Chapter 4
ALLOCATION OF PARTNERSHIP NONRECOURSE LIABILITIES AND RELATED DEDUCTIONS UNDER SECTIONS 752 AND 704(b)
LEARNING OBJECTIVES
After completing this chapter, you should be able to do the following:
• Distinguish between recourse and nonrecourse liabilities of a partnership or LLC.
• Calculate a partner's or member's share of nonrecourse liabilities of a partnership or LLC.
• Analyze the impact of a partner or LLC member's guarantee of a recourse or nonrecourse liability of the entity.
• Calculate a partner or LLC member's share of nonrecourse deductions of a partnership or LLC.
• Recognize when to treat a liability as a recognized versus contingent liability and understand how to account for partnership or LLC contingent liabilities.
Distinguishing Between Recourse and Nonrecourse Liabilities
A recourse liability is one for which any partner or related person bears personal risk of loss in the event of a partnership default.1 For this purpose, a partner bears a personal risk of loss if he or she would be obligated to make a payment, either to a creditor or to the partnership, in the event the partnership's assets (including cash) became completely worthless, and it was unable to satisfy its obligations. If no partner would be obligated to make any additional payments with respect to a partnership debt in this hypothetical scenario (known as a constructive liquidation), the liability is classified as a nonrecourse liability.
OBLIGATION TO MAKE PAYMENT
In determining whether a partner would be obligated to make a payment in the event of partnership default, the regulations consider contractual obligations outside the partnership (for example, guarantees, indemnifications, and so on), obligations imposed by the partnership agreement (for example, deficit restoration requirements, additional capital contributions, and so on), and obligations imposed by state law.2 Contingent obligations, however; are generally disregarded.3 Thus, if a partner would be obligated to make a payment only in the event that, say, another partner defaulted on his or her obligation, this obligation would be disregarded.
PARTNER GUARANTEE OF INTEREST ON NONRECOURSE LOAN
As noted in chapter 3, the regulations expressly require that a partner's guarantee of an otherwise nonrecourse loan will cause such loan to be recharacterized as a recourse debt. The regulations also require recharacterization of a portion of a nonrecourse loan where a partner (or partners) has guaranteed more than 25 percent4 of the interest which accrues on the loan. In such a case, the loan is recharacterized as a recourse debt to the extent of the present value (discounted at the interest rate charged on the loan) of the remaining interest payments which the guarantor(s) would be obligated to pay if the partnership should default.5 Any excess of the loan amount over the present value of the guaranteed interest payments is treated as a nonrecourse loan. This recharacterization rule does not apply if the interest guarantee covers a period of no more than five years or one-third of the term of the loan, whichever is less.6
Example 4-1
C and D form a general partnership to purchase an apartment complex. The partnership obtains a $1,500,000 nonrecourse loan and purchases an apartment building for $2,000,000. The terms of the loan call for annual payments of interest only over 10 years, with the principal payable in a lump sum at the end of the ten-year loan term. C guarantees the payment of all interest on the loan. Interest accrues at a 14 percent annual rate.
At the time the partnership obtains the loan, the present value of the remaining interest payments guaranteed by C is $1,095,384.7 Accordingly, only $404,616 of the $1,500,000 loan is a nonrecourse obligation under Section 752. If the partnership makes the first annual interest payment, the amount of its nonrecourse obligations in year 2 will increase to $461,262 ($1,500,000 less $1,038,738, the present value of the remaining 9 years interest payments). C's basis in the partnership would in general decrease with the decrease in recourse debt from the interest assumed by C, even though it is partially offset by the increase in nonrecourse debt, because D would also share in the nonrecourse debt (qualified nonrecourse financing).
KNOWLEDGE CHECK
1. C and D form a general partnership to purchase an apartment complex. The partnership obtains a $1,500,000 nonrecourse loan, bearing interest at 8 percent per year, and purchases an apartment building for $2,000,000. The terms of the loan call for annual payments of interest only over 10 years, with the principal payable in a lump sum at the end of each period. C guarantees the payment of all interest on the loan. How much of the loan will be recharacterized as a recourse loan, allocable to C?
a. None of it.
b. All of it.
c. 80 percent of it.
d. An amount equal to the present value of the guaranteed interest.
