share of partnership liabilities affects the basis of the
partnership interest in the following manner:
increase in partnership liabilities increases a partner's
basis in the partnership.
- A decrease
in partnership liabilities decreases a partner's basis in
the partnership. IRC Sec. 752(a)
partners' can share in partnership liabilities for basis purposes
a determination must be made as to which of the partnership's
obligations will be treated as liabilities
Although the final §752 regulations do not specifically define
the term "liability," the definition of a liability in the
previously issued temporary regulations probably provides
a good working definition of the term. For purposes of §752,
under former Temp. Treas. Reg. §1.752-1T(g), an obligation
is considered a liability only to the extent that incurring
or holding the obligation gives rise to:
in property (including cash) owned by the obligor,
deduction that is taken into account in computing taxable
income of the obligor, or
expenditure that is not deductible in computing the obligor's
taxable income and is not properly chargeable to capital.
Treas. Reg. §1.752-1(g). See Treas. Reg.
§1.752-1T(k), Example (2).
of Cash Method Partnerships, Etc.
payable. For partnership taxable years beginning prior
to September 19, 1988, partnership liabilities include the
partnership's obligations for repayment of trade accounts,
notes, and accrued expenses even if those items are not recorded
on the partnership's books due to its use of the cash method
of accounting. Rev. Rul. 60-345, 1960-2 C.B. 211. For partnership
taxable years beginning after September 18, 1988, such obligations
will not be considered partnership liabilities of a cash basis
partnership for purposes of §752. Rev. Rul. 88-77, 1988-2
Contributions of accrued liabilities. Contributions made
after March 31, 1984, of accrued but unpaid liabilities (e.g.,
accounts payable) by a cash method partner to a partnership
will be treated similarly to §357(c) items in a corporate
tax context. Thus, those items should not be treated as liabilities
for purposes of §752. Staff of the Joint Committee on Taxation,
General Explanation of the Revenue Provisions of the Tax Reform
Act of 1984 (P.L. 98-369), 215 (the "Staff Report").
Deferred income. Unrestricted progress payments received
by a partnership using the completed contract method of accounting
represent deferred income rather than a partnership liability.
Rev. Rul. 73-301, 1973-2 C.B. 215. However, a partnership's
prepaid subscription income constitutes a partnership liability.
A limited partner's basis for his or her interest in a first
tier limited partnership includes that partner's share of
the second tier partnership's liabilities which are allocated
to the first tier partnership. Rev. Rul. 77-309, 1977-2 C.B.
to Capital Versus Loans
Loans to partners. A partner's receipt of money from
a partnership under an obligation by the partner to repay
the funds constitutes a loan, and thus a liability of the
partnership, rather than a distribution. To the extent such
obligation is canceled, the obligor partner will be considered
as having received a distribution at the time of the cancellation.
Treas. Reg. §1.731-1(c).
Loans by the general partner. Nonrecourse loans by
the general partner to either the limited partners or the
partnership may constitute capital contributions to the partnership
by the general partner, rather than loans. Rev. Rul. 72-135,
1972-1 C.B. 200.
Convertible debt. A nonrecourse loan by an unrelated
third party to a partnership, secured by the partnership's
property and convertible at the option of the lender into
an interest in the partnership's profits may be treated as
a capital contribution rather than as a loan. Rev. Rul. 72-350,
1972-2 C.B. 394.
Advances to the partnership by the partners considered
equity. Advances to a partnership by a partner have been
held to be capital contributions (rather than loans) where
the loans were noninterest-bearing, unsecured, subordinated
debt. Hambuechen v. Commissioner, 43 T.C. 90 (1964).
Advances to the partnership by the partners considered loans.
Advances to a partnership by a partner were held to be loans
(rather than capital contributions) where repayments were
made regularly, notes were given, the advances were not subordinated,
and the partnership's capitalization was not abnormal. Kingbay
v. Commissioner, 46 T.C. 147 (1966).
Validity of Debt Issues
certain circumstances the IRS has taken the position that
a debt does not exist for tax purposes. Critical factors in
this determination are whether or not the debt is nonrecourse
and whether the value of the collateral can support the purported
debt. This determination is generally made when the debt is
Estate to Franklin, 64 T.C. 752, (1975), aff'd,
CA-9, the Tax Court determined that nonrecourse debt
used to purchase real estate in a sale-leaseback transaction
was not valid debt. The rent payments were constructed
to cover the debt service and the Court found the
purchase price to be significantly inflated.
