Prop. Regs. on Partnerships Assumption of Partners Liabilities 

In June 2003, Treasury issued two sets of regulations (TD 9062, REG-106736-00) on a partnerships assumption of a partners liabilitiesTemp. Regs. Sec. 1.752-6T and Prop. Regs. Sec. 1.752-7. The regulations were issued in response to the enactment of Sec. 358(h) by Section 1(a)(7) of the Community Renewal Tax Relief Act of 2000 (2000 Act), and are intended to prevent the duplication and acceleration of losses through a partnerships assumption of a partners liabilities.

As is explained below, the temporary regulations apply retroactively to assumptions of fixed and contingent liabilities (as broadly defined in Sec. 358(h)(3)) occurring after Oct. 18, 1999 and before June 24, 2003. The proposed regulations include an expansive definition of the term liability, as well as complex rules on the deduction that occurs on economic performance as to the liability; the proposed rules generally would apply to liability transfers occurring after June 23, 2003. However, a taxpayer can elect to apply them retroactively to liability transfers occurring after Oct. 18, 1999. The election must be made on the first timely filed partnership income tax return filed after Sept. 23, 2003; thus, in certain cases, a tax adviser will need to promptly consider whether to elect to apply the proposed rules retroactively. 

Overall, the regulations (particularly the proposed ones) are extremely complex. Careful analysis of their potential tax consequences is needed to assess properly the advantages and/or disadvantages of electing to apply the proposed regulations retroactively.

Background

Congress included Sec. 358(h) in the 2000 Act to thwart certain loss-duplication transactions. It was primarily concerned with a transfer of property to a corporation in exchange for stock and the corporations assumption of certain of the transferors contingent obligations. The transferor would assert that the corporations assumption of the obligations reduced the fair market value (FMV)but not the basisof the stock received in the exchange, then later sell all or a portion of the stock and claim a loss.

In response, Congress enacted Sec. 358(h), on the assumption of liabilities in corporate nonrecognition exchanges. Sec. 358(d) generally provides that a transferor has to treat certain liabilities assumed in an exchange as money received; however, for this purpose, liability does not include one excluded under Sec. 357(c)(3). In turn, Sec. 357(c)(3) refers to liabilities the payment of which either (1) would give rise to a deduction or (2) would be described in Sec. 736(a) (guaranteed payments), provided that such liabilities did not result in the creation of, or an increase in, the basis of property.

Generally, Sec. 358(h)(1) provides that, if the basis of stock received in a nonrecognition exchange exceeds its FMV (after applying the Sec. 358 provisions discussed above), the basis must be reduced (not below FMV) by any liability assumed in such exchange. However, there are some exceptions. Sec. 358(h)(2) generally provides that Sec. 358(h)(1) does not apply to any liability if (1) the trade or business with which the liability is associated is transferred to the person assuming the liability as part of the exchange or (2) substantially all the assets with which the liability is associated are transferred in the exchange. For Sec. 358(h) purposes, Sec. 358(h)(3) defines liability to include any fixed or contingent obligation to make payment, regardless of whether the obligation is otherwise taken into account for Code purposes. Sec. 358(h) applies to liability assumptions after Oct. 18, 1999.

When Congress drafted Sec. 358(h), it was aware that taxpayers could engage in loss-duplication transactions involving partnerships. As a result, 2000 Act Section 309(c)(1) directed Treasury to prescribe rules to provide appropriate adjustments under subchapter K...to prevent the acceleration or duplication of losses through the assumption of (or transfer of assets subject to) liabilitiesin transactions involving partnerships... Congress indicated that these rules should be effective for liability assumptions after Oct. 18, 1999, unless Treasury prescribed a later effective date.

Notice 2000-44: The IRS later issued Notice 2000-44 as a stopgap measure to discourage the marketing of certain loss-duplication transactions involving partnerships, making such transactions listed transactions. The regulations reflect a more comprehensive response to the Congressional directive in the 2000 Act. As is explained below, the temporary regulations reinforce Notice 2000-44 and generally apply the Sec. 358(h) approach to partnerships, with some modifications.

Comments: Some commentators have argued that the temporary regulations are not valid, because they retroactively address liability assumptions by partnerships and are not limited to transfers by partnerships as shareholders; see Internal Revenue Service Public Hearing on Proposed Regulations Relating to Assumption of Partner Liabilities, 2003 TNT 200-37 (statement of Philip F. Postlewaite, representing the Coalition Against Regulatory Excess (CARE)). In addition, some commentators have argued that the Temporary regulations are invalid because they were adopted to assist the IRS in litigation; see id. (statement of Thomas L. Evans, representing CARE). This article assumes the validity of the temporary regulations without expressing a view on that issue.

