IRS Issues Regulations on Disguised Sale Rules and Allocation of Partnership Liabilities: The Regulations Essentially End Leveraged Partnership Contribution Transactions and Affect the Tax Consequences of Other Partnership Transactions

Sullivan & Cromwell LLP - October 11, 2016

The Treasury Department and the Internal Revenue Service (the “IRS”) recently issued final, temporary and proposed regulations (the “Final Regulations,” the “Temporary Regulations” and the “New Proposed Regulations,” respectively, and collectively, the “new regulations”) that change the partnership disguised sale rules and the rules regarding allocation of partnership liabilities.

Significantly, the Temporary Regulations effectively treat all partnership liabilities (with limited exceptions) as nonrecourse liabilities for disguised sale purposes.  This change significantly limits a contributing partner’s ability to be allocated a disproportionate share of a partnership’s debt, thereby limiting the opportunity for such partner to receive tax-free cash distributions from a partnership related to a contribution of appreciated property.  The Final Regulations also expand several exceptions to the disguised sale rules and clarify many aspects of the disguised sale rules where there had previously been uncertainty.

In addition, the new regulations affect the allocation of partnership liabilities outside of the disguised sale context.  In particular, (i) the Temporary and New Proposed Regulations do not recognize “non-commercial” guarantees and similar arrangements (including so-called “bottom-dollar” guarantees), and (ii) the New Proposed Regulations would add and expand an anti-abuse rule that would limit when a partner’s guarantee of a partnership’s liability would be respected for purposes of treating such liability as recourse to the partner.