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PARTNERSHIP LIABILITY SHARING PURSUANT TO INTERNAL REVENUE CODE SECTION 752

Michael W. Hurwitz, CPA, MSTJune 23, 2016

• Recognize why it is important to determine a partner’s share of partnership liabilities

• Recognize how a partner’s share of liabilities affect the partner’s outside basis

• Allocate recourse and nonrecourse liabilities among the partners

• Recognize how partner loans and guarantees affect the allocation of liabilities

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OBJECTIVES

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WHEN MUST YOU DETERMINE A PARTNER’S SHARE OF DEBT?

• When there’s a need to know the partner’s outside basis (generally, at the end of the partnerships tax year)

• When a partnership interest is sold

• Special allocations

• When preparing the partnership tax returns (reported on the partner Schedule K-1’s)

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WHY IS IT IMPORTANT TO DETERMINE A PARTNER’S SHARE OF DEBT?

Partner gets additional tax basis in the partnership (outside basis) to deduct losses (will certain limitations – IRC Sections 465 and 469) allocated or to

receive tax-free / deferred distributions

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WHAT IS A LIABILITY?

• The creation of, or increase in, the basis of any of the obligor's assets (real estate)

• A deduction taken into account in computing taxable income of the obligation (accrued office supplies)

• A nondeductible, noncapitalizable expenditure (accrued interest payable to a cash method tax partners or accrued penalties)

• Creditors claims to your assets

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GENERAL PRINCIPLES FOR LIABILITIES

• Pursuant to Section 752(a), an assumption of a partnership liability by a partner or an increase in a partner’s share of partnership liabilities is treated as a contribution of cash, there upon increasing the tax basis in the partnership interest

• Pursuant to Section 752(b), an assumption of a partner’s liability by a partnership or a decrease in a partner’s share of partnership liabilities is treated as a distribution of cash, there upon decreasing the tax basis in the partnership interest

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GENERAL PRINCIPLES - EXAMPLE

M and J purchase land for $100,000 with 20% down by splitting the down payment; afterwards M and J decide to form a 50/50 partnership and each contribute their equal parcels of land (TIC interests). The newly formed M&J LLC assumes the $80,000 liability.

What is the effect of this transaction on each of the partner’s outside basis / basis in the partner’s interest?

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GENERAL PRINCIPLES - SOLUTION

The balance sheet of the M&J LLC immediately after formation would be:

Land $100,000Debt $80,000Partners Capital $20,000

The partner’s tax capital and outside basis in the M&J LLC immediately after formation would be:

Basis of assets contributed $50,000Assumption of debt (752b) <40,000>Partners tax capital $10,000Share of partnership debt (752a) 40,000Partners outside basis $50,000

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GENERAL PRINCIPLES - EXAMPLE

M and J form a general partnership. Partner M contributes real estate worth $20,000 which has a tax basis of $15,000 and is encumbered by a $10,000 liability (net equity of $10,000). Partner J contributes $10,000 in cash. Assume each partners share of the liability after the contribution is $5,000.

What would the balance sheet look like after the contribution and further, show the effects on the partners tax capital accounts and outside basis in

the M and J Partnership?

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GENERAL PRINCIPLES - SOLUTION

The balance sheet of the M&J Partnership immediately after formation would be:

Cash $10,000Real Estate $15,000Debt $10,000Tax Capital $15,000

M&J’s tax capital accounts are not the same however, their 704(b) capital accounts are the same!

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SOLUTION (CONTINUED)

Partner M’s tax capital and outside basis in the M&J Partnership immediately after formation would be:Basis of assets contributed $15,000Assumption of debt (752b) <10,000>Partners tax capital: $ 5,000Share of partnership debt (752a) 5,000Partners outside basis: $10,000

Partner J’s tax capital and outside basis in the M&J Partnership immediately after formation would be:Basis of assets contributed $10,000Assumption of debt (752b) < None >Partners tax capital: $10,000Share of partnership debt (752a) 5,000Partners outside basis: $15,000

• Recourse Liabilities• Nonrecourse Liabilities• Partner Nonrecourse Liabilities

Let’s thinks about these types of debts as they relate to general partnership’s, limited partnership and limited liability company’s

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TYPES OF DEBT

Recourse LiabilityTreasury Regulations 1.752-1(a)(1)

A recourse liability is any liability for which any partner or person related to a partner bears the economic risk of loss for the liability!

