This column continues the discussion of tax issues resulting when a loan secured by real property (Troubled Loan) defaults or is restructured with a review of actions an individual limited partner or limited liability company (LLC) member can take apart from the actions at the limited partnership or LLC level.
Partner or LLC member level actions afford more flexibility for individual investors to time and choose the technique that is the most appropriate for their particular set of circumstances. Consequently, actions at the partner or member level allow individuals to adopt a technique that will minimize the adverse tax consequences that are normally associated with bailing out of a Troubled Loan property. Various techniques available to the individual partners include:
(1) contribute additional capital to the partnership or LLC;
(2) holding onto the partnership or LLC interest;
(3) a taxable sale of the partnership or LLC interest;
(4) contributing the partnership or LLC interest to charity;
(5) making a gift of the partnership or LLC interest to family members;
(6) conveying the partnership or LLC interest to creditors;
(7) transferring the partnership or LLC interest to a controlled corporation;
(8) holding the partnership or LLC interest until death; and
(9) abandoning the partnership or LLC interest.
As used herein, "Interest" refers to either a partnership or LLC interest.
Although this is possibly the simplest solution to the partnership or LLC’s cash flow problems, it is not very practical because most limited partners or LLC members in a Troubled Loan transaction will refuse to invest additional cash above their initial capital contribution for their interest. However, some partnership and LLC agreements enable the general partner or managing member to call upon the limited partners or members to make additional capital contributions in the event of cash flow problems.
Consequently, the situation may arise where the limited partners of a troubled investment may be required to contribute additional capital as a temporary restructuring device. Note, however, that where additional capital may be necessary to cover anticipated expenses and not all the partners or members are willing or able to contribute their pro rata share of the necessary funds, the infusion of additional capital by some could adversely affect the allocation of nonrecourse liabilities under Section 752, thereby triggering gain to the existing partners or members.
The situation described above often arises in the context of a real estate investment in the form of a limited partnership in which the limited partners contribute most of the equity capital necessary to acquire the property, with the balance of the financing provided by third-party nonrecourse financing. The limited partners are allocated most of the partnership’s profits and losses until the partnership has sufficient cash flow or proceeds from the sale or refinancing of its property to distribute to the limited partners their capital contributions plus a reasonable return. Until that time, however, the limited partners are allocated partnership losses which exceed their capital investment.
If, however, the partnership begins to falter and is not doing as well as expected, additional capital may be necessary to pay partnership expenses. The general partner will often call upon the limited partners to contribute additional capital to cover these expenses. In a typical capital call provision, the limited partners who participate in the capital call are allocated all of the partnership’s deductions attributable to their additional capital contributions and all of the partnership’s profits until such time as the contributing partners’ capital accounts are brought to the level necessary to return their additional capital contributions to them. Once this event has occurred, the noncontributing partners will again share in the partnership profits.
Noncontributing Partner Tax Issues. An issue that arises under Section 752 regulations relates to the limited partners who do not make additional capital contributions to the partnership. Because all of the partnership profits are now first being allocated to the contributing partners in order to restore the balances in their capital accounts, the noncontributing partners may be deemed to have lost their entire share of partnership nonrecourse liabilities.
Although the noncontributing partners may have a sizable profit allocation upon the eventual disposition of the partnership’s property, in the capital call facts described above they will have a zero allocation of partnership profits until such time as the contributing partners’ capital accounts are restored. Thus, although it was not the intention of the general partner to cause a tax problem for the noncontributing partners, if they are deemed to no longer have any share of partnership nonrecourse liabilities because their relevant profit-sharing ratios are zero, they will be treated as receiving a cash distribution equal to the decrease in their proportionate share of the partnership’s nonrecourse liabilities. As a result, the noncontributing partners will be forced to recognize gain equal to the amount by which their shares of partnership losses and distributions, if any, have exceeded their original capital contributions.
The Section 752 regulations1 first allocate partnership nonrecourse debt among the partners in an amount equal to their shares of partnership minimum gain. As a result, a partner’s share of partnership profits is not an allocating factor under Section 752 regulations until a later stage of the allocation process. Consequently, the allocation to the noncontributing partners of partnership nonrecourse liabilities in an amount equal to their shares of partnership minimum gain (i.e., their shares of partnership nonrecourse deductions) will generally eliminate the potential gain-triggering event that can result from the shift in the partnership’s profit allocation.
In addition to the potential income recognition that may result if a partner’s share of partnership liabilities is deemed to decrease, potential problems may exist under Section 751(b) to the extent there is any change in a partner’s share of partnership liabilities. As illustrated in Revenue Ruling 84-1022 a decrease in a partner’s profit-sharing ratio coupled with a corresponding decrease in his share of partnership liabilities can be deemed a sale or exchange of a portion of his share of the partnership’s unrealized receivables or substantially appreciated inventory items (Section 751 Hot Assets). This gain-triggering event can take place upon the admission of a new partner or the infusion of additional capital into the partnership, situations in which partnership profit-sharing ratio often change (even though the existing partners may retain sufficient partnership liabilities to support their negative capital accounts).
Nonrecourse liabilities are allocated among the partners in accordance with their respective interests in partnership profits only if they are in excess of a partner’s share of minimum gain and inherent Section 704(c) gain. Reg. §1.752-3(a)(3) provides a special safe harbor that allows the partnership agreement to specify the partners’ shares of residual partnership nonrecourse liabilities in excess of nonrecourse liabilities allocable by reason of a partner’s share of minimum gain and Section 704(c) gain.
In order to come under the safe harbor of the Section 752 regulations, the allocation must be reasonably consistent with the allocation of some other significant item of partnership income or gain that has substantial economic effect. The flexibility afforded by the safe harbor, however, will generally not be sufficient in itself to totally avoid the impact of Section 751(b) because there will be a shift in partnership liabilities whenever nonrecourse deductions are reallocated upon the admission of new partners or the infusion of new capital thereby resulting in a potential Section 751(b) Hot Asset gain to the existing partners.
Some commentators believe that the deemed cash distribution under Section 752(b) that results from a shift in liabilities and, which can theoretically cause immediate gain recognition under Section 751(b)(1)(B), can be avoided by a provision in the partnership agreement that specifically provides that a partner’s share of the partnership’s Section 751(b) Hot Assets will not be diminished upon the admission of a new partner to the partnership or as a result of an infusion of new capital.3 However, this result is not guaranteed because it is unclear whether the partners can allocate the ordinary income portion of the depreciation recapture based on the prior sharing of deductions giving rise to the recapture, or whether an allocation of merely the character of the gain would violate the substantiality requirement of Reg §1.704-1(b)(2)(iii).
Peter M. Fass is a partner at Proskauer Rose.
1. Reg. §1.752-3(a).
2. 1984-2 C.B. 119.
3. See, Levine, Loffman & Presant, "A Practical Guide to the Section 752 Temp. Regs—Part II," 70 J. Tax’n 260 at 264 (May 1989); Levun, Code Section 752 Regs Protect Infusions of Capital, 30 Partnership Tax Rep. 4 at 6 (April 30, 1990).