1. ADVANCED PARTNERSHIP DEBT ALLOCATIONS Howard E. Abrams Warren Distinguished Professor USD School of Law April - June 2016

2. BASIC RULES  Recourse debt is allocated in accordance with risk of loss, usually based on a hypothetical zero-value sale and liquidation.  Nonrecourse debt is allocated according to three tiers:  T1: The minimum gain tier.  T2: The minimum §704(c) gain tier.  T3: The residual (profits interests) tier.  Note: There is no third category of partnership debt. If a debt is partially recourse and partially nonrecourse, it is treated as two separate debts.

3. DYNAMIC RECOURSE DEBT: EX. 1  P and Q each contribute $30 to the PQ general partnership in exchange for 50% of profits and losses. The partnership borrows $40 on a fully recourse basis. How is the debt allocated between P and Q? PQ CAOBCAOB 30 -50 -20----20---

4. DYNAMIC RECOURSE DEBT: EX. 1  Putting the debt into the outside bases as the partners share risk of loss, the books become: PQ CAOBCAOB 30 20 30503050

5. DYNAMIC RECOURSE DEBT: EX. 1  Suppose the partnership now distributes $40 of cash to partner P. The books of the venture become: PQ CAOBCAOB 30503050 -40 00 -10103050

6. DYNAMIC RECOURSE DEBT: EX. 1  But we need to consider the possibility that the distribution works a reallocation of the debt even though the amount of the debt has not changed and loss sharing ratios have not changed. PQ CAOBCAOB -10103050 -30 -40---$ 0---

7. DYNAMIC RECOURSE DEBT: EX 1  The debt has thus shifted entirely to P, and so the books actually become: PQ CAOBCAOB -10103050 20-20 -1030 Even though the distribution was made only to P, each partner’s outside basis declines by $20 from $50 to $30.

8. DYNAMIC RECOURSE DEBT: EX. 2  X contributes $10 while Y and Z each contribute $100 to the XYZ general partnership. Each partner has a one-third share of profits and losses. The partnership borrows $60 on a fully recourse basis. A zero- value sale and liquidation yields a negative capital account only for X, and so X is allocated all of the debt. The books become: XYZ CAOBCAOBCAOB 10 100 6000 1070100

9. DYNAMIC RECOURSE DEBT: EX. 2  Suppose the partnership now distributes $70 to X. That reduces the partnership’s cash down to $200, and a zero-value sale and liquidation will leave only X with a capital account deficit. Accordingly, all of the debt remains with X and the books of the venture become: XYZ CAOBCAOBCAOB 1070100 -70 0000 -600100

10. DYNAMIC RECOURSE DEBT: EX. 2  Now suppose that the partnership distributes $80 to Y. That reduces the partnership’s cash down to $120. Prior to any reallocation of the debt, the books become: XYZ CAOBCAOBCAOB -600100 00-80 00 -60020 100

11. DYNAMIC RECOURSE DEBT: EX. 2  Now let’s do a zero-value sale and liquidation. The partnership has $120 of cash, and assuming that falls in value to zero, each partner is allocated $40 of the loss. After the zero-value sale, the books of the venture become: XYZ CAOBCAOBCAOB -60020 100 -40 -100-2060

12. DYNAMIC RECOURSE DEBT: EX. 2  Because the debt is now allocated 5/6’s to X and 1/6 to Y, one-sixth of the debt (that is, $10 of the debt) is shifted to Y. But because X’s outside basis is already zero, that means the cash distribution to Y triggers gain recognition to X. XYZ CAOBCAOBCAOB -60020 100 (10)100 -6002030100

13. 13 CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE  P Contributes Cash of $240,000  Q Contributes Property  Value = $160,000  Adjusted Basis = $100,000  Debt = $80,000 (nonrecourse; nonqualified)  P and Q agree to divide all profits and losses 75% to P and 25% to Q, and assume the debt is allocated in the same proportions.

14. 14 CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE  Three-Quarters ($60,000) of Debt Is Shifted to P

15. 15 CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE  Three-Quarters ($60,000) of Debt Is Shifted to P  Disguised Sale Fraction = 60,000/160,000 (3/8)

16. 16 CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE  Three-Quarters ($60,000) of Debt Is Shifted to P  Disguised Sale Fraction = 60,000/160,000 (3/8)  Basis Allocated to Sale = Three-Eighths of $100,000, or $37,500

17. 17 CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE  Three-Quarters ($60,000) of Debt Is Shifted to P  Disguised Sale Fraction = 60,000/160,000 (3/8)  Basis Allocated to Sale = Three-Eighths of $100,000, or $37,500  Gain = $60,000 - $37,500, or $22,500

18. 18 CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE  Three-Quarters ($60,000) of Debt Is Shifted to P  Disguised Sale Fraction = 60,000/160,000 (3/8)  Basis Allocated to Sale = Three-Eighths of $100,000, or $37,500  Gain = $60,000 - $37,500, or $22,500  Gain Affects Inside Basis and Outside Basis

19. CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE SUMMARY TotalSale PortionContribution Debt80,00060,00020,000 Value160,00060,000100,000 Basis100,00037,50062,500 Equity80,000 PQ Capital Acc’tOutside BasisCapital Acc’tOutside Basis 240,000 80,00062,500

20. CONTRIBUTION OF ENCUMBERED PROPERTY: EXAMPLE SUMMARY TotalSale PortionContribution Debt80,00060,00020,000 Value160,00060,000100,000 Basis100,00037,50062,500 Equity80,000 PQ Capital Acc’tOutside BasisCapital Acc’tOutside Basis 240,000 80,00062,500 060,00000 240,000300,00080,00062,500

21. NONRECOURSE DEBT: DEPRECIATION AND BOOK-UPS  X contributes $1,000,000 and Y contributes Blackacre to XY-LLC, and Blackacre is worth $1,000,000 with an adjusted basis of $200,000 at the time of contribution. The partnership borrows $2,000,000 and uses its cash of $3,000,000 to improve Blackacre. These improvements can be recovered straight-line over 25 years, and the debt encumbers Blackacre as well as the improvements. On these figures, the property has an initial book value of $4,000,000, an adjusted basis of $3,200,000, and a depreciable basis of $3,000,000. There is depreciation of $120,000 per year for 25 years.

22. NONRECOURSE DEBT: DEPRECIATION AND BOOK-UPS YearBook ValueAdj. BasisDep. BasisDebt 04,000,0003,200,0003,000,0002,000,000 162,080,0001,280,0001,080,0002,000,000 171,960,0001,160,000960,0002,000,000 201,600,000800,000600,0002,000,000 YearTier 1Tier 2Tier 3Total 0002,000,000 160720,0001,280,0002,000,000 1740,000800,0001,160,0002,000,000 20400,000800,000 2,000,000

23. RELATED PARTY DEBT RULES  New related party debt rules were proposed on December 16, 2013, as Prop. Reg. §1.752-4(b). The following discussion is based on these proposed regulations.

24. RELATED PARTY DEBT RULES Loan from Z to XY P YXZ XY

25. RELATED PARTY DEBT RULES Loan from Z to XY P YXZ XY Guarantee

26. RELATED PARTY DEBT RULES Loan from Z to XY P YXZ XY Partial Guarantee

27. II. USING DEBT TO EXIT A PARTNERSHIP  The ABCD partnership has four equal partners, each having an outside basis of $10 and a capital account of $10. The partnership owns a nondepreciable capital asset with inside basis of $40, book value of $40, and current fair market value of $100. Each partner’s share of the unrealized appreciation is $15.

28. REVERSE DISGUISED SALE  Suppose the partnership borrows $75, guaranteed only by D. The property, encumbered by the debt, is then distributed to D in a liquidating distribution. What are the books of the venture immediately after D’s exit?

29. REVERSE DISGUISED SALE ABC CAOBCAOBCAOB 251025102510 AssetsBook ValueAdj. BasisValue Cash75 Note: There is a suspended $45 inside basis adjustment but no gain recognized on the distribution.

30. PARTIAL SALE  If a partner owning a single partnership interest sells a portion of that interest, gain is computed by comparing the amount realized on the sale with a proportionate part of the outside basis.  The same rule applies if the partner owns multiple interests in the venture and sells only a part of his ownership interest without regard to how the interests were acquired (no tracing of basis).  A partner has a single, unified outside basis.  A partner has a single, unified capital account.  After the sale, the capital account of the selling partner that is attributable to the interest transferred carries over to the transferee.

31. PARTIAL SALE EXAMPLE  T joins the P partnership by contributing cash of $5,000 in exchange for a general partnership interest. Sometime later, T acquires a limited partnership interest for $7,000. Thereafter, when T’s combined outside basis in the two interests is $12,000, T sells one of the interests for its fair market value of $5,000. At the time of the sale, the two interests are worth $15,000.  T recognizes a gain of $1,000 on the sale (amount realized of $5,000 less $4,000 allocable portion of adjusted basis).  Note that it does not matter which interest is sold or whether that particular interest has increased or decreased in value (no tracing).

32. PARTIAL SALE: REV. RUL. 84-53  If a partner sells a portion of his partnership interest and the selling partner has been allocated a share of the partnership’s liabilities, those liabilities not shifting as a result of the sale are removed from the selling partner’s outside basis immediately prior to the sale for the purpose of computing gain or loss on the sale.  Suppose X and Y each own half of the XY partnership, and XY owns Blackacre with inside basis of $400, value of $500, and subject to a debt of $380. Each partner has an outside basis of $200 including each partner’s $190 share of the debt.  Suppose Y sells one-half of her partnership interest to Z for its fair market value of $30.

