated under Section 752(b) as if she received a distribution of $24,000 cash upon the partnership's assumption of the mortgage encumbering her property.
Since her basis in the partnership interest cannot be less than zero, she must recognize a $6,000 gain under Section 731(a). Her basis in her partnership interest will be zero after taking the gain into account. D will recognize no gain on the contribution of cash to the partnership and will have a tax basis in her partnership interest of $28,000 ($12,000 cash contributed plus $16,000 share of the mortgage).
Note that while J cannot have a negative basis in her partnership interest, she can and does have a negative balance in her capital account on the partnership's tax basis balance sheet (unless a Section 754 election is in effect). (She has a positive $30,000 – $24,000 = $6,000 capital balance on the partnership's Section 704(b) balance sheet.) A deficit in a partner's capital balance on the books of the partnership is okay. It means that in the event of partnership liquidation, the partner would owe additional monies to the partnership.
In contrast, a partner can never individually have a negative tax basis in the partnership interest – any event that would cause the partner's basis to fall below zero will trigger recognition of gain by the partner in an amount necessary to restore basis to zero.
Caveat: Note that the above results would not apply if the mortgage on the property contributed by J had been a nonrecourse, rather than recourse, debt. In such a case, the nonrecourse mortgage would have been allocated first to J to the extent of the minimum amount of gain that would be allocated to her under Section 704(c) in the event that the lender were to foreclose upon the property in satisfaction of the nonrecourse mortgage.
In this case, the minimum gain would be $14,000 under the facts above. This concept, “Section 704(c) minimum gain,” is based on the tax treatment of forgiven indebtedness under Section 1001, and is discussed in more detail in chapter 4. However, the 704(c) gain does not override the 704(b) gain.
KNOWLEDGE CHECK
2. A and B form the equal AB partnership with the following contributions. A contributes property with a basis of $200,000 and a fair market value of $600,000, but subject to a recourse debt of $400,000, incurred several years ago to finance the original acquisition of the property. B contributes property with a basis of $200,000 and a fair market value of $300,000. It is subject to a debt of $100,000, also incurred several years ago when the property was originally acquired. A and B share all items of partnership income, gain, loss, and deduction equally. They share partnership liabilities in the same ratio. What will be A's basis in her partnership interest immediately after formation?
a. $0.
b. $200,000.
c. $50,000.
d. None of the above.
If a continuing partner contributes encumbered property to a partnership, that partner will only recognize gain if the net debt relief exceeds the basis of the property contributed and the partner's pre-contribution basis in the property. Note that where more than one encumbered property is contributed to the partnership, the partners each account for their shares of aggregate partnership debt in determining whether they must report any gain on formation.
Example 3-3
Q and R form an equal partnership with the following contributions:
Q
R
Basis
FMV
Liability
Basis
FMV
Liability
Prop 1
$ 160
$ 480
$ 300
Prop 2
$ 150
$ 450
$ 360
Q receives a two-thirds interest in the partnership and R receives a one-third interest. Assume they share partnership liabilities in these same ratios. Under Section 752(a), Q will be deemed to have contributed money to the partnership in the amount of $440 (two-thirds of the partnership's aggregate indebtedness of $660). Her deemed distribution under Section 752(b) is $300. Thus, she recognizes no gain under Section 731, and her basis in her partnership interest is $300 ($160 basis in property 1, plus $440 share of partnership debt, less $300 deemed distribution under Section 752(b)).
In addition to property 2, R will be treated as having contributed money of $220 to the partnership, and will have a deemed distribution of $360. Thus, he will recognize no gain under Section 731 and will have a $10 basis in his partnership interest ($150 plus $220, less $360).
Admission of New Partners or Payment of Partnership Debt
Section 752(b) poses a potentially dangerous trap for the unwary. As noted above, distributions in excess of a partner's basis in her partnership interest trigger taxable gain under Section 731 (a). This gain is taxed as a gain from the sale of the partnership interest. Since Section 752(b) treats a decrease in a partner's share of partnership debts as a distribution of cash, an unexpected gain under Section 731 (a) may be triggered as a result of a partnership's payment of its debts, or on the admission of a new partner
Example 3-4
A and B form the equal AB partnership with the following contributions. A contributes property with a basis of $100 and a fair market value of $600, but subject to a recourse debt of $300. B contributes property with a basis of $200 and a fair market value of $400. It is subject to a debt of $100. Six months later, C is admitted as a 25 percent partner in exchange for $200 cash. Following C's entry, A's and B's interests in partnership capital fall from 50 percent to 37.5 percent. Assume they share partnership liabilities in the same ratios.
