allocation of debt under section 752 howard e. abrams warren distinguished professor, usd school of...

Allocation of Debt Under Section

752Howard E. Abrams

Warren Distinguished Professor, USD School of Lawwww.taxnerds.com

Copyright 2015 by Howard E. Abrams

http://www.taxnerds.com/

Partnership Indebtedness and Outside Basis When a partnership borrows money, inside basis

increases automatically. To maintain equality between aggregate inside and aggregate outside bases, partnership indebtedness must increase outside basis.

Section 752(a) provides “any increase in a partner’s share of the liabilities of a partnership, or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership.”

Partnership Indebtedness and Outside Basis For the purposes of §752, a liability of the

partnership includes any obligation to the extent that incurring the obligation created or increased the basis of the partnership in any of its assets, gave rise to an immediate deductions, or gave rise to a nondeductible, noncapitalizable expenditure. Reg. §1.752-1(a)(4).

Not all partnership obligations are “liabilities.” Examples of obligations that are not liabilities include unaccrued payables and unaccrued OID.

Partnership Indebtedness and Tiered Partnerships Tiered Partnerships- If the owner of a partnership

interest is itself a partnership, indebtedness of the lower-tier partnership will percolate through the upper-tier partnership into the outside basis of the upper-tier partners.

Note: the specific allocation rules under section 752 applicable to the upper tier partnership may differ from those applicable to the lower tier partnership.

Recourse and Nonrecourse Debt A partnership debt is recourse to the extent one or

more partners bears the economic risk associated with the debt if the partnership is unable to pay the debt in full. The extent of the partnership’s liability is irrelevant to this determination.

A partnership debt is nonrecourse to the extent no partner bears the economic risk associated with nonpayment of the debt.

A debt which is in part recourse and in part nonrecourse is bifurcated into two separate debts.

Recourse Debt Allocation

Section 752 attempts to allocate recourse liabilities in accordance with risk of economic loss.

A partner is at risk of economic loss of a partnership liability to the extent the partner would be forced to make a payment to any person (including a contribution to the partnership) as the result of a constructive zero-value sale and liquidation of the partnership. See Reg. §1.752-2(b)(1).

A zero-value sale and liquidation means a liquidation of the partnership after all of its assets, including cash, are worth $0 and are sold for $0. In effect, we see what happens if the debts became due and the partnership has $0 assets.

Presumption of Solvency

In determining a partner’s potential risk of loss from repayment of a partnership liability, it is assumed that all persons will make full payment of their obligations as those obligations come due. Thus, we ask who is required to make a payment and not who will be able to make a payment.

Note: the presumption of solvency is subject to an anti-abuse rule, discussed below.


P and Q each contribute $30 to the PQ general partnership in exchange for 50% of profits and losses. The partnership borrows $40 on a fully recourse basis. How is the debt allocated between P and Q?

P Q

CA OB CA OB

30 30 30 30


The partnership has $100 of book value immediately after the borrowing, and we assume that goes to $0 value and is sold for $0. Putting this book loss in the t-accounts in accordance with the partnership agreement, we get:

P Q

CA OB CA OB

30 30 30 30

-50 -50

-20 --- -20 ---

Recourse Debt Answer

Putting the debt into the outside basis of each partner in proportion to their risk of loss if the partnership is unable to pay its debts yields the following:

P Q

CA OB CA OB

30 30 30 30

0 20 0 20

30 50 30 50

Recourse Debt with Guarantee Suppose partner Q gives a personal guarantee to

the lender promising full repayment. How does this affect allocation of the debt?

P Q

CA OB CA OB

30 30 30 30

0 20 0 20

30 50 30 50

Recourse Debt with Guarantee Suppose partner Q gives a personal guarantee to

the lender promising full repayment. How does this affect allocation of the debt?

It has no effect because Q is subrogated to the rights of the lender.

P Q

CA OB CA OB

30 30 30 30

0 20 0 20

30 50 30 50

Nonrecourse Debt with Guarantee Suppose partner Q gives a personal guarantee to

the lender promising full repayment and the loan is otherwise nonrecourse. How does this affect allocation of the debt?

