Warren Distinguished Professor University of San Diego School of Law Partnership Update Howard E. Abrams Warren Distinguished Professor University of San Diego School of Law www.taxnerds.com www.taxllc.com

Topics 1. October 5, 2016 Regulations A. Section 752 B. Disguised Sales 2. Section 751(b) Proposed Regulations

Section 752: Bottom Dollar Guarantees A “bottom dollar payment obligation” is a guarantee, indemnity or similar arrangement in which a partner’s payment obligation is not triggered by the first dollar of loss. With one exception, such a bottom dollar payment obligation is ignored for determining economic risk of loss under the recourse debt regulations. Exception: A bottom dollar indemnity will be recognized as shifting the economic risk of loss if it covers at least 90% of the indemnitee’s payment obligation.

Examples A guarantee of otherwise nonrecourse debt of $100,000 that is triggered only if the lender loses more than $40,000 is a bottom dollar payment obligation of $60,000 and is not recognized. A guarantee of an otherwise nonrecourse debt of $100,000 that is limited to a maximum of $60,000 is recognized if the lender can go after the guarantor if the partnership fails to pay the debt in any amount. A vertical slice guarantee or indemnity is recognized.

Examples (90% Limitation) Suppose partner X guarantees an otherwise nonrecourse debt of $100,000 in its entirety. Partner Y agrees to indemnify partner X if X is forced to pay more than $10,000 on the guarantee. This indemnity is recognized despite being a bottom dollar guarantee because it covers 90% of X’s payment obligation. As a result, economic risk of loss is borne 10% by X and 90% by Y. Surprisingly, a 90% bottom guarantee that runs directly to the lender (rather than an indemnification benefitting another partner) does not qualify for the 90% exception.

Example (Multiple Liabilities) LLC borrows $400,000 on a nonrecourse basis, with the debt guaranteed by partner P. As part of the same “plan, transaction, or arrangement,” LLC also borrows $600,000, guaranteed by partner Q. Assume the $600,000 loan is subordinate to the $400,000 loan. On these facts, the loans will be treated as a single, $1,000,000 obligation, and P’s payment obligation is an unrecognized bottom dollar payment obligation (because P has guaranteed the senior loan). As a result, the $600,000 obligation is allocated to Q under the recourse debt rules with the $400,000 loan allocated among the partners under the nonrecourse debt rules.

Effective Date Partnership debts incurred after October 5, 2016, are covered by the new rules. Partnership debts incurred prior to October 5, 2016, are covered under the prior rules unless and until the debt is refinanced or modified after October 5, 2016. If such a debt is refinanced or modified after October 5, 2016, and prior to October 5, 2019, so much of the debt as equals the “Transition Partner’s” share of the debt in excess of the Transition Partner’s outside basis as of October 5, 2016, is covered under the old rules for up to 7 years from the date of refinancing or modification.

Disguised Sales The most important changes to the disguised sales regulations are: The transferor’s risk of loss is ignored in allocating the debt; and Debt treated as nonrecourse is allocated for disguised sale purposes in accordance with each partner’s share of partnership profits, determined by taking account of all facts and circumstances. Technical changes were made to the exception for reimbursement of preformation expenditures. The anti-abuse rule for anticipated reductions of liabilities was modified, capturing anticipated reductions not subject to entrepreneurial risks of the partnership.

Example 1: Facts Individual T contributes property to a partnership in exchange for a 50% partnership interest. The property has adjusted basis of $40,000, fair market value of $100,000, and is encumbered by a debt of $60,000 that is fully recourse as to T. The liability is not a “qualified liability.” The partnership takes the property subject to the debt but does not assume it, and T remains fully liable for repayment of the debt.

Example 1: Analysis T must recognize $18,000 of gain, computed as follows: No partner other than T has any economic risk of loss from the property. Accordingly, the entire debt is allocated using partnership profit shares, here 50%/50%. Accordingly, one-half of the $60,000, or $30,000, is treated as shifting to other partners and so constitutes an amount realized. Because this represents 30% of the value of the property, T allocated 30% of his $40,000 basis, or $12,000, to the sale portion of the property, and so his gain equals $30,000 minus $12,000, or $18,000.

Example 2: Facts Use the facts of Example 1 with the following change: the partnership assumes the $60,000 liability, and each partner is jointly and severally liable for repayment with a right of contribution against the other partner.