Neither partner A or B recognizes income or loss as a result of his original contribution to the partnership. A's basis in his partnership interest is zero ($100 property contributed + $200 increase in his share of partnership debt – $300 debt transferred to the partnership). B takes a basis of $300 in his partnership interest ($200 property contributed + $200 increase in his share of partnership debt – $100 debt transferred to the partnership).
C's subsequent entry, however, changes the partners' debt sharing ratios. C now shares 25 percent of the partnership debt, reducing A's and B's shares by 12.5 percent, or $50, each. This reduction is treated as a cash distribution under Section 752(b) of $50 each to A and B. This deemed distribution reduces B's basis in his partnership interest to $250. A's deemed $50 distribution triggers a $50 gain under Section 731(a).2 His basis remains zero.
Caveat: Regulations Section 1.704-1(b)(2)(iv)(f) allows partnerships to revalue their properties following the admission of a new partner. Revaluation of the partnership's assets, and thus the partners' capital accounts, is generally advisable in these situations. If the partnership in this example had opted to revalue its assets following C's admission, the resulting tax consequences would depend on the nature of the partnership's debt. If the debt were recourse, as in the original example, the same results would apply—A would recognize a $50 gain under Section 731(a) following C's entry to the partnership. However, if the debt were nonrecourse, revaluation of the partnership's assets would create Section 704(c) minimum gain, allocable to A, “protecting” his share of partnership liabilities, and preventing them from being shifted away from him to C (see chapter 4).
KNOWLEDGE CHECK
3. Assume the same facts as in the previous question. Assume further that the partnership admits a third partner, C, six months later in exchange for a cash contribution of $200,000. C will receive a one-third interest in partnership capital, profits, and losses. Assume further that she is allocated one-third of the partnership's liabilities under Section 752. A and B's shares of partnership liabilities under that statute decline to one-third each. Assuming no change in other facts, how much gain will A be required to recognize upon the admission of C?
a. $0.
b. $33,333.
c. $83,333.
d. None of the above.
Distributions in Partial Liquidation of a Partner's Interest
Receipt of a non-liquidating distribution by a partner is generally nontaxable unless the partner receives cash in excess of basis.3 In some cases, however, a seemingly nontaxable distribution can trigger gain under Section 731(a) if the distribution alters the partner's share of partnership liabilities. Recall that Section 752(b) treats a reduction in the partner's share of partnership debt as a distribution of money by the partnership to the partner. This deemed distribution, when coupled with an actual cash distribution, can trigger unexpected gain to the partner.
Example 3-5
Until December, Z was a one-third partner in Alphabet Partners, an insurance partnership. Her tax basis in her partnership interest was $10,000, consisting of her deficit capital balance of ($20,000) and her one-third share of the partnership's $90,000 in outstanding liabilities.
On December 18, Z received an $8,000 cash distribution from the partnership. Assume that the distribution reduces Z's interest in the partnership from one-third to one-fifth, and reduces her share of partnership liabilities to 20 percent as well.
The reduction in her share of partnership liabilities from $30,000 (one-third) to $18,000 (one-fifth) is treated under Section 752(b) as a cash distribution in the amount of $12,000. When coupled with the actual cash distribution of $8,000, Z's total “cash” distribution is $20,000, which exceeds her basis in the partnership interest by $10,000. Accordingly, she must recognize a $10,000 gain under Section 731(a).4
Note that the deemed cash contribution under Section 752(b) is accounted for before accounting for any distribution of property (other than money) associated with the redemption of some or all of the partner's interest in the partnership.5 Thus, unless the partner's net debt relief as a result of the distribution exceeds his or her basis in the partnership interest (for example, the partner has a negative tax basis capital account before the distribution), a property distribution never triggers gain under Section 731 (a), even if it reduces the partner's allocable share of partnership liabilities.
Example 3-6
S received a distribution of property valued at $500 from the TSX Partnership (tax basis of the property was $325). The distribution reduced S's interest in the partnership from one-third to one-fifth. It also reduced her share of partnership liabilities from one-third to one-fifth. Immediately prior to the distribution, S's basis in her partnership interest was $250 and her share of partnership liabilities was $200 (one-third of the partnership's $600 in outstanding debt).
Under Section 752(b), S will be treated as having received a cash distribution of $80 (the difference between one-third and one-fifth of the partnership's outstanding indebtedness) in addition to the property actually distributed.
The deemed cash distribution is accounted for first, reducing her tax basis in the partnership interest from $250 to $170. She will then take a $170 basis in the property received from the partnership under Section 732. Her remaining basis in her partnership interest will be zero.