P Q

CA OB CA OB

30 30 30 30

0 20 0 20

30 50 30 50

Nonrecourse Debt with Guarantee Suppose partner Q gives a personal guarantee to

the lender promising full repayment and the loan is otherwise nonrecourse. How does this affect allocation of the debt?

Now the debt is entirely allocated to Q.

P Q

CA OB CA OB

30 30 30 30

0 0 0 40

30 30 30 70

Complex Recourse Debt Example P and Q each contribute $30 to the PQ general

partnership with P allocated 90% of losses and Q allocated 10% of losses. The partnership borrows $40 on a fully recourse basis. How is the debt allocated between P and Q?

P Q

CA OB CA OB

30 30 30 30

Complex Recourse Debt Analysis The partnership has $100 of book value

immediately after the borrowing, and we assume that goes to $0 value and is sold for $0. Putting this book loss in the t-accounts in accordance with the partnership agreement, we get:

P Q

CA OB CA OB

30 30 30 30

-90 -10

-60 --- 20 ---

Complex Recourse Debt Answer This shows that all of the debt is allocated to P even

though P’s share of loss allocations equals 90%. Putting this result into the t-account yields:

P Q

CA OB CA OB

30 30 30 30

0 40 0 0

30 70 30 30

Recourse Debt with Distribution Reconsider the PQ example where each partner

contributes $30 in exchange for a 50% interest in profits and losses. The partnership then borrows $40 on a fully recourse basis. The books become:

P Q

CA OB CA OB

30 30 30 30

0 20 0 20

30 50 30 50

Recourse Debt with Distribution The partnership now distributes $40 to P. This

reduces P’s capital account and outside basis by the amount of the distribution:

P Q

CA OB CA OB

30 50 30 50

-40 -40 0 0

-10 10 30 50

Recourse Debt with Distribution But we must determine if this distributions works a

reallocation of the debt. The partnership now has only $60 of cash, and if that is sold for zero, the book loss is allocated as follows:

P Q

CA OB CA OB

-10 10 30 50

-30 -30

-40 0

Recourse Debt with Distribution This shows that all of the debt is now allocated to P.

As a result, P’s share of the debt increases from $20 to $40 while Q’s share of the debt declines from $20 to $0. Putting these changes into the t-account yields:

P Q

CA OB CA OB

-10 10 30 50

0 20 0 -20

-10 30 30 30

Recourse Debt with Distribution Notice what has happened: a distribution to P has

caused an outside basis reduction to both partners. On these facts, the outside basis reduction was the same for each partner. Such a result is extremely counterintuitive.

P Q

CA OB CA OB

-10 10 30 50

0 20 0 -20

-10 30 30 30

Dynamic Recourse Debt Example X contributes $10 while Y and Z each contribute

$100 to the XYZ general partnership. Each partner has a one-third share of profits and losses. The partnership borrows $60 on a fully recourse basis. A zero-value sale and liquidation yields a negative capital account only for X, and so X is allocated all of the debt. The books become:

X Y ZCA OB CA OB CA OB

10 10 100 100 100 100

60 0 0

10 70 100 100 100 100

Dynamic Recourse Debt Analysis Suppose the partnership now distributes $70 to X.

That reduces the partnership’s cash down to $200, and a zero-value sale and liquidation will leave only X with a capital account deficit. Accordingly, all of the debt remains with X and the books of the venture become:


10 70 100 100 100 100

-70 -70 0 0 0 0

-60 0 100 100 100 100

Dynamic Recourse Debt Analysis Now suppose that the partnership distributes $80

to Y. That reduces the partnership’s cash down to $120. Prior to any reallocation of the debt, the books become:


-60 0 100 100 100 100

0 0 -80 -80 0 0

-60 0 -20 20 100 100

Dynamic Recourse Debt Analysis Now let’s do a zero-value sale and liquidation. The

partnership has $120 of cash, and assuming that falls in value to zero, each partner is allocated $40 of the loss. After the zero-value sale, the books of the venture become:


-60 0 20 20 100 100

-40 -40 -40

-100 -20 60

Dynamic Recourse Debt Analysis Because the debt is now allocated 5/6’s to X and

1/6 to Y, one-sixth of the debt (that is, $10 of the debt) is shifted to Y. But because X’s outside basis is already zero, that means the cash distribution to Y triggers gain recognition to X.


