1. Partnership Update
Tax Allocations, Allocation of Partnership Debt, and Section 751(b)
Professor Howard E. Abrams

2. Professor Howard E. Abrams
Howard E. Abrams is Warren Distinguished Professor and Director of Tax Programs at the University of San Diego School of Law. Professor Abrams is a partnership and corporate tax specialist, receiving his B.A. from the University of California (Irvine) and his J.D. from Harvard University. He has written four books, the BNA Tax Management Portfolios on Disregarded Entities and on Partnership Options (forthcoming), and more than fifty articles on taxation. Professor Abrams taught at Emory University from 1983 until 2013, spent the academic year with the national office of Deloitte Tax as the Director of Real Estate Tax Knowledge, and from January of 2003 through August of 2004 was of counsel to Steptoe & Johnson in Washington, DC. He teaches regularly at Leiden University in the Netherlands and is a member of the American Law Institute and the California and DC Bars. Prior to joining the Emory faculty, Professor Abrams was a law clerk to Chief Judge Theodore Tannenwald, Jr., of the United States Tax Court and practiced in Los Angeles with the firm of Brobeck, Phleger & Harrison. Professor Abrams has taught as a Visiting Professor at Cornell, Berkeley, Yale, and Harvard.

3. Allocations of Partnership Level Tax Items
A partnership must allocate its tax items in accordance with the requirement of “substantial economic effect.” Under the regulations, this statutory requirement is diivided into two components: (1) the requirement of economic effect, and (2) the requirement that the economic effect be substantial. This second component is defined poorly in the regulations.

4. The General Test for Economic Effect
The general test for economic effect requires three things:
Capital accounts be maintained in accordance with Reg. § (b)(2)(iv).
Upon the liquidation of an interest in the venture, if the exiting partner has a capital account surplus in his capital account, he must have a legal right to receive the amount of that excess from the partnership.
Upon the liquidation of an interest in the venture, if the exiting partner has a capital account deficit, the exiting partner must have a legal obligation to contribute the amount of the deficit to the partnership with 90 days.
These rules generally ensure that tax consequences will mirror the underlying economic arrangement among the partners.

5. The General Test: Example
A and B each contribute $100 to the AB partnership. The partnership purchases equipment depreciable at a rate of $40 per year for 5 years. Each year, the partnership generates $60 of income. The partners agree that they will divide everything equally except that depreciation will be allocated entirely to B.

6. Example: Year 1 Capital AccountsB
$ 100
Capital Contributions 30
Distributive Share of Income
-40
Distributive Share of Depreciation
130 90
Totals After Year 1

7. Example: Years 2 – 5 Capital AccountsB
$ 130
$ 90
Start of Year 2
120
Distributive Share of Income
-160
Distributive Share of Depreciation
250 50
Totals After Year 5
The partnership now owns cash of $300 as well as a fully depreciated asset. If the asset actually is worth zero, the final capital balances show how the partnership’s cash will be distributed.
The partners’ outside bases mirror the capital accounts. The touchstone of economic effect is that if all the partnership’s assets are converted into cash and all of the partnership’s debts are repaid, capital accounts will equal outside bases. That is, there should be no gain or loss on liquidating distribution.

8. The Alternate Test for Economic Effect
The Alternate Test for Economic Effect removes the requirement of an unlimited, unqualified deficit restoration obligation, replacing it with three substitute rules:
No allocation of deduction can reduce the partner’s capital account below zero except to the extent of the partner’s limited capital account deficit restoration obligation, if any.
The partner’s capital account must be reduced immediately for an future events that will reduce the capital account if those future events reasonably can be anticipated (the “look ahead” rule); and
If the partner’s capital account becomes more negative than allowed (by reason of an unanticipated reduction), the partner must be allocated items of partnership gross income to eliminate the excess negative balance as quickly as possible (the “qualified income offset” rule).