Distributions of Encumbered Property
When a partner receives a distribution of property encumbered by liabilities, the consequences are slightly more complicated. Under Section 752(a), the assumption by the partner of partnership liabilities is treated as a contribution of cash by the partner to the partnership. This deemed contribution must be taken into account for purposes of applying the basis determination rules of Sections 732 and 733.
The tax treatment in these situations is further complicated by Section 752(b), which treats a decrease in a partner's share of partnership liabilities as a cash distribution by the partnership to the partner. Since a distribution of encumbered property will generally decrease the partnership's outstanding liabilities, it will decrease every partner's share of partnership debt. The actual distribution of encumbered property to a single partner will thus be accompanied by a deemed cash distribution to all partners. The distributee-partner must account for both the deemed cash contribution and the deemed cash distribution in addition to the actual distribution of property received from the partnership. Note that the deemed cash contribution will, in most cases, result in an increase in the partner's basis in the partnership interest rather than in the encumbered property.
Example 3-7
ABC Partnership had the following balance sheet as of December 31:
Basis
FMV
Basis
FMV
Cash
$ 45,000
$ 45,000
Mtg, P1
$ 15,000
$ 15,000
Prop 1
30,000
95,000
Mtg, P2
30,000
30,000
Prop 2
15,000
55,000
Capital, A
15,000
50,000
Capital, B
15,000
50,000
Capital, C
15,000
50,000
$ 90,000
$ 195,000
$ 90,000
$ 195,000
On that date, the partnership distributed property 2 to C, reducing her interest in the partnership from one-third to one-fifth. Assume that C's share of partnership liabilities was also reduced from one-third to one-fifth. C took property 2 subject to the related mortgage.
Under Section 731(a), C recognizes no gain on the distribution of property 2, since she did not receive cash in excess of her basis in her partnership interest. Prior to the distribution, C's basis in her interest was $30,000 (her $15,000 tax basis capital account plus her one-third share of the partnership's liabilities). The distribution reduces her interest in the partnership from one-third to one-fifth. It also reduces the partnership's outstanding liabilities from $45,000 to $15,000. Thus, her share of partnership debt falls from $15,000 (one-third of $45,000) to $3,000 (one-fifth of $15,000), and she is treated under Section 752(b) as having received a distribution of $12,000 cash from the partnership.
At the same time, her assumption of the partnership's $30,000 mortgage on property 2 is treated as a cash contribution to the partnership. Thus, although property 2 is encumbered by a $30,000 liability, her basis in it is only $15,000 (carryover basis). Meanwhile, her basis in her partnership interest actually increases by $3,000, to $33,000 (original $30,000 basis, plus $30,000 deemed cash contribution, less $12,000 deemed cash distribution, less $15,000 basis in property 2 received from the partnership).
The transfer of liabilities from the partnership to C also has tax consequences for the other two partners. Although their interests in the partnership increase from 33 percent to 40 percent, after accounting for the transfer to C, their shares of partnership liabilities fall by $9,000 (from one-third of $45,000 to 40 percent of $15,000). Thus, although they were not directly involved in the transaction, each of their bases in their partnership interests fall from $30,000 to $21,000.
KNOWLEDGE CHECK
4. ABC Partnership had the following balance sheets as of December 31:
Basis
FMV
Basis
FMV
Cash
$ 45,000
$ 45,000
Mtg, P1
$ 45,000
$ 45,000
Prop 1
30,000
80,000
Mtg,P2
30,000
30,000
Prop 2
15,000
70,000
Capital, A
5,000
40,000
Capital, B
5,000
40,000
Capital, C
5,000
40,000
$ 90,000
$ 195,000
$ 90,000
$ 195,000
On that date, the partnership distributed property 2 to C in complete liquidation of her interest in the partnership. C took property 2 subject to its mortgage. How much gain will C recognize in connection with the distribution?
a. $0.
b. $55,000.
c. $65,000.
d. $35,000.
EFFECT OF LIABILITIES ON PARTNERS' AND LLC MEMBERS' AMOUNTS AT RISK
Under Section 465, a partner or LLC member's deduction for flow-through losses allocated to him or her from the partnership or LLC is limited to the amount he or she has “at risk” as a result of his or her investment in the entity. The partner's or member's amount at risk is computed in a manner similar to the computation of basis, except that it does not include the partner's or member's share of entity-level nonqualified nonrecourse financing or seller-financing. Thus, in measuring the amount at risk under Section 465, the investor must distinguish among his/her share of different types of entity liabilities.
Nonrecourse financing is generally not considered to increase the partners' or members' amounts at risk unless it is “qualified” nonrecourse financing. Generally, speaking, qualified nonrecourse financing is financing that is obtained from a qualified, unrelated lender and that is secured by real estate. A qualified lender is broadly defined as a lender whose regular business includes lending money or a lender whose loans are backed by the U.S. government or an agency thereof.
