Peter M. Fass ()
The IRS issued proposed regulations (“Prop. Regs.”) on Jan. 29, 2014 that would amend the rules regarding allocation of partnership liabilities and disguised sales. See, generally, REG-119305-11; FR Doc. 2014-01637 (Jan. 30, 2014). According to published reports, the Prop. Regs. if finalized as proposed, would negatively impact a variety of real estate investments which use the partnership vehicle. For REIT-based (real estate investment trust) investments, the Prop. Regs. would affect the structuring of REIT investments using the umbrella partnership (UPREIT).1
Under the liability allocation rules set forth in the Prop. Regs.:
• Non-commercial guarantees and similar arrangements (including so-called “bottom-dollar” guarantees) would not be recognized;
• A partnership would be permitted to allocate recourse liabilities to a partner, other than an individual or estate, only to the extent of the partner’s “net value,” determined without regard to the partner’s interest in the partnership;
• A partner would not be considered to bear economic risk of loss for a liability if the partner has a right of reimbursement from any person, including unrelated parties; and
• Partnerships would have less flexibility in allocating “excess nonrecourse liabilities,” which generally would be required to be allocated based on the partners’ “liquidation value percentages.”
The regulations under Section 752 address the treatment of partnership recourse and nonrecourse liabilities. According to the Preamble to the Prop. Regs., the IRS believes it is appropriate to reconsider the rules under Section 752 regarding the payment obligations that are recognized under Reg. §1.752-2(b)(3), the satisfaction of payment obligations under Reg. §1.752-2(b)(6), and the methods available for allocating excess nonrecourse liabilities under Reg. §1.752-3(a)(3).
Current Rules on Partnership Recourse Rules. The regulations governing the allocation of partnership liabilities provide that partnership liabilities should be allocated to partners who would be required to pay the liability in the event that the partnership is unable to do so, because such partners are considered to bear the economic burden for the liability. If a lender would have no recourse to any partner if the partnership is unable repay the liability, then the liability can only be satisfied out of partnership profits. The regulations allocate partnership nonrecourse liabilities among the partners in accordance with the manner in which profits of the partnership would be allocated among the partners.
Under the current Section 752 regulations, a partnership liability is allocated to a partner as a partnership recourse liability to the extent that such partner bears the “economic risk of loss” for the liability under the worst case scenario constructive liquidation test (CLT). Pursuant to Reg. §1.752.2-2(b), a partner is treated as bearing the economic risk of loss for a partnership liability to the extent that, if the partnership’s assets were worthless and the partnership liquidated, the partner or a related person would be obligated to make a payment because the liability becomes due and payable. For this purpose, obligations of the partner or a related person with respect to the liability, including obligations to the lender, the partnership or other partners, are taken into account.
Reg. §1.752-2(b)(6) sets forth a general presumption that a partner or related person will in fact satisfy an obligation to make a payment to a creditor or the partnership in connection with the constructive liquidation of the partnership irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. The current regulations contain an anti-abuse rule that disregard an obligation of a partner or a related person “if facts and circumstances indicate that a principal purposes of the arrangement between the parties is to eliminate the partner’s economic risk of loss with respect to that obligation or create the appearance of the partner or related person bearing the economic risk of loss when, in fact, the substance of the arrangement is otherwise.” Reg. §1.752-2(f)(i).
IRS Rationale for Changes. The Preamble to the Prop. Regs. sets forth the IRS’s positions. The IRS has considered whether the current approach is appropriate given that, in most cases, a partnership will satisfy its liabilities with partnership profits, the partnership’s assets do not become worthless, and the payment obligations of partners or related persons are not called upon. The IRS is concerned that some partners or related persons have entered into payment obligations that are not commercial solely to achieve an allocation of a partnership liability to such partner. The IRS believes that Section 79 of the Tax Reform Act of 1984 directed the IRS to prescribe regulations under Section 752 that would ensure that bona fide, commercial payment obligations would be given effect under Section 752.
Factors for Payment Obligation to Be Respected. The Prop. Regs. provide a rule that obligations to make a payment with respect to a partnership liability (excluding those imposed by state law) will not be recognized for purposes of Section 752 unless certain factors are present. These factors, if satisfied, are intended to establish that the terms of the payment obligation are commercially reasonable and are not designed solely to obtain tax benefits. Specifically, the rule requires a partner or related person to maintain a commercially reasonable net worth during the term of the payment obligation or be subject to commercially reasonable restrictions on asset transfers for inadequate consideration. In addition, the partner or related person must provide commercially reasonable documentation regarding its financial condition and receive arm’s-length consideration for assuming the payment obligation.
