Allocation of Debt Under Section 752 Howard E. Abrams Warren Distinguished Professor, USD School of Law Copyright 2015 by Howard E. Abrams

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. § (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. § (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.

Recourse Debt Allocation  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? PQ CAOBCAOB 30

Recourse Debt Allocation  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: PQ CAOBCAOB

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: PQ CAOBCAOB

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? PQ CAOBCAOB

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. PQ CAOBCAOB

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? PQ CAOBCAOB

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. PQ CAOBCAOB

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? PQ CAOBCAOB 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: PQ CAOBCAOB

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: PQ CAOBCAOB

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: PQ CAOBCAOB

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: PQ CAOBCAOB

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: PQ CAOBCAOB

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: PQ CAOBCAOB

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. PQ CAOBCAOB

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: XYZ CAOBCAOBCAOB

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: XYZ CAOBCAOBCAOB

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: XYZ CAOBCAOBCAOB

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: XYZ CAOBCAOBCAOB

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. XYZ CAOBCAOBCAOB

Reg. § (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 Intermediary Regulation Section (j) X Co. Y Partnership Recourse Debt Owns little but interest in lower tier partnership. Sub Co. Consolidated Group

Poorly-Funded Intermediary Regulation Section (j) X Co. Y LLC X Partnership Recourse Debt Owns little but interest in lower tier partnership.

Disregarded Intermediary Regulation Section (k) Y Partnership Recourse Debt Owns little but interest in lower tier partnership. X LLC X

Holding a Partnership Interest Through 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. § (b). The following discussion is based on these proposed regulations.

Related Party Debt Rules Nonrecourse Loan from Z to XY P YXZ XY

Related Party Debt Rules Nonrecourse Loan from Z to XY P YXZ XY Guarantee

Related Party Debt Rules Nonrecourse Loan from Z to XY P YXZ 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. § (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.

Nonrecourse Debt Allocation  Partnership nonrecourse liabilities (that is, liabilities as to which no partner is liable) are allocated in three tiers. Reg. § (a). (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.

Nonrecourse Debt Allocation  Partnership nonrecourse liabilities (that is, liabilities as to which no partner is liable) are allocated in three tiers. Reg. § (a). (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:

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 XY CAOBCAOB 30,000 10,000 Contributions 030,0000 Nonrecourse Debt 30,00060,00010,00040,000Totals AssetBook ValueAdj. BasisDebt Property100,000 60,000

Nonrecourse Debt Analysis XY CAOBCAOB 30,00060,00010,00040,000Start of Year 1 -7,500 -2,500 Depreciation 22,50052,5007,50037,500End of Year 1 AssetBook ValueAdj. BasisDebt Property90,000 60,000

Nonrecourse Debt Analysis XY CAOBCAOB 22,50052,5007,50037,500Start of Year 2 -22,500 -7,500 Depreciation Years ,0000 End of Year 4 AssetBook ValueAdj. BasisDebt Property60,000

Nonrecourse Debt Analysis XY CAOBCAOB 030,0000 Start of Year 5 -7,500 -2,500 Depreciation Year 5 -7,50022,500-2,50027,500End of Year 5 AssetBook ValueAdj. BasisDebt Property50,000 60,000

Debt Reallocation XYTotal Tier 17,5002,50010,000 Tier 2000 Tier 325,000 50,000 Total32,50027,50060,000 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 XY CAOBCAOB -7,50022,500-2,50027,500Starting Values 02,5000-2,500Debt Shift -7,50025,000-2,50030,000End of Year 5 AssetBook ValueAdj. BasisDebt Property50,000 60,000

Nonrecourse Debt Analysis XY CAOBCAOB -7,50025,000-2,50025,000Start of Year 6 -37, ,500 Depreciation Years 6-10 AssetBook ValueAdj. BasisDebt Property000

Debt Reallocation XYTotal Tier 145,00015,00060,000 Tier 2000 Tier 3000 Total45,00015,00060,000 This table shows that X’s debt share increases to $45,000 (from $32,500) – an increase of $12, while Y’s debt share decreases to $15,000 (from $27,500) – a decrease of $12,500.

Nonrecourse Debt Analysis XY CAOBCAOB -7,50025,000-2,50025,000Start of Year 6 -37, ,500 Depreciation Years , ,500Debt Reallocation -45, ,0000End of Year 10 AssetBook ValueAdj. BasisDebt Property000

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.