Most nonrecourse financing obtained by real estate partnerships or LLCs is obtained from a qualified lender and can be included in the at-risk amounts of the partners or members. One problem for LLCs is that the members are legally protected from personal liability from creditors of the entity (subject to many restrictions as described in the beginning course). As a result, many of the LLC's debts will be classified as nonrecourse liabilities because no member has personal responsibility for repayment in the event of default by the LLC. These liabilities cannot be included in the at-risk amounts of the LLC's members unless they are secured by real estate (and were obtained from a qualified lender).
In many cases, however, certain debts of the LLC will be guaranteed by one or more members. In such cases, as discussed in chapter 4, the debt will be classified as a recourse liability, because the guarantor, at least, has personal risk of loss in the event of LLC default. If the guarantor would not have recourse against other members of the LLC in the event the entity defaulted and the guarantor had to make the payment, the liability would be allocated to the guarantor-member. In such cases, the debt should be treated as a recourse liability and included in the amount at risk for the guarantor member.6
KNOWLEDGE CHECK
5. Under what circumstances will debt allocated to a partner or an LLC member increase both the tax basis of the partnership interest and the partner's or member's amount at risk?
a. When the debt is nonrecourse.
b. When the debt is encumbered by real estate.
c. When the partner is a general partner.
d. When the debt is recourse debt or qualified nonrecourse debt.
Allocation of Liabilities Among the Partners: In General
Prior to 1989, the allocation of partnership liabilities was a relatively simple process. Recourse liabilities were allocated among general partners in accordance with their loss-sharing ratios. This allocation scheme was intended to reflect the way in which the true risks of these liabilities were actually shared by partners. Since recourse lenders have no access to the personal assets of limited partners, limited partners were not allocated any share of recourse liabilities. Moreover, the rules were based on the conceptual foundation that these debts would only be paid by general partners if the partnership lost a sufficiently substantial portion of its assets so that it could no longer pay them on its own. Thus, general partners would become liable for recourse debts of the partnership only in the event it lost money. They were therefore deemed to share in these debts in the same ratios in which they shared in partnership losses.
Nonrecourse liabilities were subject to a different allocation scheme. By definition, no partner would be personally liable for a partnership nonrecourse debt. Thus, the partners would bear the burden of repayment of these debts only in the form of a reduced share of partnership operating profits. Accordingly, these debts were allocable among all partners and were to be shared in accordance with the partners' profit-sharing ratios. Agreements between partners to shift the risk of certain liabilities were generally ignored.
Indeed, in Raphan,7
the court held that a general partner's guarantee of a partnership nonrecourse loan did not affect the character of that loan under Section 752. The limited partners were allowed to increase their basis by their proportionate shares of the loan. In response to the Raphan decision, Congress instructed the IRS to revise the regulations under Section 752 so that the allocation of partnership liabilities more closely resembled the economic reality of the partners' true risks.8 The Service issued the first set of temporary regulations under Section 752 on January 30, 1989. A second set of slightly modified regulations was issued on July 29, 1991.
Caution: The allocation of debt to a partner under Section 752, while increasing the partner's basis in his or her partnership interest, does not necessarily increase the partner's amount at risk under Section 465. As discussed above, the partner's at-risk amount is only increased by allocations of recourse and qualified nonrecourse debt.
The regulations now provide a more substantive framework for analysis of the partners' economic risk with respect to debts incurred by the partnership. This framework is consistent with that established in the Section 704(b) regulations issued during the same time period. Together, these two sets of regulations provide a comprehensive approach to evaluating the underlying economic impact of partnership operations on the partners and require that the tax consequences of the allocation of partnership liabilities more closely reflect economic reality.
RECOURSE VERSUS NONRECOURSE LIABILITIES
The regulations retain much of the conceptual framework of the old rules. Recourse liabilities can only be allocated to partners who would actually have to pay those liabilities in the event of partnership default, while nonrecourse liabilities can be allocated among all partners. This means that recourse liabilities generally cannot be allocated to limited partners.
The allocation of recourse liabilities among the partners is based on an analysis of the partners' individual responsibilities in the event of partnership default. Since partnership default occurs only if the partnership loses money, the focus remains on how the partners share the risks associated with nonprofitable operations. However, this analysis is much more thorough than merely looking to the partner's shares of partnership or LLC loss. The regulations require an analysis of the partners' liability-sharing responsibilities in a hypothetical, worst-case scenario known as a “constructive liquidation.”
The regulations also impose a comprehensive approach to allocating nonrecourse liabilities. These provisions are discussed in detail in chapter 4.