PARTNER PROVIDING COLLATERAL FOR A PARTNERSHIP NONRECOURSE LOAN
The regulations also reclassify otherwise nonrecourse loans where such loans are collateralized by property owned by a partner, rather than the partnership. In such cases, the partner who owns the collateral bears the ultimate economic risk in the event the partnership defaults on the loan and the loan will be recast as a recourse debt to the extent of the fair market value of the property serving as collateral, as of the date such property was pledged against the loan.8 A promissory note contributed to the partnership by a partner does not count as property unless it is readily tradable on an established securities market.9
The regulations treat certain property contributions as indirect pledges against partnership loans. Specifically, where a partner contributes property to a partnership which is used by the partnership as security for a nonrecourse loan, and substantially all of the items of income, gain, loss or deduction attributable to such property are allocated to the contributor, the contributor will be treated as having collateralized the nonrecourse loan. As a result, the loan will be recharacterized as a recourse loan to the extent of the fair market value of the property serving as collateral.10
KNOWLEDGE CHECK
2. E and F form a general partnership to purchase an apartment complex. The partnership obtains a $1,000,000 nonrecourse loan and purchases an apartment building for $1,500,000. E owns real estate outside the partnership that she pledges as collateral for the loan. How much of the loan will be recharacterized as a recourse loan, allocable to E?
a. None of the loan will be recharacterized as a recourse loan unless the bank seizes the collateral pledged by E. At that point, a portion of the loan equal to the value of the collateral will be recharacterized as a recourse loan.
b. An amount equal to the present value of the property pledged as collateral, measured as of the date of the loan.
c. An amount equal to the present value of the property pledged as collateral, measured as of the end of each partnership taxable year as long as the loan remains outstanding.
d. An amount equal to the excess of the loan balance over the value of the apartment building purchased with the proceeds of the loan.
NONRECOURSE LOANS BY PARTNERS
Similarly, where a nonrecourse loan is obtained from a partner or from a lender related to a partner, such partner will be considered to bear the economic risk of loss for the loan, and the loan will be treated as a recourse debt.11 Related lenders are defined by reference to Sections 267 and 707, except that siblings and less than 80 percent owned corporations are not treated as related parties.12
Example 4-2
A and B form a general partnership with cash contributions of $50,000 each. The partnership then purchases an office building for its $100,000 cash and a nonrecourse note in the amount of $300,000 that is secured by the building. The nonrecourse financing is obtained from a bank owned 100 percent by B. Because B owns the bank, she bears the ultimate economic risk of loss in the event of partnership default. Accordingly, the loan will be treated as a recourse obligation. Note that if B owned less than 80 percent of the outstanding stock of the bank, and the remainder was owned by an unrelated party (to B), the loan would be treated as a nonrecourse loan for purposes of Section 752.
“WRAPPED” DEBT
Where the nonrecourse loan provided by a partner or related lender wraps around another nonrecourse loan provided by an unrelated lender, only the excess of the wrap-around note over the original loan will be treated as a recourse debt.13
Example 4-3
Assume similar facts as in example 4-2. A and B form a partnership with cash contributions of $50,000 each. The partnership then purchases a building for $400,000. It pays $100,000 cash and borrows the remainder obtaining a nonrecourse mortgage in the amount of $300,000 from a bank owned 100 percent by partner B. The nonrecourse loan obtained from B's bank wraps around a $250,000 underlying nonrecourse note issued by the seller to an unrelated lender in connection with her original acquisition of the building. In this case, if the partnership defaults on the loan, B will be at risk for only $50,000 – the remaining risk on the mortgage will be borne by the other lender. Accordingly, of the $300,000 note obtained from B's bank, only $50,000 will be reclassified as a recourse obligation of the partnership.
DE MINIMIS EXCEPTIONS
A qualified nonrecourse loan obtained from a partner or related person is not recharacterized as recourse debt if the partner who makes the loan, or to whom the lender is related, has an interest in “each item of partnership income, gain, loss, deduction or credit” of 10 percent or less for every taxable year that the partner is a member of the partnership.14 Similarly, a partner's guarantee of an otherwise qualified nonrecourse liability, or the interest thereon, does not cause the loan, or any portion thereof, to be recharacterized as recourse if the partner's interest in partnership income, gain, loss, deduction or credit does not exceed 10 percent in every taxable year in which the partner is a member of the partnership.15
Whether a nonrecourse loan is qualified for purposes of the de minimis exception is determined under Section 465(b)(6), disregarding the type of activity financed by the loan. Thus, a qualified nonrecourse loan for this purpose is a nonconvertible loan for which no person is personally liable for repayment and which is obtained from a qualified lender. Qualified lenders include any Federal, State, or local government or instrumentality thereof, and any lender whose loans are guaranteed by a Federal, State, or local government or instrumentality thereof. In addition, any other lender who is “actively and regularly engaged in the business of lending money” is a qualified lender unless such lender is the person from whom the borrower acquired the property financed by the nonrecourse debt (or a person related to the seller), or a person receiving a fee with respect to the borrower's investment in such property.
