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Allocation of Liabilities

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					Allocation of Liabilities


       Section 752
Effect of Liabilities on Basis

   Section 752(a) - As a partner‟s
    percentage of liabilities goes up –
    deemed cash contribution

   Section 752(b) - As a partner‟s
    percentage of liabilities goes down –
    deemed cash distribution
Partnership liabilities: definition

   Section 752 liabilities are partnership
    obligations that either:
       Create or increase the asset basis
       Give rise to an immediate deduction
       Give rise to a nondeductible and noncapitalized
        expense

   Section 752 divides liabilities into recourse
    and nonrecourse liabilities

   Treas. Reg. §1.752-7 liabilities are obligations
    that are not §752 liabilities.
How are liabilities allocated?

   Regulations under 1.752 address this
    issue

   The ultimate goal is to allocate debt to
    the person who is “ultimately liable” to
    pay the debt
Regulation 1.752-1

   The regulations broadened the
    coverage of Section 752 from partner
    to partner and related parties.

   Related parties are defined under
    Section 267(b) and Section 707(b)(1) –
    but you must change the percentage
    to 80%.
Regulation 1.752-1

   Reg. 1.752-1(e) allows the netting
    method for increases and decreased in
    liabilities in the same transaction.

   Reg. 1.752-1(i) separates liabilities
    between recourse and nonrecourse
    liabilities.
How are partnership liabilities
allocated?
   Recourse liabilities: partner‟s
    economic risk of loss (EROL)
       Partner‟s required payments or
        contributions upon constructive partnership
        liquidation

   Nonrecourse liabilities: partner‟s
    interest in partnership profits
       Partner‟s share of three tiers of partnership
        profits
Change in share of partnership
liabilities
   Partnership incurs, refinances or liquidates liability
   New partner is admitted to partnership
   Partner contributes asset to partnership, or receives
    distribution of asset from partnership, encumbered by
    liability
   Partnership sells assets encumbered by liability
   Partnership recourse liability converted to
    nonrecourse liability or vice versa
   Partner or related person guarantees partnership
    liability
   Entity conversion (general partnership to limited
    partnership or LLC, or vice versa)
    Change in share of partnership
    example
   On 15 October 20X9, ABC Partnership, which uses a
    calendar year, admits new Partner D, who receives a 25%
    partnership interest. Partner C, whose partnership interest
    decreased from 35% to 25%, had an outside basis of
    $10,000 on 15 October 20X9.

    If the partnership has a $25,000 nonrecourse liability and
    C‟s profit share for the 2009 year-end is $500, what are
    the tax consequences to Partner C resulting from the
    admittance of new Partner D?

    How would this change if C‟s basis was only $1,000 at
    10/15?
Solution
Situation One
 C‟s share of partnership liabilities would
  decrease from $8,750 to 6,250 on the
  deemed distribution.
 The deemed distribution would not
  create a gain.
 C‟s basis at 12/31 would be $8,000
  ($10,000 beg. basis - $2500 deemed
  distribution + $500 share of income).
Solution

Situation Two
 C would have a gain from the deemed
  distribution of $1,000 ($1,000 beg.
  basis - $2500 deemed distribution +
  $500 share of income)
 C‟s basis at 12/31 would be $0.
       Example
   A limited partnership is formed to construct office condos.
    The general partner‟s interest is 1%, and the limited
    partners‟ interests are 99%. The general partner is solely
    liable for $900 construction loan financing. On 1 January
    20X9, 80% tenant occupancy is reached, and the
    construction loan is converted to mortgage financing
    secured by the building, which releases the general partner
    from liability. On 1 January 20X9, the partnership‟s book-tax
    balance sheet is assets, $900; mortgage debt, $900;
    general partner capital account, $(50); and limited partner
    capital accounts, $50.
    What are the tax consequences to the partners on 1
    January 20X9?
Solution

   The limited partners’ tax bases for their
    partnership interests are increased by $891 (99%
    x $900), from $50 to $941.

   The general partner’s tax basis is decreased by
    $891, from $850 ($(50) + $900) to $0.

   The general partner recognizes gain of $41 from a
    deemed cash distribution ($900 deemed
    distribution - $850 outside basis).
Recourse liability: definition


   A recourse liability is any liability for
    which any partner (or person related to
    a partner) bears the economic risk of
    loss for the liability.
                      Treas. Reg. §1.752-1(a)(1)
Recourse liabilities (economic
risk of loss)
   Recourse liabilities are allocated to partners
    based on their share of the economic risk of
    loss

   Generally, a partner bears economic risk of
    loss if, upon constructive liquidation of the
    partnership, the partner (or a related person)
    is obligated to make either:
     A payment to any person

     A contribution to the partnership
Allocation of recourse liabilities

    Treas. Reg. §1.752-2(b)(1) uses a
     constructive liquidation to allocate
     recourse liabilities

    On the determination date, the following
     events are deemed to occur:
    1.   Assets become worthless
              Including cash
              Excluding specially pledged assets

    2.       Assets are deemed sold for no consideration
Allocation of recourse liabilities
(cont.)
3.   All assets securing nonrecourse debt
     are transferred to creditors for no
     consideration other than relief of the
     nonrecourse debt.
4.   Gain or loss recognized on the deemed
     asset dispositions are allocated to the
     partners.
5.   Partners and related parties fulfill their
     obligations to the partnership and
     creditors.
Allocation of Recourse Debt

   After the constructive liquidation the
    partner that must restore a negative
    capital account is the partner that the
    liability is allocated.