RECOURSE LIABILITY DEFINED
A Partner is responsible for a recourse liability to the extent that the partner, or related person, bears the economic risk of loss for that liability in the event of a partnership default (under § 1.752-2). For example, unless the debt contract states explicitly that the lender's only recourse in the event of partnership default is against the property serving as collateral for that debt, the lender can pursue payment from the general partners. Such a debt will be classified as a recourse liability with respect to the general partners.9
In many cases, the debt contract may say on its face that the lender has recourse only against property serving as collateral for the loan. Such a loan would ordinarily be characterized as a nonrecourse liability. In some cases, however, other circumstances may apply that result in a debt which is nonrecourse on its face being classified as a recourse liability. For example, if the lender is a partner in the partnership (or is related to a partner in the partnership), the lender or partner will suffer economic loss in the event of a partnership default. In that case, the debt is reclassified as recourse and will be allocable solely to the lender or partner.
Similarly, if a partner guarantees part or all of a note, or interest payments on the note, the note will be wholly or partly reclassified as recourse debt with respect to the guarantor. The same result will apply if a partner pledges property as collateral for an otherwise nonrecourse note. Because partnership default would cause the partner to lose the property serving as collateral, the note will be reclassified as recourse to the extent of the value of the property (and will be allocable solely to the partner pledging collateral).
Under Proposed Regulations issued in January 2014,10 the IRS identifies five commercial requirements all of which must be satisfied for a liability to be classified as a recourse liability. The requirements are as follows:
• Borrower is required to maintain a commercially reasonable net worth or is subject to commercially reasonable restrictions on asset transfers for inadequate consideration.
• Borrower required to provide documentation of its financial condition periodically.
• Payment obligation does not end before term of liability.
• Borrower not required to maintain liquidity in excess of reasonable needs.
• Borrower received arm's length consideration for assuming the payment obligation.
As proposed regulations, these rules will not be effective until published in the Federal Register as final regulations. They dramatically change the definition of recourse liabilities, and have drawn criticism from the profession.11 At this point, therefore, it is difficult to estimate the likelihood that these new requirements will ultimately be formally adopted by the Treasury Department.
Allocation of Recourse Liabilities
GENERAL RULES: “CONSTRUCTIVE LIQUIDATION”
Partnership recourse liabilities are allocated among general partners in accordance with the way those partners bear the economic risk of loss for those liabilities. Partners bear the economic risk of loss for a liability to the extent they would be required to make a net contribution to the lender, or to the partnership, in the event of a partnership constructive liquidation. In this hypothetical constructive liquidation scenario all the partnership's assets (including money) are sold for no consideration, and the partnership is liquidated without paying any of its outstanding liabilities. The losses recognized in the deemed sale are then allocated to the partners in accordance with their loss-sharing ratios and their capital accounts are analyzed to determine each partner's potential personal liability.
This hypothetical liquidation determines each partner's economic risk for partnership liabilities in a manner quite similar to the determination of his or her economic interest in partnership items of income and loss under Section 704(b). In fact, it follows the rationale under Section 704(b) – the hypothetical book losses are allocated to the partners as provided in the partnership agreement, and recorded in their capital accounts. Those partners with deficits in their capital accounts following this hypothetical transaction would be obligated to restore those deficits under Section 704(b). Restoration of deficit capital accounts would be required in order for the partnership to pay its creditors. Thus, their shares of the partnership's recourse liabilities are equal to the deficit balances they would be required to repay in the hypothetical worst-case scenario reflected in the constructive liquidation.
Example 3-8
A and B form a general partnership with cash contributions of $50,000 each. The partners agree to share all items of income and loss equally. The partnership borrows $90,000 on a recourse note and purchases a shopping center for $190,000. A constructive liquidation of the partnership, in which all partnership assets are assumed to become worthless, and all liabilities payable in full, would yield the following partner capital accounts:
A
B
Beginning Capital
$ 50,000
$ 50,000
Loss on Shopping Center
(95,000)
(95,000)
Hypothetical capital balance
$ (45,000)
$ (45,000)
Since A and B would each be required by law to make a net contribution of $45,000 to the partnership, they share risk of loss for the partnership recourse debt equally.
KNOWLEDGE CHECK
6. Which of the following definitions of a constructive liquidation is the most accurate?
a. A constructive liquidation is a hypothetical scenario in which all the partnership's assets (including money) are sold for no consideration and it is liquidated without paying any of its outstanding liabilities.
b. A constructive liquidation is a hypothetical scenario in which the all of the partnership's liabilities are deemed to come due and are payable by the partners in accordance with the ratio established in the partnership agreement.
c. A constructive liquidation is a hypothetical scenario in which all the partnership's assets are sold for their book values and the partnership is liquidated.
d. A constructive liquidation is a hypothetical scenario in which all the partnership's as sets are sold for their tax bases and the partnership is liquidated.
