I. Introduction
In September 2021, Senate Finance Committee Chair Ron Wyden (D. Or.) released a draft proposing what would be the most substantial changes to Subchapter K since 1954 (“Wyden Proposals”). One of the more controversial changes to these partnership taxation provisions is the one to section 752, which allocates partnership debt to the partners. The current “economic risk of loss” rules for sharing recourse debt would be jettisoned, and partners would share recourse debt in the same manner in which they share profits.
Deciding on the manner in which a partnership should be allowed to allocate liabilities to its partners is a challenging undertaking. There are no perfect solutions. The current system for allocating recourse debt is exceptionally complex, but in its current formulation works reasonably well. The Wyden Proposals on section 752 constitute a sea change. The primary advantage of the Wyden Proposals is that they would substantially simplify the section 752 Regulations and avoid some abuses, but in its current form, likely would impede many legitimate business deals that are permitted under the current system for allocating recourse debt. The arguments in favor of the Wyden Proposals become the most cogent for large partnerships.
Part II of the Article provides a basic review and an analysis of section 752(a), its Regulations, and the challenges created by the rules for allocating recourse debt, while Part III discusses the Wyden Proposals, their pros and cons, and their best application. Part IV provides a conclusion.
II. A Basic Review and an Analysis of Section 752 and Its Regulations
A. General Rules
Partnerships for tax purposes include both state-law partnerships and, under the default rule, limited liability companies (“LLCs”) with two or more members. Section 752(a) provides that an increase in a partner’s share of partnership liabilities is treated as a contribution of money by the partner to the partnership, which increases the partner’s basis in her partnership interest under section 721(a). I will sometimes call the partner’s basis in the partnership interest “outside basis.” Outside basis is highly important, as a partner’s loss deductions cannot exceed that basis under section 704(d). Conversely, section 752(b) provides that a decrease in a partner’s share of a partnership’s liabilities is treated as a distribution of money to that partner, reducing a partner’s outside basis under section 733. If the reduction exceeds the partner’s outside basis, the partner has gain under section 731(a)(1). Similarly, a partner’s assumption of a partnership liability is treated as a contribution of money by that partner to the partnership, and the assumption by a partnership of an individual partner’s liability is treated as a distribution of money to that partner. Regulation section 1.752-1(f) provides that where the same transaction produces both an increase and decrease in a partner’s share of partnership liabilities, only the net increase is treated as a contribution of money by the partner and only the net decrease is treated as a distribution of money to the partner. Finally, section 752(d) provides that liabilities associated with a partner’s partnership interest are included in the selling partner’s amount realized.
Not all obligations count as liabilities for section 752 purposes. Under the Regulations, to count as such a liability, the liability must increase the basis of any of the obligor’s assets (importantly, including cash); give rise to an immediate deduction to the obligor; or give rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. A contingent liability may be a genuine obligation of the partnership, but should not count as a liability for section 752 purposes. Regulation section 1.752-7 addresses certain abusive uses of non-liability obligations and is discussed briefly below.
The ability of entity-level debt to increase owner-level basis is unique to partnership taxation and has resulted in entities taxable as partnerships often being the preferred vehicle for the conduct of business or holding investment property. Partnerships have an advantage over S corporations in this regard since corporate liabilities do not increase a shareholder’s basis in her stock. The ability of a partner to include partnership liabilities in her basis for her partnership interest enables the partner to claim deductions flowing to her through the partnership in excess of the amount actually contributed by the partner to the partnership.
Allowing a partner to increase her basis in her partnership interest by her share of liabilities can put the partner in the same place in which the partner would have been, had she conducted the activity as an individual. To illustrate, if individual A purchased an office building for $1,000,000 on leased land, paying $200,000 in cash and borrowing $800,000 on a mortgage loan, A has a $1,000,000 basis in the office building. A would be permitted to depreciate the entire cost of the office building, even though he only paid $200,000 out of pocket. If, instead, A and individual B form a partnership to purchase the office building, the partnership’s basis in the office building is also $1,000,000. If A and B were not permitted to increase their bases for their partnership interests by the amount of the mortgage loan, however, because of the loss limitation of section 704(d), the losses which could be claimed by the partners would be limited to $200,000, a problem not faced by A when buying the apartment building in his individual capacity.
That said, the rules of section 752(a) apply to all partnership liabilities, even if the loan proceeds are put in the bank or another liquid investment. If an individual borrows money on an unsecured basis and puts it in the bank or other liquid investment, the bases of the individual’s other assets are unaffected, and the money sitting in the bank, or liquid investment typically offers no tax benefits. If a partnership does the same thing, the partners will get a basis increase in their partnership interests. This disjuncture, at least in its current form, is hard to justify and has contributed to some of the abuses that have occurred with partnership debt. I will return to this issue after laying out the regulatory system for allocating recourse and nonrecourse debt.