-60 0 20 20 100 100

0 -10 0 10 0 0

-60 0 -20 30 100 100

Reg. §1.752-2(j)(1): Anti-Abuse Rule “An obligation of a partner or related person to

make a payment may be disregarded or treated as an obligation of another person for purposes of [section 752] if facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the partner’s economic risk of loss with respect to that obligation or create the appearance of the partner or related person bearing the economic risk of loss when, in fact, the substance of the arrangement is otherwise.”

Poorly-Funded IntermediaryRegulation Section1.752-2(j)

X Co.

Y

Partnership Recourse Debt

Owns little butinterest in lower tier partnership.

Sub Co.

Consolidated Group

Poorly-Funded IntermediaryRegulation Section 1.752-2(j)

X Co.

YLLC

X



Disregarded IntermediaryRegulation Section 1.752-2(k)

Y



X LLC

X

Holding a Partnership InterestThrough a Disregarded Entity When a partner interposes a single-member LLC

between himself and the partnership, we must distinguish between the partner for non-tax purposes and the partner for tax purposes.

The partner for non-tax purposes is the single-member LLC.

The partner for tax purposes is the owner of the single-member LLC.

Impact of the DE

Because assets of the owner of the DE cannot be reached by creditors of the partnership (unless those assets are placed into the DE), no share of partnership recourse debt will, in general, be allocable to the owner of the DE under the section 752 rules.

Exceptions Guarantee part of the debt. Place assets into the DE.

Guarantee Entity Debt

Guarantee of the entity-level debt will not work unless the guarantor has no rights of subrogation. That means either that the creditor had no rights against any partner or that rights of subrogation are waived.

Note that if X guarantees repayment of the debt, X not only receives basis under section 752 but also has a deficit restoration obligation.

Assets Owned by the DE

Partnership debt can be allocated to the owner of the DE to the extent of the net fair market value of any assets owned by the DE (excluding the value of the partnership interest itself).

Issues include How to determine the “net value” of the DE. When to determine the “net value” of the DE.

Related Party Debt Rules

New related party debt rules were proposed on December 16, 2013, as Prop. Reg. §1.752-4(b). The following discussion is based on these proposed regulations.


Nonrecourse Loan from Z to XY

P

YX Z

XY



P

YX Z

XY

Guarantee



P

YX Z

XY

Partial Guarantee

Nonrecourse Debt Allocation Partnership nonrecourse liabilities (that is, liabilities

as to which no partner is liable) are allocated in three tiers. Reg. §1.752-3(a).

(1) Minimum Gain Tier: Nonrecourse liabilities are allocated to each partner in an amount equal to each partner’s share of partnership minimum gain. Partnership “minimum gain” equals the excess of the outstanding nonrecourse debt over the book value of the property securing the nonrecourse debt.



(2) Minimum 704(c) Tier: The remaining nonrecourse liabilities are then allocated to each partner in an amount equal to the partner’s §704(c) tax gain (including reverse §704(c) tax gain) that would be recognized if the property were sold for the outstanding liability and no other consideration.



(3) Residual Profits Tier: All remaining nonrecourse liabilities are allocated among the partners in proportion to their profits interests, broadly defined. The partnership is permitted (but not required) to allocate debt under this tier in proportion to any §704(c) gain (including reverse §704(c) gain) not taken into account in tier 2. [I call this the 3A tier.]

Nonrecourse Debt Allocation The Residual Profits Tier [i.e., the 3B tier] can be

allocated in one of three ways

i. According to general profits interests;

ii. In a manner reasonably consistent with other tax items; or

iii. In a manner which reasonably anticipates how nonrecourse deductions will be allocated.