9. Revenue Ruling 97-38
Partners sometimes will agree to a capital account deficit restoration obligation in favor of a lender but not in favor of other partners. Rev. Rul provides that in such circumstances, this limited deficit restoration obligation is recognized only to the extent the debt exceeds the book value of the property securing the debt.
Example: XY LLC is formed with each partner contributing cash of $10,000. XY then purchases property for $100,000 by borrowing $80,000, secured by the property. Each partner agrees to restore a capital account deficit in favor of the lender but not in favor of the other partner. The partnership’s cash flow each year just equals its expenses, so there is a net loss each year equal to its annual depreciation of $8,000, allocated 75% to X and 25% to Y.

10. Revenue Ruling 97-38 (part 2)
In year 1, the partnership agreement allocates the depreciation deduction $6,000 to X and $2,000 to Y, reducing X’s capital account to $4,000 and Y’s capital account to $8,000. The book value of the property is reduced to $92,000.
In year 2, the partnership agreement again allocates the depreciation $6,000 to X and $2,000 to Y. This would reduce X’s capital account to negative $2,000 and Y’s capital account to $6,000. Because the book value of the property is now $84,000 while the debt remains at $80,000, there is no recognized deficit restoration obligation. Accordingly, X’s capital account cannot go negative and so $2,000 of the depreciation in year 2 must be reallocated to Y, making X’s capital account $0 and Y’s capital account $4,000.

11. Revenue Ruling 97-38 (part 3)
In year 3, the partnership agreement again allocates the depreciation $6,000 to X and $2,000 to Y, and this would reduce X’s capital account to negative $6,000 and Y’s capital account to positive $2,000. The book value of the property equals $76,000 while the debt remains at $80,000 so there is a recognized deficit restoration obligation of $4,000. Once again, X’s capital account is too negative, so $2,000 of the depreciation must be reallocated to Y, bringing X’s capital account balance to negative $4,000 and Y’s capital account balance to $0.

12. Revenue Ruling 97-38 (part 4)
In year 4, the partnership agreement again allocates the depreciation $6,000 to X and $2,000 to Y, and this would reduce X’s capital account to negative $10,000 and Y’s capital account to negative $2,000. The book value of the property equals $68,000 while the debt remains at $80,000 so there is a recognized deficit restoration obligation of $12,000. There is thus a recognized capital account deficit restoration obligation of $12,000 which exactly covers the combined capital account deficits. Accordingly, there is no reallocation of any of the depreciation in year 4 (and succeeding years).

13. Partnership Debt Allocations
Under section 752(a), any increase in a partner’s share of partnership debt is treated (for purposes of outside basis) as a contribution of cash and, under section 752(b), any decrease in a partner’s share of partnership debt is treated (for purposes of sections 731 and 733) as a distribution of cash.
There are different rules for the allocation of recourse and nonrecourse debt. A debt is recourse to the extent any partner (or person related to a partner) bears the economic risk of loss for the debt if the partnership is unable to pay its debts when they come due. If a debt is recourse in part and nonrecourse in part, it is treated as two separate debts.

14. Recourse Liabilities
In general, allocation of recourse debt among the partners is determined by using a hypothetical zero value sale and liquidation: that is, the partnership’s assets (including cash!) are treated as going to zero value and then are sold for $0, followed by a liquidation of the partnership. The book loss arising from the hypothetical sale creates deficit capital accounts, and the hypothetical liquidation then triggers deficit restoration obligations. The debt is then allocated among the partners as they would have to restore such deficit capital account balances (after taking account of any indemnifications and similar agreements).

15. Recourse Liability Example: Facts
A contributes $600 and B contributes $400 to form the AB general partnership. Partnership profits will be allocated equally but partnership losses will be allocated 60% to A and 40% to B. The partnership borrows $9,000 on a fully recourse basis, and its cash of $10,000 is used to purchase Blackacre. How is the indebtedness allocated between A and B?

16. Recourse Liability Example: Analysis
Blackacre was purchased for $10,000 so its book value equals $10,000 (cost). If Blackacre declines in value to $0 and then is sold, there will be a book loss of $10,000. Under the partnership agreement, this loss is allocated 60% to A and 40% to B, so that A’s capital account will decline for $600 to negative $5,400 while B’s capital account will decline from $400 to negative $3,600. These allocations have economic effect if each partner has an unlimited capital account deficit restoration obligation. If the partnership were now to liquidate, A would be required to contribute $5,400 and B would be required to contribute $3,600. These contributions would then be used to repay the lender in full. Accordingly, the debt is allocated $5,400 to A and $3,600 to B based on their relative payment obligations following the hypothetical zero value sale and liquidation.

