The IRS is reverting to old rules on leveraged partnerships in response to an executive order calling for the removal of burdensome regulations, but bottom-dollar guarantees didn’t make the cut.
The change came in a June 18 proposed regulation (REG-131186-17) that eliminates proposed and temporary regulations (T.D. 9788) on the treatment of liabilities for disguised sale purposes under section 707 . However, bottom-dollar guarantees — situations in which a partner guarantees a specific amount of outstanding debt to increase his basis in the partnership interest — aren’t part of the reversion.
By going back to the old partnership disguised sale rules on debt allocation, the IRS is “putting the tax community in a time machine and letting us out during the age of the leveraged partnership,” joked Eric B. Sloan of Gibson, Dunn & Crutcher. Sloan added that the move back to the old section 707 regulations will be a “fun time” for tax planners.
Under the now-displaced temporary regulations, the IRS essentially treated all liabilities as nonrecourse liabilities for disguised sale purposes, a shift so dramatic that some practitioners questioned the agency’s authority to do so. These proposed and temporary regulations were targeted for elimination shortly after President Trump issued Executive Order 13789 in April 2017, calling for the review and possible removal of all significant tax regulations issued after January 1, 2016. The disguised sale rules were among eight regulations the IRS highlighted for possible removal in a report issued three months later (Notice 2017-38, 2017-30 IRB 147).
The IRS followed through on that removal warning in the June 18 proposed regulation, saying it will go back to the old approach of applying separate rules for a partnership’s recourse and nonrecourse liabilities. That approach treats a partner’s share of recourse liabilities in reg. section 1.707-5(a)(2)(i) as the same share of recourse liabilities under section 752. It then treats a partner’s share of nonrecourse liabilities in reg. section 1.707-5(a)(2)(ii) by applying the same percentage the partner used to determine the partner’s share of excess nonrecourse liabilities under reg. section 1.752-3(a)(3), which looks only to a partner’s profit interest in allocating the liability.
“It’s important to keep in mind that the IRS and Treasury have asked for comments on the proper approach to allocating liabilities under the disguised sale rules,” Sloan said. “This makes me think that if taxpayers go overboard with leveraged partnerships, then when the IRS and Treasury finish issuing guidance implementing the Tax Cuts and Jobs Act [P.L. 115-97], the section 707 regulations may once again be revisited.”
Out With the New, In With the Old
Glenn Dance of Grant Thornton LLP said the return of the old disguised sale rules is a move back to the “steroid era” of tax planning. Dance said the IRS’s 2016 temporary regs were designed to ensure that transactions couldn’t be bulked up through the use of questionable guarantees, but added that the IRS may have made the wrong policy call in the regs.
However, Dance warned that taxpayers shouldn’t celebrate just yet because the proposed regs restoring the old regime are only that: proposed. “So it would be fair to describe this as an effort to relitigate the call made in the early ’90s on the question of what the rule should be,” Dance said.
Along with the other changes, the proposed regulations reinstate the contingent liability rules, which treat partnership liabilities under reg. section 1.752-7 as either recourse or nonrecourse based on the section 752 language. However, the IRS said additional guidance on this topic is still needed because some transfers of contingent liabilities to a partnership may be abusive. The temporary regulations under section 752 will remain on the books to prevent abuses, and the IRS claimed that the proposed rules don’t meaningfully increase regulatory burdens for the taxpayers affected.
Steven R. Schneider of Baker McKenzie said it’s important for taxpayers to keep in mind that proposed regulations under section 752 on the requirements for what constitutes a good guarantee still exist and should be considered. Schneider said the withdrawal of the section 707 rules, coupled with the proposed section 752 guarantee rules (REG-122855-15) that still exist, means taxpayers “aren’t out of the woods, but now they’re in the game.”
“However, a partnership and its partners may apply all the rules in the new proposed regulations in lieu of the 707 temporary regulations to any transaction with respect to which all transfers occur on or after January 3, 2017,” Schneider explained. He added that the IRS received a lot of criticism for using temporary regulations for such a significant departure from long-standing law, so it’s good to see it taking a step back to think through the rules, even if it took an executive order to force the issue.