recourse and non-recourse liability in...

Recourse and Non-Recourse

Liability in Partnerships Minimizing the Tax Impact of Partner Liability and Debt Allocations Under Sections 752 and 704

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WEDNESDAY, OCTOBER 17, 2012

Presenting a live 110-minute teleconference with interactive Q&A

Andrew W. Ratts, Partner, Winston & Strawn, Chicago

Jon R. Stefanik, Buckingham Doolittle & Burroughs, Akron, Ohio

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Recourse And Non-Recourse Liability In Partnerships Seminar

Jon R. Stefanik, Buckingham Doolittle & Burroughs

[email protected]

Oct. 17, 2012

Andrew W. Ratts, Winston & Strawn

[email protected]

Today’s Program

Overview Of Sect. 752 Liabilities And Interplay

With Sect. 704 Allocations

[Andrew W. Ratts]

Distinguishing Recourse And Non-Recourse Liabilities

[Jon R. Stefanik]

Recent Transactions And Cases Interpreting Sect. 752

Allocations

[Andrew W. Ratts]

Planning Strategies And Techniques

[Jon R. Stefanik]

Slide 8 – Slide 26




Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

7

OVERVIEW OF SECT. 752 LIABILITIES AND INTERPLAY WITH SECT. 704 ALLOCATIONS


9

Allocation Of Partnership Income: Introduction

In determining its income tax, each partner must take into account separately its “distributive share” (whether any cash or property is distributed) of partnership items of income, gain, loss, deduction and credit. §702

A partner‟s distributive share of “book” income is determined by §704(b) and the regulations thereunder.

A partner‟s distributive share of taxable income generally follows its §704(b) share, but with modifications under §704(c).

9

Allocation Of Income: Sect.704(b)

Treas. Reg. §1.704-1(b) provides the rules to determine whether an

allocation provided in the partnership agreement will be respected for

tax purposes as either:

(i) Having substantial economic effect, or

(ii) Being in accordance with the partners‟ interest in the partnership.

10

Allocation Of Taxable Income: Sect. 704(c)

Income, gain, loss and deduction with respect to property contributed

by a partner to a partnership shall, under regulations, be shared among

the partners so as to take account of the variation between the basis of

the property to the partnership and its FMV at the time of contribution.

(§704(c)(1)(A))

Treas. Reg. §1.704-3 provides three methods for eliminating book/tax

disparities: The traditional method, the traditional method with curative

allocations, and the remedial method.

The partnership is also permitted to use any reasonable

method of making the allocations. The partnership is not

limited to the three methods described in the regulations.

The choice of method may be made on a property-by-property

basis.

11

Allocation Of Taxable Income: Sect. 704(c), Cont.

Traditional method

- Tax allocations to the non-contributing partner of cost recovery

deductions with respect to the 704(c) property must equal book

allocations of those deductions, to the extent possible.

– The “ceiling rule” provides that total income, gain, loss or deduction

may not exceed the partnership‟s total income, gain, loss or

deduction recognized for tax purposes.

12


Example: Traditional method

13


Traditional method with curative allocations

If the ceiling rule applies, then the partnership looks for another tax

item of the same amount and character as the item limited by the

ceiling rule.

Remedial allocation method

Two elements:

– The partnership steps into the shoes of the contributing partner for

the portion of the book value equal to the adjusted tax basis.

– The remainder of the book value (book value less tax basis) is

recovered as if it were a newly purchased asset placed in service at

the time of the contribution. 14


Example: Traditional method with curative allocations

Use the same facts given for the traditional method, but assume that

the partnership also has $4,000 of ordinary income to be allocated.

15


Example: Remedial allocation method

16

Outline Of Sect. 752

Increase in partner‟s liabilities (§752(a) and Reg. §1.752-1(b))

– Considered a contribution of money by the partner to the partnership

– Includes:

Any increase in the partner‟s share of partnership liabilities

Any increase in the partner‟s individual liabilities by reason of the partner‟s assumption of partnership liabilities

Decrease in partner‟s liabilities (§752(b) and Reg. §1.752-1(c))

– Considered a distribution of money by the partner from the partnership

– Includes:

Any decrease in the partner‟s share of partnership liabilities.