7. Which capital accounts do the regulations look to in determining the partners' shares of partnership recourse debts in a hypothetical constructive liquidation?
a. The Section 704(b) book capital accounts.
b. The capital accounts under GAAP.
c. The tax capital accounts.
d. The hypothetical capital accounts.
LIMITED PARTNERS
Because limited partners typically cannot be obligated to make payments to the partnership or to the partnership's creditors beyond their initial contributions, the regulations generally prevent them from sharing in partnership recourse debts. However, where a limited partner is required to restore a deficit in his or her capital account, this obligation will entitle him or her to a share of partnership recourse debts. Similarly, where a limited partner obtains his or her partnership interest in exchange for cash and a promissory note obligating him or her to make additional contributions in the future, he or she will be entitled to share in partnership recourse debts to the extent of the outstanding balance of the promissory note.
KNOWLEDGE CHECK
8. Q and L form a limited partnership to invest in residential rental property. Q, the general partner, invests $50,000 for a 10 percent interest in partnership capital, profits, and losses. L, a group of limited partners, invests $450,000 in exchange for the remaining 90 percent interest in capital, profit, and loss. The partnership borrows $1,500,000 to construct the rental property. The initial financing takes the form of a recourse bridge loan, guaranteed by Q. Upon completion of construction, the project is to be refinanced with a nonrecourse loan. What is partner Q's share of the recourse bridge loan?
a. $0.
b. $1,500,000.
c. $750,000.
d. $150,000.
BOOK VERSUS TAX CAPITAL ACCOUNTS
The regulations under Section 752 are corollaries of the earlier regulations issued under Section 704(b). The Section 704(b) regulations, governing partnership accounting generally, form the foundation on which the liability sharing regulations are based. Thus, it is important to recognize that the hypothetical capital account calculations required in the constructive liquidation process are based on the partners' book capital accounts under Section 704(b).
Example 3-9
Q and L form a partnership with the following contributions of property and/or cash. Q contributes real estate with a fair market value of $750,000 and a tax basis of $450,000. The real estate is unencumbered by liabilities of any kind. L contributes cash of $750,000. The partnership then borrows $500,000 against the real estate contributed by Q to construct an office building. The loan is a recourse loan for which Q and L, as general partners, each assume joint and several liabilities. Q and L agree to share in partnership capital, profits and losses equally. A constructive liquidation immediately after the partnership incurs the liability would yield the following results:
Q
L
Beginning capital balances
$ 750,000
$ 750,000
Hypothetical loss
(1,000,000)
(1,000,000)
Hypothetical capital balance
$ (250,000)
$ (250,000)
Note that the hypothetical loss allocated between the two partners is the amount of the book loss that would result if the partnership disposed of all its assets for no consideration. Where the partnership has only recourse liabilities outstanding, the hypothetical loss will be equal to the aggregate book value of the partnership's assets. In this case, the partnership would lose $2 million. Allocating this loss equally among the two partners leaves each with a $250,000 deficit balance in their hypothetical capital accounts. These reflect the amounts each partner would be required to pay the partnership in order to allow the partnership to pay its creditors. Since each partner would owe $250,000, they share the $500,000 partnership recourse liability equally.
EFFECT OF PARTNER GUARANTEES
Where one or more partners or LLC members guarantee partnership or LLC liabilities, the guarantee may or may not affect the allocation of the guaranteed debt. The consequences of a guarantee depend on the nature of the debt being guaranteed (in other words, recourse versus nonrecourse) and the nature of the guarantor's claims against the partnership or one or more individual partners should he or she have to make good on the guarantee.
Guarantees of Recourse Debt
Partner guarantees of partnership recourse debts may be relevant in determining who bears economic risk. However, the regulations provide that where the guarantor has recourse against another partner, such as a general partner (as is usually the case under state law), or where the guarantee is enforceable only after the creditor exhausts his or her remedies against the partnership, the guarantee is disregarded. In such cases, the guarantor is not obligated to make a net payment to the partnership, or its creditors, in excess of that amount which would be required without the guarantee, and so the partners' debt sharing ratios are not affected.12
Example 3-10
E and F form a limited partnership with cash contributions of $20,000 each. E, the general partner, and F, the limited partner, agree to share all profits and losses equally.
The partnership purchases real property for $40,000 cash and a recourse note for $60,000. F guarantees the recourse note. In the event of a partnership default, F would be obligated to pay the outstanding balance of the note, but would be subrogated to the seller's rights against the partnership. F has no other obligations to make additional payments to the partnership. Because F is subrogated to the seller's rights against the partnership, he would be entitled to recover from the partnership any amount paid under the guarantee upon partnership default. Thus, F would not be obligated to make a net payment with respect to the liability in a constructive liquidation.
