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Firm Seeks Changes to Partnership Allocation Regs

OCT. 18, 2019

Firm Seeks Changes to Partnership Allocation Regs

DATED OCT. 18, 2019
DOCUMENT ATTRIBUTES
  • Authors
    Lipton, Richard M.
  • Institutional Authors
    Baker McKenzie
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Tax Analysts Document Number
    2019-40000
  • Tax Analysts Electronic Citation
    2019 TNTF 203-21

October 18, 2019

Mr. Charles Rettig, Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Mr. David Kautter, Assistant Secretary
for Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Mr. Michael Desmond, Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Mr. Jeffrey Van Hove
Senior Advisor, Office of Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Dear Sirs:

The recently issued regulations concerning the treatment of guarantees for purposes of allocating liabilities to the partners in a partnership under Section 752 contain a so-called "Factors Test" in Reg. 1.752-2(j)(3)(ii) (the "Regulation") which is thoroughly flawed because it is based on a misunderstanding of the purpose of two types of loan guarantees, (i) top dollar loan guarantees subject to a cap (Capped Guarantees) and (2) vertical slice guarantees (VSG), both of which are specifically authorized by the Regulation (collectively referred to herein as commercial loan guarantees). The Regulation sets forth seven factors (the "Factors"), the absence of which indicate that there may be a plan to circumvent or avoid liability on the guarantee. However, most commercial loan guarantees will fail to satisfy a majority (often five) of these Factors. Thus, the Regulation will certainly lead to continuing controversies between the IRS and taxpayers, and even more importantly, cause annual uncertainty for partnerships in the preparation of tax returns which must state how each guaranteed loan is allocated.

The fundamental error underlying the Regulation is the government's misunderstanding of the purpose of such commercial loan guarantees. Lenders primarily seek Capped Guarantees, particularly from individual guarantors, in order to ensure attention more than collection. The lender wants to make sure that the guarantor has "skin in the game" and will take every reasonable action to ensure that the lender gets repaid. A VSG is less frequently requested by a lender, but assuming that such a guarantee is furnished, the borrower will again have "skin in the game." The Regulation sets forth the Factors as indicators of a plan to circumvent or avoid the guarantee, but generally only two of these Factors are relevant to the lender. In the hundreds of commercial loan guarantees in which I have been involved, where a loan guarantee is furnished in a transaction with a third-party lender, only rarely would the guarantee satisfy most of the Factors in the Regulation. Indeed, the most relevant Factor is the last one — that the lender has knowledge of the guarantee and it is enforceable against the guarantor.

As a brief background, Section 752 provides that a liability is treated as a recourse liability allocated to a partner if the partner (or a related person) bears the risk of loss if the assets of the partnership are worthless. The recently-issued final regulations eliminated the ability of a partner to treat a bottom dollar guarantee ("BDG") as a liability for this purpose, but a partner would continue to treat as a recourse liability for this purpose either a Capped Guarantee (e.g., the partner guarantees a $10 million loan but only to the extent of $3 million of loss) or a VSG (in which the partner guarantees 10% of the lender's loss). The Factors are intended to provide guidance concerning when a guarantee that is not a BDG will nonetheless fail to be respected because there was no risk of loss to the guarantor.

It is questionable whether the drafters of this Regulation have sufficient knowledge of the "real world" and the terms of commercial loan guarantees, particularly for individual guarantors and particularly for otherwise-nonrecourse loans relating to real estate. These loan guarantees often arise in a transaction in which a partnership, which may be comprised of individuals and/or financial investors or a combination thereof, forms a special-purpose limited liability company (an "SPE") to acquire assets using third-party financing. The lender will insist on the utilization of an SPE so that the borrower is bankruptcy remote, i.e., a bankruptcy involving the partnership or its partners will not impact the lender's security interest in the underlying assets. The loan guarantee may be furnished by some or all of the partners. The guarantee could be a Capped Guarantee or a guarantee of an undivided percentage of the loan (i.e., a VSG).