Any decrease in the partner‟s individual liabilities by reason of the partnership‟s assumption of the partner‟s individual liabilities

17

Outline Of Sect. 752 (Cont.)

Liability to which property is subject (§752(c))

– Considered a liability of the owner of the property to the extent of

the FMV of the underlying property

Sale or exchange of a partnership interest (§752(d) and Reg. §1.752-

1(h))

– Liabilities are treated in the same manner as liabilities in connection,

with the sale or exchange of property not associated with

partnerships.

– The reduction in the transferor partner‟s share of partnership

liabilities is treated as an amount realized under §1001 and the

regulations thereunder.

18

Liability Defined

An obligation is a liability only if, when, and to the extent that incurring

the obligation:

– Creates or increases the basis of any obligor‟s assets (including

cash),

– Gives rise to an immediate deduction of the obligor, or

– Gives rise to an expense that is not deductible in computing the

obligor‟s taxable income and is not properly chargeable to capital.

An obligation is a fixed or contingent obligation to make

payment, without regard to whether the obligation is otherwise

taken into account for purposes of the Code.

19

Recourse/Non-Recourse Liabilities Definition of “recourse liability”

– Partnership liability to the extent any partner or related person bears the economic risk of loss for that liability under Reg. §1.752-2

Definition of a “non-recourse liability”

– Partnership liability to the extent that no partner or related person bears the economic risk of loss for that liability under Reg. §1.752-2

Non-recourse liabilities are allocated in three tiers:

– The partner‟s share of partnership minimum gain under §704(b);

– The amount of any taxable gain that would be allocated to the

partner under Sect. 704(c) (or in the same manner as Sect. 704(c)

in connection with a revaluation of partnership property), if the

partnership disposed of all partnership property in full satisfaction of

the liabilities and for no other consideration; and

– The partner‟s share of the partnership‟s excess recourse liabilities

(flexibility!).

20

Allocations Attributable To Non-Recourse Liabilities (Reg.

1.704-2)

Deductions attributable to partnership nonrecourse liabilities (“non-

recourse deductions”) cannot have economic effect.

Non-recourse deductions must be allocated in manner deemed to be

in accordance with the partners‟ interests in the partnership, as

provided in Reg.

1.704-2(e).

– Partnership agreement must comply with capital account

maintenance rules.

– Partnership agreement allocates non-recourse deductions “in a

manner that is reasonably consistent” with allocations that have

substantial economic effect of some other significant item

attributable to the property securing the non-recourse liabilities.

– Partnership agreement must contain a “minimum gain chargeback”

provision. 21


1.704-2), Cont.

“1st tier/minimum gain” layer: Partnership minimum gain generally

equals the recapture of non-recourse deductions as a gain that the

partnership would realize if it disposed of property subject to a non-

recourse liability, for no consideration other than full satisfaction of that

liability.

– Increases and decreases in minimum gain from separate properties

are netted for a partnership taxable year.

– Net increase or decrease in partnership minimum gain for any

partnership taxable year is determined by comparing the

partnership minimum gain on the last day of the immediately

preceding taxable year with the partnership minimum gain on the

last day of the current taxable year.

22


1.704-2), Cont.

“2nd tier/

704(c)” layer: Generally equals the gain the partnership

would realize if it disposed of property subject to a non-recourse

liability, for no consideration other than full satisfaction of that

liability

–

704(c) method (traditional, curative or remedial) is relevant.

– “Reverse”

704(c) is included.

23


1.704-2), Cont.

