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Three Cheers for Proposed Changes to Partnership Debt Basis Allocation Rules

Posted on Oct. 25, 2021
David Hasen
David Hasen

David Hasen is a professor at the University of Florida Levin College of Law.

In this article, Hasen explains problems with the rules regarding the allocation of basis credit among partners for the partnership’s third-party debt, and why the proposed change from Senate Finance Committee Chair Ron Wyden, D-Ore., would go a long way toward solving them.

Copyright 2021 David Hasen.
All rights reserved.

Among the proposed amendments to subchapter K that Senate Finance Committee Chair Ron Wyden, D-Ore., released on September 10 is new section 752(e)(1).1 It reads, in relevant part, “all liabilities of a partnership shall be allocated among partners in accordance with each partner’s share of partnership profits.” By tying basis credit to profits, the provision would dramatically improve the rules for the allocation of basis credit among partners for third-party recourse debt of the partnership. It would move the tax treatment of partnership debt close to economic reality, in sharp contrast to the current regulations’ treatment of recourse and even some nonrecourse debt; and it would eliminate the discontinuity in treatment between recourse and nonrecourse debt and the easy manipulability of basis credit for recourse obligations under current rules, thereby reducing tax planning opportunities.

“Great minds think alike.” Or, more likely, the drafter of the Wyden proposal and I think alike. In a recent paper, I argued that basis credit for partnership borrowing should be allocated on essentially the same terms as those laid out in the Finance Committee’s proposal.2 This article explains problems with the current rules for the allocation of basis credit among partners and why the proposed change would go a long way toward addressing those problems.

Basis Credit Under Section 752

Section 752 adopts a cash contribution and distribution equivalence rule for partnership borrowing but says nothing about how basis credit for third-party debt of the partnership is to be allocated among the partners.3 Instead, Congress has left that task to Treasury. Under regulations that have been around for 30 years,4 the analysis depends in the first instance on whether the debt is recourse or nonrecourse. Subject to exceptions, recourse debt, defined as a partnership obligation for which any partner or related party is liable,5 is allocated among the partners according to who bears the economic risk of loss (ERL) of the debt.6 Nonrecourse debt, defined as any partnership obligation for which no partner or related party is liable,7 is allocated according to partnership profits, subject to special rules.8 ERL as operationalized in the section 752 regulations9 allows partners to indulge a labile fantasy to determine the significant real-world tax effects of partnership borrowing. The nonrecourse debt regulations, by contrast, frequently allocate basis credit sensibly.

Recourse Debt: Current Law

Treasury implements the ERL analysis under what might be termed the “catastrophe procedure.”10 The catastrophe procedure allocates basis to partners based on the extent to which they would be on the hook if essentially all assets of the partnership (including cash) immediately became worthless, and the debt was due in full.11 Suppose ABC’s three partners share all items of partnership income, gain, loss, and deduction equally, other than the net losses of ABC over its lifetime, which are allocated solely to A. ABC’s operating agreement satisfies the alternate test for economic effect set forth in the section 704(b) regulations.12 A is the sole general partner, and B and C are each limited partners having no obligation to restore a deficit balance to their capital accounts. Under the ERL rules, basis credit for all of ABC’s recourse borrowing goes entirely to A because the catastrophe causes the partners’ capital accounts to go negative by $100,000 total (assuming no other recourse liabilities of ABC), but only A will be obligated to restore the deficit.13

The evident theory of the catastrophe procedure is that the obligation to repay the loan represents its real economic burden.14 In fact, as I argue below, because the economic burden of borrowing is mostly reflected in interest paid and has almost nothing to do with a repayment obligation, the catastrophe procedure is a poor method for allocating basis credit. It suffers from three major problems: (1) it is unmoored to economic reality, (2) it is easily manipulated, and (3) it leads to sharply different allocations from those that result for many nonrecourse obligations that are economically similar to recourse obligations.

Economic Reality

Appearances possibly to the contrary, a loan is very much like a rental of property, which suggests that the true burden of a loan, apart from the provision of collateral, is interest, similar to how rent, and not the obligation to return leased property, is the true burden of an ordinary lease. Although a lease involves the transfer and retransfer of possession of the underlying property, the legal arrangement is a purchase of a time slice of the property, not a purchase and resale of the underlying asset. The transfer and retransfer of possession are incidental to the parties’ bargain. If that were not the case, withholding of rent often would not matter much in terms of the lessee’s fulfillment of her obligations under the lease, much as other minor violations ordinarily entitle the lessor to damages but not repossession. A lessee of Blackacre for 25 years could withhold rent for one year but retain possession on the basis that nonpayment of rent amounted to a nonmaterial breach of the lease terms. In fact, nonpayment of rent that is not timely cured ordinarily cancels the lease and entitles the lessor to immediate repossession of the property.

A loan is closely similar to a lease, and interest is the close analog of rent. Like the subject property in an ordinary lease, a loan does not consist of an acquisition of the funds in full coupled with an obligation to return them; it is instead the purchase of the use of the funds — a time slice of them — in exchange for rent denominated as interest. Also as under a lease, uncured nonpayment of interest ordinarily triggers an immediate right of repossession — the loan is canceled. That is, the lessee/borrower retains no right of possession based on an independent and offsetting obligation to return the asset at the term so that smaller damages only for nonpayment of interest might apply. The deal is rent (interest) for use (liquidity).

