Effective date language in final regulations on recourse debt means partnerships should go back and see if the requirements that partners pony up money to restore capital accounts still hold up.
That’s because the regulatory change to section 704(b) regarding deficit restoration obligations (DROs) appears to be effective for all obligations, even those entered into before the enactment of the regulations, according to practitioners.
“All existing DROs will now need to be reexamined under the regulation, as opposed to other payment obligations where the effective date is limited to, in most cases, new arrangements,” Andrea Whiteway of EY told Tax Notes.
Stuart L. Rosow of Proskauer Rose LLP said one question he has is, even if the final section 704(b) rules apply to existing DROs, what are the consequences?
“If it prevents [partners] from claiming deductions in the future, I don’t know that I can get terribly exercised for that, frankly,” Rosow said. He said he hoped the IRS would apply the rule so that if a partner has liabilities in excess of basis issue and they’ve been relying on those liabilities to prevent gain recognition, then running afoul of the final DRO requirements wouldn’t trigger gain recognition.
Creating Recourse
The IRS and Treasury on October 4 issued regs (T.D. 9876) that withdrew 2016 temporary guidance on the treatment of debt for disguised sales purposes, which means partnerships can treat recourse debt under section 752 the same way for disguised sale purposes.
But on the same day, the government also issued final regs (T.D. 9877) under section 752 that bar bottom-dollar guarantees from treatment as a valid payment obligation. Included in those final regs were antiabuse rules under reg. section 1.752-2(j)(3) and changes to the rules on DROs under reg. section 1.704-1(b)(2)(ii), both of which have to do with making sure a valid payment obligation for a partner exists in order for debt to be treated as recourse to them.
Debt that is treated as recourse to a partner means that the partner bears the economic risk of loss, and one day they may have to pay up on the debt. That risk means the partner gets outside basis in their partnership interest, which allows them to take losses or receive distributions tax free.
One way for debt to be treated as recourse to a partner is if they have a valid guarantee, but another way is if the partner agrees to restore negative capital accounts when the partnership liquidates — a DRO.
A partner’s capital account tracks their investment in the business, along with allocated items of income and loss. If the partner is allocated losses to the point that their capital account balance is zero, losses would be allocated to other partners.
That’s not the case if the partner has a DRO. Essentially, the partnership could still allocate losses to the partner with a capital account deficit because the partner would promise to pay back that negative balance when the partnership liquidates.
New Rules
The IRS in 2016 said it would consider the extent to which DROs are valid; for one thing, the partnership may never liquidate, so that obligation may never materialize. But the bigger issue was whether the DRO was even valid and whether the partner could actually pay if the obligation was triggered.
The final rules included four factors in the section 704(b) regs to determine whether a plan exists to circumvent a DRO, which means the obligation will be disregarded for both section 704 and section 752 purposes. Those four factors are:
(1) the partner is not subject to commercially reasonable provisions for enforcement and collection of the obligation;
(2) the partner is not required to provide (either at the time the obligation is made or periodically) commercially reasonable documentation regarding its financial condition to the partnership;
(3) the obligation ends or could, by its terms, be terminated before the liquidation of the partner’s interest in the partnership or when the partner’s capital account as provided in section 1.704-1(b)(2)(iv) is negative (other than when a transferee partner assumes the obligation); and
(4) the terms of the obligation are not provided to all the partners in the partnership in a timely manner.
However, the effective date for the changes to the section 704(b) regs apply to the taxable year ending on or after the date of the publication of the rules in the Federal Register, which was October 9.
Whiteway said that effective date language means agreements already in existence may not meet all the criteria in the final antiabuse rules, creating uncertainty as to whether such arrangements are respected.
“It is conceivable that existing deficit restoration obligations do not require commercially reasonable documentation regarding the partner’s financial condition under the second factor, may not have been provided to all partners under the fourth factor, and in some cases include termination rights that are not in accordance with the third factor,” Whiteway said.
Correction, October 11, 2019: The final regs were published in the Federal Register on October 9.