“3rd tier/excess” layer: (Very) generally in accordance with “partnership

profits” or in accordance with facts and circumstances

– Option 1: As such profits interests are specified, provided that the

specified profits interests “are reasonably consistent” with the

allocations of some other significant item of partnership income or

gain

– Option 2: In the manner in which it is reasonably expected that the

deductions attributable to such non-recourse liability will be

allocated (taking into account

704(c))

– Option 3: Up to the amount of the remaining

704(c) gain (including

reverse

704(c) gain) not taken into account under the 2nd tier, with

any remaining amount under another method

A different method may be applied each year. 24

Allocations Attributable To Recourse Liabilities (“Partner Non-Recourse

Deductions”)

Deductions attributable to partnership liabilities for which a partner or

related person bears the economic risk of loss must be allocated to

that partner.

– Ordering rules

– Partner non-recourse debt minimum gain chargeback.

Limited DRO and limited guarantees

Creation of recourse obligation

– Obligation must be enforceable.

– “Plan to avoid or circumvent obligation”

– DRO/guarantee may be “eliminated or reduced.”

May not affect prior allocations

Does not result in remaining impermissible negative capital

account

25

Possible Changes To Current Regulations

Treasury is working on new §752 and §707 rules, which are

expected to address the following topics:

– Further guidance on allocating “3rd tier/excess” non-recourse

liabilities (including whether a preferred return is a significant

item)

– Guidance on allocating “partner non-recourse liabilities” when

partners have overlapping economic risk of loss

– Additional factors illustrating the line under the anti-abuse rule

in Reg. §1.752-2(j), including guidance on how much net value

an indemnitor needs for its guarantee or indemnity to be

respected

26

DISTINGUISHING RECOURSE AND NON-RECOURSE LIABILITIES


28

Recourse Vs. Non-Recourse Relevance Of Classification

• Sections 1001/108

– Sales and exchange vs. COD income

• Sect. 752

– Basis of partnership interest

• Sect. 704

– Allocations of non-recourse deductions, e.g.

• Sect. 465

– At-risk basis

29

Classification Of Liabilities (State Law Purposes)

• Recourse

– Creditor has recourse to all of debtor‟s assets to satisfy the

underlying debt.

• Non-recourse

– Obligation is secured by specific property.

– Creditor is limited to such property to satisfy the obligation.

30

Sect. 1001

• No statutory definition of recourse/non-recourse

• No regulatory definition

• State law definition understood to control

• Effect of distinction (see example, next two slides)

31

Example 1

• A purchases a tractor from B for $1,000 cash and a seller note of

$9,000.

• A becomes delinquent at a time when the balance due on the note is

$7,000, A‟s basis in the tractor is $3,000, and the FMV of the tractor

is $5,000.

• B forecloses and accepts return of the tractor in full payment of the

note.

32

Example 1 (Cont.)

• If the note is non-recourse

– Full $7,000 note balance is treated as “amount realized,” and A has gain of $4,000 ($7,000 amount realized less $3,000 basis).

• If the note is recourse

– A is treated as having sold the tractor for $5,000 (its FMV), resulting in $2,000 of Sect. 1001 gain.

– A also has $2,000 of COD income (excess of note balance over FMV of tractor).

33

Sections 465/704/752

• Partnership definitions of recourse and non-recourse apply

– 465 Partner is not “at-risk” under Sect. 465 for his share of non-recourse debt.

• Exception for qualified NR financing

– 752 Allocation of debt among partners

– 704 Deductions funded by debt attributable to partner(s) to whom debt is allocated

34

Classification Of Liabilities (Partnership Rules)

• Recourse

– A partner or a related person bears the economic risk of loss for

the liability.

• Non-recourse

– No partner or a related person bears the economic risk of loss

for the liability.

• Allocated in accordance with three tiers

35

Economic Risk Of Loss

• Constructive liquidation test

– A partner bears the economic risk of loss with respect to a liability, to the extent the partner would have to pay the liability if the partnership liquidated and all of the partnership‟s assets were worthless.

• Guarantees and other arrangements

– In determining who must pay a partnership liability, consideration is given to all guarantees and other contractual arrangements among the parties, and to other relevant facts and circumstances.

– Guarantor is deemed able to pay irrespective of net worth.

36

Disregarded Entities

• Special rule applies where a partner holds his partnership interest through a DE.