To be sure, most loans involve the risk that the funds will not be returned, suggesting that more than the mere transfer of a time slice is in play in a typical loan. But that “more” is not an additional obligation to return the funds in exchange for an initial transfer of them. Like interest for liquidity, the lender is compensated for the additional burden by means of additional ongoing payments (commonly termed a risk premium) that compensate the lender for the prospect that the funds will be dissipated and the borrower unable to make good on its obligation to repay. Together, payment for the liquidity and for the risk the lender assumes constitute the burden of an unsecured loan; they are the quid pro quo for use of the funds. Treating the real burden of the loan, instead, as an obligation to return the funds, as the ERL rules do, is a red herring.

Things are slightly more complicated when debt is collateralized, but the presence of collateral does not move the arrangement any closer to the current ERL procedure. In a collateralized loan, the terms of the loan include limitations placed on the use of the security, so that one might consider the owner of the security to bear some of the burden of the loan apart from the interest obligation that party bears. If ABC borrows $X on a recourse basis and puts up partnership assets as security, ABC doubtless will be limited in what it may do with the assets without violating its loan covenants. Because these limitations also constitute a burden of the loan, to assign basis credit among the partners it would make sense to examine the extent to which each individual partner is limited by the security covenants placed on the assets. But these burdens are likely to be relatively small (as measured by value) in relation to interest obligations and to the value of the security, and they are much more likely to follow partnership economics (profit shares) than they are the obligation to repay on default.

Easy Manipulation

The ERL rules permit dramatic variations in basis credit at little economic cost. This feature of the rules is unsurprising given that they do not track the real economics of the loan but instead a feature incidental to them. As a result, apart from some aggressive schemes targeted in the regulations,15 the partners are largely free to assign recourse debt basis credit among themselves in tax-advantaged ways that do not correspond to significant economic adjustments. Suppose that in our ABC example, limited partner B promises to reimburse general partner A for any amount she would be required to pay on default of the loan. Under the catastrophe procedure, B is now entitled to all the basis credit on the $100,000 borrowing16 even though the cost of shifting the risk is vastly less than $100,000.

Recourse-Nonrecourse Discontinuity

The rules for allocation of basis credit in nonrecourse debt differ sharply from the rules for recourse debt.17 Apart from special provisions concerning “partnership minimum gain”18 and some gain that would be recognized to contributing partners,19 nonrecourse debt basis is allocated according to each partner’s share of partnership profits (the “partnership profits rule,” or PPR).20 The PPR is sometimes grounded in a kind of lament: We would like to allocate nonrecourse debt basis credit under ERL principles, but because the lender is said to bear the risk that the outstanding principal will at some point exceed the value of the security, we cannot do so without treating nonrecourse debt differently from recourse debt in ways that are impracticable under the income tax.21 Because both types of debt are ubiquitous and because they are to some extent interchangeable, a principle that preserves basis credit exclusively to the borrower in a nonrecourse debt arrangement is needed.

As the discussion above suggests, this reasoning is misguided at best. The actual burden of the loan is mostly reflected in interest paid. The borrower bears the risk of loss by paying the lender the fair market value of assuming that risk. The principle is no less operative in nonrecourse debt situations in which the lender can be expected to charge an additional premium to reflect its inability to seek a remedy for default beyond the security the borrower provides. In short, recourse and nonrecourse debts are relatively close economic substitutes. The main difference is that in a nonrecourse loan, the lender relies more on the security, meaning that the burden of the debt allocable to ownership of the security is greater than in a recourse loan. Still, the burden of the loan remains with the borrowers (and anyone else who puts up security) and, as noted, commonly the partners will own partnership assets in proportion to their profit interests.

The economic similarity between recourse and nonrecourse debt presents a tax planning opportunity similar to that between the different results of catastrophic default that partners can arrange under the ERL rules. Just as the economic differences between different arrangements under the catastrophe procedure may be minimal, a lender may be willing to make an otherwise recourse loan nonrecourse, or vice-versa, with minor adjustments to the loan terms to satisfy the partners’ tax objectives. The reason, of course, is that there often will not be much difference between the two arrangements. A slightly higher interest rate may suffice to move from recourse to nonrecourse if the collateral’s value greatly exceeds the loan amount, or the borrower may put up collateral that is less likely to decline in value below the debt principal. Moving from one arrangement to the other allows the partners to allocate basis credit with the same kind of flexibility available for recourse borrowing when the partners are willing to shift the ultimate liability for the (remotely likely) catastrophe.

ERL and the Burden of Interest

I have argued that the true burden of borrowing is mostly interest expense, regardless of whether the debt is recourse or nonrecourse. However, the Finance Committee’s proposal would tie basis credit to partnership profits, not to the payment of interest. If interest expense ought to be the touchstone, why is the PPR a proper method for basis allocation?