Nonrecourse Debt Allocation It is easiest to visualize the three tier method by

creating the following worksheet for each problem:

X Y Z

T1 + + = T1 total Minimum gain x profit interests

T2 + + = T2 total §704(c) built in tax

gain

T3 + + = T3 total 3A option excess book

up then 3B profits interests

Debt X’s Share + Y’s Share + Z’s Share = Debt

Nonrecourse Debt Example

Assume X contributes $30,000 and Y contributes $10,000 to form the XY general partnership. XY purchases depreciable property for $100,000 by paying $40,000 in cash and signing a nonrecourse note for $60,000. Assume all profit and loss is split equally but the annual depreciation of $10,000 per year is allocated 75% to X and 25% to Y.

Nonrecourse Debt Analysis

X Y

CA OB CA OB

30,000 30,000 10,000 10,000 Contributions

0 30,000 0 30,000 Nonrecourse Debt

30,000 60,000 10,000 40,000 Totals

Asset Book Value Adj. Basis Debt

Property 100,000 100,000 60,000


X Y

CA OB CA OB

30,000 60,000 10,000 40,000 Start of Year 1

-7,500 -7,500 -2,500 -2,500 Depreciation

22,500 52,500 7,500 37,500 End of Year 1


Property 90,000 90,000 60,000


X Y

CA OB CA OB

22,500 52,500 7,500 37,500 Start of Year 2

-22,500 -22,500 -7,500 -7,500 Depreciation Years 2-4

0 30,000 0 30,000 End of Year 4


Property 60,000 60,000 60,000


X Y

CA OB CA OB

0 30,000 0 30,000 Start of Year 5

-7,500 -7,500 -2,500 -2,500 Depreciation Year 5

-7,500 22,500 -2,500 27,500 End of Year 5


Property 50,000 50,000 60,000

Debt Reallocation

X Y Total

Tier 1 7,500 2,500 10,000

Tier 2 0 0 0

Tier 3 25,000 25,000 50,000

Total 32,500 27,500 60,000

Because the debt of $60,000 now exceeds the book value of the property, there is now an allocation under tier 1 of $10,000. There is no tier 2 allocation because there is no book/tax disparity in the property. This table shows that X’s debt share increases to $32,500 (from $30,000) while Y’s debt share decreases to $27,500 (from $30,000).

Debt Reallocation

X Y

CA OB CA OB

-7,500 22,500 -2,500 27,500 Starting Values

0 2,500 0 -2,500 Debt Shift

-7,500 25,000 -2,500 30,000 End of Year 5


Property 50,000 50,000 60,000


X Y

CA OB CA OB

-7,500 25,000 -2,500 25,000 Start of Year 6



Property 0 0 0

Debt Reallocation

X Y Total

Tier 1 45,000 15,000 60,000

Tier 2 0 0 0

Tier 3 0 0 0

Total 45,000 15,000 60,000

This table shows that X’s debt share increases to $45,000 (from $32,500) – an increase of $12,500 -- while Y’s debt share decreases to $15,000 (from $27,500) – a decrease of $12,500.


X Y

CA OB CA OB

-7,500 25,000 -2,500 25,000 Start of Year 6


0 12,500 0 -12,500 Debt Reallocation

-45,000 0 -15,000 0 End of Year 10


Property 0 0 0

Nonrecourse Debt Example

If property encumbered by a nonrecourse debt has a §704(c) book/tax disparity the analysis becomes more complicated.

Assume A and B form a general partnership with A contributing property with an adjusted basis of 4,000 and FMV of 10,000, subject to nonrecourse liability of 6,000, and B contributing 4,000 of cash. They agree to be equal partners except as required by §704(c). The property is ratably depreciable over five years.


A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

[Debt Shift Goes Here]

Asset Book Value

Adj. Basis Debt 704(c) Amount

Property 10,000 4,000 6,000 6,000

Cash 4,000 4,000

Debt Allocation

A B Total

Tier 1 0 0 0

Tier 2 2,000 0 2,000

Tier 3 2,000 2,000 4,000

Total 4,000 2,000 6,000

Using this debt allocation, we see that A’s share of the debt is now $4,000, and that represents a decrease of $2,000. We also see that B’s share of the debt is now $2,000, and that represents an increase of $2,000