The proposed regulations are lengthier and more complex; they provide a broad definition of the term liability for Sec. 752 purposes, attempt to deal with difficult issues on how and when the deduction attributable to the contingent liability can be taken into account and contain various conforming amendments and other technical rules (including those on liability assumptions by corporations from partners and partnerships).

Temp. Regs.

The temporary regulations specifically prohibit partners and partnerships from entering into transactions described in, or substantially similar to, those outlined in Notice 2000-44, by applying Sec. 358(h). Under Temp. Regs. Sec. 1.752-6T(a), if a partnership assumes a partners liability (as defined in Sec. 358(h)(3), other than a liability to which Sec. 752(a) and (b) apply) in a transaction described in Sec. 721(a), after the application of Sec. 752(a) and (b), the partner reduces its basis in its partnership interest by the liability assumed, but not below the interests adjusted value (i.e., its FMV increased by the partners share of partnership liabilities, as determined under Regs. Sec. 1.752-1 through -5).

Temp. Regs. Sec. 1.752-6T(b) contains exceptions to the above rule. Generally, the exceptions in Sec. 358(h)(2)(A) (on the transfer of the trade or business associated with the liability) and (B) (on the transfer of substantially all of the assets associated with the liability) apply to Temp. Regs. Sec. 1.752-6T, except that, under Temp. Regs. Sec. 1.752-6T(b)(2), if a liability (as defined in Sec. 358(h)(3)) is assumed in a Notice 2000-44 transaction, Sec. 358(h)(2)(B) does not apply.

Temp. Regs. Sec. 1.752-6T(d) provides that the temporary regulations are effective for assumptions of Sec. 358(h)(3) liabilities occurring after Oct. 18, 1999 and before June 24, 2003.

Prop. Regs.

The proposed regulations are intended to prevent loss duplication and acceleration via a partnerships assumption of a partners 1.752-7 liability. Under Prop. Regs. Sec. 1.752-7(b)(2),  a 1.752-7 liability is any fixed or contingent obligation not described in Prop. Regs. Sec. 1.752-1(a)(1). In turn, Prop. Regs. Sec. 1.752-1(a)(1) generally defines a liability for Sec. 752 purposes as any obligation, fixed or contingent (including the premium received for the grant of an option), that (1) creates or increases basis in an asset (including cash), (2) creates an immediate deduction on the obligations incurrence or (3) constitutes a nondeductible noncapital expenditure. (This definition, in effect, would (1) codify in regulatory form the IRSs holding in Rev. Rul. 88-77 and (2) affirm the IRSs holding in Rev. Rul. 95-26 and the decision in Salina Partnership LP, TC Memo 2000-352, but (3) reverse the decision in Helmer, TC Memo 1975-160.) As a result, 1.752-7 liabilities would generally include obligations (such as pension and environmental obligations) that have not yet generated basis or a deduction and, due to their contingent nature, do not yet constitute a noncapital nondeductible expenditure.

Under Prop. Regs. Sec. 1.752-7(a)(1), if a partnership assumed a partners 1.752-7 liability, Sec. 704(c) principles would apply. Under those rules, the liability would be treated as built-in loss (BIL) property when assumed by the partnership; the partner would be deemed the contributing partner. Prop. Regs. Sec. 1.752-7(a)(1) generally provides for the contributing partner to deduct the BIL on the partnerships or assuming partners economic performance of the obligation. For this purpose, Prop. Regs. Sec. 1.752-7(b)(2)(ii) defines a 1.752-7 liability as the amount of cash a willing assignor would pay to a willing assignee to assume the liability in an arms-length transaction.

Significantly, unlike the temporary regulations, Prop. Regs. Sec. 1.752-7 does not require the contributing partner to reduce its partnership-interest basis when the partnership assumes the 1.752-7 liability; thus, the full basis generally would be available to absorb both cash distributions and loss allocations from the partnership attributable to items other than the economic performance of the contingent obligation. Prop. Regs. Sec. 1.752-7(e)(1) requires that, if the partnership or an assuming partner satisfies the liability while the contributing partner is still a partner, the deduction associated with the economic performance of the 1.752-7 liability the partnership assumed would be specially allocated to the contributing partner under Sec. 704(c) principles.  

Under Prop. Regs. Sec. 1.752-7(e)(1), if the contributing partner (1) disposes of or (2) liquidates its partnership interest or (3) another partner assumes the 1.752-7 liability, the contributing partners basis in its partnership interest is reduced immediately before the occurrence of such event, by the lesser of the (1) excess of basis at that time over adjusted value or (2) the remaining BIL on the 1.752-7 liability. The reduction would be based on the lesser of the two amounts, to take into account the results of partnership operations between the time the partnership assumed the obligation and the time one of the three events listed above occurred.