17. Recourse Liability Variation
Reconsider the last problem but assume each partner contributed cash of $500. The hypothetical zero value sale and liquidation again generates a book loss of $10,000, again allocated $6,000 to A and $4,000 to B. This reduces A’s capital account to negative $5,500 and B’s capital account to negative $3,500. Thus, the debt is now allocated $5,500 to A and $3,500 to B. Loss shares do not fully determine sharing of recourse debt: capital account balances also play a role.

18. Nonrecourse Liabilities
Nonrecourse liabilities are allocated under a three tier system:
Tier 1, the minimum gain tier, allocates so much of the debt as exceeds the book value of the security as the partners would share book gain if the security were sold for the debt and nothing else.
Tier 2, the minimum 704(c) tier, allocates so much of the debt as equals the amount of tax gain that would be allocated under section 704(c)(1)(A) (including reverse allocations using 704(c)(1)(A) principles) if the property were sold for the debt and nothing else.

19. Nonrecourse Debt (continued)
Tier 3 (the residual tier):
First, the partners may agree to allocate debt as they would share tax gain in excess of that allocated under tier 2.
The remainder of the debt, if any, is then allocated:
In a manner consistent with the allocation of a significant item of partnership income or gain from the security;
In a manner consistent with the way it is reasonably expected that deductions attributable to the indebtedness (i.e., nonrecourse deductions) will be allocated among the partners; or
In accordance with the partners’ interest in profits of the partnership, taking account of all facts and circumstances.
The residual allocation can be changed at least yearly.

20. Update on Debt Allocations Under Section 752
Partnership recourse liabilities are allocated among the partners as they share economic risk of loss (“EROL”).
Bottom Dollar Payment Obligations: Temporary and Proposed regulations now provide that (with one exception) bottom dollar payment obligations will be ignored for determining EROL.

21. Bottom Dollar Payment Obligation Defined
A “bottom dollar payment obligation” is a guarantee, indemnity or similar arrangement that is not triggered by the first dollar of loss.
Example: Guarantee of a $100,000 partnership liability that is triggered only if the lender recovers less than $60,000 is a bottom dollar payment.
Counter-Example: A similar guarantee limited to $60,000 but which is triggered if the lender is not fully repaid is not a “bottom dollar guarantee.”

22. The 90% Exception
A bottom dollar payment obligation that covers at least 90% of the benefitted party’s obligation is recognized for determining EROL.
Example: Partner X has a recognized payment obligation and Y gives X a bottom dollar indemnity equal to 90% of X’s obligation. This indemnity is recognized for determining EROL.
Surprisingly, this exception does not apply to a 90% bottom dollar payment obligation that runs directly to the lender. For example, if an LLC borrows $50,000 and one partner makes a guarantee of the bottom $45,000 of the debt, the debt is treated as entirely nonrecourse.

23. Combining Multiple Liabilities
Suppose a partnership borrows $400,000 on a fully nonrecourse basis and also borrows $600,000 on a subordinated basis from the same lender. A guarantee of the $400,000 loan is a bottom dollar payment obligation unless the same partner is liable on the subordinate loan as well.
A guarantee of the $600,000 is not a bottom dollar payment obligation without regard to any guarantee of the $400,000 loan.
If the two loans are obtained from different lenders, the outcome is less clear: were the two liabilities incurred “pursuant to a common plan, or as part of a single transaction or arrangement with a principal purpose of avoiding having at least one of such liabilities being treated as a bottom dollar payment obligation.”

24. Disclosure Requirements
All bottom dollar payment obligations including those that will be recognized for determining EROL because they satisfy the 90% exception must be disclosed on Form 8275 and attached to the return of the partnership for the year in which the obligation is undertaken or modified.
A list of what must be disclosed is listed on page 12 of the materials.

