| ||Exculpatory Liabilities and Partnership Nonrecourse Allocations |
Karen C. Burke*
*Warren Distinguished Professor, University of San Diego School of Law; Smith College, B.A. 1972; Harvard University, M.A. 1975; Ph.D. 1979; Stanford Law School, J.D. 1982. The author acknowledges generous research support from the University of San Diego School of Law.
The rise of limited liability companies (LLCs) classified as partnerships for federal income tax purposes challenges traditional assumptions concerning the treatment of recourse and nonrecourse liabilities under Subchapter K. The complex rules of sections 704(b) and 752 give little attention to liabilities that are recourse to the entity under section 1001 but for which no member bears the economic risk of loss under section 752. In comparison to traditional general or limited partnerships, however, LLCs are much more likely to incur such "exculpatory" liabilities because of the limited liability shield under state law. Under the existing regulations for section 704(b) and 752 (the "section 704(b)/752 regulations"), the classification of liabilities as either recourse or nonrecourse is essential for purposes of allocating basis and deductions attributable to such liabilities. Although exculpatory liabilities are functionally quite similar to traditional nonrecourse liabilities secured by all of an LLC's assets, literal application of the section 704(b)/752 regulations with respect to such liabilities is fraught with difficulties.
Under these regulations, the allocation of tax items attributable to nonrecourse liabilities is extraordinarily permissive: since no partner bears the economic risk of loss attributable to such liabilities, the corresponding deductions may be allocated in virtually any manner the parties desire. Upon disposition of the underlying property, however, the partners who received such deductions must be allocated offsetting gain and income to restore any capital account deficits, thereby vindicating the earlier loss allocations. The underlying premise of the nonrecourse allocation rules is that it is possible to identify the partnership's nonrecourse liabilities and track the deductions generated by such liabilities for purposes of allocating the corresponding basis and losses. Because of their hybrid nature as recourse liabilities for purposes of section 1001 and nonrecourse liabilities for purposes of section 752, exculpatory liabilities challenge the basic premises of this somewhat oversimplified description of the nonrecourse allocation rules. Indeed, as two recent articles demonstrate, the uncertainty and lack of consensus concerning the treatment of exculpatory liabilities within the framework of the section 704(b)/752 regulations is quite remarkable.
This article seeks to disentangle the treatment of exculpatory liabilities under the nonrecourse allocation rules and suggests several needed reforms. Part II concludes that an exculpatory liability should be treated similarly to a traditional nonrecourse liability for purposes of determining economic risk of loss upon a constructive liquidation. Part III argues that the mechanical provisions of the nonrecourse allocation rules can be properly applied to exculpatory liabilities once it is clearly understood that the nonrecourse standard of sections 704(b) and 752 diverges fundamentally from the nonrecourse standard of section 1001. Part IV discusses related problems that arise because exculpatory liabilities are secured not by particular assets but rather by all of an LLCÕs assets. Finally, Part V suggests that the section 704(b) regulations should be amended to harmonize the treatment of guaranteed recourse liabilities of an LLC (or recourse loans from an LLC member) and functionally similar guaranteed nonrecourse liabilities of an LLC (or nonrecourse loans from an LLC member).
While clarifying these issues is necessary to provide certainty in the tax treatment of exculpatory liabilities, this article also suggests the need to rethink the nonrecourse definition under sections 704(b), 752, and 1001. Upon a disposition of property encumbered by liabilities in excess of fair market value, the section 1001 regulations draw a distinction between recourse and nonrecourse liabilities; the latter generate section 1001 gain through relief from the underlying liability, while the former generate a combination of section 1001 gain (or loss) and ordinary income from discharge of indebtedness.10 Although the conceptual model underlying the section 704(b)/752 regulations is derived from section 1001 and Tufts v. Commissioner, the drafters failed to clearly articulate and rationalize the manner in which the nonrecourse allocation rules deviate from the section 1001 standard. Consequently, uncertainty persists concerning the precise boundaries between the nonrecourse definitions of sections 704(b), 752, and 1001. Ultimately, such uncertainty can be dispelled only if the section 704(b)/752 regulations construct a theory of nonrecourse allocations that is explicitly independent of the section 1001 standard.