An alternative situation in which a loan guarantee is often used involves a co-investment by a financial institution and an individual developer in a real estate project. The financial institution will often commit 80% to 90% of the equity (the individual developer will put up the balance of the equity) and the financial institution will also provide a secured loan to the SPE which holds the property to be developed. The individual will provide a VSG equal to the individual's share of the equity in order to ensure that the individual is allocated a share of tax deductions in proportion to the individual's proportionate share of the equity in the development project. Thus, the utilization of a VSG is often driven by tax considerations, but they are explicitly permitted by the regulations.

In these situations, there will be a written guarantee of the loan by the individual guarantors, and this guarantee will be provided to the lender. In most situations, the guarantee will not be for the entire amount of the loan; there will be a Capped Guarantee or it will be a VSG. Will these "standard commercial guarantees" be respected under the Factors Test? The seven Factors indicative of a plan to circumvent or avoid a payment obligation are as follows:

1. The partner or related person is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment, including restrictions on transfers for inadequate consideration or distributions by the partner to equity owners in the partner;

2. The partner or related person is not required to provide commercially reasonable documentation regarding the partner's or related person's financial condition to the benefitted party, including balance sheets and financial statements;

3. The term of the payment obligation ends prior to the term of the partnership liability, or the partner or related person has a right to terminate its payment obligation if the purpose of such limitation is to terminate such payment obligation prior to the occurrence of an event that increases the risk of economic loss to the guarantor or the benefitted party, although this Factor is not present if the termination occurs because of an event that decreases the risk of loss, such as completion of construction or satisfaction of a coverage ratio;

4. There exists a plan or arrangement in which the primary obligor or any other related person directly or indirectly holds money or other liquid assets in an amount that exceeds reasonably foreseeable needs of such obligor;

5. The payment obligation does not permit the creditor to promptly pursue payment following a payment default on the partnership liability;

6. In the case of a guarantee or similar arrangement, the terms of the partnership liability would be substantially the same had the partner or related person not agreed to provide the guarantee; and

7. The creditor or other party benefitting from the obligation did not receive executed documents with respect to the payment obligation from the partner or a related person before, or within a commercially reasonable time after, the creation of the obligation.

Taking these Factors in order, it is obvious that in most cases, few of the Factors (other than the third one and the last one) will be satisfied:

1. The first Factor is present if the guarantor can make asset transfers without adequate consideration. This Factor is derived from Canal Corp., 135 TC 199 (2010), in which the guarantor was an SPE that had limited assets but also had the right to transfer those assets without consideration, effectively giving the SPE the practical right to avoid the guarantee. In that limited situation, the Factor might be relevant, but the Regulation includes all guarantors and not just guarantors which are SPEs.

This Factor does not make sense for a guarantor that is not an SPE. In the case of an individual guarantor, this would prohibit the guarantor from making any transfer without consideration, such as making gifts to her husband, paying for her children's education, paying for a wedding, and a host of common transactions. In the case of a guarantee by a publicly-traded corporation, this Factor would prevent dividends from being paid to shareholders. Application of this Factor to guarantors other than SPEs, particularly individual guarantors, is patently inappropriate.

2. The second Factor requires the guarantor to provide a balance sheet and financial statements. This Factor rarely is satisfied in situations in which there is a long-term relationship between the guarantor and the lender, such as the fact pattern described above where an individual developer will guarantee a portion of the loan made by a financial institution investor. Likewise, as discussed above, in many transactions an unrelated lender requires a commercial loan guarantee to make certain that the guarantor is focused on the business to which the loan is made (and not to ensure that every dollar of the loan is repaid). This is particularly the case when the guarantee is subject to a cap or the guarantor has made a VSG, since the lender knows that the guarantee only provides for partial repayment of the loan. The lender does not require the guarantee to assure repayment of the loan — the lender wants the guarantee simply to create risk for the guarantor, assuring that repayment of the debt has the guarantor's full attention.

I have been involved in numerous real estate development and other transactions in which an individual developer, or a person related to such developer, has been required by a third-party lender to provide a limited guarantee, with the limitation usually being in terms of an overall cap on liability. Only rarely, if ever, does the lender require a financial statement or balance sheet from the guarantor in such event, because the guarantee is not being used to assure collection of the loan — the guarantee is requested by the lender to make certain that the guarantor is very focused on the business at hand.