The rule also requires that the payment obligation’s term must not end prior to the term of the partnership liability and that the primary obligor or any other obligor must not be required to hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor. The rule would also prevent certain “bottom-dollar” guarantees from being recognized for purposes of Section 752.
Payment Obligations. The Prop. Regs. would impose several restrictions on the recognition of a payment obligation of a partner (or related person) in respect of a partnership liability that arises by obligation of contract and not by operation of state law. Such obligations generally include guarantees, indemnities and similar arrangements, as well as obligations imposed by a partnership agreement, such as obligations to make capital contributions or restore capital account deficits.2 A partner would not be considered to bear the economic risk of loss of a partnership liability as a result of such an obligation unless the obligation (payment obligation) satisfied the following six-prong test.
1) Reasonable Net Worth. The obligor must either be required to maintain a commercially reasonable net worth for the term of the obligation or be subject to commercially reasonable restrictions on transfers of assets for inadequate consideration.3
2) Documentation of Financial Condition. The obligor must be required to provide commercially reasonable documentation regarding its financial condition.4
3) Term of Payment Obligation. The term of the payment obligation must not be shorter than the related partnership liability.5
4) Excessive Liquidity Requirement on Primary Obligor. The primary or any other obligor with respect to the related partnership liability must not be required to hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor.6
5) Arm’s-Length Consideration.The obligor must receive arm’s-length consideration for assuming the payment obligation.7
6) Dollar-for-Dollar Obligation. The obligor must be liable for 100 percent of each dollar of the related partnership liability up to the full amount of the payment obligation.8 This provision is intended to eliminate “bottom-dollar” guarantees. For example, if a partnership has a liability of $1,000 and a partner guarantees the partnership liability only to the extent that the creditor recovers less than $200, the partner would not be recognized as bearing any economic risk of loss of the liability pursuant to the guarantee, because the partner would not be liable for each dollar of the partnership liability up to the $200 amount of the guarantee.9 However, if a partner provided a guarantee of a $1,000 partnership liability for any amount the partnership failed to satisfy, up to $300, the guarantee could be recognized since the guarantee is dollar-for-dollar up to the amount of the guarantee.10
In addition, if a partner guaranteed every dollar of a partnership liability for 25 percent of the amount the partnership failed to satisfy, the partner would not be recognized as bearing any economic risk of loss of any of the liability pursuant to the guarantee, because the partner would not be liable for 100 percent of each dollar.11
In determining whether an obligation satisfies this requirement, any right of indemnity, reimbursement or similar arrangement would be taken into account, excluding rights of contribution between co-obligor partners (and related persons) who are jointly and severally liable for the payment obligation. For example, if a partner guarantees 100 percent of each dollar of a partnership liability, but another partner provides an indemnity for 75 percent of each dollar paid under the guarantee, the indemnity would be treated as modifying the guarantee such that the partner is only liable for 25 percent of each dollar of the partnership liability.12 Accordingly, since neither partner would be liable for 100 percent of each dollar of the partnership liability, neither the guarantee nor the indemnity would be recognized.
Peter M. Fass is a partner at Proskauer Rose.
1. See, NAREIT’s Weekly Newsletter, News Brief (May 5, 2014) at 1-2.
2. Prop. Reg. §§1.752-2(b)(3)(i)(A)-(B) and -2(b)(3)(ii).
3. Prop. Reg. §1.752-2(b)(3)(ii)(A).
4. Prop. Reg. §1.752-2(b)(3)(ii)(B).
5. Prop. Reg. §1.752-2(b)(3)(ii)(C).
6. Prop. Reg. §1.752-2(b)(3)(ii)(D).
7. Prop. Reg. §1.752-2(b)(3)(ii)(E).
8. Prop. Reg. §1.752-2(b)(3)(ii)(F).
9. Prop. Reg. §1.752-2(f), Ex. 10.
10. Prop. Reg. §1.752-2(f), Ex. 10.
11. Prop. Reg. §1.752-2(f), Ex. 12.
12. Prop. Reg. §1.752-2(f), Ex. 11.