B. Definition of Allocation of Recourse Liabilities
1. Economic Risk of Loss
Regulation section 1.7521(a)(1) provides that a liability is a recourse liability of a partnership to the extent that any partner bears “the economic risk of loss” (“EROL”) for that liability. EROL, especially in its original formulation, speaks to bottomline obligation on a debt after taking into account all facts and circumstances, including rights of contribution among partners. Assume a general partnership that is not a limited liability partnership, has two partners, one who holds a 60% interest and one who holds a 40% interest. Unsurprisingly, they usually will share the EROL on any partnership recourse debt 60/40. Now assume a limited partnership, where A is the general partner and B is the limited partner. Under the typical limited partnership statute, the general partner has all of the EROL on any partnership recourse debt, and the limited partner has none. It is possible for a limited partner to voluntarily take on some part of that EROL, however, by making an agreement to that effect with the lender, the partnership and/or the general partner. Limited partners often want to do this to increase their bases in their partnership interests, allowing them to deduct more losses, to avoid recognizing gain on distributions, or because the lender insists upon it.
2. Capital Accounts
A brief review of capital accounts is necessary to the explication of EROL. Usually, each partner has a capital account. A capital account could be thought of as a measure of a partner’s economic investment in the partnership. Generally, capital accounts are increased by money contributed, the fair market value (not basis) of property contributed net of any liabilities, and partnership income. They are decreased by money distributed, the fair market value of property distributed net of any liabilities, and partnership losses. Note that liabilities do not go into the calculation of capital accounts (other than reducing the value of contributed or distributed property), unlike tax basis. Capital accounts can be negative, while a partner’s outside basis can never be negative, as section 704(d) does not allow a loss deduction in excess of outside basis. Under some circumstances, the section 704(b) Regulations permit partners to have negative capital accounts; in the recourse debt context, typically the partner must pay any negative balance in the capital account to the partnership by the end of the tax year in which his partnership interest is liquidated (or, if later, 90 days after liquidation). A deficit restoration obligation can be relevant in the calculation of EROL.
If property is contributed to the partnership, the partnership accounts will show its carryover tax basis under section 723. But the partnership accounts will also show the property’s “book value” (or what a few law school professors like to call book basis). The book value of a property is its fair market value on acquisition by the partnership, in this case gross of liabilities. If the partnership pays cash for property, its tax basis and book value in the property are the same. In calculating the partners’ capital accounts, depreciation deductions and gains and losses from property dispositions (to list a few examples) are calculated using book values.
For a partner who, for example, contributes cash and is allocated partnership liabilities, the partner’s outside basis will initially exceed the partner’s capital account. Assume A contributes $1,000 to a new partnership and is properly allocated $500 of partnership recourse liabilities that are incurred on formation of the partnership. Initially, A’s outside basis is $1,500, but his capital account is $1,000. Deductions allocated to A, say for losses, can reduce the A’s outside basis in the partnership interest and A’s capital account. Since the outside basis was higher to begin with, the capital account will go negative before the tax basis is “used up.” For example, if at the end of the first tax year A is allocated a net partnership loss of $1,100, A’s outside basis is reduced to $400, and his capital account to a negative ($100).
3. Regulations
On to the Regulations: What could be seen as a baseline technique for ascertaining the EROL is contained in Regulation section 1.7522(b)(1), which I discuss below. Ultimately, though, the EROL is determined based on all of the facts and circumstances. All statutory and contractual obligations relating to the partnership liability are taken into account, including (1) contractual obligations outside the partnership agreement, such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors, to other partners, or to the partnership; (2) obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership; and (3) payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state or local law, including the governing state or local law partnership statute. A direct or indirect pledge of a partner’s non-partnership property can increase a partner’s EROL up to the fair market value of the pledged property.
Regulation section 1.7522(b)(1) provides that a partner bears the EROL with respect to a liability if: (i) the partnership is constructively liquidated, (ii) as a result of the constructive liquidation, the partner would be obligated to make a payment to any person because the liability became due and payable, and (iii) the partner would not be entitled to reimbursement from another partner or a person related to another partner.
a. Constructive Liquidation. In a constructive liquidation, the following events are deemed to have occurred simultaneously (this is sometimes called “the nuclear bomb test”):
- all of the partnership’s liabilities become payable in full;
- all of the partnership’s assets, including cash, have a value of zero, other than property contributed by a partner to secure a partnership liability;
- the partnership disposes of all of its property in a fully taxable transaction for no consideration other than the release of liability with respect to nonrecourse liabilities;
- all items of income, gain, loss, etc. are allocated among the partners; and
- the partnership liquidates.