Example 2: Analysis (corrected) T must recognize gain of $35,000, computed as follows: Because the other partners have an economic risk of loss of $30,000, that amount of the liability is allocated to those other partners. The remaining $30,000 of the debt must be allocated among the partners in accordance with their profits interest, and that means T's debt share equals 50% of $30,000, or $15,000. Accordingly, the remaining $45,000 (75%) portion of the debt is treated as an amount realized to T. T is permitted to use 25% of the $40,000 adjusted basis in the property, or $10,000. As a result, T's gain equals $45,000 minus $10,000, or $35,000.

Observations The way debt treated as nonrecourse is allocated for disguised sale purposes is taken from the allocation of third tier nonrecourse debt under section 752. I asked the person who proposed the approach adopted in the new regulations if determination of profits interests “taking account of all facts and circumstances” wasn’t problematic. His reply: “It is a problem, but a known problem.” Not true! If the allocation of third tier nonrecourse debt is important, no one uses the ambiguous approach mandated by the disguised sale regulations because the other approaches are much more clearly defined.

Problems Book profits or tax profits? The examples consistently assume book profits. Special allocations: how do they affect the analysis? Allocations that vary over time: how do they affect the analysis? Preferred returns: should the partnership make predictions of future events?

Reverse Disguised Sale: Facts A, B, C and D are each one-quarter partners in the ABCD LLC. The partnership owns a single capital asset with inside basis of $40 and fair market value of $120. Each partner has a $10 outside basis. The partnership borrows $90 on a nonrecourse basis, secured by its asset, and guaranteed by D. ABCD distributes the asset subject to the liability to D in a liquidating distribution.

Reverse Disguised Sale: Analysis Under the old rules, this transaction would be tax-free to all parties and D would take the asset with a basis of $100. Partners A, B, C would have in effect sold their interests in the asset for cash and yet have paid no tax. Under the new rules, this is a disguised sale by the partnership to D. The amount realized equals $67.50, yielding a gain of $45, divided equally between A, B, and C. The deferral has declined from $20 per partner to $5 per partner Note: $67.50 is 56.25% of $120. 56.25% of $40 is $22.50.

Effective Date This change to the disguised sale rules generally is effective as of October 5, 2016.

Proposed Section 751(b) Regulations Each partner determines her share of ordinary income immediately before and immediately after a distribution. If a nondistributee sees a reduction in share, that partner recognizes ordinary income equal to such excess. Outside basis is increased by this income and the inside basis of the distributed asset is increased immediately prior to the distribution. If the distributee sees a reduction in share of ordinary income, she recognizes ordinary income equal to such excess. The distributee’s outside basis is increased by the amount of such income immediately prior to the distribution, and the inside basis of undistributed 751(b) property is increased by such income.

Example 1: Facts P, Q and R are each one-third partners in the PQR partnership owning cash of $150 along with three unrealized receivables, each having an inside basis and book value of $0 as well as current fair market value of $30. Each partner has an outside basis of $50 in its interest worth $80. P is distributed $20 of cash along with two of the unrealized receivables in a liquidating distribution.

Example 1: Analysis (part 1) Immediately prior to the distribution, each partner has a $30 share of the partnership’s section 751(b) gain. After the distribution, Q and R have a share equal to only $15, for a reduction of $15 each. Accordingly, Q and R each recognize ordinary income of $15 and each increases outside basis from $50 to $65. Immediately prior to the distribution, the inside basis of the two distributed receives is increased from $0 each to $15 each ($30 total). The distribution to P is then taxed under section 731 to P, and that yields no gain or loss on the cash and a carryover basis of $15 in each receivable.

Example 1: Analysis (part 2) When P sells the distributed receivables, P will recognize ordinary income of $15 on each, or P’s $30 share of ordinary income in total. Further, when the partnership sells the remaining receivable, it will recognize ordinary income of $30, or $15 per remaining partner. That $15 per remaining partner, when combined with the $15 to Q and to R recognized on the distribution to P, represents the proper ordinary income share to Q and to R.

Example 2: Facts P, Q and R are each one-third partners in the PQR partnership owning cash of $150 along with three unrealized receivables, each having an inside basis and book value of $0 as well as current fair market value of $30. Each partner has an outside basis of $50 in its interest worth $80. P is distributed $80 of cash in a liquidating distribution.

Example 2: Analysis P’s share of the partnership’s section 751(b) gain was $30, and it drops to $0 after the distribution. Accordingly, P is taxed in $30 of ordinary income under section 751(b), and P’s outside basis increases from $50 to $80. This increase ensures that P is not taxed a second time on the distribution of $80 of cash. The partnership increases its inside basis from $0 to $10 in each of the three (undistributed) unrealized receivables.

Warren Distinguished Professor University of San Diego School of Law Partnership Update Howard E. Abrams Warren Distinguished Professor University of San Diego School of Law www.taxnerds.com www.taxllc.com