Peter M. Fass
Peter M. Fass ()

The Internal Revenue Service (IRS) has issued final, temporary and proposed regulations (Final Regulations, the Temporary Regulations and the New Proposed Regulations, respectively, and collectively, the New Regulations) that change the partnership disguised sale rules. See T.D. 9787, 81 Fed. Reg. 69,291 (Oct. 5, 2016); T.D. 9788, 81 Fed. Reg. 69,292 (Oct. 5, 2016).

The Current Regulations on Disguised Sales. Distributions of cash from a partnership to a partner are generally not taxable unless the cash distributed exceeds the partner’s basis in its partnership interest. A partner generally includes its share (as determined under the relevant regulations) of a partnership’s liabilities in the partner’s basis. As a result, partnership liabilities can allow a partner to receive a tax-free cash distribution of the debt proceeds (or other cash), as long as the partner’s basis in the partnership interest (including the partner’s share of the partnership’s debt) exceeds the amount distributed.

Section 707 provides rules treating the contribution of property to a partnership followed by a distribution of cash by the partnership to the contributor as a “disguised sale” for tax purposes. Under certain circumstances, §707 also treats the assumption of a liability of, or the receipt of encumbered property from, a contributing partner as a disguised sale. One significant exception to the disguised sale rules is the so-called “debt financed distribution” rule, which provides an exception for distributions financed by a partnership borrowing to the extent the partner to whom the distribution is made is allocated a share of the borrowing. As a result, a distribution of money to a partner by a partnership is not considered a disguised sale to the extent the distribution is traceable to a partnership borrowing and the amount of the distribution does not exceed the partner’s allocable share of the liability incurred to fund the distribution.

Prior to the New Regulations, for purposes of the disguised sale rules, a partnership liability was allocated among the partners in a manner consistent with the general allocation rules of §752, which depend significantly on whether a liability is “recourse” (because one or more partners bears the “economic risk of loss” by providing a guarantee of the partnership liability) or “nonrecourse.” A partner contributing appreciated assets and receiving a leveraged distribution in a single transaction could avoid current gain recognition by guaranteeing the debt used to fund the distribution. For example, under the prior regulations, gain recognition by a partner contributing appreciated property to a partnership, in exchange for a 50 percent interest in the partnership and a leveraged distribution, generally would be deferred if the partner (or its affiliate) personally guaranteed the loan used to fund the distribution, such that the partner was treated as bearing the “economic risk of loss” with respect to the loan. In such a case, the loan would be considered “recourse” under Reg. §1.752-1(a), and the partner would be allocated 100 percent of the loan for purposes of the disguised sale rules.

Prior to the New Regulations, the method for allocating partnership liabilities depended on whether the debt was “recourse” or “nonrecourse” to a partner. Debt that was “recourse” to a partner was generally allocated to partners to which the debt was recourse. Debt that was “nonrecourse” was generally allocated between or among the partners in accordance with three methods set forth in the Regulations.

Common Partnership Transactions. A common structure that relied on the rules before the New Regulations allowed a partner to defer gain on appreciated property contributed to a partnership in a “leveraged partnership contribution transaction.” In a leveraged partnership contribution transaction, a partner contributes appreciated property to a partnership and guarantees debt incurred by the partnership. Under the prior regulations, the partnership liability becomes recourse to the contributing partner to the extent of the partner’s guarantee, increasing the partner’s basis in its partnership interest by the amount of the guarantee and thus allowing the contributing partner to, under the debt-financed distribution exception to the disguised sale rules, receive a distribution of cash from the partnership up to the amount of the partner’s guarantee without triggering current tax.

As discussed in the last column,1 the allocation of partnership liabilities can also enable a partner to defer gain by protecting and preserving the partner’s negative basis or the excess of debt encumbering contributed property over the partner’s basis in such property. When a partner contributes encumbered property to a partnership, the partner is treated as receiving a distribution (or sales proceeds) to the extent the partner’s share of the partnership’s liabilities is less than the debt encumbering the contributed property. This distribution could result in gain recognition even if the transfer would not otherwise be treated as a disguised sale.