25. Effective Dates
These rules are effective for bottom dollar payment obligations arising on or after October 5, 2016.
The old rules apply to partnership indebtedness incurred prior to October 5, 2016, provided the debt is not modified after that debt.
For pre-effective date debts that are modified after October 5, 2016, but prior to October 5, 2019, there is a special transition rule.

26. Transition Rule
The “Transition Partner” is the partner whose pre-existing bottom dollar payment obligation is modified during the transition period.
The “Transition Partnership” is the partnership having the debt that is modified.
The Grandfathered Amount is the excess of the Transition Partner’s outside basis as of October 5, 2016 (determined under the old rules) over the Transition Partner’s outside basis as of the same date determined under the new rules. It lasts for seven years
The Grandfathered Amount can be reduced (but not increased) by reduction of the debt, disposition of the security for the loan, or change in ownership of the Transition Partner if the Transition Partner is an S Corporation, a partnership, or a disregarded entity.

27. Deferred Payment Obligations
The government has requested comments on partner payment obligations that do not become payable immediately upon default of the underlying loan. This would include payment obligations triggered only after collection from the partnership has been unsuccessful as well as payment obligations arising from deficit capital account payment obligations.

28. Proposed Regulations Under Section 751(b)
Enacted in 1954, section 751(b) has played a small role in the taxation of nonliquidating distributions because of its complexity and incoherence.
Proposed regulations both reduce the complexity (somewhat) and dramatically increase the coherence of section 751(b). Assuming these proposed regulations are finalized, the application of section 751(b) to nonliquidating distributions will be limited. And while section 751(b) will continue to have significant application to liquidating distributions, so did the old rules and the new rules are easier to apply.

29. Section 751(b) Assets
Assets described in section 751(b) include both “unrealized receivables” and inventory if the inventory is “substantially appreciated.”
Inventory includes an asset which, if sold, would produce gain other than capital gain and gain described in section 1231.
Under current law, both unrealized receivables and realized receivables are included in the term “inventory.” Under the proposed regulations, unrealized receivables are not included in “inventory.”
Inventory is “substantially appreciated” if its aggregate fair market value exceeds 120% of it adjusted basis. This is done in the aggregate rather than on an item-by-item basis.

30. Unrealized Receivables
For purposes of section 751(b), “unrealized receivables” include assets having an ordinary income component such as equipment and machinery subject to depreciation recapture under section 1245.
Under the proposed regulations, such an asset is treated as two assets: an unrealized receivable with a zero basis and a capital or section 1231 asset having a positive adjusted basis (if the asset has a non-zero adjusted basis) as well as the remainder of the fair market value of the asset.
Example: The partnership owns depreciable equipment with adjusted basis of $100, fair market value of $500, and subject to depreciation recapture of $350. This is treated as an unrealized receivable having zero basis and value of $350 as well as a 1231 asset having basis of $100 and value of $150.

31. Computing the Section 751(b) Gain
With respect to every partnership distribution (whether liquidating or nonliquidating), the partnership must determine for each partner his share of the section 751(b) gain immediately prior to the distribution and immediately after the distribution. For any partner whose share declines, that partner must recognize ordinary income equal to the decrease.
If the partnership owns any section 751(b) assets immediately after the distribution, the partnership is required to revalue its assets and restate capital accounts (optional under current law).
Distributed assets must be revalued and capital accounts restated immediately prior to the distribution, as under current law.

32. Determining Pre-Distribution Share of §751(b) Gain
Immediately prior to the distribution, each partner’s share of the section 751(b) gain equals the amount of ordinary income that would be allocated to that partner if the partnership sold all of its section 751(b) assets immediately prior to the distribution.
This computation necessarily implicates all the rules under section 704(b) including the requirement of “substantial economic effect” including minimum gain chargebacks and partner minimum gain chargebacks.

33. Determining Post-Distribution Share of §751(b) Gain
Post-distribution share of section 751(b) gain is determined the same way except that a partner must include in such share the amount of any section 751(b) gain that would be recognized if all distributed property were sold for its fair market value immediately after the distribution.
There are some technical problems with this rule: (1) it is possible that, immediately after the distribution, the remaining partnership’s inventory is not “substantially appreciated” even though it was prior to the distribution, or vice versa; (2) it is unclear what “substantial appreciation” means with respect to distributed property.