KNOWLEDGE CHECK
3. Under the de minimis exception in the Treasury Regulations, a qualified nonrecourse loan received by the partnership from a lender who has an interest in the partnership will not be recharacterized as recourse if
a. The lender is a limited partner, rather than a general partner in the partnership.
b. The lender does not own a direct interest in the partnership, but is merely related through one or more partners.
c. The lender has a 10 percent or lesser interest in each item of partnership capital and profits (including credits) in all tax years of the partnership.
d. The lender agrees not to pursue any individual partner for repayment in event of a partnership default.
Allocation of Nonrecourse Debts
CONCEPTUAL DIFFICULTIES IN ALLOCATING NONRECOURSE LIABILITIES
As discussed, nonrecourse liabilities are those liabilities for which no partner or LLC member (or related person) bears personal risk of loss. In the event of default by the entity, the lender can foreclose upon any property serving as collateral for the loan, but has no further recourse against either the partnership or LLC or any partner therein. If the lender is itself a partner or LLC member, or a related party to a partner or member, then at least one partner bears personal risk of loss and the liability, although structured as a nonrecourse loan, will be treated as a recourse loan for purposes of Section 752 (subject to the de minimis exceptions discussed previously). Similarly, if the loan is guaranteed by one or more partners, then it will not be treated as a nonrecourse loan under Section 752.
Nonrecourse liabilities create interesting problems from a tax policy standpoint. Although none of the partners has any personal obligation to repay them, the lender would not make a loan that it did not expect to be repaid, so the indebtedness is real. It therefore is included in each partner's tax basis. The question then becomes how to allocate the debt (and the related tax basis) among the partners. An evaluation of the partners' economic risks is irrelevant to the question—none of them have any economic risk. Thus, the question becomes how the partners will share in the repayment of the loan. Historically, Section 752 has looked to the partners' interests in partnership profits to answer this question.
NONRECOURSE LIABILITIES ALLOCATED BY REFERENCE TO PARTNERS' PROFITS INTERESTS
If they are to be repaid at all, partnership nonrecourse liabilities will essentially be paid from partnership profits. If the partnership is not profitable, it will be more likely to default on the loan. Thus, the regulations provide that nonrecourse liabilities are to be allocated in accordance with the partners' profit-sharing ratios. The regulations do, however, give priority to certain kinds of partnership profits over others. In particular, because partnership minimum gain is used in the Section 704(b) regulations as a mechanism for restoring deficit capital balances, the Section 752 regulations look first to minimum gain to guide the allocation of partnership liabilities.
MINIMUM GAIN
Partnership minimum gain is that gain which will be recognized by the partnership upon a disposition of property encumbered by a nonrecourse debt, even if the property becomes worthless. Because the satisfaction of nonrecourse debt in exchange for the encumbered property (for example, as in foreclosure) is treated as a sale or exchange, the minimum sales price that can be realized from the disposition of any property is the amount of the outstanding nonrecourse debt encumbering that property. Thus, where the book value (in other words, Section 704(b) value) of the property falls below the outstanding principal balance of the nonrecourse mortgage, the minimum amount of gain that would be recognized upon disposition of such property is the difference between the basis of the property and the remaining principal. More gain could be recognized, but never less.
Example 4-4
Partnership GH owns real estate acquired several years ago with a remaining tax basis of $500,000. The property is encumbered by a $750,000 nonrecourse mortgage incurred to finance acquisition of the property. The lender has no recourse against the partnership. Should the partnership default on its loan payments, the lender has the right to foreclose upon the property, taking it in complete satisfaction of the outstanding debt balance. In effect, in the event that the partnership becomes unwilling or unable to make payments on its loan, it will transfer the property to the lender in satisfaction of the loan.
Thus, for tax purposes, foreclosure will be treated by the partnership as a taxable sale of the property; even if the property becomes completely worthless, the partnership will merely transfer it to the lender in satisfaction of the remaining unpaid balance of the nonrecourse loan.
This feature of the loan agreement effectively creates a minimum selling price for the partnership. Regardless of economic circumstances, it can sell its property to the lender for this minimum sales price. Sale at this price would generate a gain, in this case, of $250,000.16 This gain, the minimum amount that can be triggered for tax purposes, is known as the minimum gain.
KNOWLEDGE CHECK
4. J Dean Properties is a partnership that owns real property with a tax basis and book value of $800,000. The property is encumbered by an $850,000 nonrecourse mortgage. The fair market value of the property is $1,000,000. What is the minimum gain associated with the property?
a. $150,000.
b. $50,000.
c. $0.
d. $200,000.
Under the Section 704(b) regulations, the existence of partnership minimum gain allows partners' capital accounts to fall below zero even in the absence of any requirement on their parts to make additional capital contributions to restore these deficit balances. As long as the deficits do not exceed the partners' shares of partnership minimum gain, any deficit in their capital accounts can be made up – restored — with an allocation of minimum gain. This allocation has tax consequences in that it increases the partner's taxable income. These consequences give the underlying loss allocations economic effect under the Section 704(b) regulations. Following the same rationale, the regulations under Section 752 look to the allocation of minimum gain to support the allocation of the underlying nonrecourse debt associated with that minimum gain.