E, the sole general partner, would, however, be required under state law to make a $60,000 payment to the partnership in a constructive liquidation. Thus, F's guarantee is disregarded and E is considered to bear the economic risk of loss for the entire $60,000 partnership liability.
Guarantees of Nonrecourse Debt
Different results apply when a partner or LLC member guarantees a nonrecourse debt of the partnership or LLC. In this case, the lender has no claim against any partners in the partnership other than the guarantor. Thus, even if the guarantor has the right of subrogation, he or she would have no claim against the partnership or any other partner for reimbursement after satisfying his or her guarantee. Thus, in these cases, the nonrecourse note is reclassified as recourse debt and is allocated wholly to the guarantor.
KNOWLEDGE CHECK
9. S is a 10 percent partner in ST Partners. T, a group of limited partners, owns the remaining 90 percent interest in the partnership. All items of partnership income and loss are shared proportionately by each of the partners. The partnership borrowed $1,000,000 on a nonrecourse loan to construct an apartment complex on land purchased earlier by the partnership. S guaranteed this loan. How much of the loan will be allocated to S under Section 752?
a. 0 percent.
b. 10 percent.
c. 100 percent.
d. The portion that exceeds the aggregate capital balances of the limited partners.
Note that an interesting aspect of these provisions is that the allocation of the partnership's liabilities and the allocation of partnership losses will generally match. For recourse liabilities, the allocation of the liabilities is expressly tied to the measurement of how the partners would truly share in a catastrophic loss of the partnership. Where one or more partners have guaranteed a nominally nonrecourse debt of the partnership, in contrast, the partnership will essentially be required to allocate its losses to the partners to whom the (now recourse) liability has been allocated. This requirement follows the prohibition in the Section 704(b) regulations against creating or increasing deficits in the partners' capital accounts in excess of the amounts they are required to restore (either through recognition of “minimum gain” or by making an additional contribution to capital) upon liquidation of the partnership. Thus, Section 752 and 704(b) fit together seamlessly.
Example 3-11
B and Z form a limited partnership to construct and manage residential rental property. B, the general partner, contributes $50,000 cash in exchange for a 10 percent general partnership interest. Z, a group of limited partners, contributes $450,000 in exchange for an aggregate, limited, interest in the partnership of 90 percent. The partnership borrows $1,500,000 on a nonrecourse loan to acquire real estate and construct an apartment complex. In order to secure agreeable terms, B guarantees the loan. Since the loan is now a recourse loan, it must be allocated using the constructive liquidation process. Immediately after the loan is obtained, a constructive liquidation would yield the following results:
B
Z
Beginning capital balances
$ 50,000
$ 450,000
Hypothetical loss (10:90)
(200,000)
(1,800,000)
Hypothetical balances
(150,000)
(1,350,000)
Reallocation to avoid deficit in Z's capital account
(1,350,000)
1,350,000
Adjusted hypothetical balances
$ (1,500,000)
$ —
Although the partnership agreement allocates 90 percent of the partnership's losses to Z, this allocation will not be recognized under Section 704(b). Allocations to the partners can create a deficit balance in their capital accounts only to the extent of their obligations to restore those deficits at liquidation, or their shares of partnership minimum gain. Since the partnership liability is properly classified as a recourse liability (due to B's guarantee), there is no partnership minimum gain. Thus, loss allocations can create a deficit balance in B's capital account, since she is a general partner, but not in Z's.
Accordingly, the bulk of the partnership's actual and potential future losses must be allocated to B, as must the recourse liability.
Arrangements Tantamount to a Guarantee
The regulations provide that certain contractual arrangements which have the effect of insulating the lender from risk will be treated as guarantees. If a partner or related person enters into a contractual obligation with the lender, which has the effect of insulating “substantially all the risk to the lender that the partnership will not satisfy its obligations under the loan,” and a principal purpose of the contractual arrangement is to allow other partners to be allocated shares of the loan, then the partner or related person will be treated as having guaranteed the loan.13 The regulations suggest that a lease agreement between a partner or related person and the partnership in which the partnership receives above-market lease payments is an example of this type of “indirect” guarantee.
Loans by a Partner or Related Person
Similar rules apply to loans obtained from partners or related parties. If the loans are recourse, so that the lender has a claim against the partnership, and thus against all the general partners, the loan is allocated among the general partners following the hypothetical constructive liquidation scenario. If, in contrast, the loan from a partner or related party is structured as a nonrecourse loan, so that the lender has no claim against the partnership or any partner, in the event of default, it will be classified as a recourse loan, allocable to the partner who either made the loan, or is related to the lender. Where more than one partner is related to the lender, the loan is allocated to that partner with the most significant relationship. If multiple partners are equally related to the lender, the loan is allocated equally among these partners.