34. Recognition Under Section 751(b)
For any partner who whose share of section 751(b) declines, ordinary income must be recognized immediately prior to the distribution in an amount equal to the decline.
There is a dollar for dollar increase in such partner’s outside basis, also immediately prior to the distribution. In addition, there is an increase in asset basis (again immediately prior to the distribution).
This scheme is very much like that imposed under section 704(c)(1)(B) with section 751(b) gain replacing built-in gain.
Note that there is no such thing as section 751(b) loss even though the partnership may own inventory items having adjusted basis in excess of fair market value.

35. Observation
The mandatory book-up of the partnership’s undistributed section 751(b) assets is absolutely crucial to this computation because it “locks-in” undistributed section 751(b) gain into the partners’ capital accounts. As a result, such gain should not shift by reason of the distribution unless the distribution is in complete liquidation of a partner’s interest in the venture.

36. Example: Facts
P, Q and R are each one-third partners in PQR. PQR owns cash of $150 and three unrealized receivables, each receivable having an adjusted basis of $0 and a fair market value of $30. Each partner has an outside basis and capital account of $50, and each interest is worth $80.

37. Example 1
Example 1: P exits the partnership, receiving cash of $20 and two of the receivables.
Prior to P’s exit, each partner’s share of the section 751(b) gain was $30, composed of $10 from each of the three receivables.
After P’s exit, Q and R have shares of the remaining sectin 751(b) gain of $15 from the one undistributed receivable. For each of these two partners, that is a decline of $15.
Q and R each report $15 of ordinary income.
Q and R each increase their outside basis from $50 to $65.
Immediately prior to the distribution, the inside basis of the two distributed receivables is increased from $0 to $15.
Under sections 731 and 732, P recognizes no income on the distribution and takes each receivable with a carryover basis of $15.

38. Example 2
Using the same facts, P exits by receiving cash of $80. This results in a reduction of P’s share of the section 751(b) gain from $30 to $0.
P recognizes ordinary income of $30.
P increases outside basis from $50 to $80.
Inside basis of the three undistributed receivables is increased from $0 each to $10 each.
P receives the $80 of cash tax-free.
When the receivables are collected, there will be aggregate ordinary income of $60,divided equally between Q and R.

39. Example 3
Same facts, but now a nonliquidating distribution is made to P of $40 and P reduces his going-forward share of the venture from one-third to one-fifth.
The receivables must be revalued immediately prior to the distribution, with each partner allocated one-third of the section 751(b) gain (or $30). Each capital account is increased to $30 although outside bases remain at $50 each.
Because no partner’s share of the section 751(b) is affected by the distribution (the reduction in P’s share of the venture going forward is irrelevant because the book-up is done immediately prior to the distribution), section 751(b) does not trigger any gain.
The distribution is tax-free to P, with P reducing his capital account from $80 to $40 and P reducing his outside basis from $50 to $10. When the receivables are collected, each partner will report $30 of ordinary income.

40. New Facts
Our new partnership owns six identical unrealized receivables, each having a zero inside basis and book value and a fair market value of $30. X, Y and Z are each one-third partners having $0 outside basis and capital account in their interests, each worth $60.

41. Example 4
The partnership liquidates, distributing two of the receivables to each partner.
Each partner’s share of the section 751(b) gain both before and after the distribution equals $60, so there is no taxation under section 751(b). Note that the composition of their shares has changed. Prior to the distribution, each partner’s $60 share of the section 751(b) gain was composed of a $10 (one-third) share from each of six assets. After the distribution, each partner’s $60 share is composed of $30 from each of the two assets distributed to that partner. Because only the totals matter and not the composition, section 751(b) imposes no taxation on any partner.

42. Example 5
Same facts, but now the distribution consists only of one receivable to each partner.
Each partner’s share of the section 751(b) gain remains unchanged, so section 751(b) imposes no taxation on any partner.
Note that the composition of the shares of the section 751(b gan has changed. Prior to the distribution, each partner had a $10 share from each of six assets. After the distribution, each partner has a $30 share from the asset distributed to that partner pus a $10 share from each of the three undistributed assets. Section 751(b) looks only to the totals.