• Partner is treated as being at risk of loss only to the extent of the net value of the DE.

– This rule does not apply when the partner is otherwise liable for the obligation (e.g., via a guarantee).

37

DE: Example

• A owns 100% of LLC; LLC is a DE.

• LLC and B each contribute $100k to AB.

• AB borrows $200k.

• LLC has a DRO, but B does not.

• LLC has no net value.

• For tax purposes, A is treated as direct owner of LLC‟s interest in AB.

• Even though A has a DRO (through LLC), there no EROL, because state law limits his exposure to LLC‟s debts. Thus, debt is NR.

38

Interplay Of Sections

• Does state-law or Sect. 752 definition apply?

• See Great Plains Gasification Associates v. Comm‟r, TC Memo 2006-276

• TP argues for recourse classification so that COD income can be excluded under Sect. 108.

• Tax Court finds that the liability is non-recourse, because no partner bears risk of loss (i.e., Sect. 752 standard applied).

– Even though creditor had recourse to all of the LLCs assets (i.e., the state law standard)

RECENT TRANSACTIONS AND CASES INTERPRETING SECT. 752 ALLOCATIONS


Leveraged Partnership Structure

Sub

LLC

Seller

Partner

Debt

Market

Cash equal to 90% of Business

value Debt Instrument

Assets Business Assets 90% Equity Interest in LLC

(1) Cash equal to 90% of business

value and (2) 10% equity

interest in LLC

Guarantee

1. Sub and Partner form LLC.

2. Sub contributes business assets to the LLC in exchange for (1) a cash payment equal to, for example, 90% of the value of the contributed business assets and distributes the cash to Sub tax-free .

3. Partner contributes assets in exchange for a 90% equity stake in the LLC.

4. The LLC incurs debt (secured by the LLC’s assets) in an amount equal to 90% of the contributed business assets and distributes the cash to Sub tax-free (see Step 2 above).

5. Sub guarantees debt of the LLC equal to the amount of cash Sub receives.

6. Sub distributes 70-75% of cash to the Seller.

1 2 3

6

5

4

40

G-I Holdings Mixing Bowl In re: G-I Holdings, Inc. (D.N.J. 2009)

RPSSLP

Citibank Rhone-Poulenc GAF

Surfactant business assets

($480M)

Class A LP

interest GP

interest $9.8M

Class B LP

interest

Cash and assets

($480M)

41

G-I Holdings Mixing Bowl (Cont.)

RPSSLP

GAF Credit Suisse Rhone-Poulenc

$460M

Pledge of Class

A LP interest

Class A priority

return (equal to

interest on loan) Guarantee of Class

A priority return and

additional financial

obligations under

the partnership

agreement

42

43

Partnership Anti-Abuse

Subchapter K is intended to permit taxpayers to conduct joint

business activity through a flexible economic arrangement without

incurring an entity-level tax.

Implicit in this intent are three requirements:

– The partnership must be bona fide and used for a substantial

business purpose,

– The transaction must be respected under a substance over form

analysis, and

– The resulting tax consequences must clearly reflect income (or

else the distortion must be clearly contemplated by the

applicable provision). Teas. Reg.

1.701-2(b)

Does compliance with regulatory provisions of sections 707 and 752

mean partnership anti-abuse rule does not apply?

44

IRS Response To Levpar Transactions

CCA 2002-46-014 (Aug. 8, 2002)

Facts:

– Taxpayer‟s subsidiary, Y, contributed assets to a partnership, Z.

– Z borrowed money from a syndicate of banks and made a special

distribution to Y. Y then distributed this amount as a dividend to the

taxpayer.

– Y guaranteed Z‟s liability, increasing its basis in its interest in Z

(which allowed Y to avoid recognizing income on the distribution

from Z).

45

C.C.A. 2002-46-014 (Cont.)

IRS disregarded Y‟s guarantee, finding that Y‟s lack of capital and

the restrictive prerequisites for Y‟s performance under the

guarantee suggested the existence of a plan to avoid any

performance obligation from Y on the guarantee.

