On October 4, 2019, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) issued final regulations (Treasury Decision 9877) (the “Final Regulations”) regarding Internal Revenue Code Section 704 and Section 752, which govern the treatment of bottom dollar obligations in determining a taxpayer’s basis in a partnership interest. These Final Regulations conform to prior proposed regulations issued by Treasury, which generally disallowed the treatment of bottom dollar obligations as recourse liabilities of which the taxpayer had an economic risk of loss.
Background and Definitions
In general, Section 752 allows a partner in a partnership to increase basis in the respective partnership interest (referred to as “outside basis”) by an amount equal to that partner’s share of the liabilities of the partnership.1 Stated simply, if a taxpayer has a 50 percent interest in a general partnership, and the partnership takes on $100,000 of debt, the taxpayer will be able to increase his or her basis in the partnership interest by $50,000 (i.e., the partner’s respective share of the partnership’s $100,000 of liabilities). However, the exact method by which liabilities are allocated is more complex than just looking to a partner’s interest in the partnership.
Recourse Liabilities vs. Nonrecourse Liabilities
First, it is important to determine whether the partner has any personal liability for the debt. Any liability in which the lender can pursue the personal assets of a partner is considered a “recourse liability”.2 Alternatively, debt which is secured only by assets of the partnership and which no partner has individually guaranteed is considered a “nonrecourse liability”.3 Additionally, there is also debt which is originated by certain lenders and secured by real property, which is a “qualified nonrecourse liability”.4 Qualified nonrecourse liabilities are important for purposes of the “At-Risk” rules under Section 465, but for purposes of Section 752, qualified nonrecourse liabilities and nonrecourse liabilities are functionally identical. Importantly, for purposes of this Tax Alert, a single liability can be in part recourse and in part nonrecourse, if a portion of an otherwise nonrecourse liability is personally guaranteed by a partner.
State Law Partnership Liability
In addition to the classification of a liability under its own terms, the form of a partnership under state law can impact the classifications of liabilities. In a general partnership, all partners bear personal responsibility for debts of the partnership. Therefore, unless otherwise specified, liabilities of a general partnership will be recourse to all partners.
Under a limited partnership, the general partner will be personally liable for liabilities of the partnership, but limited partners will generally not bear any personal liability for debts of the partnership. Therefore, loans of the limited partnership will, unless otherwise specified, be recourse only to the general partner.
Finally, in the case of a limited liability company (“LLC”), all members of the LLC will not bear personal responsibility for liabilities of the LLC. Therefore, unless otherwise specified, all liabilities of the LLC will be nonrecourse.
For purposes of this analysis, all references to a “limited partner” indicate a partner with limited liability or an LLC member.
General Application of IRC Section 752
With respect to recourse liabilities, each partner is allocated the liability according to the partner’s “economic risk of loss.”5 In other words, the partner is allocated the amount of the liability that the partner would be obligated to repay if all of the assets (including cash) of the partnership were deemed to be worthless and are sold for nothing, and the liabilities of the partnership become due. Alternatively, nonrecourse liabilities are allocated based on each partner’s share of profits (after first accounting for minimum gain and/or specific allocations of liabilities related to contributed property under Section 704(c)).6
As such, in a partnership where income, expenses, gains, and losses are allocated differently, the character of the liability is essential in determining each partner’s basis in his or her respective partnership interest. Particularly, in the context of a partnership in which losses are specifically allocated to a specific partner, the distinction between recourse and nonrecourse debt can be critical to the overall economics of the deal. Limited partners or members in an LLC will generally not want any risk of loss greater than their investment in the partnership. However, depending on the share of profits and losses of a partnership, and the amount of losses generated by the partnership, a limited partner might need recourse liabilities for which the partner has economic risk of loss to generate sufficient at risk tax basis and avoid having allocated losses suspended due to a lack of at risk basis in the partnership interest.
To address this issue, tax planners developed the bottom dollar obligation (also referred to as a bottom dollar guarantee). The purpose of the bottom dollar obligation was to convert a portion of a nonrecourse liability to recourse so that it could increase the economic risk of loss of certain partners for tax purposes, without creating any substantial risk of loss from an economic perspective. In the case of a bottom dollar obligation, a limited partner enters into an agreement with the partnership or the lender to guarantee or indemnify a certain amount of a nonrecourse liability for which the partner would otherwise not be personally liable. As a result, should the partnership not be able to satisfy the liability in full with only its assets, the limited partner would, by virtue of the guarantee, be obligated to pay the lender (either directly or indirectly) up to the guaranteed amount.
Examples Prior to Accounting for Final Regulations
The following examples illustrate how a limited partner might attempt to generate basis under Section 752 by converting a portion of nonrecourse liabilities to recourse liabilities.
Example 1: Partner A, a limited partner, agrees to guarantee the first $1,000 of a $10,000 nonrecourse loan otherwise not recoverable from the assets of the partnership. If the partnership only held a building worth $9,000 and the liability becomes due, the bank would take the $9,000 building in satisfaction of the debt, and Partner A would owe $1,000 to the bank in satisfaction of the remaining balance of the loan. Even though it is not a given that Partner A will ever be at risk of loss for this amount (e.g., the partnership may typically hold assets in excess of the balance of the loan), under the economic risk of loss test, Partner A would be allocated $1,000 of basis for this loan guarantee.