Example 4-5
A and B form a limited partnership to acquire a shopping center. A, the general partner, contributes $20,000, and B, the limited partner, contributes $180,000 to the partnership. The partnership borrows $1,800,000 on a nonrecourse loan and purchases the shopping center for $2,000,000. The partners agree to share losses 10 percent to A and 90 percent to B. Partnership income is to be shared equally. The partnership agreement complies with the requirements of Section 704(b). Minimum gain is to be shared 10/90 in order to substantiate the loss-sharing arrangement. In each of its first three years, the partnership's revenues just offset its operating expenses giving it net income of $0 before depreciation. Its annual depreciation deduction of $90,000 results in a ($90,000) annual tax loss, yielding the following partner capital accounts:
| A | B | |
| Beginning Capital | $ 20,000 |
$ 180,000 |
| Loss in years 1 and 2 | (18,000) |
(162,000) |
| Capital, end of year 2 | $ 2,000 |
$ 18,000 |
| Year 3 loss | (9,000) |
(81,000) |
| Capital, end of year 3 | $ (7,000) |
$ (63,000) |
At the end of years 1 and 2, there is no partnership minimum gain so the nonrecourse liability is allocated equally between the partners in accordance with their general profit-sharing ratios. At the end of year 3, however, partnership minimum gain is $70,000 (basis = 2,000,000 – 270,000 = 1,730,000; principal amount of loan = $1,800,000). Thus, the first $70,000 of the nonrecourse loan is allocated 10 percent to A and 90 percent to Β in accordance with the partners' interests in partnership minimum gain. The remaining nonrecourse liability of $1,730,000 (1,800,000 – 70,000) is allocated equally. Thus, at the end of year 3, A's share of partnership nonrecourse debt is $872,000 ($7,000 share of partnership minimum gain plus $865,000 share of the excess) and B's share is $928,000 ($63,000 + $865,000).
TAX VERSUS BOOK MINIMUM GAIN
Profit allocations under Section 704(c) also take priority over other profits in some cases. Where partnership property is encumbered by a nonrecourse debt, and the exchange of such property in full satisfaction of the note would generate a gain that would be allocated to one or more partners under Section 704(c), the nonrecourse liability attached to the property will also be allocated in this way. That is, where minimum gain would be allocated under Section 704(c) to one or more partners, the allocation of the nonrecourse liability follows the allocations of the minimum gain, to the extent of the minimum gain.
Example 4-6
J and K form a general partnership to provide residential property to renters. J contributes $100,000 to the partnership that it uses to acquire residential property. K contributes an apartment building valued at $175,000. The basis of the contributed building is $50,000 and it is subject to a nonrecourse debt of $75,000. The partners share all profits and losses equally. The $75,000 nonrecourse loan, however, is not shared equally by the partners. The first $25,000 of such loan is allocated to K because K would be allocated $25,000 of partnership gain under Section 704(c) if the partnership disposed of the apartment building in full satisfaction of the nonrecourse liability.17 The remainder of the nonrecourse liability is allocated between the partners in proportion to their equal interests in partnership profits. Thus, J's share of the $75,000 nonrecourse liability is $25,000 (1/2 of 50,000) and K's share is $50,000 ($25,000 + 1/2 of (50,000)).
KNOWLEDGE CHECK
5. Q Lynn Properties is a partnership that owns real property with a tax basis of $750,000 and a book value of $800,000. The property is encumbered by a $900,000 nonrecourse mortgage. The fair market value of the property is $1,000,000. What is the tax and book minimum gain associated with the property?
a. Tax minimum gain $50,000; book minimum gain $100,000.
b. Tax minimum gain $50,000; book minimum gain $200,000.
c. Tax minimum gain zero; book minimum gain $150,000.
d. Tax minimum gain $150,000; book minimum gain $100,000.
OTHER PARTNERSHIP PROFITS
In summary, each partner's share of partnership nonrecourse debts will be equal to the sum of
1. the partner's share of partnership minimum gain under Section 704(b);
2. the amount of any partnership Section 704(c) minimum gain which would be allocated to such partner; and
3. the partner's proportionate share of any remaining nonrecourse liabilities determined by reference to her interest in general partnership profits.18
If the property serving as collateral for the loan is not Section 704(c) property (in other words, property contributed to the partnership by a partner), there will be no Section 704(c) minimum gain – all minimum gain in such cases will be Section 704(b) minimum gain. Nonrecourse liabilities are generally allocated on a liability-by-liability basis, so that an accurate measurement of book and tax minimum gain, and the partners' interests therein, can be determined.19 The separately computed amounts are then added together to determine each partner's aggregate share of partnership nonrecourse liabilities.