Without the guarantee, the liability of the partnership was treated

as non-recourse, which generally caused the transaction to be

treated as a disguised sale.

46

C.C.A. 2002-46-014 (Cont.)

The IRS also sought to disregard the transaction on the following grounds:

– Partnership anti-abuse rule: Transaction was entered into with a principal purpose of reducing the partners‟ federal tax liability.

– Substance-over-form: Taxpayer effectively parted with the benefits and burdens of the assets while receiving cash equal to the value of the assets. Thus, taxpayer should be taxed in accordance with the substance of the transaction (a sale) and not its form (contribution and distribution).

– Sham partnership: Facts did not show that taxpayer and other nominal partner in good faith and acting with a business purpose intended to join together in the conduct of a business.

Canal Corp. v. Commissioner, 135 T.C. No. 9 (2010)

The court held that the formation of a joint venture between a

subsidiary of Chesapeake Corp. (now known as Canal Corp.), and

Georgia Pacific (GP) was actually a disguised sale under Sect.

707(a)(2)(B).

As a result, Chesapeake had to include an additional $524 million of

income on its consolidated return.

47

Canal Corp. vs. Commissioner (Cont.)

Wisconsin Tissue Mills Inc. (WISCO), a wholly-owned subsidiary of

Chesapeake, owned and operated a commercial tissue business that

Chesapeake wanted to get rid of.

48

Canal Corp. Structure

WISCO and GP formed Georgia Pacific Tissue LLC.

GP contributed its tissue business assets, with an agreed value of

$376.4 million, in exchange for a 95% interest.

WISCO contributed its tissue business assets, with an agreed

value of $775 million, in exchange for a 5% interest.

On the contribution date, the LLC borrowed $755.2 million from

BoA and immediately distributed the borrowed funds to WISCO as

a special distribution.

WISCO received a “should” opinion from PwC regarding the tax-

free nature of the transaction. 49

WISCO’s Indemnity GP guaranteed repayment of the loan, and WISCO agreed to

indemnify GP in the event GP made payment on its guarantee, subject to certain limitations.

Indemnity was added as a tax, rather than business, requirement.

Limitations on the indemnity included:

– WISCO, not Chesapeake, was chosen as the indemnitor, so that only the WISCO assets would be at risk.

– Indemnity only covered the loan‟s principal, not interest.

– Indemnity required GP to first proceed against the LLC‟s assets before demanding indemnification from WISCO.

– If WISCO was required to make a payment under the indemnity, WISCO would receive an increased interest in the LLC proportionate to any payment made under the indemnity.

– WISCO was not required to maintain a certain net worth.

50

WISCO’s Assets And Liabilities

WISCO used the distributed funds to repay certain inter-company

debt and to pay a dividend.

WISCO also loaned $151 million to Chesapeake in exchange for a

promissory note.

Following the transaction, WISCO‟s assets consisted of the $151

million inter-company note and a corporate jet worth $6 million (or

approximately 21% of the maximum exposure under the

indemnity).

In addition, WISCO was still subject to certain environmental

liabilities and was a guarantor on a Chesapeake line of credit. 51

Tax Court Analysis

The Tax Court presumed that a disguised sale took place, unless

the facts and circumstances indicated otherwise.

– WISCO transferred assets to the LLC, and the LLC

immediately thereafter transferred $755.2 million to WISCO.

Chesapeake argued that the debt-financed transfer exception

applied.

– Because of the indemnity, WISCO bore the entire economic

risk of loss on the LLC debt.

The IRS conceded that an indemnity is generally recognized as a

valid contractual obligation to be considered in determining who

bears the ultimate risk of loss. 52

Tax Court Analysis (Cont.)

The IRS argued, however, that WISCO‟s indemnity should be

disregarded under the anti-abuse rule applicable to partnership

debt allocations, which provides that a partner‟s obligation may be

disregarded if:

– The facts and circumstances indicate that a principal purpose of

the arrangement is to eliminate the partner‟s risk of loss or to

create a façade of the partner bearing the economic risk of loss;

or

– The facts and circumstances evidence a plan to circumvent or

avoid the obligation. Treas. Reg.