In Example 1, Partner A has generated $1,000 of tax basis under Section 752, even though it is not guaranteed that the partner would owe that much when the liability becomes due. However, Partner A, as a limited partner, may want to reduce the likelihood that he or she is ever obligated to satisfy the guarantee by limiting the circumstances in which he or she would be obligated to pay.
Example 2: Partner A agrees to guarantee $1,000, but only to the extent the lender collects $1,000 or less from the partnership. Under the economic risk of loss test, in which all the partnership’s assets are deemed worthless and sold, Partner A would be determined to be at risk for $1,000 of the liability and would be allocated that much in basis. However, realistically, Partner A has entered into an agreement under which Partner A will almost certainly never be obligated to pay, as the partnership is unlikely to ever have less than $1,000 of assets on hand with which to satisfy the loan.
Similarly, Partner A could achieve a comparable result by entering into a second agreement with another partner or third-party who agrees to guarantee a certain amount of the Partner A’s original guarantee.
Example 3: Same facts as Example 1, except Partner A enters into an agreement with Partner B, who agrees to indemnify Partner A for the first $300 Partner A would owe under her $1,000 guarantee to the partnership. In this case, Partner A has reduced the actual likelihood he or she will ever owe money under his original guarantee, even though Partner A technically has economic risk of loss for tax purposes.
Bottom Dollar Obligations Under the Final Regulations
The IRS issued the 2016 Proposed Regulations to prohibit the use of a bottom dollar obligation in allocating partnership liabilities. The Final Regulations adopt most of the 2016 Proposed Regulations and confirm bottom dollar obligations are not considered obligations for purposes of Section 752 when allocating partnership liabilities.7
The Final Regulations define a bottom dollar obligation as any guarantee, indemnity, deficit restoration obligation, or similar arrangement, other than one in which the partner (or related person) would be liable up to the full amount of the obligation if, and to the extent, that the partnership liability is not otherwise satisfied.8 Stated succinctly, a guarantee is only not a disregarded bottom dollar obligation if there are no conditions or side agreements that limit the actual amount due under the guarantee to less than its stated amount.
The Final Regulations also hold that a deficit restoration obligation will not be considered in calculating partnership minimum gain (which is used in allocating nonrecourse liabilities) to the extent such deficit restoration obligation is a bottom dollar obligation.9
Final Regulation Effect on Examples
The following demonstrates how Examples 1 through 3, described above, are treated under the Final Regulations.
Example 1:Partner A’s original $1,000 guarantee for any amounts not satisfied by the partnership is not a disregarded bottom dollar obligation. While Partner A is not assured of owing $1,000, Partner A would unconditionally owe up to that full amount if the partnership holds assets less than $10,000 when the note becomes due. However, if factors indicating Partner A had a plan to avoid this obligation, the guarantee could still be disregarded.
Example 2: Partner A’s guarantee to pay $1,000, but only to the extent the lender collects $1,000 or less from the partnership, is a disregarded bottom dollar obligation. Partner A must be liable for up to the full amount of the guarantee if any amount of the partnership’s liability is not otherwise satisfied. As Partner A’s guarantee only applies if the lender is not able to collect more than $1,000 from the partnership, it is probable that Partner A will never have an obligation to pay, even if the partnership cannot fully satisfy the debt with its assets.
Example 3:If Partner B indemnifies Partner A for the first $300 owed under Partner A’s guarantee, then Partner A’s guarantee is a disregarded bottom dollar obligation. Even though Partner A has promised to pay $1,000, Partner A will never be liable for the full amount, as Partner B will indemnify the first $300. It should be noted that Partner B’s indemnification of Partner A is not a disregarded bottom dollar obligation, and Partner B will be able to allocate $300 of the liability to his basis as a recourse obligation.
Exceptions Under the Final Regulations
The Final Regulations provide several exceptions to the bottom dollar obligation definition. First, the Final Regulations do not apply to any liability incurred or assumed prior to October 5, 2016.
Second, and most significantly, so long as a partner 10remains liable for at least 90 percent of the original guaranteed amount, the guarantee will not constitute a bottom dollar obligation.11 Using Example 3 above, if Partner B only indemnified Partner A for $100, rather than $300, Partner A would still owe $900 of the guaranteed $1,000, and the guarantee would therefore fall under this exception. Additionally, the Final Regulations clarify that an obligation is not a bottom dollar obligation merely because a partner’s obligation is limited to a fixed amount, or because a partner’s obligation is stated as a fixed percentage of every dollar of the partnership liability to which such obligation relates.12
This last clarification is critical, as it permits the so called “Vertical Slice Guarantee”. Under the Vertical Slice Guarantee, a partner agrees to repay a fixed percentage of every dollar of the outstanding liability if otherwise uncollected. For example, Partner A could guarantee to repay 10 percent of every dollar of a $10,000 liability not otherwise satisfied by the partnership. Partner A would therefore be deemed to have economic risk of loss of $1,000, as Partner A would owe that amount if all of the partnership’s assets were otherwise worthless.