KNOWLEDGE CHECK
6. Which of the following is not considered in determining a partner's share of partnership nonrecourse debts?
a. The partner's share of partnership book minimum gain under Section 704(b).
b. The partner's share of partnership losses.
c. The partner's share of partnership profits.
d. The partner's share of partnership tax minimum gain.
Example 4-7
Bedlam Partners was formed several years ago by three partners, B, F, and W. B contributed depreciable property with a tax basis of $450,000 and a fair market value of $600,000. The property was encumbered by a $400,000 nonrecourse debt. F contributed $200,000 cash and W contributed $400,000 cash. The partnership agreement allocates partnership profits 25 percent to B, 25 percent to F and 50 percent to W. Depreciation is allocated equally among the partners.
Shortly after formation, Bedlam borrowed $900,000 on a nonrecourse mortgage and began development of a large real estate project at a total cost of $1,500,000. At the end of its first year, the partnership had properties with an aggregate tax basis of $1,950,000 and an aggregate book value of $2,100,000. Its total nonrecourse debt was $1,300,000. Because the partnership has no minimum gain for book or tax, it would allocate its liabilities based on the partners' general profit shares. Thus, the liabilities would be allocated among the partners 25 percent to B, 25 percent to F and 50 percent to W.
Assume that at the end of the current year, after several years of operation, the remaining tax basis of the property contributed by B was $200,000 and its remaining book value was $266,667. The tax basis and book value of the property acquired just after formation was $1,200,000. The principal balances of the two nonrecourse liabilities remained $400,000 and $900,000 respectively. The partnership had no other properties. The nonrecourse liabilities would be allocated as follows:
| B | F | W | |
| Mtg on property contr. by B: | |||
| Book minimum gain1 | $ 44,444 |
$ 44,444 |
$ 44,444 |
| Tax minimum gain2 | 66,667 |
— |
— |
| General profits | 50,000 |
50,000 |
100,000 |
| Mtg. on acquired property: | |||
| Book minimum gain3 | — |
— |
— |
| Tax minimum gain | — |
— |
— |
| General profits | 225,000 |
225,000 |
450,000 |
| Totals | $ 386,111 |
$ 319,444 |
$ 594,444 |
Notes:
1 Book minimum gain on property contributed by B is $133,333 (400,000 – 266,667 book value). This gain is allocated equally among the partners (because they share depreciation deductions equally).
2 Tax minimum gain on property contributed by B is $66,667 ($266,667 book value less $200,000 tax basis). This gain is allocated entirely to B under Section 704(c). Total minimum gain on this property is thus $200,000.
3 There is no book or tax minimum gain on the acquired property because the book and tax basis of this property exceed the outstanding debt balance.
KNOWLEDGE CHECK
7. J and D form a limited partnership to acquire a shopping center. J, the general partner, contributes $100,000, and D, the limited partner, contributes $500,000 to the partnership. The partnership borrowed $3,400,000 on a nonrecourse loan and purchased the shopping center for $4,000,000. The partners agree to share losses 20 percent to J and 80 percent to D. Partnership income is to be shared equally. The partnership agreement complies with the requirements of Section 704(b). Minimum gain is to be shared 20/80 in order to substantiate the loss-sharing arrangement. How much of the nonrecourse liability will be allocated toj in the partnership's first year of operations?
a. $100,000.
b. $680,000.
c. $850,000.
d. $1,700,000.
8. Assume the same facts as in the previous question. Assume further that in year 7, accumulated depreciation on the shopping center is $720,000. How much of the nonrecourse liability will be allocated to J in year 7?
a. $120,000.
b. $1,640,000.
c. $1,700,000.
d. $1,664,000.
9. El Dorado LLC has property with a tax basis and book value of $850,000 that is encumbered by a $910,000 nonrecourse mortgage. The fair market value of the property is $1,250,000. Walter is a member in the LLC. His share of partnership minimum gain is 25 percent. His share of other partnership income is 10 percent. What will be his share of the partnership's nonrecourse mortgage? (Assume the partnership has no other properties or liabilities.)
a. $85,000.
b. $91,000.
c. $100,000.
d. $227,500.