Thus, in the constructive liquidation, property is generally considered to be sold for no consideration and, thus, generates losses that are allocated to the partners. These hypothetical losses could create hypothetical negative capital accounts that partners could have an obligation to restore. One of the ways a partner may have EROL is via an obligation to restore a negative capital account (including under the nuclear bomb test) because the money the partner is obligated to pay to the partnership can be used to satisfy recourse debt.
In the nuclear bomb test, there is an exception to the zero-consideration rule for property subject to nonrecourse debt. In that case, the property subject to that debt is treated as sold for an amount equal to the amount of the subject nonrecourse debt and gain or loss is recognized depending upon the partnership’s basis for the asset subject to the nonrecourse debt.
But the nuclear bomb test is not the final word because all facts and circumstances must be considered. For example, even if a partner is obligated to make a payment on a recourse debt, the partner’s obligation to make the payment (and thus the partner’s EROL) is reduced to the extent that the partner is entitled to reimbursement from another partner. In determining whether a person has a payment obligation, in the past it was generally assumed that all partners who have obligations to make payment actually perform those obligations, notwithstanding their net worth, unless there was a plan to “circumvent or avoid the obligation.” There is now a more restrictive rule, as I will discuss.
For all of the regulatory complexity, until recently, it was fairly easy to have the EROL on a recourse debt. In the typical situation, all that was required was that in a “worst case scenario” a partner had bona fide liability. This exceptionally liberal rule, which had its origins in a Tax Court case, inevitably led to abuses, the most famous of which might be the “bottom dollar guarantee,” considered below. In 2019, in response to the abuses, the Regulations were amended to provide that a partner’s obligation to make payments on a liability is not respected if the facts and circumstances indicate that at the time the partnership must determine a partner’s share of partnership liabilities there is not a “commercially reasonable” expectation that the payment obligor will have the ability to make the required payments as they become due and payable. Facts and circumstances to consider in determining a commercially reasonable expectation of payment include factors a third party creditor would take into account when determining whether to grant a loan. Previously, the Regulations provided that, for disregarded entities (typically single-member LLCs), any payment obligation is taken into account only to the extent of the net value of the entity. These rules were both complex in their details and too limited in their scope.
While no longer in the Regulations, the old rules are effectively subsumed into a new standard promulgated by the Regulations. For purposes of determining the extent to which a partner has a payment obligation and the EROL, the Regulations somewhat awkwardly append a new rule to the old one. The Regulations assume that all partners who have obligations to make payments actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate (i) a plan to circumvent or avoid the obligation under Regulation section 1.752-2(j) (discussed below), or (ii) that there is not a commercially reasonable expectation that the payment obligor will have the ability to make the required payments under the terms of the obligation if the obligation becomes due and payable. An example in the Regulations provides that an LLC without assets has no commercially reasonable expectation of repayment.
b. Partner Nonrecourse Loans to Partnership. Regulation section 1.7522(c)(1) provides that if a partner makes a nonrecourse loan to the partnership, the lending partner bears the EROL for this debt. Though the loan is nominally nonrecourse, the lending partner of course bears the EROL if the partnership fails to pay the debt. It sometimes occurs, however, that a commercial lender will take a (typically small) profits interest in the partnership in addition to being paid interest. A partnership might even be formed between the borrower and the lender to facilitate the transaction. Within reason, the Regulations did not want to prevent these arm’s length transactions. To that end, the Regulations contain a de minimis exception to the general rule. If the partner’s interest in each item of partnership income, gain, loss, deduction, or credit for every taxable year is 10% or less, and that partner makes a loan to the partnership which constitutes qualified nonrecourse financing within the meaning of section 465(b) (determined without regard to the type of activity financed), then the partner/creditor is not deemed to bear the EROL on the debt. Generally, qualified nonrecourse financing means financing by a person regularly engaged in the business of lending who is not a related person, or from a government or guaranteed by a governmental agency, which is secured by property, with respect to which no person is personally liable for repayment and which is not convertible debt. Section 465 requires qualified nonrecourse financing to be secured by real estate, but Regulation section 1.7522(d)(1) removes that requirement in the lending-partner context. The Regulations presumably removed the requirement to provide lending-partner exception with greater scope, though commercial lenders rarely make nonrecourse loans that are not secured by real estate.
