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Wednesday, April 16, 2014

ARTICLE ABSTRACT: Proposed Regulations on Debt Allocations: Controversial, and Deservedly So


Proposed Regulations on Debt Allocations: Controversial, and Deservedly So




Journal of Taxation, April 2014




Addresses proposed modifications to Section 707 and 752 Regulations relating to partnership indebtedness. The author is very critical of the changes to the Section 752 rules.


Proposed regulations discussed include Example 12 in Prop.Reg. 1.707-5(g) relating to Code §707 disguised sale rule when debt proceeds of multiple liabilities are distributed, modifications to Code §707 disguised sale rules relating to reimbursements of preformation capital expenditures, the definition of "qualified liabilities" under Code §707, consideration of reductions in a partner's share of liabilities under Code §707, tiered partnership issues under Code §707,  netting of increases and decreases in liabilities in partnership mergers and consolidations.


In regard to disguised sales by a partnership to a partner by reason of a partner receiving property subject to a liability under Treas. Regs. §1.707-6, the Service is considering whether it may be inappropriate to take into account the transferee partner's share of a partnership liability immediately prior to a distribution if the transferee partner did not have economic exposure with respect to the partnership liability for a meaningful period before the associated property is distributed to that partner subject to the liability.


Author notes that the new proposed regulations relating to the allocation of partnership liabilities reflect a complete reversal of the thinking that underlay the existing Regulations, which look at whether any partner could bear the risk of loss rather than whether any partner would bear the risk of loss.


  • Under current  Treas. Regs. §1.752-2, a partner's share recourse liabilities depends on the extent it bears the risk of loss. This is based on who would have to pay if the partnership's assets became worthless - i.e., an ultimate liability test under a worst-case scenario. Proposed Regulations now add 7 new requirements before a partner receives a share of the liability under these rules instead of the nonrecourse liability rules (ProposedTreas. Regs. §1.752-2(b)(3)(ii) and (iii)). Further such partner must have adequate "net value" to pay the obligation.  This will require the partnership to make annual valuation determinations in regard to its partners. The author notes that the new rules can lead to absurd results, and in many circumstances will allocate debt to partners who do not really bear the economic risk of loss.
  • Under current Regulations, a partner's share of nonrecourse liabilities can be allocated based on profits. The "significant item method" variation and the "alternative method" variation are done away with in the proposed Regulations. The share of profits will now be determined based on the partner's liquidation value percentage on a deemed liquidation of the partnership as of the most recent occurrence of formation or an event described in Treas. Regs. §1.704-1(b)(2)(iv)(f), regardless of whether capital accounts were adjusted for that event.



Code §707 & 752; Regulations and Proposed Regulations under those Sections


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