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).