Alternative Approach to Allocation of Portion of Nonrecourse Liabilities in Excess of Minimum Gain
The current regulations offer an alternative to the third layer of allocation, under which partnerships may allocate excess nonrecourse liabilities (in other words, amounts in excess of those allocated to reflect minimum gain and Section 704(c) minimum gain) in accordance with:
i. the way in which other “significant items” of partnership income or gain are allocated, or
ii. the way in which partners are reasonably expected to share in the future deductions attributable to those nonrecourse liabilities.20
Similar to the significant item method, future deductions attributable to nonrecourse liabilities, labelled 'nonrecourse deductions" in the Sec. 704(b) regulations,21 can be specially allocated to the partners so long as the allocation of nonrecourse deductions is “reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities.”22 Although the regulations do not provide much insight regarding the interpretation of this clause, it is reasonable (and consistent with common practice) to assume that the allocation of depreciation deductions other than nonrecourse depreciation deductions and the allocation of unrecaptured Sec. 1250 gain are significant partnership items that are attributable to the property securing the nonrecourse liabilities.23
Example 4-8
Assume the same facts as example 4-7, except that the partnership agreement allocates depreciation expense on the property contributed by B entirely to B. Further, the partners agree to allocate excess nonrecourse liabilities in accordance with the manner in which the deductions attributable to those nonrecourse liabilities will be allocated. If the agreement to allocate 100 percent of the depreciation deductions to partner is valid under Section 704(b), the partnership can allocate the excess $200,000 of nonrecourse debt on the property contributed by B entirely to B. This nonrecourse liability would thus be allocated in the following manner:
| B | F | W | |
| Mtg on property contr. by B: | |||
| Book minimum gain | $ 44,444 |
$ 44,444 |
$ 44,444 |
| Tax minimum gain | 66,667 |
— |
— |
| Remainder | 200,000 |
— |
— |
| Total share of this NR debt | $ 311,111 |
$ 44,444 |
$ 44,444 |
KNOWLEDGE CHECK
10. To be recognized for tax purposes, the allocation of a nonrecourse deduction must be “reasonably consistent” with the allocation of other significant partnership items attributable to the encumbered property (among other requirements). Which of the following is not considered an “other significant partnership item?”
a. Interest expense.
b. Gain on sale of property.
c. Cancellation of debt income.
d. The allocation of partnership recourse debt.
11. C and D form partnership CD with contributions of $25,000 each. CD then obtains a $450,000 nonrecourse loan and purchases machinery for $500,000. In its first year of operations, the partnership has a gross income of $45,000, which is exactly offset by interest and other operating expenses of $45,000. In addition, CD reports depreciation expense of $100,000. It makes no principle payments on the nonrecourse note. How much of the depreciation expense will constitute a nonrecourse deduction?
a. $0.
b. $50,000.
c. $90,000.
d. $100,000.
Proposed Regulations Eliminate “Significant Other Item” Alternatives
The premise behind the allocation of nonrecourse liabilities is that such liabilities, if paid at all, will be paid out of partnership profits, and thus should be shared among partners by reference to how their shares of such profits will be diminished by the repayment of the nonrecourse debt. Expressing concern that the allocation of excess liabilities under the “significant item” method may not accurately reflect the partners' shares of partnership profits, new Proposed Regulations (issued injanuary 2014) replace the “significant item” approach with a new approach based on the partners' “liquidation value percentages.”24 The liquidation value percentage measures the portion of the partnership's net equity that each partner would be entitled to receive if the partnership sold all of its assets for their fair market values, paid off all of its debts, and liquidated.25 It is not clear how significant this change will be, once implemented in final regulations. The primary concern for limited partners is that they can be allocated sufficient nonrecourse debt to offset any deficit in their capital accounts triggered by the special allocation of depreciation with respect to property encumbered by such nonrecourse debt. This allocation is determined by the manner in which partners share in partnership minimum gain (steps 1 and 2 of the allocation process) and therefore will not be affected by the share of debt allocated to them in step 3. Of course, to the extent that the new approach would reallocate partnership nonrecourse debt following a revaluation of partnership assets, it may pose a trap for the unwary. At any rate, the changes implemented by the proposed regulations do not take effect until issued in the form of final regulations in the Federal Register.
Treatment of Contingent Liabilities
GENERAL
Regulations issued in May 2005 govern the tax treatment of so-called “Section 1.752-7 liabilities.”26 Although poorly defined in the regulations, a Section 1.752-7 liability is essentially a contingent liability which, due to the uncertainty of either the amount of the debt or the likelihood of repayment, is not treated as a liability for purposes of Section 752(a) or (b).
The purpose of the regulations is to prevent partners or LLC members from transferring the tax deductions associated with certain contingent liabilities to the other partners or members of an LLC or partnership. They are also intended to prevent a partner or LLC member from accelerating his or her loss by disposing of his or her interest in the partnership or LLC before property subject to a contingent liability is actually disposed of. Accordingly, the new rules require that the principles of Section 704(c) (relating to built-in gains or losses inherent in contributed property) apply to contingent debt transferred between a partner or LLC member and a partnership or LLC.