   Recourse debt is only allocated to
    general partners
Example

   Two partners each own 50% of the
    partnership. Both contribute $10 cash
    to the partnership and the partnership
    borrows $80. With the $100 the
    partnership now has it buys property.
    How do we allocate the debt to the
    partners.
Twist on the example

   In this case A is a 10% partner while B
    is a 90% partner. A contributed cash
    of $10 and B contributed property with
    a FMV of $90 and a basis of $10. The
    partnership borrows $80 to buy
    additional property. How is the debt
    allocated?
Partner‟s ability to pay


   It is assumed that a partner will pay,
    regardless of partner‟s net worth

   Anti-abuse rule - a partner‟s obligation is
    disregarded if the facts and
    circumstances indicate a plan to avoid
    the obligation
Recourse liability guarantee
example
   A general partner (G) and a limited partner (L)
    form an equal partnership, with each one
    contributing $100. G has a capital account
    deficit-restoration obligation but L does not.
    The partnership purchases an asset for $500
    ($200 cash and $300 recourse loan from an
    unrelated bank). L guarantees payment of the
    loan.

    How will the partnership recourse liability be
    allocated?
Solution
   Depends on whether the limited partner has waived a
    right of subrogation.
   If the limited partner retains a right of subrogation, the
    limited partner would not bear an economic risk of
    loss with respect to the recourse liability. Thus, the
    limited partner will not be allocated any portion of the
    recourse liability and the entire liability would be
    allocated to the general partner.
   If the limited partner waives the right of subrogation
    and his a DRO the limited partner would bear the
    economic risk of loss and thus be allocated the
    liability.
Solution – Haberdashery
Products
   Under a constructive liquidation analysis, Haberdashery
    is deemed to sell all its assets for no consideration,
    which would result in the recognition of a $1,000,000
    loss.
   Messrs. Mincey and Schmidt (as limited partners) would
    be allocated $80,000 and $70,000 of the loss
    respectively (to reduce their capital accounts to zero),
    and Messrs. Oliver and Carpenter would each be
    allocated $425,000 of the loss.
   Each general partner would be required to restore the
    deficit balance in his or her capital account to satisfy the
    $600,000 recourse liabilities. Thus, Mr. Oliver‟s share of
    recourse liabilities equals $325,000 and Mr. Carpenter‟s
    share of liabilities equals $275,000.
Nonrecourse liability: definition


   A nonrecourse liability is any liability for
    which no partner (or person related to a
    partner) bears the economic risk of loss
    for the liability.

                  Treas. Reg. §1.752-1(a)(2)
     Nonrecourse liability guarantee
     example
   A general partner (G) and a limited partner (L)
    form an equal partnership, with each one
    contributing $100. G has a capital account deficit-
    restoration obligation, but L does not. The
    partnership purchases an asset for $500 ($200
    cash and $300 nonrecourse loan from unrelated
    bank). L guarantees payment of the loan.

►   How will the partnership nonrecourse liability
    be allocated?
    Solution
1. The nonrecourse loan will be allocated solely to
   the limited partner because that partner
   guaranteed the indebtedness, has no rights of
   subrogation, and the partner‟s interest in the
   partnership is greater than 10%. Thus, the limited
   partner bears the economic risk of loss.
Related persons


   Implements §§267(b) and 707(b)(1)
    rules except:
       80% entity ownership is substituted for 50%
       Brothers and sisters are not family
   Special rules apply when a person is
    related to more than one partner
                              Treas. Reg. §1.752-4
Related persons (cont.)


   Partner-controlled lender rule
       Applies if principal purpose of nonrecourse
        loan to partnership (or guarantee of a
        partnership nonrecourse liability) is to avoid
        related-person rules and partner owns 20%
        or more of the lending entity
       Result: partner is treated as lender (or
        guarantor) in proportion to ownership
        interest in lending entity
       Nonrecourse liabilities (profit
       sharing)
   The general thrust of the nonrecourse allocation rules is to
    allocate nonrecourse liabilities so as to reflect the manner in
    which the partners share partnership "profits."

   Partner‟s share of partnership nonrecourse liabilities is sum
    of:
     1. Partner‟s share of partnership minimum gain (Tier 1
        profit-share allocations)
     2. Partner‟s §704(c) minimum gain (Tier 2 profit-share
        allocations)
     3. Partner‟s share of “excess” nonrecourse liabilities (Tier 3
        profit-share allocations)
      Share of partnership minimum
      gain (Tier 1)

   Partnership minimum gain equals
    nonrecourse debt principal greater than
    §704(b) book basis of secured          property
    (computed separately for each nonrecourse
    liability [at end of each tax year], then
    aggregated)
   Partnership nonrecourse deductions equals
   Partner‟s share of partnership minimum gain
    equals
     Tier 1 allocations mini-case
     example
    On 1 January 20X9, Partnership owns one depreciable asset
     secured by a nonrecourse liability. The asset‟s §704(b) book
     (and tax) basis is $800, nonrecourse debt principal is $700
     and partner capital accounts are $100. Partnership‟s 20X9
     book (and tax) depreciation is $200. On 31 December 20X9,
     the asset basis is $600, nonrecourse debt principal is $700
     and partner capital accounts are $(100).

