IRS Issues Proposed Regulations on Allocation of Partnership Liabilities and Disguised Sales Rules: The Proposed Regulations, If Adopted, Would Affect the Tax Consequences of Many Transactions Involving Partners and Partnerships

Sullivan & Cromwell LLP - February 4, 2014

On January 29, 2014, the IRS and Treasury Department issued proposed regulations (the “Proposed Regulations”) that would amend (i) the rules regarding allocation of partnership liabilities and (ii) the partnership disguised sales rules.

Under the liability allocation rules set forth in the Proposed Regulations:

  • non-commercial guarantees and similar arrangements (including so-called “bottom-dollar” guarantees) would not be recognized;
  • a partnership would be permitted to allocate recourse liabilities to a partner, other than an individual or estate, only to the extent of the partner’s “net value,” determined without regard to the partner’s interest in the partnership;
  • a partner would not be considered to bear economic risk of loss for a liability if the partner has a right of reimbursement from any person, including unrelated parties; and
  • partnerships would have less flexibility in allocating “excess nonrecourse liabilities,” which generally would be required to be allocated based on the partners’ “liquidation value percentages.”

These rules would apply prospectively from the date that the Proposed Regulations are finalized, except that a partnership would be permitted to apply the final regulations retroactively to the beginning of the taxable year that includes such date. Moreover, the Proposed Regulations contain a limited seven-year transition rule, under which partners with so-called “negative basis” (i.e., a share of partnership liabilities in excess of the partner’s basis in its partnership interest) could continue to apply the current rules for seven years.

In addition, for purposes of the disguised sales rules, the Proposed Regulations would add a new category of “qualified liabilities” for liabilities incurred in connection with a trade or business transferred to a partnership and not in anticipation of the transfer, without a requirement that the liabilities encumber transferred property. The Proposed Regulations would also clarify many aspects of the disguised sales rules where there had previously been uncertainty. These rules would only apply prospectively from the date that the Proposed Regulations are finalized.