The reason is that as a general matter, there ordinarily will be no reason why the partners would want to assume a willingness to bear the burden of debt without realizing a corresponding benefit. The net of those offsetting positions ought to be reflected in profit shares. In the meantime, a rule that mechanically traced interest payments would be subject to easy manipulation. Put somewhat differently, a mechanical tracing rule for determining the identity of the bearer of interest expense would be susceptible to the same kinds of manipulations that plague the existing ERL regime.

Returning one last time to the ABC partnership, suppose that a mechanical rule of interest tracing replaced the ERL rules currently in effect. If ABC wanted to allocate basis credit solely to B, ABC could adopt a special allocation providing that she would bear the interest expense of the debt. B’s capital account would be reduced accordingly for interest paid, but the partners might be able to adjust other features of their arrangement to compensate B for her assumption of the payment obligation. As long as a reasonable nontax motivation could be offered for the setup (and the partnership agreement otherwise satisfied the rules of the substantial economic effect safe harbor set forth in the section 704 regulations), B would receive the basis credit.22

A solution to the mechanical tracing problem is so-called sophisticated tracing, an approach that already applies in other areas, such as under section 265(a)(2). That section disallows a deduction for interest paid on debt used “to purchase or carry obligations the interest on which is wholly exempt from taxes.” Reg. section 1.265-1 and authorities interpreting it have applied sophisticated tracing to implement the rule.23 Under sophisticated tracing, the question is whether the borrowing is a “but for” cause of either purchasing or carrying the tax-favored debt instruments. If so, the interest deduction is disallowed. Thus, the fact that the taxpayer buys tax-exempt securities with cash on hand and, separately, borrows to purchase equipment does not by itself establish that the interest deduction on the borrowing is not disallowed under section 265(a)(2). If the borrower would have purchased the equipment with the cash on hand in the absence of the purchase of the tax-favored securities, the interest deduction is disallowed because the borrowing is a but for cause of purchasing the bonds.

A PPR resembles the sophisticated tracing rule under section 265(a)(2). The partners may be able to manipulate payment streams to satisfy a mechanical tracing rule that simply “follows the money” — in this case, interest payments — but because parties dealing at arm’s length (here, the partners in relationship to each other) are likely to insist on a compensating payment for altered cash flows, a rule that looks to the net effect of the cash payment and the associated adjustments to the partnership is likely to capture the real burden of interest payments. The PPR is such a rule.

Conclusion

Enactment of proposed section 752(e)(1) would represent a substantial improvement over existing law. The PPR aligns basis credit with economic reality; it eliminates tax-motivated manipulations of essentially meaningless risk-of-catastrophic loss allocations; and it eliminates the tax disparity between economically similar recourse and nonrecourse debt arrangements. These reasons alone would suffice to recommend the provision.

Beyond them, the PPR follows a principle that the tax law should have embraced a long time ago, which is that debt is closely similar to a rental arrangement. Viewing debt in this way provides benefits beyond improving the tax rules for partnership borrowing, something that I also argued in the article mentioned above. A considered review of debt so understood could go some way to addressing other problems in the debt area, including the proper treatment of debt cancellation and other matters.

FOOTNOTES

2 David Hasen, “Debt and Taxes,” 12 Colum. J. Tax L. 89 (2021).

3 Section 752(a) treats a partner’s net increase in liabilities of the partnership as the partner’s contribution of cash to the partnership, and section 752(b) treats a net reduction as a cash distribution to the partner.

4 T.D. 8380 (finalizing reg. section 1.752-1 through -5).

11 Id. Exceptions apply for property-securing partnership nonrecourse debt, some contingent obligations, bottom-dollar payment obligations (BDPOs), and in other cases. See reg. section 1.752-2.

13 Reg. section 1.752-(f)(3).

14 Preamble to T.D. 8237 (“Under the approach taken by the temporary regulations, a partner bears the economic risk of loss for a partnership liability to the extent that the partner (or a person related to the partner) would bear the economic burden of discharging the obligation represented by that liability if the partnership were unable to do so.”).

15 The catastrophe procedure does not apply to some BDPOs, nor does it apply when a tax avoidance purpose is evident from the arrangement. Reg. section 1.752-2(b)(3)(ii), -2(b)(6) (tax avoidance purpose). In general, a BDPO is an arrangement under which a partner is required to make a payment only to the extent other partners’ payments do not cover an associated liability. Somewhat tellingly, in my view, liabilities that are disqualified as BDPOs are allocated under the rules for partnership nonrecourse debt. Reg. section 1.752-2(f)(10)(iv).

16 The ERL rules look to all agreements among the partners and related parties, not just the partnership agreement itself. Reg. section 1.752-2(b)(3).

21 See, e.g., Daniel N. Shaviro, “Risk and Accrual: The Tax Treatment of Nonrecourse Debt,” 44 Tax L. Rev. 401, 427-428 (noting that nonrecourse borrowing can be analogized to ordinary debt plus a put option the borrower purchases from the lender).

22 Reg. section 1.704-1(b)(1)(i) (third sentence).

23 See, e.g., Wisconsin Cheeseman Inc. v. United States, 388 F.2d 420 (7th Cir. 1968).

END FOOTNOTES

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