Rul. 78-79, 1978-1 C.B. 62, the Service held that
a nonrecourse note issued for the purchase of a patent
was not valid debt. The note represented 99.75% of
the purchase price. The Service determined that the
fair market value of the patent was not shown to even
approximate the amount of the nonrecourse note. Further,
the transaction seemed to be designed to generate
amortizable basis in the patent. .
D. Mayerson, 47 T.C. 340 (1966), the taxpayer
acquired a building with a minor down payment (approximately
3%), the balance due on a nonrecourse note which could
be paid off at any time but required interest only
payments during its 99-year term with a balloon payment
at the end. The Court upheld the purchase because
the value of the property appeared to support it and
was negotiated at arm's-length.
Because a liability has a direct influence on the amount of
basis that a partner is deemed to hold, a determination of
what is a partner's share of liabilities must be made. In
making this determination, two considerations must be addressed.
the liability in question a recourse or nonrecourse liability?
This is important because different sets of sharing rules
are used depending upon the type of liability.
are both recourse and nonrecourse liabilities allocated
among the partners? This is important because assorted rules
and profit sharing ratios may exist for different items
of partnership income and deductions.
basic approach used in addressing both of these issues reflects
Congress' goal in the Tax Reform Act of 1984 of ensuring that
the partner who receives the basis with respect to a partnership
liability also bears the economic risk of loss for the liability.
Regulations effective for liabilities incurred or assumed
on or after January 30, 1989, have undertaken this directive
and instituted the ultimate responsibility test, which at
times appears to resemble more closely a term of art. The
thrust of this test is to determine who bears the ultimate
financial responsibility for payment of a partnership liability.
If it can be established that a partner will have to satisfy
a liability out of his/her own funds, it is a recourse liability.
If no partner will have to defray the cost of a liability
out of his/her own funds, or if the partnership fails to do
so, then the liability is said to be a nonrecourse liability.
If a liability has nonrecourse and recourse characteristics,
the debt will be treated as two different liabilities. Reg.
recourse liability is any liability for which any partner
(or person related to a partner) bears the economic risk of
loss for the liability. A partner's share of recourse liabilities
equals the portion, if any, of the economic risk of loss for
such liability that is borne by that partner (or persons related
to such partner) if the liability is not discharged by the
partnership. To determine the risk of loss, the Regulations
adopt a hypothetical worst-case scenario called a "constructive
liquidation," which is often referred to as the "atom bomb
test' (constructive liquidation). Treas. Reg. §1.752-1(a)(1).
Under constructive liquidation, the following scenario is
deemed to occur:
partnership assets are worthless and disposed of in a taxable
transaction for zero consideration.
partnership liabilities are due and payable in full.
partnership allocates all gains and losses with respect
to the disposition according to the partner's capital accounts.
partners interests in the partnership are liquidated. Reg.
partner then would bear the economic risk of loss to the extent
that, after constructive liquidation, the partner would be
obligated to pay a creditor or make a contribution to the
capital of the partnership. A partnership contribution obligation
generally occurs when a partner is required to restore a negative
capital account balance as a result of the constructive liquidation.
Accordingly, the partner is generally allowed to include that
amount of his/her potential liability in the basis of his/her
partnership interest. This required contribution is taken
into account before the balance of the liabilities are pro
rated. Reg. Sec, 1.752-2(b)(1).
and Y are partners in the XY partnership, each sharing
profits and losses 50 percent and each obligated to
restore any negative capital account balances. The
only asset of the partnership is land with a basis
and fair market value of $60,000. X has a basis in
the partnership interest of $10,000 and Y's basis
is $50,000. If the partnership borrowed $80,000 on
a recourse basis to purchase a building, the debt
would be allocated $60,000 to X and $20,000 to Y determined
to the atom bomb test (constructive liquidation),
the land and building are deemed worthless and sold
for $0, generating the respective losses. Partner
X is obligated to contribute $60,000 while partner
Y only is obligated to contribute $20,000. Both are
required to restore their negative capital account
balances. Thus, to that extent, the liabilities are
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