c. Bottom Dollar Payment Obligations. Under prior Regulations, the liberal EROL rules created dubious results. For example, consider ABC LLC that is taxed as a partnership and operates an apartment building. The apartment building is worth $1,000. ABC LLC has borrowed $200 on a recourse basis (that is, the full faith and credit of ABC LLC is pledged) from Commercial Bank. A, a member of the LLC, has provided Commercial Bank with a guarantee for $20 (waiving subrogation rights), provided Commercial Bank collects less than $20 from ABC LLC. A’s commitment is sometimes called a “bottom dollar guarantee” or a “bottom dollar payment obligation” because A is only liable for the last $20 of the loan. If ABC LLC pays at least $20, A has no obligation to Commercial Bank. Under the nuclear bomb test, however, the apartment building would be deemed to be worthless, and A would have the EROL to the extent of $20—even though there would be very little chance that A would pay on the guarantee in reality.
In 2019, the Regulations were amended to provide that a partner generally does not have the EROL on bottom dollar payment obligations. Generally, a bottom dollar payment obligation exists unless a partner is liable up to the full amount of the partner’s payment obligation if any of the partnership’s liability goes unpaid. In the example, for A to have EROL on the $20 guarantee, under the general rule A must be liable if any part of the $200 liability goes unpaid. As that is not the case in the example above, the $20 guarantee is a bottom dollar payment obligation; $20 of the debt is treated as nonrecourse debt and is allocated under the rules for nonrecourse debt discussed below.
Consider another example demonstrating the distinction between a guarantee recognized as an obligation under the Regulations and a bottom dollar payment obligation: A, B, and C are equal members of ABC LLC that is classified as a partnership. ABC borrows $1,000 from Bank. A guarantees payment of up to $300 of the ABC liability if any amount of the full $1,000 liability is not recovered by Bank. B guarantees payment of up to $200, but only if Bank otherwise recovers less than $200. Both A and B waive their subrogation rights. Because A is obligated to pay up to $300 if, and to the extent that, any amount of the $1,000 partnership liability is not recovered by Bank, A’s guarantee is not a bottom dollar payment obligation. Therefore, A’s payment obligation is recognized, and the amount of A’s EROL is $300. Because B is obligated to pay up to $200 only if and to the extent that Bank otherwise recovers less than $200 of the $1,000 partnership liability, B’s guarantee is a bottom dollar payment obligation and, therefore, is not recognized. Accordingly, B bears no EROL for ABC’s liability. In sum, $300 of ABC’s liability is allocated to A under Regulation section 1.7522(a), and the remaining $700 liability is allocated to A, B, and C under the rules for allocating nonrecourse debt, discussed below.
d. Indemnities and Reimbursement Obligations. A special rule is provided in the Regulations with respect to indemnities and reimbursement obligations in Regulation section 1.7522(b)(3)(iii). Under this Regulation, an indemnity, reimbursement agreement, or similar arrangement will be recognized only if, before taking into account the indemnity, reimbursement agreement or similar arrangement, the indemnitee’s or other benefited party’s payment obligation is recognized and not treated as a bottom dollar payment obligation.
This Regulation can sometimes lead to surprising results. For example, assume the facts are the same as in the prior example, except that, in addition, C agrees to indemnify A up to $100 that A pays with respect to its guarantee and agrees to indemnify B fully with respect to its guarantee. The determination of whether C’s indemnity is recognized under the Regulations is made without regard to whether C’s indemnity itself causes A’s guarantee not to be recognized. Because A’s obligation would be recognized but for the effect of C’s indemnity and C is obligated to pay A up to the full amount of C’s indemnity if A pays any amount on its guarantee of ABC’s liability, C’s indemnity of A’s guarantee is not a bottom dollar payment obligation under the Regulations and, therefore, is recognized. The amount of C’s EROL under Regulation section 1.7522(b)(1) for its indemnity of A’s guarantee is $100. Because C’s indemnity is recognized, A is treated as liable for $200, i.e., to the extent any amount beyond $100 of the partnership liability is not satisfied. Because A is not liable if, and to the extent, any amount of the partnership liability is not otherwise satisfied, A’s guarantee is a bottom dollar payment obligation, and A bears no EROL under Regulation section 1.7522(b)(1) for ABC’s liability. Because B’s obligation is not recognized independently of C’s indemnity of B’s guarantee, C’s indemnity with regard to B is not recognized either. Therefore, C bears no EROL under Regulation section 1.7522(b)(1) for its indemnity of B’s guarantee. In sum, $100 of ABC’s liability is allocated to C under Regulation section 1.7522(a) and is treated as recourse debt, and the remaining $900 liability is allocated to A, B, and C under the rules for allocating nonrecourse debt.