Nonrecourse LiabilityTreasury Regulations 1.752-1(a)(2)

A nonrecourse liability is any liability for which no partner or person related to a partner bears the economic risk of loss for the liability

A partner nonrecourse liabilityis a liability which on its facts is a nonrecourse liability; however, there is at least one partner who bears the economic risk of loss with respect to that liability!

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TYPES OF LIABILITIES (CONTINUED)

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QUALIFIED NONRECOURSE DEBT

• Must be secured by the real property used in the activity• Must be borrowed with respect to the real property• Must be nonrecourse to all of the partners• Cannot be convertible into an equity interest• Must be loaned by a qualified lender or guaranteed by the government

QNRD provides individuals with additional at-risk basis[IRC Section 465]

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SHARING OF RECOURSE LIABILITIES

A partner’s share of a recourse liability equals the portion of that liability, if any, for which the partner or related person bears the economic risk of loss

Generally, a partner bears the economic risk of loss if in a constructive liquidation the partner or related person would be obligated with respect to the liability to make a payment to any person or a contribution to the partnership

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CONSTRUCTIVE LIQUIDATION

• All partnership liabilities become payable in full and further, all partnership assets including cash deemed to have zero value

• The partnership disposes of all property in a fully taxable transaction for no consideration except relief of nonrecourse debt

• All items of income, gain, loss or deduction are allocated among partners and the partnership liquidate

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OTHER FACTORS AFFECTING ECONOMIC RISK OF LOSS

To the extent which a partner:• Guarantees the repayment of the liability

• Furnishes assets to secure the repayment of the liability

• Indemnifies other partners

• Is allocated losses or has an obligation to restore any deficit balance pursuant to the partnership agreement

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REIMBURSEMENTS

• Subrogation rights

• Reimbursements from another partner or someone related to the partner

Note: it is assumed that a partner will pay regardless of that partners net worth or ability to pay.

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RECOURSE DEBT - EXAMPLE

M and J form a 50:50 general partnership. M and J contribute $20,000 and $10,000 in cash, respectively and they agree to share all items of income, gain, loss, deductions and credits equally. The partnership borrows $70,000 and purchases real estate for $90,000; leaving $10,000 in cash reserve.

The partnership’s agreement satisfies all of the requirements of the basic test for economic effect and each partner has an unlimited DRO.

Applying the rules of a constructive liquidation pursuant to Treasury Regulations 1.752-2(b)(1), determine each partners share of the $70,000

liability?

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RECOURSE DEBT - SOLUTION

1. The $70K mortgage become due and payable

2. The partnership property is assumed worthless

3. The assets are deemed to be disposed of for no consideration resulting in a $100K loss

4. The loss is allocated to the partners according to the partnership agreement

5. The partnership liquidates

6. The debt is repaid with the cash contributed by the partners as a result of the unlimited deficit restoration obligation

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SHARING ON NONRECOURSE LIABILITIESTREASURY REGULATIONS 1.752-3(A)

Partner’s share of:1. Partnership’s 704(b) gain 2. Partnership’s 704(c) gain - *3. Partnership’s “excess nonrecourse liabilities”

Note * – the lesser of the partnership’s 704(c) minimum gain or the partner’s remaining 704(c) built-in-gain

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SHARING OF EXCESS NONRECOURSE LIABILITIES

• Generally based on share of partnership profits based upon all the facts and circumstances

• Can be allocated first to any of the remaining 704(c) gain

• Can be allocated in accordance with the manner in which it is expected that future deductions attributable to nonrecourse debt will be allocated

• Can specify Tier III nonrecourse sharing in the partnership agreement provided that it is reasonably consistent with another significant allocation that has substantial economic effect

• Tier III nonrecourse sharing method can be changed from year to year – very flexible

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NONRECOURSE DEBT - EXAMPLE

M and J form a 50:50 partnership. M contributes $80,000 in cash. J contributes land with an adjusted basis of $40,000, a fair market value of $150,000 and is subject to a mortgage in the amount of $70,000 (secured by the land only). The partnerships agreement satisfies all of the requirements of the basic test for economic effect.