1.752-2(j)(1), (3)

Therefore, the Tax Court had to determine if the indemnity was

used as a device to make it appear that WISCO had an obligation

for which it did not bear the actual economic risk or loss.

53

Tax Court Analysis (Cont.)

The Tax Court found that WISCO did not in substance bear the

economic risk of loss for the partnership‟s loan.

“We find that WISCO‟s agreement to indemnify GP‟s guaranty

lacked economic substance and afforded no real protection.”

In reaching this conclusion, the court relied on the following

factors:

– GP did not require the indemnity;

– The indemnity covered only the loan‟s principal amount, not

interest;

– GP was required to proceed against the LLC before it could

pursue an indemnity claim against WISCO; and

– If WISCO made a payment under the indemnity, it would

receive a proportionately increased interest in the LLC. 54

55

Tribune Newsday Transaction: Step 1

Tribune Co.

Newsday, Inc.

CSC Holdings, Inc.

(Cablevision)

NMG Holdings, Inc.

Newsday

Holdings,

LLC

Newsday,

LLC

100% 100%

Membership interest

Newsday assets and liabilities

Membership interest

Specified amount and

$650 million of 8% notes

Sale Of Newsday: Step 2

Tribune Co.

Newsday, Inc.

CSC Holdings, Inc.

(Cablevision)

NMG Holdings, Inc.

Newsday

Holdings,

LLC

Newsday,

LLC

100% 100%

2.8571% membership interest

$612 million cash (distribution)

$18 million cash (pre-paid rent)

97.1429% membership interest

$650 million

notes

Unaffiliated

Third

Party

$650 million

56

57

Tribune’s Cubs Transaction

ESOP

Tribune Co.

Cubs

LLC

Premium

Tickets

LLC

DQ

LLC

WGN

Broadcasting Co.

Dominican

LLC

CSN

Chicago

100%

100% 100% 100% 100%

25% 100%

58

Sale Of Cubs: Step 1

Tribune Co.

Joe and Marlene

Ricketts

Grandchildren’s Trust

Cubs

Entities

Ricketts

Acquisition

LLC

Newco

LLC

Newco

Subs

Membership interest

100% 100%

Membership

interest

$100 million cash

Direct Cubs

contributed assets

Cubs

contributed

assets

59

Sale Of Cubs: Step 2

$698.75

million

notes

Tribune Co.

Ricketts

Acquisition

LLC

Newco

LLC

Unaffiliated

Third Parties $740 million cash

$698.75

million

cash

5% membership interest 95% membership interest

60

Relied-Upon Exception To Disguised Sale Rules

If, as here, a partner transfers property to a partnership, and the

partnership incurs a liability, and all or a portion of the proceeds

of that liability are allocable to a transfer of money to the partner

made within 90 days of incurring the liability …

Then, the transfer of money to the partner is taken into account

(as proceeds of a disguised sale) only to the extent that the

amount of money transferred exceeds the partner's allocable

share of the partnership liability.

– See Treas. Reg.

1.707-5(b)(1)

61

Guarantee In Bankruptcy?

Newsday and Tribune have only 2.8571% and 5% membership

interests, respectively, in the new partnerships but are allocated

substantially greater amounts of the debt pursuant to

guarantees.

In the Newsday deal, Tribune indemnified Cablevision for any

payments made under Cablevision‟s guarantee of the

Newsday, LLC credit facility.

However, should Tribune‟s obligation be disregarded pursuant

to Treas. Reg.

1.752-2(j)?

– Tribune filed for bankruptcy on Dec. 8, 2008.

– Generally, Tribune‟s obligation should be respected so long

as Tribune did not know its bankruptcy was imminent at the

time it entered into the indemnification agreement.

62

Guarantee In Bankruptcy (Cont.)