The second example above illustrates how the Regulations can easily result in a trap for the unwary. In the first example, A has $300 of EROL, but no EROL whatsoever in the second example as a result of another partner taking the first $100 of A’s risk. It may have been the intention of the parties that A and C would split the $300 “top dollar” guarantee, $200 allocated to A and $100 allocated to C. However, even though two partners in the aggregate make a $300 top dollar guarantee, which would be respected if made by one partner, A’s $200 of that EROL is instead completely ignored for debt allocation purposes. It is relatively easy to resolve this problem—just have A and C jointly provide a $300 top dollar guarantee or have C guarantee two-thirds of A’s obligation with both being liable for their respective shares on a top dollar basis. Thus, careful planning is required but, in truth, when it comes to partnership taxation that is true across the board.
There is a de minimis exception for bottom dollar payment obligations. A bottom dollar payment obligation will be recognized as an existing obligation if the partner is liable for at least 90% of the partner’s initial payment obligation. Thus, in the above example, B can have the EROL on the entire $200 guarantee, as long as B is liable up to at least $180 (90% of $200) if any part of the $1,000 debt goes unpaid.
e. Deficit Restoration Obligations. A capital account deficit restoration obligation is not a bottom dollar payment obligation provided the partner is obligated to restore the full amount of the partner’s deficit capital account. This fact leads to a planning opportunity. Assume A and B each contribute $200 to an LLC taxed as a partnership. The partnership plans to borrow an additional $1,600. The partners would prefer for A to be liable first and B only thereafter, but that could create a bottom dollar payment obligation. Instead, A and B can each agree to be liable for their deficit capital account balances. The partnership agreement allocates the first $400 of losses equally, the next $800 of loss to A, and the last $800 of loss to B. The partnership allocates income and gain first to A to reverse losses allocated to A, then to B to reverse losses allocated to B, and then equally to A and B. Since A and B are fully liable for their deficit capital accounts, there are no bottom dollar payment obligations. Yet the economics of this allocation structure is quite similar to what would have occurred if A had given an $800 top dollar guarantee and B had given an $800 bottom dollar guarantee: A is liable for the “top” $800 of loss on the $1,600 loan, and B for the “bottom” $800. There is a bit more risk for B as the deficit restoration obligation applies regardless, even if created by other partnership losses, such as those arising out of tort. But in most contexts, B likely would be willing to take the risk.
4. Anti-Abuse Rule
In 2019, the Regulations also beefed up the anti-abuse rules. Under Regulation section 1.7522(j)(1), an obligation of a partner to make a payment may be disregarded or treated as an obligation of another person if the facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner’s EROL or create the appearance that the partner bears the EROL when, in fact, the substance of the arrangement is otherwise. Regulation section 1.7522(b) deals with obligations to make a payment, and essentially the same rule that is found in Regulation section 1.7522(j)(1) is also found in Regulation section 1.7522(b)(6). In some version, the Regulation section 1.7522(b)(6) rule has been incorporated into the Regulations for some time and played a large role in the seminal 2010 Canal case. But Regulation section 1.7522(j)(1) expands on this general rule.
Partners can effectively shift the EROL with respect to partnership liabilities via many types of contractual arrangements that are not direct payment or contribution obligations. To address this issue, Regulation section 1.7522(j)(2) includes an anti-abuse rule for “arrangements tantamount to a guarantee” and provides that they will be treated as shifting the economic risk of loss under certain circumstances (and typically away from the partner to whom the parties wished to assign EROL). Irrespective of the form of a contractual obligation, a partner is considered to bear the EROL (and not the partner to whom the parties wished to give the EROL) with respect to a partnership liability, or a portion thereof, to the extent that (i) the partner or related person undertakes one or more contractual obligations so that the partnership may obtain or retain a loan; (ii) the contractual obligations of the partner or related person significantly reduces the risk to the lender that the partnership will not satisfy its obligations under the loan, or a portion thereof; and (iii) either (1) one of the principal purposes of using the contractual obligations is to attempt to permit partners (other than those who are directly or indirectly liable for the obligation) to include a portion of the loan in the basis of their partnership interests, or (2) another partner enters into another payment obligation and a principal purpose of the arrangement is to cause the first payment obligation to be disregarded under the general facts and circumstances test of Regulation section 1.7522(b). For example, a lease between a partner and a partnership that is not on commercially reasonable terms may be tantamount to a guarantee by the leasing partner of a partnership liability.