For example, if the contributing partners basis in its partnership interest (unreduced by the obligation assumption) was used to absorb partnership distributions and economic performance of the obligation has not yet occurred, it is likely that there will be no excess of basis over adjusted value and, thus, no reduction in the outside basis of the contributing partners partnership interest. But, because the contributing partners deduction is also based on the lesser of these two amounts (as is discussed below), neither the contributing partner nor the partnership can take a deduction for the economic performance of the BIL.

Under Prop. Regs. Sec. 1.752-7(e)(1), after the occurrence of one of the above-described events, the partnership cannot take a deduction or capital expense on the economic performance of the 1.752-7 liability to the extent of the remaining BIL associated with it. If, however, the partnership notified the contributing partner of the economic performance of the 1.752-7 liability, the contributing partner could take a deduction or loss when economic performance occurred, equal to the lesser of (1) partnership-interest basis over adjusted value or (2) remaining BIL on the obligation.

Conforming changes: The proposed regulations also make conforming amendments to (1) Regs. Sec. 1.704-1(b)(2) (by providing that a partners capital account is reduced by a partners 1.752-7 liability a partnership assumes); (2) Regs. Sec. 1.704-2(b)(3) (by treating a 1.752-7 liability as nonrecourse for purposes of the partnership allocation rules); and (3) Regs. Sec. 1.705-1 (by directing taxpayers to Regs. Sec. 1.358-1(b) and the proposed regulations for basis adjustments needed to coordinate Sec. 705 with Sec. 358(h) and the proposed regulations). In addition, Prop. Regs. Sec. 1.752-7(i) applies the above rules to tiered-partnership structures.

Exceptions: Similar to the temporary regulations, the proposed regulations contain certain exceptions. In the corporate context, Sec. 358(h) does not apply when the trade or business, or substantially all of the assets, associated with the liability, is transferred to the corporation assuming the liability. For partnerships, the proposed regulations provide for a variation: under Prop. Regs. Sec. 1.752-7(d)(2)(i)(A), the ex-ception for transferring the trade or business associated with the liability applies only when a partnership assumes a 1.752-7 liability as part of a contribution of that trade or business and the partnership continues to conduct that trade or business after the contribution. In addition, the proposed rules do not include the exception for transfers of substantially all the assets associated with the liability, out of concern that it could allow transactions to occur that are barred by Notice 2000-44.

De minimis rule: Prop. Regs. Sec. 1.752-7(d)(2)(i)(B) adds a de minimis exception not present in Sec. 358(h). Under this exception, certain of the proposed rules do not apply if, immediately before the (1) contributing partners disposition of the partnership interest, (2) liquidation of the contributing partners partnership interest or (3) assumption of the 1.752-7 liability by another partner, the remaining BIL on all the 1.752-7 liabilities the partnership assumed (other than 1.752-7 liabilities assumed by the partnership with an associated trade or business) does not exceed the lesser of (1) 10% of the gross value of the partnerships assets or (2) $1 million.

Effective Date/Retroactivity Election

The proposed regulations, if finalized in their current form, would be effective for all liability transfers occurring after June 23, 2003; nevertheless, they allow a taxpayer to elect to apply them retroactively to liability transfers occurring after Oct. 18, 1999. To make the election, under Prop. Regs. Sec. 1.752-7(j)(2), a partnership must attach a statement to its first timely filed Federal return after Sept. 23, 2003. Thus, if a calendar-year partnership files its 2002 return pursuant to a valid extension before Sept. 23, 2003, the election would not be made on that return, but on the one for its 2003 calendar year (the first timely return filed after Sept. 23, 2003). If, however, such partnership files its first timely return for 2002 after Sept. 23, 2003, the election would be made on that return.

Benefits: An advantage of making the election can be that the proposed regulations do not require an immediate basis reduction in the partnership interest on assumption of the obligation. In addition, the proposed rules set forth a way to determine how and when the deduction attributable to the contingent obligation is taken into account.

Burdens: A possible disadvantage is that the definition of liability for Sec. 752 purposes is expanded to encompass a broad range of contingent-type obligations. It may be argued that the certainty the proposed regulations provide makes up for their complexity and that, generally, the election should be made. Nonetheless, the facts of each situation should be taken into account in determining whether to make the election.

Application to S Corporations

The preamble to the proposed regulations indicates that, although Sec. 358(h) applies to S corporations, the proposed rules do not address S corporations assumption of liabilities. The preamble also explains, however, that any rules applicable to assumptions of liabilities by corporations would apply equally to S corporations, in the absence of provisions to the contrary.

From Timothy P. Carpenter, CPA, MST, New York, NY, and Monte Jackel, J.D., LL.M., Carol Kulish Harvey, J.D., and Eric Sloan, J.D., LL.M., Washington, DC