3. The third Factor, in which the guarantor has the right to terminate the guarantee other than as a result of a definable event (such as building completion or achieving a debt-coverage ratio), is consistent with common commercial practice and not objectionable.

4. The fourth Factor is triggered if the primary obligor holds money or other liquid assets that exceed the reasonably foreseeable needs of such obligor. This Factor is completely contrary to common sense. Lenders want well-capitalized borrowers; the fact that the borrower is well capitalized does not mean that the guarantee is meaningless because the lender is usually more concerned with the guarantor paying attention to the project and the loan. This Factor would push lenders to make loans only to undercapitalized borrowers, which is not something that anyone wants. The Factor encourages non-economic behavior, which should be the exact opposite purpose of a tax regulation. If the goal of this Factor was to disregard a guarantee of a loan for which the partnership itself has posted cash collateral with the lender (so that the guarantor could never have any risk), then the Regulation should have said so.

5. The fifth Factor requires that the lender be able to immediately take action against the guarantor if there is any payment default on a liability. This Factor is contrary to almost every commercial loan guarantee in the real estate context, which covers ultimate collection by the lender and not payment by the primary obligor. Every commercial loan guarantee required by lenders which has been executed by my clients in the real estate context has been a guarantee of collection, not payment — the Factor in the Regulation is inconsistent with this basic economic reality.

6. The sixth Factor is likely the most absurd, because it requires that the guarantor prove that the terms of the partnership liability would not have been substantially the same had the partner or related person not agreed to provide the guarantee. Thus, in order to respect the guarantee, the guarantor must show that the lender provided loan terms with and without the guarantee. I have never seen a lender do this. Instead, the lender simply will refuse to make a loan if an appropriate guarantee is not arranged. And the lender seeks the guarantee, as discussed above, primarily to assure that the guarantor is focused on the transaction and not to assure repayment of the loan. This is particularly the case for a Capped Guarantee or a VSG, both of which are permissible under the regulations.

7. The seventh Factor, that the lender receives written documentation concerning the guarantee in connection with the creation of the obligation, is reasonable.

What is the practical impact of the Factors Test in the Regulation? Any partnership that is preparing its tax return must determine the partners to which a liability is allocated; that information is stated on the K-1s furnished to each partner. If a customary commercial loan guarantee, subject to a cap or a VSG, is provided by one of the partners, such as in the situations described above, what should the partnership do in preparing its K-1s? The loan likely will violate four or five of the seven Factors, whether it is a VSG permitted under the regulations or a commercially reasonable Capped Guarantee by a partner that was requested by the lender. There was no uncertainty concerning reporting of the liability prior to the Regulation — the Regulation creates uncertainty because the Regulation is not based on commercial reality.

Moreover, how should the partnership's financial auditors conduct their review of potential tax exposure when the Factors Test is almost certain to be failed? If the guarantor is a public corporation, will it need a reserve on its financial statements because of this rule? (And matters get even worse if the tax returns are examined, because an IRS agent will likely use the Factors as a checklist to determine whether or not the guarantee should be respected — almost no guarantee will pass this test.)

There is a simple solution to this problem. The inclusion of the Factors Test was highly criticized when the Regulation was first proposed. The Regulation now needs to be revised to focus on the two Factors which actually matter — (1) the lender has knowledge of the guarantee and it is enforceable pursuant to its terms, and (2) a partner cannot terminate liability on the guarantee except as a result of objective facts (such as completion of construction or satisfaction of a debt service coverage ratio) — which are terms that are present in most commercial loan guarantees. These tests are appropriate whether the loan guarantee is a
Capped Guarantee or a VSG. The remaining Factors are not based on commercial reality and should be jettisoned. 

Sincerely,

Richard M. Lipton
Baker & McKenzie LLP
Chicago, IL

cc:
Krishna Vallabhaneni
Amy F. Guiliano
Tax Notes 

DOCUMENT ATTRIBUTES
  • Authors
    Lipton, Richard M.
  • Institutional Authors
    Baker McKenzie
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Tax Analysts Document Number
    2019-40000
  • Tax Analysts Electronic Citation
    2019 TNTF 203-21
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