Finally, Regulation section 1.7522(j)(3) contains a rule that an obligation of a partner to make a payment is not recognized if the facts and circumstances evidence a plan to circumvent or avoid the obligation. This limitation, as such, has been in the Regulations for many years. But in 2019, the Regulations added a nonexclusive list of relevant facts and circumstances. Commercial reasonableness dominates these factors. As by now should be apparent, the Regulations should have contained the commercially reasonable standard from the outset, and if they had, many problems would have been avoided. The factors listed in Regulation section 1.7522(j)(3) are as follows: (A) The partner or related person is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment. (B) The partner or related person is not required to provide (either at the time the payment obligation is made or periodically) commercially reasonable documentation regarding the partner’s or related person’s financial condition to the benefited party, including, for example, balance sheets and financial statements. (C) The term of the payment obligation ends prior to the term of the partnership liability, or the partner or related person has a right to terminate its payment obligation, if the purpose of limiting the duration of the payment obligation is to terminate such payment obligation prior to the occurrence of an event or events that increase the risk of economic loss to the guarantor or benefited party. (D) There exists a plan or arrangement in which the primary obligor or any other obligor (or a person related to the obligor) with respect to the partnership liability directly or indirectly holds money or other liquid assets in an amount that exceeds the reasonably foreseeable needs of such obligor (but not taking into account standard commercial insurance (such as, for example, casualty insurance). (E) The payment obligation does not permit the creditor to promptly pursue payment following a payment default on the partnership liability, or other arrangements with respect to the partnership liability or payment obligation otherwise indicate a plan to delay collection. (F) In the case of a guarantee or similar arrangement, the terms of the partnership liability would be substantially the same had the partner or related person not agreed to provide the guarantee (a particularly problematic factor, as I will discuss). (G) The creditor or other party benefiting from the obligation did not receive executed documents with respect to the payment obligation from the partner or related person before, or within a commercially reasonable period of time after, the creation of the obligation.
One should likely not be too focused on any single factor, particularly in light of the fact that the list is not exclusive, not weighted, and not ranked, a problem with these lists generally. Further, it seems unlikely that the Service would attempt to apply Regulation section 1.7522(j)(3) based on the existence of a single factor. That said, factor “F” is problematic. The point, presumably, is that a guarantee has little substance if the terms of the liability would not be affected. But applying this factor would be problematic as it requires a partner to prove what would have happened in an alternative universe where the partner made no such guarantee—an alternate universe that may never have actually existed.
There is an example that in part looks at this factor in the Regulations. It involves very egregious, mostly unrealistic facts, limiting its utility: (i) In 2020, A, B, and C form a domestic limited liability company (LLC) that is classified as a partnership. Also in 2020, LLC receives a loan from a bank. A, B, and C do not bear the EROL with respect to that partnership liability, and, as a result, the liability is treated as nonrecourse in 2020 under Regulation section 1.752–1(a)(2). In 2022, A guarantees the entire amount of the liability. The bank did not request the guarantee and the terms of the loan did not change as a result of the guarantee. A did not provide any executed documents with respect to A’s guarantee to the bank. The bank also did not require any restrictions on asset transfers by A, and no such restrictions exist. The Regulations provide that, under Regulation section 1.752-2(j)(3), A’s 2022 guarantee is not recognized. The example states that the following factors indicate a plan to circumvent or avoid A’s payment obligation: the partner is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment, such as restrictions on transfers for inadequate consideration or equity distributions; the partner is not required to provide (either at the time the payment obligation is made or periodically) commercially reasonable documentation regarding the partner’s or related person’s financial condition to the benefited party; in the case of a guarantee or similar arrangement, the terms of the liability are the same as they would have been without the guarantee; and the creditor did not receive executed documents with respect to the payment obligation from the partner or related person at the time the obligation was created. The example concludes that LLC’s liability continues to be treated as nonrecourse. Importantly, the example does not rely merely on factor F.
It is unclear whether the liability can be bifurcated into a “commercially reasonable” recourse portion and a nonrecourse portion, or whether there is a this-is-an-all-or-nothing “cliff” effect. Thoughtful tax planning may mitigate this problem by limiting a partner’s EROL to that portion of the liability that it is commercially reasonable to believe the partner can pay, while avoiding the prohibition on bottom dollar payment obligations.