Nonrecourse Debt Analysis AB CAOBCAOB 4,000 Contributions [Debt Shift Goes Here] AssetBook Value Adj. BasisDebt704(c) Amount Property10,0004,0006,000 Cash4,000

Debt Allocation ABTotal Tier 1000 Tier 22,0000 Tier 32,000 4,000 Total4,0002,0006,000 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

Nonrecourse Debt Analysis AB CAOBCAOB 4,000 Contributions 0-2,00002,000Debt Shift 4,0002,0004,0006,000Totals AssetBook Value Adj. BasisDebt704(c) Amount Property10,0004,0006,000 Cash4,000

Debt Allocation ABTotal Tier 1000 Tier 22,0000 Tier 32,000 4,000 Total4,0002,0006,000 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 ABTotal Tier 1000 Tier 22,0000 Tier 34,0000 Total6,0000 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 10,0004,000 -4,0002,000 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.

Nonrecourse Debt Analysis AB CAOBCAOB 4,000 Contributions -2,000 Book Loss First, we put in the book loss following the partnership agreement (always subject to the requirement of substantial economic effect).

Nonrecourse Debt Analysis AB CAOBCAOB 4,000 Contributions -2,000 Book Loss 2,0000Tax 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.

Nonrecourse Debt Analysis AB CAOBCAOB 4,000 Contributions -2,000 Book Loss 2,0000Tax Gain -2,000Remedial 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.

Nonrecourse Debt Analysis AB CAOBCAOB 4,000 Contributions -2,000 Book Loss 2,0000Tax Gain -2,000Remedial Allocation 2,000Remedial 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.

Nonrecourse Debt Analysis AB CAOBCAOB 4,000 Contributions -2,000 Book Loss 2,0000Tax Gain -2,000Remedial Allocation 2,000Remedial 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 ABTotal Tier 1000 Tier 24,0000 Tier 31,000 2,000 Total5,0001,0006,000 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 AB CAOBCAOB 4,000 Contributions 0-1,00001,000Debt Shift 4,0003,0004,0005,000Totals AssetBook Value Adj. BasisDebt704(c) Amount Property10,0004,0006,000 Cash4,000

Remedial Allocations; Tier 3A ABTotal Tier 1000 Tier 24,0000 Tier 32,0000 Total6,0000 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 AB CAOBCAOB 4,000 Contributions 0000No Debt Shift 4,000 Totals AssetBook Value Adj. BasisDebt704(c) Amount Property10,0004,0006,000 Cash4,000

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) CAOBCAOB 4,0002,0004,0006,000Starting Value AssetBook Value Adj. BasisDebt704(c) Amount Property10,0004,0006,000 Cash4,000

No Remedials, No Tier 3A A (4,000)B (2,000) CAOBCAOB 4,0002,0004,0006,000Starting Value -1, Depreciation [Debt Shift Goes Here] AssetBook Value Adj. BasisDebt704(c) Amount Property8,0003,2006,0004,800 Cash4,000

No Remedials, No Tier 3A ABTotal Tier 1000 Tier 22,8000 Tier 31,600 3,200 Total4,4001,6006,000

No Remedials, No Tier 3A A (4,000)B (2,000) CAOBCAOB 4,0002,0004,0006,000Starting Value -1, Depreciation (corrected) Debt Shift Goes Here 3,0002,4003,0004,800After Year 1 AssetBook Value Adj. BasisDebt704(c) Amount Property8,0003,2006,000 Cash4,000

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) CAOBCAOBCAOB 3,000 2,00015,000Starting Values [Debt Shift Goes Here] AssetBook Value Adj. BasisDebt704(c) Amount Property20,00015,00018,0005,000 Cash6,000

Final Problem: Z Joins XYZTotal Tier Tier 2003,000 Tier 35,625 3,75015,000 Total5,625 6,75018,000 XYZ CAOBCAOBCAOB 3,000 2,00015,000Starting Values 05, ,250Debt Shift 3,0008,6253,0008,6252,0003,750After Z Joins

Depreciation X (5,625)Y (5,625)Z (3,750) CAOBCAOBCAOB 3,0008,6253,0008,6252,0003,750Starting Values -3,000 -2,000Book Depreciation 0-3, Tax Depreciation 05, ,750 AssetBook Value Adj. BasisDebt704(c) Amount Property12,0009,00018,0003,000 Cash6,000

Final Problem: Z Joins XYZTotal Tier 12,250 1,5006,000 Tier 2003,000 Tier 33,375 2,2509,000 Total5,625 6,75018,000 X (5,625)Y (5,625)Z (3,750) CAOBCAOBCAOB 05, ,750Starting Values Debt Does Not Shift! 05, ,750After Depreciation

Allocation of Debt Under Section 752 Howard E. Abrams Warren Distinguished Professor, USD School of Law