43. Example 6
Same facts, but now only a single asset is distributed to partner X in a nonliquidating distribution.
Prior to the distribution, each partner has a $60 share of the section 751(b) gain.
After the distribution, Y and Z each have a one-third share of the five undistributed receivables, or $50 (remember that they are booked-up immediately prior to the distribution).
Y and Z each include $10 of ordinary income.
The inside basis of the distributed receivable is increased from $0 to $20.
On this distribution, X cannot absorb the now positive inside basis of the distributed receivable.
If there is no section 754 election in effect, X takes a $0 basis in the distributed asset.
If there is a section 754 election in effect, X still takes a $0 basis in the distributed asset but now there is an inside basis adjustment of $20 in favor of all the partners.

44. Example 6 (continued)
If there is a section 754 election in effect, the proposed regulations will not permit an inside basis adjustment to the undistributed assets because that will reduce Y and Z’s shares of the remaining section 751(b) gain. Instead, X must recognize $20 of capital gain immediately prior to the distribution, increasing X’s outside basis to $20 and thereby eliminating the basis adjustment under section 734(b).
If no such election is in place, then X may elect to recognize $20 of gain, yielding the same result, or not recognizing that gain and having the newly increased inside basis of the distributed asset disappear.

45. Example 6: Questions
How can there be recognition of capital gain when the partnership owns only ordinary income assets?
What is the rate of tax imposed on such capital gain? 20%? 25%? 28%?
Is the gain short-term or long-term?
Since X can receive two receivables without any tax imposed on anyone, why does the distribution to X of a single receivable trigger section 751(b)?
Note that the solution to these problems is clear: all of the gain in the distributed receivable should be allocated to X (because X will in fact report that gain), and X’s share of the gain in the other assets should not be one-third of $150 (i.e., $50) but only one-fifth (i.e., $30). That leaves Y and Z’s shares at $60 each, for no change and so no taxation under section 751(b).

46. A Nickel Introduction to the Partnership Audit Rules
Starting with partnership taxable years after 2017, TEFRA has been replaced by a new audit scheme. Note that for partnership returns covering taxable years before 2018, TEFRA will continue to apply.
Under the new audit rules, there are three possibilities:
A deficiency will be determined at the partnership level and paid by the partnership. As a economic matter, this burdens partners in the partnership as of the year the audit is conducted (the “audit year”) even though it should burden partners in the partnership for the year under review (the “reviewed year”).
A partnership sending out no more than 100 K-1s can elect out of the new regime, going back to pre-TEFRA (i.e., individual partner) audits. For S corporation partners, all of the S corporation shareholders are treated as K-1 partners for this purpose. No trusts, estates or disregarded entities are permitted (may be softened by regulations). The election is made on a year-by-year basis. This is called the “opt-out” route.

47. Finally, there is the “push-out” route by which the partnership-level adjustments are sent to all partners in the reviewed year in which case it is in effect an amended K-1. Note that the reviewed year partners have no right to challenge the changes.
If the partnership has not validly opted out, then the partnership representative has exclusive rights to negotiate with the government, receive notice of an administrative action, and bind all the partners. The partnership representative need not be a partner but must have a substantial US presence.

48. What Should a New Partner Do?
If there is an audit of a partnership taxable year prior to admission of a new partner, then (1) if the partnership validly opted out, the new partner generally will not care what happens; (2) if the partnership validly pushes any adjustment out to the reviewed year partners, the new partner generally will not care what happens; but (3) if a liability is imposed on the partnership, the new partner will unfairly bear a portion of the liability. What should the new partner do?
Get an indemnity from the selling partner or from the historic partners?
Insist on being designated the partnership representative?
Use an “Up-K” (my name) for a lower-tier partnership formed by the existing partnership and the new partner. This isolates audit problems of earlier review years away from the incoming partner.

49. Partnership Update
Tax Allocations, Allocation of Partnership Debt, and Section 751(b)
Professor Howard E. Abrams