In order to minimize adverse tax consequences related to deemed distributions that result from a partnership receiving property encumbered by debt, it is not unusual for partners contributing encumbered property to a partnership to guarantee debt of the partnership to maximize the contributing partner’s allocable share of partnership debt. Many of those guarantees were often accomplished through “bottom-dollar” guarantees, in which the contributing partner would guarantee a partnership liability only to the extent that the creditor recovered less than the guaranteed amount, even if the amount of the guaranteed debt was significantly greater.2

The New Regulations and Disguised Sales. The New Regulations effectively treat all partnership liabilities (with limited exceptions) as nonrecourse liabilities for disguised sale purposes. This change significantly limits a contributing partner’s ability to be allocated a disproportionate share of a partnership’s debt, thereby limiting the opportunity for such partner to receive tax-free cash distributions from a partnership related to a contribution of appreciated property. The effect is to put an end to tax-deferred leveraged partnership transactions in which a partner could contribute appreciated property to a partnership in exchange for cash proceeds from partnership borrowings that remain “recourse” to the contributing partner that is responsible for payment of the debt under state law, a guarantee or other similar arrangement. Although a distribution of cash to a partner upon contribution would generally be treated as “disguised sale” proceeds, an exception provides that a distribution will not be treated as such if the distribution is traceable to partnership debt and the amount of the distribution does not exceed the partner’s allocable share of the debt incurred to fund the distribution. The Final Regulations also expand several exceptions to the disguised sale rules and clarify many aspects of the disguised sale rules where there had previously been uncertainty.

The New Regulations now deem all partnership loans to be “nonrecourse” for purposes of the disguised sale rules so that the partner-guarantor is no longer able to increase its liability allocation by entering into a guarantee or other arrangement. Under the New Regulations, a partner’s share of a liability now is determined, for disguised sale purposes, in the manner in which “excess nonrecourse liabilities” are allocated under Reg. §1.752-3(a)(3). The New Regulations thus disregard any “economic risk of loss” borne by a contributor-guarantor and, for disguised sale purposes, allocate liabilities solely based on the partner’s share of partnership profits. Under the new rule, the partner in the example above would be allocated only 50 percent of the liability; thus, the excess of the amount distributed to the partner over 50 percent of the liability may be treated as proceeds from the disguised sale of the contributed property.

The New Regulations also exclude from a partner’s share of partnership liabilities any portion of the liability for which another partner bears the economic risk of loss and reserve with respect to the treatment of Reg. §1.752-7 contingent liabilities for disguised sale purposes. The New Regulations under §707 were effective for any transaction with respect to which all transfers occur on or after Jan. 3, 2017 (the date which was 90 days after the New Regulations were published).

The New Regulations affect a number of potential transactions involving partnerships:

• End the use of leveraged partnership contribution transactions.

• Largely ignore bottom-dollar guarantees for purposes of determining whether debt is considered recourse to a partner.

• (1) Expand the preformation expenditures exception and other exceptions to the disguised sale rules, (2) clarify many aspects of the disguised sale rules where there had previously been uncertainty, and (3) maintain flexibility for partnerships in allocating excess nonrecourse liabilities in contexts other than for disguised sale purposes.

• Add an anti-abuse rule that would, if implicated, further limit the ability for debt to be classified as recourse to a partner.


The adoption of the New Regulations should end the use of leveraged partnership contribution transactions in which cash is distributed tax-free to partners who have contributed appreciated property to the partnership. Mandating that partnership liabilities be allocated in accordance with the partners’ interests in partnership profits for disguised sale purposes limits partners to their pro rata shares of partnership liabilities. As a result, the New Regulations generally prevent partners from reducing the proceeds of a disguised sale by the full amount of debt guaranteed by the contributing partner.


1. See Peter M. Fass, “IRS Issues Regulations on Allocation of Partnership Liabilities,” N.Y.L.J. (May 26, 2017), for a discussion of the regulations on disguised sale rules.

2. As discussed in the May 26, 2017 New York Law Journal column, the New Regulations effectively end the use of “bottom-dollar” guarantees, effective Oct. 5, 2017.