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Final Regulations Revert Back to Prior Partnership Disguised Sale Rules

On October 4, 2019, regulations were finalized that address the allocation of partnership liabilities for disguised sale purposes.

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On October 4, 2019, regulations were finalized that address the allocation of partnership liabilities for disguised sale purposes.

On October 4, 2019, regulations were finalized that address the allocation of partnership liabilities for disguised sale purposes. This final regulation reinstates pre-2016 temporary regulation rules whereby a partner’s share of recourse and nonrecourse liabilities are treated distinctly and in accordance with IRC §752. In other words, under the reinstated rules of Reg. §1.707-5(a)(2), recourse debt and nonrecourse debt are allocated in the same manner as they would be with respect to a partner’s basis, which follows each partner’s share of the economic risk of loss.

This opens the door once again for taxpayers to defer gain on partnership contributions and leveraged distributions through the use of guarantees or other similar methods.

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This change comes in the wake of an April 2017 Executive Order (E.O. 13789) on reducing tax regulatory burdens. In response, the IRS identified the 2016 final and temporary regulations in T.D. 9788 as implicating some of those regulatory burdens. In turn, in June of 2018 the IRS issued the 2018 Proposed Regulations, which proposed to withdraw the “§707 Temporary Regulations” under T.D. 9788 and reinstate the regulations under Reg. §1.707-5(a)(2). Now, the IRS has adopted the 2018 Proposed Regulations, thereby reinstating the rules prior to the 2016 §707 Temporary Regulations.

The §707 Temporary Regulations were originally issued in October 2016 in an effort to tighten the disguised sale rules and restrict certain transactions that the IRS regarded to be abusive. Under these rules, a partnership would determine all partnership liabilities for disguised sales purposes—both recourse and nonrecourse—by applying the same percentage used to determine a partner’s share of excess nonrecourse liability under Reg. §1.752-3(a)(3) (T.D. 9788). In essence, it treated all liabilities as nonrecourse thereby disregarding the actual economic risk of loss associated with the underlying liability.

The 2016 final and temporary regulations also addressed the issue of bottom-dollar payment obligations. However, while the 2019 final regulations revise the rules for liability allocation with respect to disguised sales, it makes no such revision with respect to bottom-dollar payments. Therefore, these will continue to not be respected by the IRS as true recourse liabilities in this context.

Treasury and the IRS will continue to study the merits of the approach in the §707 Temporary Regulations and other approaches, including the final regulations, to determine which results in the most appropriate treatment of liabilities in the context of disguised sales.

The final regulations apply to any transaction with respect to which all transfers occur on or after October 4, 2019, the date that the 2016 Temporary Regulations expired. However, partnerships and their partners may choose to apply the final regulations to any transaction where all transfers occur on or after January 3, 2017, the applicable date of the 2016 Temporary Regulations, up until the October 4, 2019 mandatory date.

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