33. REV. RUL. 84-53 EXAMPLE  If half of Y’s share of the debt shifts to Z, then gain on the sale equals amount realized of $125 (cash received plus debt shifted) less allocable portion of adjusted basis of $100, for a gain of $25.  If no part of the debt shifts, then gain on the sale equals amount realized of $30 (cash received) less allocable portion of outside basis with debt removed (that is, one-half of ($200 - $190)) of $5, for a gain of $25.

34. SALE AFTER DEFT-FINANCED DISTRIBUTION  X and Y own 60% and 40% of the profits and losses of XY-LLC. The partnership owns a single, nondepreciable asset with inside basis and book value of $0 but current value of $2,000. Each partner has a capital account and outside basis of $0. The partnership has an election under section 754 in effect and the partnership agreement provides that partnership assets will be booked to fair market value whenever allowable.  The partnership borrows $500 on a recourse basis, allocable 60% to X and 40% to Y. The loan proceeds are then distributed in those percentages.  Y sells half of her interest to Z for its value of $300.

35. SALE AFTER DEFT-FINANCED DISTRIBUTION XYZ CAOBCAOBCAOB 000000 0300020000 12000800000 -300 -200 00 00-3000300 90003000

36. SALE AFTER DEBT-FINANCED DISTRIBUTION: SALE OF PROPERTY XYZ COBCAOBCAOB 90003000 0120004000 00000-400 0-3000-20000 900 300200300

37. THE BEST TAX SHELTER EVER!  X and Y each contribute $100 to form the XY partnership as equal 50% partners. The partnership purchases Blackacre and Whiteacre for $100 each. Blackacre increases in value to $190 and Whiteacre increases in value to $200. If the partnership sells is assets, the books become: XY CAOBCAOB 100 Formation 45 Sale of Blackacre 50 Sale of Whiteacre 195 Totals

38. AND NOW FOR THE SHELTER...  Suppose that instead of selling Blackacre, it is distributed to X in a nonliquidating distribution. Whiteacre is again sold for $200, leaving the books at: XY CAOBCAOB 100 Formation 45 Book-up of Blackacre -190-10000Book-out of Blackacre 50 Sale of Whiteacre 550195150Totals

39. THE §752 PROPOSED REGULATIONS  In 2014, Treasury proposed modifications to existing regulations under section 752, generally effective upon finalization.  These modifications significantly alter the allocation of partnership debt currently treated as recourse.  These modifications also reduce much of the flexibility currently available to the allocation of third tier nonrecourse debt.  The following comments apply only to the allocation of recourse debt under the proposed regulations.

40. OVERVIEW  The proposed regulations generally continue the approach of the current regulations by looking at a hypothetical zero-value sale and liquidation as well as all other legal obligations including guarantees and indemnities.  However, new requirements are imposed on every obligation to make a payment following the zero-value sale and liquidation, causing many payment obligations recognized under current law to be treated in a very different manner. If a payment obligation does not satisfy all of the applicable requirements, its fails to shift the debt to the nominal obligor yet succeeds in shifting the debt away from the obligee; that is, the debt becomes nonrecourse.

41. EXAMPLE  G and L form the GL limited partnership, with G the general partner and L the limited partner. The partnership borrows $10,000, and assume that under the proposed regulations the debt is allocated to G as a recourse debt.  If L agrees to repay G should the lender come after G, and assuming this indemnification fails to satisfy the requirements imposed by the proposed regulations, then the debt is treated as nonrecourse under the section 752 rules and presumably for the section 704(b) allocation rules as well.

42. THE SEVEN NEW REQUIREMENTS  1. The partner or a related person is required to maintain a commercially reasonable net worth through the term of the payment obligation or is subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration.  2. The partner or related person is required periodically to provide commercially reasonable documentation regarding the partner's or related person's financial condition.  3. The term of the payment obligation does not end prior to the term of the partnership liability.

43. NEW REQUIREMENTS (CONTINUED)  4. The payment obligation does not require that the primary obligor or any other obligor with respect to the partnership liability directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor.  5. The partner or related person received arm's-length consideration for assuming the payment obligations.  6. In the case of a guarantee or similar arrangement, the partner or related person is or would be liable up to the full amount of such partner's or related person's payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied. In other words, there could not be any “bottom-dollar guarantees” under which only a portion of a liability is guaranteed. Vertical guarantees are likewise invalidated.

44. NEW REQUIREMENTS (CONTINUED)  7. In the case of an indemnity, reimbursement agreement or similar arrangement, the partner or related person is or would be liable up to the full amount of such partner's or related person's payment obligation if, and to the extent that, any amount of the indemnitee's or other benefited party's payment obligation is satisfied.

45. THE “NET WORTH” REQUIREMENT  In additional to the general seven requirements identified above, a new worth requirement is imposed on every partner and related person other than individuals and estates.  This requirement is taken from the current net worth requirement imposed on disregarded entities in Reg. sec. 1.752-2(k)(2) including the definition of valuation and revaluation events.

46. ADDITIONAL READING  For further detail, read closely Examples 11 and 12 of the proposed regulation, Prop. Reg. sec. 1.752-2(f) (examples 11 and 12).