C. Definition and Allocation of Nonrecourse Liabilities
The definition of a nonrecourse liability is very simple. It is any liability that is not a recourse liability. Typically, nonrecourse liabilities are secured by one or more assets of the partnership. In the case of LLCs and LLPs that are taxed as partnerships, generally no owner has personal liability for the obligations of the entity. It is possible for an unsecured obligation of the entity to be treated as a nonrecourse liability for section 752 purposes, even though the obligation is nominally recourse to the entity. These hybrid liabilities are sometimes called “exculpatory liabilities.” Exculpatory liabilities are beyond the scope of this Article.
Nonrecourse liabilities are allocated based upon a three-tier “stacking rule” set forth in Regulation section 1.752-3(a). Nonrecourse liabilities are allocated in the following order of priority:
Tier 1: First, there is allocated to the partners their respective shares of partnership “minimum gain.” As noted, minimum gain is the amount by which a nonrecourse debt exceeds the book value of property. For example, if the principal amount of the nonrecourse debt is $1,000 and the book value of the property securing the debt is $800, there is $200 of minimum gain. Normally, minimum gain arises when a partnership has held a property subject to nonrecourse debt for some time, and the book value of the property has been depreciated below the outstanding amount of the debt. Minimum gain plays a key role in the allocations of nonrecourse deductions in Regulation section 1.704-2 (in the main, nonrecourse deductions are deductions attributable to nonrecourse debt).
Tier 2: Second, the nonrecourse liability is allocated to the partners to the extent of their shares of the taxable gain that would be allocated to them under section 704(c) if the partnership disposed of the property that is subject to the nonrecourse liability in satisfaction of that liability and for no other consideration.
While a detailed look at section 704(c) is beyond the scope of this Article, a brief example would be useful: Assume partner A contributes property to a partnership with a fair market value of $1,000, a tax basis of $100, and the property is subject to a nonrecourse debt of $400. There is no minimum gain here, as minimum gain only exists to the extent that the nonrecourse debt exceeds book value. Here book value is $1,000. Under Tier 2, however, $300 of the nonrecourse debt is allocated to partner A (i.e., the amount by which the nonrecourse debt exceeds tax basis, $400 − $100 = $300).
Tier 3: Third, there is allocated to the partners their share of the balance of the nonrecourse liabilities (referred to as “excess nonrecourse liabilities”) in accordance with the partners’ shares of partnership profits.
The partners’ interest in profits is determined by taking into account all of the facts and circumstances relating to the partners’ interests in the partnership. The Regulations, however, allow the partnership agreement to determine the partners’ interest in partnership profits for purpose of allocating excess nonrecourse liabilities under certain specified methods. One is the “significant item method.” A specified profits interest will be respected if it is reasonably consistent with allocations that have “substantial economic effect” of some other significant item of partnership income or gain, typically involving the underlying property. The “substantial economic effect” rules form a safe harbor for allocating loss and deduction to partners under section 704(b) and its Regulations, with which I will not burden the reader. Suffice it to note that an allocation of nonrecourse deductions, as such, cannot have substantial economic effect. But other items associated with a given property may indeed be allocable under the substantial economic effect rules. Nonrecourse deductions consist first of depreciation deductions associated with the underlying property. If nonrecourse deductions are exactly equal to depreciation deductions, then the allocation of any other deductions associated with the property, e.g. interest and maintenance expenses, can have substantial economic effect. This reality gave rise to Tier 3’s significant item method. For example, if allocations of interest and maintenance expenses indeed can have substantial economic effect, a valid Tier 3 allocation of nonrecourse debt would be one that is made in the same way that the partnership allocated interest and maintenance expenses, e.g., an allocation of 10% of the nonrecourse debt to the partner who is allocated 10% of interest and maintenance expenses.
The Regulations also permit excess nonrecourse liabilities to be allocated among the partners in accordance with how the deductions attributable to those nonrecourse liabilities are expected to be allocated (the “alternative method”). Finally, the Regulations permit excess nonrecourse liabilities to first be allocated to a partner to the extent of the built-in gain that is allocable them under section 704(c)(2), if the gain exceeds the gain allocated to that partner in Tier 2 (“the built-in gain method”). If the partnership uses the built-in gain method but is not able to allocate all of the excess nonrecourse liabilities using that method, the balance of the excess nonrecourse liabilities must be allocated using one of the other methods. Excess nonrecourse liabilities are not required to be allocated under the same method each year.
D. Tiered Partnerships
A partnership may own an interest in another partnership. This structure, especially common amongst family businesses, is referred to as tiered partnerships. The partnership that is the partner in another partnership is referred to as the “upper-tier partnership,” and the partnership having a partnership as a partner is referred to as the “lower-tier partnership.” Where there are tiered partnerships, it is necessary to know how the liabilities of the lower-tier partnership will be shared by the partners of the upper-tier partnership.