A.   What is the amount of Partnership‟s minimum gain?
B.   What portion of the $700 nonrecourse debt is allocated to
     Tier 1?
C.   Which partners will receive an allocation of the Tier 1
     nonrecourse liability?
    Solution

   The partnership minimum gain at the beginning of the
    year = $0 ($700 nonrecouse debt - $800 adjusted
    basis of asset). The partnership minimum gain at the
    end of the year = $100 ($700 nonrecouse debt - $600
    adjusted basis of asset).

   Nonrecourse deductions = $100 (the increase in
    minimum gain). Thus, the first $100 of the debt is
    allocated under Tier 1.

   All partners who have a share of minimum gain will
    be allocated a percentage of the debt under Tier 1.
Share of partner §704(c)
minimum gain (Tier 2)

   Partner §704(c) minimum gain (Tier 2)
       Section 704(c) gain (and reverse §704(c)
        gain resulting from §704(b) partnership
        revaluations) that would be allocated to
        contributing partner if all partnership assets
        secured by nonrecourse liabilities were
        disposed of in a taxable transaction in full
        satisfaction of liabilities with no other
        consideration
         Tier 2 allocations mini-case
         example
        X contributes an asset to a partnership in
         exchange for a 20% partnership interest in a
         §721 transaction. The asset‟s tax basis is $600
         and its FMV is $1,000. The partnership takes
         the asset subject to X‟s nonrecourse liability of
         $700 (secured by the asset), which is the
         partnership‟s only nonrecourse liability.
A.   What is X‟s §704(c) built-in gain?
B.   What is X‟s §704(c) minimum gain (Tier 2 allocations)?
C.   How much of the debt is allocated to X, assuming no
     minimum gain under Tier 1?
Solution

   X‟s §704(c) built-in gain is $400 ($1,000 FMV - $600
    tax basis).

   X‟s §704(c) minimum gain is $100 ($700 nonrecourse
    liability - $600 tax basis).

   X‟s share of the partnership nonrecourse liabilities is
    $220 ($100 Tier 2 Allocation + $120 Tier 3 Allocation,
    which is 20% of the remaining liability of $600 [$700-
    $100]).
Share of „excess‟ nonrecourse
liabilities (Tier 3)
    Allocation based on partner‟s interest in
     partnership profits (economic arrangement of
     partners)
    Alternative methods
    1.   Partnership agreement may specify interest in
         partnership profits if allocation is reasonably
         consistent with an allocation (having substantial
         economic effect) of some other significant item of
         partnership income or gain
    2.   Allocate in same manner in which reasonably
         expected nonrecourse deductions will be allocated
    3.   Priority to excess §704(c) gain or reverse §704(c)
         gain
How is nonrecourse debt
allocated?

   New regulations allow partners to allocate
    additional Section 704(c) gain to
    contributing partners if the amount of debt
    they are allocated is reduced because of the
    Section 704(b) minimum gain layer

   Nonrecourse debt is allocated to both
    general and limited partners
      Solution – NJ Partnership
a.   Christopher‟s outside basis is computed as follows.
     Adjusted basis of contributed property                       $240,000
     Share of existing recourse liabilities                             75,000
     Share of recourse mortgage                                         50,000
     Relief of recourse mortgage                                  (200,000)
     Outside basis                                               $165,000

b.   Christopher‟s outside basis is computed as follows.
     Adjusted basis of contributed property                        $10,000
     Share of recourse liabilities                                       75,000
     Share of recourse mortgage                                         50,000
     Relief of recourse mortgage                                      (200,000)
     Outside basis                                                     -0-

     Christopher recognizes the $65,000 excess relief of the recourse mortgage as
     section 731(a) gain.
      Solution – NJ Partnership
c. Christopher‟s outside basis is computed as follows.
   Adjusted basis of contributed property                  $240,000
   Share of recourse liabilities                             75,000
   Share of nonrecourse mortgage (third-tier allocation)     50,000
   Relief of nonrecourse mortgage                          (200,000)
   Outside basis                                           $165,000

d. Christopher‟s outside basis is computed as follows.
   Adjusted basis of contributed property                   $10,000
   Share of recourse liability                               75,000
   Share of nonrecourse mortgage:
   second-tier allocation                                   190,000
   third-tier allocation                                      2,500
   Relief of nonrecourse mortgage                          (200,000)
  Outside basis                                             $77,500
   Solution – NJ Partnership

2. Each other partner‟s outside basis would
 decrease by $12,500 ($12,500 allocation of
 the nonrecourse mortgage liability - $25,000
 decreased share of existing recourse
 liabilities).

				
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