MECHANICS
Under the regulations, the assumption of a partner's or member's contingent liability by a partnership or LLC in connection with the transfer of property to the partnership or LLC is treated as a built-in loss under Section 704(c). Accordingly, when the partnership or LLC satisfies all or part of a contingent liability, any resulting tax deduction or loss must be allocated to the contributing partner or member to the extent of the built-in loss at the date of contribution.27
Example 4-9
A, B, and C form Waste Solutions, LLC to develop and operate a landfill. The LLC elects to be treated as a partnership for federal tax purposes. A contributes vacant land with a fair market value and tax basis of $400,000. The land is subject to potential environmental liabilities in the amount of $100,000. In exchange, A receives a 25 percent interest in the LLC. B contributes $300,000 cash in exchange for a 25 percent interest in the LLC, and C contributes $600,000 cash in exchange for a 50 percent interest. The LLC subsequently pays $250,000 to satisfy the environmental liability on the property contributed by A. Assume that the $250,000 payment is deductible by the LLC. The first $100,000 of this deduction must be allocated to A. The remainder will be allocated in accordance with the members' loss-sharing ratios (presumably 25:25:50, although a different sharing ratio will be acceptable as long as the requirements of Section 704(b) are satisfied).
Note: The regulations imply that Section 1.752-7 liabilities are treated as liabilities for book (in other words, Section 704(b)) purposes, but not for tax purposes (if a liability is recognized for purposes of Section 752(a) or (b), it is by definition not a Section 1.752-7 liability). Thus, a partner's or member's Section 704(b) capital account must be reduced by the value of the contingent liability, while his or her capital account on the entity's tax balance sheet will not be affected. See Regulations Section 1.752-7(c)(2) example.
Caution: The regulations do not provide a meaningful description of the valuation of a Section 1.752-7 liability. The term is defined as “the amount of cash that a willing assignor would pay to a willing assignee to assume the Section 1.752-7 liability in an arm's-length transaction.”28 Thus, at this point, practitioners are on their own for purposes of attempting to measure such liabilities.
SALE OR TRANSFER OF INTEREST IN PARTNERSHIP OR LLC
When a partner or LLC member sells his or her interest in the partnership or LLC before the Section 1.752-7 liability has been satisfied by the partnership or LLC, the regulations require that the basis of the partnership or LLC interest be reduced by the remaining Section 1.752-7 liability amount.29 The basis reduction is deemed to occur immediately before the sale, exchange, or other disposition of the interest. The effect of this provision is to increase the selling partner's or member's gain (or reduce the recognized loss). If and when the partnership or LLC subsequently satisfies the Section 1.752-7 liability, it is not allowed a deduction or capital expense to the extent of the remaining built-in loss associated with the liability. Moreover, no adjustment is required to be made to the capital accounts of the remaining partners or LLC members. If the partnership or LLC notifies the original contributing partner that the Section 1.752 liability has been satisfied, such partner will be allowed a loss or deduction to the extent of the lesser of the built-in loss (the reduction in basis) or the amount paid to satisfy the liability.
Example 4-10
Assume the same facts as example 4-9. A contributes raw land with a tax basis and fair market value of $400,000 to Waste Solutions, LLC, in exchange for a 25 percent interest therein. A's tax basis in her Waste Solutions interest will be $400,000. However, due to a contingent environmental liability of $100,000, her interest is worth only $300,000. Assume that A later sells her LLC interest to F for $300,000. Under Section 1.752-7(e)(1), A must reduce her tax basis in the LLC interest by the $100,000 potential environment liability. Thus, she will recognize no gain or loss on the sale to F. If the LLC subsequently satisfies the obligation for $250,000, it will be entitled to a $150,000 deduction (the amount paid to satisfy the obligation over the estimated amount of the liability at the date of A's contribution to the LLC). If the LLC contacts A, she will be entitled to a $100,000 deduction for the built-in loss inherent in the property attributable to the environmental liability.
Warning: Nothing in the regulations obligates the partnership or LLC to notify the former partner or LLC member that the Section 1.752-7 liability has been satisfied. Departing partners or LLC members would be wise to obtain a commitment from the entity to provide notification in the event that the Section 1.752-7 liability is subsequently paid in a future year. The Section 1.752-7 partner must attach a copy of the notification received from the partnership or LLC to his or her tax return in the year the deduction is claimed. The notification must include30
• the amount paid in satisfaction of the liability;
• whether the amount(s) paid was in partial or complete satisfaction of such liability;
• the name and address of the person satisfying the liability;
• the date of payment of such liability; and
• the character of the loss triggered by payment of the liability.
KNOWLEDGE CHECK
12. G sold U.S. Treasury Bonds short, receiving $5 million in proceeds. She contributed these proceeds, along with the obligation to close the short position, to a real estate partnership in which she owned a 20 percent interest. Prior to making the contribution to the partnership, her tax basis in her partnership interest was $1 million. What will be her tax basis in the partnership interest immediately following the contribution?
a. $1 million.
b. $6 million.
c. $2 million.
d. $5 million.