Anti-Abuse Rules Under the Final Regulations
The Final Regulations also clarify that any contractual obligation may be considered a guarantee even if not legally identified as such and that, conversely, any guarantee may be disregarded if there exists a plan to circumvent or avoid making the payment required under the obligation.13 Factors indicating such a plan to avoid the obligation include: the obligor is not required to provide commercially reasonable documentation regarding its ability to satisfy the obligation; the obligation ends prior to the term of the partnership liability; and the terms of the partnership liability would be substantially identical had the partner not agreed to the guarantee. For example, the guarantee entered into in Example 1 above might be disregarded under the anti-abuse rules if the nonrecourse liability would have been entered into with the same terms without Partner A’s guarantee and such guarantee expires prior to the end of the liabilities full term.
In addition to the rules related to bottom dollar obligations, the Final Regulations provide a modification to one of the general assumptions of Section 752. Generally, in calculating economic risk of loss, it is assumed that all partners (and related persons) will have the economic means to satisfy their obligation.14 Thus, the regulations assume a partner will have the cash available to repay any obligations. In prior iterations of the regulations, an exception was made for disregarded entities, which were presumed to only have the means to satisfy an obligation up to the net value of the assets held by the disregarded entity. The Final Regulations expand on this by creating a broader exception to the presumption that all partners (and related persons) will have the means to satisfy their obligation. If for any partner, regardless of form, there is not a commercially reasonable expectation that the partner (or related person) will be able to satisfy an obligation, then the obligation is disregarded for purposes of Section 752.15 The facts and circumstances considered include factors a third-party creditor would consider when determining whether to grant a loan. For purposes of this rule, a disregarded entity is considered an entity separate from its owner.
Using Example 1 from above, assume Partner A owns an interest in the partnership through a single member LLC which is disregarded for tax purposes, and the LLC guarantees the first $1,000 of liability not otherwise satisfied by the partnership’s assets. Under general tax principals, Partner A would be considered to be a direct partner in the partnership; however, because Partner A owns her interest through an LLC, and because the LLC is the legal guarantor, it is necessary to look to the LLC to determine whether or not the guarantee should be respected. If the LLC holds no assets other than its interest in the partnership, it will never be able to satisfy the obligation under the guarantee. Therefore, even though the guarantee is not otherwise a disregarded bottom dollar obligation, the guarantee would be disregarded because there is not a realistic way the LLC will be able to meet its obligation.16 Note that, if the LLC held $1,000 in cash in addition to its interest in the partnership, this would not be the case.17
Finally, it should be noted that a partner must disclose to the IRS any bottom dollar obligation on Form 8275, regardless of whether or not such obligation is disregarded for purposes of Section 752.18 For example, under Example 3, Partner A would have to disclose the $1,000 guarantee on amounts not satisfied by the partnership if Partner B only indemnified $100, even though such amount is not disregarded under the Final Regulations due to the 90 percent exception.
The Form 8275 must be attached to the partnership’s tax return in the year the bottom dollar obligation is entered into or modified, and must include the following information:
The Final Regulations’ treatment of bottom dollar obligations confirm the recent government guidance as to the treatment of such obligations for the purpose of partnership liabilities allocations. Therefore, partnerships may want to revisit their current treatment and allocation of partnership liabilities. If a partner has claimed recourse liability treatment based on a bottom dollar obligation, such treatment may not afford the partner with the sufficient amount of “at risk” tax basis as the partner initially intended. The absence of sufficient “at risk” tax basis could prohibit the partner from claiming tax losses.
For any questions regarding the Final Regulations, please contact FGMK.
Jeffrey L. Golds
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.
FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For 50 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.
 Treas. Reg. §705-1(a)(6)
 Treas. Reg. §1.752-1(a)(1)
 Treas. Reg. §1.752-1(a)(2)
 Treas. Reg. §1.752-1(a)(2)
 Treas. Reg. §1.752-2(a)
 Treas. Reg. §1.752-3(a)
 Treas. Reg. § 1.752-2(b)(3)(ii)(A)
 Treas. Reg. § 1.752-2(b)(3)(ii)(C)
 Treas. Reg. § 1.704-1(c)(4)(A)
 Treas. Reg. § 1.752-2(l)
 Treas. Reg. § 1.752-2(b)(3)(ii)(B)
 Treas. Reg. § 1.752-2(b)(3)(ii)(C)(2)
 Treas. Reg. § 1.752-2(j)(3)(ii)
 § 1.752-2(b)(6)
 Treas. Reg. § 1.752-2(k)(1)
 See Treas. Reg. § 1.752-2(k)(2)(i) Example 1
 See Treas. Reg. § 1.752-2(k)(2)(i) Example 2
 Treas. Reg. § 1.752-2(b)(3)(ii)(D)