At the time of the Cubs sale, Tribune was in bankruptcy.

Tribune guaranteed repayment of debt of Newco, LLC.

– Only provided a guarantee of collection, which requires

exhaustion of all lender remedies against Newco, all other

guarantors, and all collateral before Tribune is required to

perform on its guarantee

Should Tribune‟s guarantee be disregarded?

– See CCA 2002-46-014 (Aug. 8, 2002), discussed previously

Circular 230 Disclosure

These materials are intended for internal discussion purposes only. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or any other state or local law, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

59

PLANNING STRATEGIES AND TECHNIQUES


65

“Zombie Partnership”

• IRS Partnership Audit Technique Guide, Chap. 8 – Real Estate Issues in Partnerships

– “Partnerships which are no longer actively engaged in business but which still wander aimlessly about shedding tax benefits or postponing gain are called „Zombie Partnerships.‟”

66

Zombie Characteristics

• Zombie partnership traits:

– Debt

– Partners have negative capital accounts.

– Little or no assets or economic activity

– Asset may have been disposed while debt remains on books (attempt to defer Tufts gain).

– Or, interest accruals and depreciation exceed rental income; principal of debt plus accrued interest exceed value of underlying property.

67

COD Income Vs. Tufts Gain

• Depending on circumstances, TP could benefit from either NR or

recourse characterization.

– If TP has a capital loss CF favor NR and Tufts gain

– IF TP is insolvent favor recourse characterization and

corresponding (excludable) COD income

• Will “11th hour guarantee” work?

• IRS scrutinizes reporting of COD income vs. Tufts gain.

68

Audit Technique Guide • “Analyze all loan documents to determine whether loan was non-

recourse or recourse. If the loan is determined to be non-recourse, analyze all sales documents to determine whether there were two transactions or one interrelated transaction. If it is determined that there was one transaction, then the full amount of non-recourse debt should be treated as sales proceeds.”

• “If inspection of the partnership return indicates that COD income was reported, property decreased on the balance sheet, and a loss/very small gain/ or no gain on sale of partnership property was reported, determine whether partnership properly reported transaction.”

• “If a guarantee of non-recourse debt was made at the eleventh hour, it may not change the status of the loan from non-recourse to recourse. For example, if the guarantee provides that a partner must repay the loan only if he fights the foreclosure sale, this would be considered a contingent guarantee and would not change the loan from non-recourse to recourse. If you have an 11th hour guarantee issue, call a Partnership Technical Advisor.”

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Abandonment Of Interest

• Sect. 165(a)

– Allows a deduction for loss sustained during year

• Sect. 165(f)

– Losses from sale/exchange of capital asset not governed by general rule of Sect. 165(a)

• Sect. 741

– Partnership interest is a capital asset.

• Sect. 752(b)

– Decrease in share of partnership liabilities = distribution

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Abandonment: Rev. Rul. 93-80

• If partnership liabilities are allocated to abandoning partner:

– 752(b) treats reduction in liabilities as a distribution, resulting in

“sale” of a capital asset.

– Accordingly, resulting loss is loss from the sale or exchange of a

capital asset capital loss.

• This treatment applies even if liabilities allocated to abandoning

partner are de minimis.

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Abandonment: Rev. Rul. 93-80 (Cont.)

• If no liabilities allocated to abandoning partner:

– No deemed distribution and thus no “sale”

– Resulting loss is thus ordinary under 165(a)

• General partners will have difficulty establishing ordinary loss.

– But see In re Kreidle, 146 B.R. 464 (general partner remained liable for liability; thus, no 752 distribution)

• Planning with non-participating preferred partners

– No liabilities allocated – limit Tier 3 allocations to non-preferred partners

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Establishing Abandonment

• Partner must prove that:

– He intended to abandon his interest.

– He undertook an affirmative act of abandonment.

– Intent and affirmative act are communicated to all relevant

parties.

• A letter to partnership indicating intent to abandon and refusal to

contribute or otherwise associate should suffice.

recourse and non-recourse liability in...

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