13. Assume the same facts as in the previous question. If G sells her interest in the partnership for $6,000,000 before the partnership has closed the short sale, how much gain will be recognized on the sale?
a. $4,000,000.
b. $5,000,000.
c. $0.
d. $6,000,000.
LIQUIDATING DISTRIBUTION TO A SECTION 1.752-7 PARTNER OR DISTRIBUTION OF PROPERTY SECURED BY A SECTION 1.752-7 LIABILITY TO ANOTHER PARTNER
Two other types of transactions trigger the application of the basis adjustment rules described previously:
1. Receipt of a liquidating distribution by a Section 1.752-7 partner or member from the partnership or LLC;31
or
2. Assumption of the Section 1.752-7 liability by another partner or member of the partnership or LLC32 (for example, as when the property encumbered by the Section 1.752-7 liability is distributed to another partner).
In such cases, the Section 1.752-7 partner or member (in other words, the partner or member who contributed the property subject to the contingent liability) is required to reduce his or her basis in the partnership interest by the remaining built-in loss associated with the Section 1.752-7 liability. To the extent of the built-in loss at the date of distribution or assumption, neither the partnership or LLC nor the assuming partner or member are allowed a deduction should the liability subsequently be satisfied.33 If the partnership or LLC notifies the Section 1.752 partner that the liability has been discharged (fully or partially), the partner will be entitled to a deduction in an amount equal to the lesser of the built-in loss associated with the liability or the amount paid in satisfaction thereof.
Special rules apply where another partner or member assumes the contributor's responsibility for the Section 1.752-7 liability. First, immediately following the assumption of the Section 1.752-7 liability from the partnership or LLC by a partner or member other than the Section 1.752-7 liability partner or member, the partnership or LLC must reduce its basis in its assets by the remaining built-in loss associated with the liability. The basis adjustment is allocated among the entity's assets as if it were an adjustment under Section 734(b).
The assuming partner or member, on the other hand, is not allowed to account for the Section 1.752-7 liability until such time as the liability is satisfied. At that time, the assuming partner or member adjusts his or her basis in the partnership interest, any assets distributed by the partnership or LLC to such partner, or gain or loss on disposition of the partnership or LLC interest as if a recognized liability had been assumed. The amount of the adjustment is equal to the lesser of the amount paid in satisfaction of the debt or the remaining built-in loss associated with the debt. Any amounts paid in excess of such amount are deductible or treated as a capital expenditure by the assuming partner.34
Example 4-11
J, D, and R form the JDR Partnership. J contributes property 1 with a tax basis and fair market value of $5,000,000. The property is subject to a contingent liability valued at $2,000,000. In return, she receives a 25 percent interest in the partnership. D contributes $3,000,000 in cash in exchange for a 25 percent interest, and R contributes $6,000,000 cash in exchange for a 50 percent interest. The partnership uses the cash provided by D and R to purchase additional property.
Two years later, the partnership distributes property 1 to R in partial liquidation of R's interest in the partnership. R took the property subject to the $2,000,000 Section 1.752-7 liability. Upon the distribution of property 1 to R, J is required to reduce her basis in her partnership interest by $2,000,000 (to $3,000,000). Similarly, the JDR Partnership is required to reduce its tax basis in its other properties by $2,000,000. R takes a $5,000,000 carryover basis in property 1, equal to its tax basis in the hands of the partnership. Assuming that R's tax basis in the partnership interest remained $6,000,000 prior to receipt of the distribution, her remaining tax basis in the interest will be reduced to $1,000,000.
Assume that R subsequently pays $1,500,000 to satisfy the Section 1.752-7 liability. R will not be entitled to a tax deduction for the payment. Instead, R will increase the tax basis of the encumbered property (property 1) by the $1,500,000 payment. If R notifies J that the debt has been satisfied, J will be entitled to a $1,500,000 ordinary loss for the amount paid by R in satisfaction of the debt, and a $500,000 capital loss deduction for the excess of the built-in loss over the amount paid in satisfaction of the Section 1.752-7 liability.
EXCEPTIONS
The provisions of Regulations Section 1.752-7 do not apply to contingent liabilities transferred in either of the following situations:
• The partnership or LLC assumes the liability in connection with a contribution by the partner or LLC member of the trade or business with which such liability is associated and the entity continues to carry on that trade or business after the contribution.
• Just prior to the contribution, the remaining built-in loss associated with the Section 1.752-7 liability(ies) is less than the lesser of 10 percent of the gross value of all partnership assets or $1,000,000.
• The Section 1.752-7 partner transfers his or her interest in the partnership or LLC (in whole or in part) in a nonrecognition transaction (for example, under Sections 351 or 721).