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Is your partnership debt basis at risk?
Did you know that Treasury and IRS officials appear close to issuing newly proposed Treasury regulations that could significantly impact the way partnership debt is characterised and allocated? Taxand USA discusses the Tax Court's decision in Canal Corporation and Subsidiaries v. Commissioner and how it could prompt the Government to re-evaluate rules for allocating debt among partners of a partnership.
In the Canal Corporation case, the Tax Court held that the anti-abuse rules applied to a leveraged partnership transaction and, as a result, the Court disregarded certain contractual obligations of a partner to a make a payment that would otherwise have resulted in debt basis to the partner in question. As a result, the partner lacked sufficient debt basis and was the recipient of taxable disguised sale proceeds.
In response to the Tax Court's ruling in Canal Corporation, the Treasury and IRS officials have indicated that proposed regulations may be issued that will drastically alter the rules for characterising and allocating partnership liabilities.
Based on informal comments made by Government officials, these proposed regulations, if and when issued, are believed to contain at least 2 key provisions that will impact many existing partnership arrangements:
- They would impose a "commercial" requirement for purposes of assessing the validity of contractual obligations to make a payment
- They would extend the net-worth requirement (which currently applies solely to disregarded entity partners) to all entities and possibly individuals
The inclusion of these types of provisions would seem to result in a fundamental change from the payor of last resort standard that taxpayers have historically based tax planning and reporting decisions upon.
Also published in Thomson Reuters' Taxnet Pro, 7 November 2013
Now is the time for companies to evaluate whether their partnership liability allocations would be subject to reduction in light of recent case law and/or upon the issuance of newly proposed 752 regulations. To the extent that a liability reduction occurs, then a deemed cash distribution under IRC Section 752(b) or, worse yet, ordinary income recapture under the at-risk rules may result.
Taxpayers should be aware of certain types of contractual obligations (ie deficit restoration obligations, limited indemnification provisions, bottom side guarantees etc) that they believe give rise to 752 liability allocations under current law, but that could be at risk as a result of the potential new requirement that they be "commercial." To assess the potential risk, it may be prudent to compare the current legal terms of any contractual obligations to other unrelated third-party transaction terms. If a company's legal terms/protections are lacking, it may be possible to amend them prior to the issuance of a Treasury regulation that contains an effective date. However, any meaningful amendments would likely result in additional business risk that would need to be weighed against the benefit of the business' debt basis allocation.