FSA Provides Favorable Guidance on Liability Allocation in Partnership Division

In FSA 200131013, a partnership (Upper-Tier I) owned an interest in a lower-tier partnership (LTP) that had incurred debt. Upper-Tier I had taken nonrecourse deductions. It transferred part of its interest in LTP to another partnership (Upper-Tier II) that had the same ownership structure. After some debt restructuring, LTP allocated most of its debt to Upper-Tier II. The FSA concluded that, under Sec. 752(b) or 731, any debt shifting from Upper-Tier I to Upper-Tier II should not create gain for Upper-Tier I partners, because each partnership had identical ownership structures. The IRS respected Upper-Tier I and Upper-Tier II as separate partnerships, creating separate partnership interests with separate tax basis.

The rationale for the conclusion on the debt-shift issue seemed to be based on the Service's treatment of Upper-Tier I's transfer of the LTP interest as a division of Upper-Tier I. The IRS also indicated that the division of Upper-Tier I was similar to a conversion of a state-law partnership to a state-law limited liability company, citing Rev. Rul. 95-37 for the nonrecognition treatment of Upper-Tier I's division.

The FSA also addressed the allocation of cancellation of debt (COD) income at the LTP level. After LTP restructured its debt, it recognized COD income allocated solely to partners who were withdrawing from the partnership (i.e., partners other than Upper-Tier I and Upper-Tier II). The partnership agreement failed to satisfy the Sec. 704(b) safe harbors; thus, the FSA concluded that the partnership had to allocate COD income among the partners, according to their partnership interests.

From Jeffrey A. Erickson, J.D., Washington, DC