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New Final, Temporary, and Proposed Partnership Regulations Impacting Allocation of Liabilities Using Bottom Guarantees and Disguised Sales

February 24, 2017
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Contributor- Brooke Bodziner

Bottom Guarantees
Effective October 5, 2016, new Temporary Regulations were published that disallow the use of ‘bottom dollar obligations’ for purposes of allocating partnership liabilities. The phrase ‘bottom dollar obligation’ or ‘bottom guarantee’ denotes a guarantee made by a partner for the repayment of a partnership’s mortgage liability. What makes this type of guarantee unique is the fact that, the partner’s obligation to pay the liability will only be triggered if the decrease in the value of the property securing the mortgage surpasses a previously agreed upon dollar amount. or percentage of the total liability. A bottom guarantee is used to make sure that there is a sufficient amount of liabilities allocated to a specific partner to “cover” their negative capital account in situations where, absent a bottom guarantee, there would not be enough liabilities allocated to that partner. For example, a partner may guarantee the bottom $4,000,000 of a $20,000,000 mortgage liability, which means that the partner will have to satisfy their guarantee only to the extent that the property is worth less than $4,000,000; $4,000,000 of the mortgage liability would be allocated to that partner as a recourse debt, and the balance of the liability would be allocated to all partners (including the guaranteeing partner) as a non-recourse debt.

In practice, the likelihood of these types of obligations coming due are extremely rare. Therefore, the Treasury Department has issued guidance that, due to the of lack economic risk of loss (EROL) to the partner, these guarantees are to be disregarded for purposes of allocating a partnership’s debts and the debt is treated as a non-recourse liability, notwithstanding the partner’s guarantee.
Disguised Sale Rules
Transactions occurring on, or after January 3, 2017, are subject to recently issued revisions in partnership disguised sale regulations. The majority of the changes made to the existing regulations revise, clarify, and refine the previously issued exceptions, and limitations to these rules. 

The new regulations provide that all partnership liabilities shall be treated as nonrecourse liabilities, solely for purposes of disguised sale rules, and allocated amongst the partners in proportion to their percentage interests in partnership profits. The previously issued temporary regulations, related to the limitation of available allocation methods applicable in determining a partner’s share of excess non-recourse liabilities for disguised sale purposes, have been revised and finalized, with a focus on anti-abuse provisions.

Specific emphasis has been placed on limiting the use of leveraged partnership structures to defer taxable gains by severely restricting the use of ‘leveraged distributions.’  

Previous law provided that, a partner may contribute appreciated property to a partnership without immediate tax, and separately, a partner may receive a distribution of cash tax-free, to the extent of outside basis in the partnership interest. A contemporaneous distribution to the contributing partner may otherwise be treated as taxable but for the contribution by this partner. An exception to this rule under previous tax law is related to a “debt financed distribution,” when the contributing partner receives funds from a third party lender, but only to the extent that the debt is allocated to such partner under the previous allocation rules, or by virtue of a guarantee.

Under the new regulations for Section 707 purposes, a partner’s guarantee, or other similar arrangement, will no longer cause the debt to be allocated solely to the guaranteeing partner. This change in the method of debt allocation will, in effect, cause the proceeds distributed in excess of the partner’s allocable share, to be deemed as a currently taxable sale.