The general rule is that the upper-tier partnership’s share of the liabilities of the lower-tier partnership is treated as a liability of the upper-tier partnership. Thus, the normal rules may be applied with respect to how the deemed liability of the upper-tier partnership is to be allocated. Consider this very simple example: Partnership AB has two equal partners, A and B. AB is a 10 percent partner in Partnership XYZ, which has nonrecourse debt of $1,000. AB is the upper-tier partnership and XYZ is the lower-tier partnership. Assume 10 percent of that debt, or $100, is properly allocable to AB. AB then allocates the $100 of debt to its partners, presumably $50 each.
E. Regulation Section 1.752-7: Another Anti-Abuse Rule
In an effort to combat certain types of questionable obligations, the Service has issued Regulation section 1.752-7. These Regulations are designed to prevent the acceleration or duplication of loss through the assumption of certain types of obligations. Prior to the promulgation of Regulation section 1.752-7, taxpayers would transfer assets to a partnership and the partnership would assume a contingent liability (such as a potential environmental liability). The taxpayer would take the position that the assumed liability was not a liability for purposes of section 752, thus, the taxpayer was not required to reduce the basis of the taxpayer’s partnership interest by the relevant amount of the liability. The taxpayer would then sell the partnership interest to a third party for an amount which was significantly less than the taxpayer’s basis (because the purchaser would take the liability into account) and claim a loss. When the liability was paid, the partnership would claim a deduction. Thus, the same liability would produce a double deduction. This is yet another example of the challenges liabilities may present in the partnership context. As discussed earlier, it is doubtful that contingent liabilities “count” for section 752 purposes, but Regulation section 1.752-7 also provides an anti-abuse rule in this regard. The specifics of the rule are decidedly complex, and I will not detail them here. But it is worth noting that the Wyden Proposals would tend to reduce the likelihood that fact patterns would trigger Regulation section 1.752-7.
F. Aligning Section 752 with the Rules for Individuals
As noted previously, if an individual borrows money on an unsecured basis and simply keeps it in a bank or similar account, the individual normally receives no tax benefits. Possible tax benefits only arise when the individual either invests the borrowed funds in property or spends them on business expenses. But if a partnership borrows money on the same basis, section 752(a) will allow the partners to receive an increase in their outside bases and possibly associated tax benefits. Thus, if a partner has inadequate basis to take a loss deduction, the partnership can borrow funds and simply deposit them in the bank. As a result, the partner may be able to receive a loss deduction even though the loan otherwise has no business purpose. The anti-abuse provisions in the Regulations list “[holding] money or other liquid assets in an amount that exceeds the reasonably foreseeable needs” of the obligor as a suspect factor. However, the anti-abuse rules are normally not self-executing and again present the question whether a single factor will trigger the anti-abuse provisions. A fix that should not prove too burdensome to implement (either for the Service or taxpayers) is simply to have section 752(a) not apply to unsecured liabilities where the proceeds are either unspent or spent in a way that neither generates basis nor a deductible expense. Section 752 would first apply when the funds are appropriately expended. Tracing rules would be required, but for most taxpayers that should not prove too burdensome. Under this proposal, most secured liabilities would fall under the regular rules. An individual can borrow against a business or investment asset without generating adverse tax consequences, thus the rule should be the same for partnerships. End-arounds where money is borrowed and secured by close cash equivalents such as treasury bills should also fall outside of section 752(a). Making these tweaks to the Regulations should reduce such misuse of debt without necessarily requiring the Service to catch the misuse on an audit as would typically arise under the anti-abuse rule. A disclosure requirement for this type of debt should make enforcement easier.
A somewhat similar system already exists in the nonrecourse debt context, albeit not under the section 752 Regulations, but instead under the section 704(b) Regulations for allocating nonrecourse deductions. As noted, a partner is allocated a share of nonrecourse debt to the extent of that partner’s share of partnership minimum gain. Partnership minimum gain is the excess of nonrecourse debt securing a property over the property’s book value, and a partner shares minimum gain to the extent that the partner is allocated nonrecourse deductions. If the partnership makes an additional nonrecourse borrowing against a given property but does not invest the proceeds in the property, the basis of the property is unaffected. But a partner also shares in minimum gain to the extent a partner is allocated distributions of the proceeds of the nonrecourse borrowing. What if the partnership makes an additional nonrecourse borrowing but neither invests the proceeds in the property nor distributes the proceeds to the partners? In this case, none of the relevant minimum gain is allocated to the partners. It is held in abeyance until either the borrowing proceeds are invested in the property or, more likely, distributed to the partners in a later year.
