
James F. McDonough
Of Counsel
732-568-8360 jmcdonough@sh-law.comFirm Insights
Author: James F. McDonough
Date: July 23, 2014
Of Counsel
732-568-8360 jmcdonough@sh-law.comIRS published new regulations in January that would upset 25 years of treatment of the allocation of liabilities. Under current rules, the determination of whether a liability is recourse to a partner (or related person) is determined by whether the partner has an obligation to make a contribution to any person because a liability is due and payable and the partner does not have a right to reimbursement from anyone. Under the proposed regulations, seven additional requirements must be satisfied before the partner may receive the allocation. The seven rules, presented in an abbreviated form, are: (1) the partner must maintain a reasonable net worth; (2) the partner provide reasonable commercial documentation; (3) the term of the partner’s obligation does not end before the liability is due; (4 ) the partnership is not required to hold liquid assets in excess of the business needs of the partnership; (5) the partner-guarantor receives reasonable compensation in exchange for his guarantee; (6) the partner’s guarantee is not a “bottom-dollar” guarantee; (7) the partner is liable for the full amount of the other person’s liability in the case of indemnity or reimbursement arrangement. Failure to satisfy all seven rules converts recourse debt into non-recourse debt. In fact, the proposed rules create a bias toward non-recourse debt.
There is also a new net value requirement that acts to limit the amount of the liability that will be treated as recourse. The net value requirement also produces odd results. Assume A and B are partners in a limited liability company. If A guarantees the entire debt, it would be recourse to A. Assume, however, that A is a member of a partnership and the partnership guarantees the debt. The only asset of the partnership is its interest in the limited liability company and the new net value test prevents the liability from being allocated to A.
The examples in the proposed regulations suggest the potential for more strange results. Partnership borrows $1,000 and partner A guarantees $300, while B guarantees the bottom $200. C agrees to reimburse A for up to $50. A and B waive their rights against each other. Because A does not bear the full risk of loss on his guarantee, the proposed regulations cause $250 of the obligation to be treated a non-recourse despite the fact that A is liable to the bank for $300. The expectation is, of course, that A would have $300 of recourse debt allocated to him.
The effective date of the 752 proposed regulations is the date they are finalized. This means that liabilities and payment obligations incurred after that date will be subject to these rules. Many existing partnership agreements will have to be revised if new debt is incurred or payment obligations are undertaken.
If you are interested in reading about other changes being made by the Inter Reveneu Servue here are some additional articles by Frank L. Brunetti, Joseph Doengan, and me:
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