A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

0 -2,000 0 2,000 Debt Shift

4,000 2,000 4,000 6,000 Totals

Asset Book Value


Property 10,000 4,000 6,000 6,000

Cash 4,000 4,000

Debt Allocation

A B Total

Tier 1 0 0 0

Tier 2 2,000 0 2,000

Tier 3 2,000 2,000 4,000

Total 4,000 2,000 6,000

This analysis ignores the allowable tier 3A. That is, we picked up only $2,000 of the $6,000 built-in gain under tier 2 because that is the amount of tax gain without book gain that would be recognized if the property were sold for the debt (of $6,000). But if the property were sold for its book value of $10,000, there would be a 704(c) amount of $6,000, and under tier 3A we can allocate debt to A to the extent of the 704(c) gain not captured by tier 2.

Debt Reallocation

A B Total

Tier 1 0 0 0

Tier 2 2,000 0 2,000

Tier 3 4,000 0 4,000

Total 6,000 0 6,000

Taking advantage of the tier 3A alternative gives this as an initial debt allocation, for no debt shift.

Tier 2 Detailed analysis

There are in fact other debt allocations on these facts. To see this, let us compute the tier 2 allocation by actually computing the book gain (or loss) and the tax gain (or loss) that would arise if the property were sold for the debt and nothing else. Once that is done, we will allocate those gains (and losses) among the partners in accordance with the partnership agreement and put them into the t-accounts. The tier 2 allocation is the tax gain without matching book gain allocated to A from this computation.

Tier 2 Detailed Analysis

Book Gain (Loss) Tax Gain (Loss)

6,000 6,000

10,000 4,000

-4,000 2,000

This chart shows that if the property were sold for the amount of the debt and nothing else, there would be a book loss of $4,000 and a tax gain of $2,000. The book loss is allocated between equally between the partners as per the partnership agreement, and the tax gain is allocated to the contributing partner (that is, to A). This creates a ceiling limitation problem.


A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

-2,000 -2,000 Book Loss

First, we put in the book loss following the partnership agreement (always subject to the requirement of substantial economic effect).


A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

-2,000 -2,000 Book Loss

2,000 0 Tax Gain

Next, we put in the tax gain, a 704(c) amount because it is a tax item without a corresponding book item. This shows why we allocated $2,000 of the debt to A under tier 2. But this analysis tacitly assumes we were not using the remedial allocation method. Let’s redo the analysis assuming we use remedial allocations.

This is the tier 2 amount.


A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

-2,000 -2,000 Book Loss

2,000 0 Tax Gain

-2,000 Remedial Allocation

First, we remedy the book/tax disparity for the noncontributing partner (that is, to B) caused by the ceiling limitation. Here, that requires we give B a $2,000 ordinary deduction.


A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

-2,000 -2,000 Book Loss

2,000 0 Tax Gain


2,000 Remedial Allocation

Next, we give the same dollar amount with the opposite sign to the contributing partner (that is, to A). Thus, A must report an additional $2,000 of ordinary income.


A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

-2,000 -2,000 Book Loss

2,000 0 Tax Gain


2,000 Remedial Allocation

Now, the tier 2 amount to A is $4,000, $2,000 plus $2,000.These are now the tier 2 amounts.

Remedial Allocations; No Tier 3A

A B Total

Tier 1 0 0 0

Tier 2 4,000 0 4,000

Tier 3 1,000 1,000 2,000

Total 5,000 1,000 6,000

This chart shows the debt allocation if the partnership elects not to use tier 3A (excess 704(c) gain). A’s debt share declines from $6,000 to $5,000 while B’s debt share increases from $0 to $1,000.

Remedial Allocations; No Tier 3A

A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

0 -1,000 0 1,000 Debt Shift

4,000 3,000 4,000 5,000 Totals

Asset Book Value


Property 10,000 4,000 6,000 6,000

Cash 4,000 4,000

Remedial Allocations; Tier 3A

A B Total

Tier 1 0 0 0

Tier 2 4,000 0 4,000

Tier 3 2,000 0 2,000

Total 6,000 0 6,000

This chart shows the debt allocation of the partnership elects to use tier 3A (excess 704(c) gain). A’s debt share remains at $6,000 while B’s debt share remains at $0.