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NONRECOURSE DEBT - SOLUTION

Book-704(b) TaxCash $ 80,000 $80,000Land $150,000 $40,000 ($110,000 = built-in-gain)

[704(b) MG] [704(c) MG]NR Debt $ 70,000 $70,000Capital M $ 80,000 $80,000Capital J $ 80,000 $<30,000>

How with the nonrecourse debt be shared by the partners if the excess nonrecourse liabilities will be shared by the partner’s profit-sharing ratio?

M JTier I $ 0 $ 0

Tier II $ 0 $30,000Tier III $20,000 $20,000

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NONRECOURSE DEBT – SOLUTION (CONTINUED)

How with the nonrecourse debt be shared by the partners if the excess nonrecourse liabilities will be shared if the remaining 704(c) built-in-gain is taken into account in determining Tier III allocations?

MJ

Tier I $ 0 $ 0Tier II $ 0 $30,000Tier III $ 0 $40,000

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NONRECOURSE DEBT – EXAMPLE

Same facts as previous example but, now assume the partnership repays $30,000 of the outstanding debt balance before year end. Again, the partnerships agreement satisfies all of the requirements of the basic test for economic effect.

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NONRECOURSE DEBT – SOLUTION (CONTINUED)

Book-704b TaxCash $ 50,000 $50,000Land $150,000 $40,000 ($110,000 = built-in-gain)

[704(b) MG] [704(c) MG]NR Debt $ 40,000 $40,000Capital M $ 80,000 $80,000Capital J $ 80,000 $<30,000>How with the nonrecourse debt be shared by the partners if the excess nonrecourse liabilities will be shared by the partner’s profit-sharing ratio (50:50)?

M JTier I $ 0 $ 0Tier II $ 0 $ 0Tier III $20,000 $20,000 - *Note * – J will recognize $10,000 of recognized gain; IRC Section 731 gain!

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NONRECOURSE DEBT – SOLUTION (CONTINUED)

How with the nonrecourse debt be shared by the partners if the excess nonrecourse liabilities will be shared if the remaining 704c built-in-gain is taken into account in determining Tier III allocations?

MJ

Tier I $ 0 $ 0Tier II $ 0 $ 0Tier III $ 0 $40,000 - *Note * - J avoids a recognized gain by specially allocating debt!

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PARTNER NONRECOURSE LIABILITIESTREASURY REGULATIONS 1.752-2(C)&(D)

• Partner-lender

• Partner-guarantor (of what would otherwise constitute a nonrecourse debt)

• This type of debt is allocated to the grantor-partner; treated as recourse to the partner

• De-minimis exception: if partners interest is less than 10% for all years

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OTHER CONSIDERATIONS

• Partner guarantees: top-dollar v. bottom-dollar guarantees / anti- abuse rules

• Related persons: Section 267(b) and 707(b)(1) rules apply except 80% is substituted for 50%, brother and sisters are not considered family and special rules apply when one person is related to more than one partner – also applies to partner-controlled lenders

• Tiered partnerships: lower tier debt

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LIABILITY SHARING RULES SUMMARY

• Recourse Debt = Constructive Liquidation

• Nonrecourse Debt = Three-Tiered Analysis

• Partner Nonrecourse Debt = Allocate to partner bearing the economic risk of loss

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QUESTIONS – COMMENTS – 1.800.ASK.MIKEOR EXT. 2230

THANK YOU AND HAPPY FILINGS