SPECIAL ALLOCATIONS OF PARTNERSHIP INCOME AND LOSS
The allocation of recourse debts generally follows the allocation of partnership capital, profits, and losses unless partnership losses are not allocated in accordance with capital ratios. Where the partnership agreement provides for special allocations of partnership profits or losses, the allocation of partnership recourse liabilities can differ dramatically from both the partners' loss-sharing ratios and capital ratios.
KNOWLEDGE CHECK
10. Q and L form a general partnership with the following contributions of property and cash. Q contributes real estate with a fair market value of $750,000 and a tax basis of $450,000. The real estate is encumbered by a recourse liability of $500,000, incurred to finance the original acquisition of the property. L contributes cash of $250,000. The partnership agreement allocates profits equally between Q and L. Losses, however, are allocated 80 percent to Q and 20 percent to L. How much of the $500,000 recourse liability will be allocated to partner L under Section 752?
a. $0.
b. $100,000.
c. $250,000.
d. None of the above.
Example 3-12
J and D form a general partnership with cash contributions of $150,000 each. The partnership subsequently borrows $300,000 on a recourse note and purchases a shopping center for $600,000. The partners agree that profits are to be shared equally, but losses will be allocated 75 percent to J and 25 percent to D. At inception of the partnership, a constructive liquidation would yield the following capital accounts:
J
D
Beginning capital balances
$ 150,000
$ 150,000
Hypothetical loss on Shopping Center
(450,000)
(150,000)
Ending Balance
$ (300,000)
$ —
Thus, J would be required to make a net contribution of $300,000 to the partnership which would be used by the partnership to retire its debt. Accordingly, J bears the economic risk of loss for the entire $300,000 of partnership recourse debt. Although she is only allocated 75 percent of the partnership's losses, she will be allocated 100 percent of the debt.
Note that special allocations of partnership profits can also affect the allocation of recourse debts under the constructive liquidation process.
Example 3-13
M, N, and S form a general partnership, each contributing $50,000 for a one-third interest in partnership capital. The partnership agreement allocates profits 50 percent to M and 25 percent each to N and S. The three partners share losses equally.
Shortly after formation, the partnership borrows $350,000 on a recourse loan and purchases depreciable real estate for $500,000. Over its first few years of operations, it reports net profits of $200,000, of which $100,000 are allocated to M and $50,000 each to N and S. Assume it has the following balance sheet at the end of this period:
Cash and equivalents
$ 225,000
Land and improvements
500,000
Accumulated depreciation
(50,000)
Total assets
$ 675,000
Mortgage, real estate
$ 325,000
Capital, M
150,000
Capital, N
100,000
Capital, S
100,000
Total liabilities and capital
$ 675,000
A constructive liquidation at this point would yield the following hypothetical results:
M
N
S
Beginning capital balance
$ 150,000
$ 100,000
$ 100,000
Hypothetical loss
(225,000)
(225,000)
(225,000)
Constructive capital balance
$ (75,000)
$ (125,000)
$ (125,000)
Thus, the partnership allocates the recourse liability $75,000 to M, $125,000 to N and $125,000 to S, even though their loss ratios are one-third each.
As the above examples illustrate, the constructive liquidation computations should be recalculated every time the partnership is required to report to the partners their shares of partnership indebtedness. For example, the computations should be recalculated every year when the partnership files its tax returns and the accompanying Schedules K-1. Fresh computations are also necessary whenever a partner sells all or part of his or her interest in the partnership, whenever a new partner is admitted to the partnership and whenever partnership property is distributed to a partner, whether in partial or total redemption of his or her interest in the partnership.
KNOWLEDGE CHECK
11. D and E form a general partnership with cash contributions of $150,000 each. The partners agree to share income equally. Losses are to be allocated 60 percent to D and 40 percent to E. The partnership borrows $700,000 on a recourse note and purchases a shopping center for $1,000,000. How much of the debt will be allocated to D under Section 752 in the partnership's first year of operations?
a. $0.
b. $350,000.
c. $450,000.
d. $700,000.
12. A and B formed a general partnership with cash contributions of $100,000 each. The partnership subsequently borrowed $400,000 on a recourse note and purchased a shopping center for $600,000. The partners agreed that profits were to be shared equally, but losses would be allocated 75 percent to A and 25 percent to B. How much of the recourse liability will be allocated to B under Section 752?
Example 3-1