Remedial Allocations; Tier 3A

A B

CA OB CA OB

4,000 4,000 4,000 4,000 Contributions

0 0 0 0 No Debt Shift

4,000 4,000 4,000 4,000 Totals

Asset Book Value


Property 10,000 4,000 6,000 6,000

Cash 4,000 4,000

Depreciation

Let’s continue this example one more year, putting depreciation into the books. We will start with the books as they appear immediately after the borrowing, assuming the remedial allocation method was not used and we elected to skip tier 3A. Putting the current debt allocation into the top of the chart for convenience, the books were:

No Remedials, No Tier 3A

A (4,000) B (2,000)

CA OB CA OB

4,000 2,000 4,000 6,000 Starting Value

Asset Book Value


Property 10,000 4,000 6,000 6,000

Cash 4,000 4,000


A (4,000) B (2,000)

CA OB CA OB

4,000 2,000 4,000 6,000 Starting Value

-1,000 0 -1,000 -800 Depreciation


Asset Book Value


Property 8,000 3,200 6,000 4,800

Cash 4,000 4,000


A B Total

Tier 1 0 0 0

Tier 2 2,800 0 2,800

Tier 3 1,600 1,600 3,200

Total 4,400 1,600 6,000


A (4,000) B (2,000)

CA OB CA OB

4,000 2,000 4,000 6,000 Starting Value

-1,000 0 -1,000 -800 Depreciation (corrected)

0 400 0 -400 Debt Shift Goes Here

3,000 2,400 3,000 4,800 After Year 1

Asset Book Value


Property 8,000 3,200 6,000 6,000

Cash 4,000 4,000

Final Problem

X and Y are equal partners in the XY general partnership with capital accounts and outside basis of $3,000 each. Z joins by contributing machinery to the partnership in exchange for a 25-percent interest in profits and losses. At the time of Z’s admission, the machinery has an adjusted basis to Z of $15,000, a fair market value of $20,000, and is encumbered by an $18,000 nonrecourse debt. The partnership’s only other asset is $6,000 in cash. In the first taxable year after Z joins, the partnership is entitled to a $6,000 tax depreciation deduction from the machinery. What are the partners’ outside bases?

Start

X (0) Y (0) Z (18,000)

CA OB CA OB CA OB

3,000 3,000 3,000 3,000 2,000 15,000 Starting Values


Asset Book Value


Property 20,000 15,000 18,000 5,000

Cash 6,000 6,000

Final Problem: Z Joins

X Y Z Total

Tier 1 0 0 0 0

Tier 2 0 0 3,000 3,000

Tier 3 5,625 5,625 3,750 15,000

Total 5,625 5,625 6,750 18,000

X Y Z

CA OB CA OB CA OB

3,000 3,000 3,000 3,000 2,000 15,000 Starting Values

0 5,625 0 5,625 0 -11,250 Debt Shift

3,000 8,625 3,000 8,625 2,000 3,750 After Z Joins

Depreciation

X (5,625) Y (5,625) Z (3,750)

CA OB CA OB CA OB

3,000 8,625 3,000 8,625 2,000 3,750 Starting Values

-3,000 -3,000 -2,000 Book Depreciation

0 -3,000 0 -3,000 0 0 Tax Depreciation

0 5,625 0 5,625 0 3,750

Asset Book Value


Property 12,000 9,000 18,000 3,000

Cash 6,000 6,000

Final Problem: Z Joins

X Y Z Total

Tier 1 2,250 2,250 1,500 6,000

Tier 2 0 0 3,000 3,000

Tier 3 3,375 3,375 2,250 9,000

Total 5,625 5,625 6,750 18,000

X (5,625) Y (5,625) Z (3,750)

CA OB CA OB CA OB

0 5,625 0 5,625 0 3,750 Starting Values

0 0 0 0 0 0 Debt Does Not Shift!

0 5,625 0 5,625 0 3,750 After Depreciation

Allocation of Debt Under Section

752Howard E. Abrams

Warren Distinguished Professor, USD School of Law

allocation of debt under section 752 howard e. abrams warren distinguished professor, usd school of...

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