By David Donnelly, CPA-Houston and Barry Corbitt, CPA-Houston
On Oct. 5, 2019, the IRS issued final regulations under IRC Section 752 regarding ”bottom dollar” payment obligations and how these obligations affect a partner’s basis in a partnership.
Essentially, the final rules do not allow recognition of basis as a result of a bottom dollar payment obligation. The intent is that no basis will be allowed in excess of the amount for which the partner has an economic risk of loss.
Bottom Dollar Obligation Defined
A bottom dollar obligation is an arrangement where a partner guarantees a liability in an amount less than the full face value of the liability.
A typical arrangement might have a partner guarantee the last $1 million of a $20 million bank note; for instance, the guarantee would only be paid if the bank foreclosed on the property and suffered a loss in excess of $19 million ($20 million less the $1 million guarantee). Absent these regs, the bottom dollar guarantee would be treated as recourse debt and provide basis to the partner.
The final regulations define a bottom dollar obligation as one of the following:
- A guarantee or similar arrangement where the partner is not liable up to the full amount of the liability if the liability is not otherwise satisfied;
- An indemnity with the same economic effect as the guarantee listed in No. 1 above; or
- A tiered partnership structure, which produces the same economic effect as No. 1 above.
The regs explain that an obligation will not be treated as a bottom dollar obligation if the partner is liable for at least 90% of the underlying obligation. The regs also exclude arrangements where a partner is responsible for the partner’s proportionate share of a liability, or responsible for a percentage or fixed amount of an obligation—these are not by definition bottom dollar obligations.
Capital Contribution Obligations and Deficit Restoration Obligations
The regs also provide that a bottom dollar obligation includes a capital contribution obligation or a deficit restoration obligation that does not require full payment of the capital or full payment of the restoration obligation.
In the situation where a capital contribution obligation or a deficit restoration obligation does not expressly require the payment by the partner, the partner can provide a promissory note to the partnership to provide the basis otherwise excluded. The regs address the terms that must be present in such a note in order to provide basis.
Given the complexities of this issue, Reg. Section (1.752-2(j)(3) has a catch-all, which represents the factors that are relevant to whether an arrangement has economic risk of loss:
- The partner is not subject to commercially reasonable restrictions to protect the likelihood of payment.
- The partner is not required to provide documentation regarding the partner’s financial condition as part of the obligation.
- The term of the obligation ends before the partnership liability ends or if the partner can terminate the obligation. There are exclusions to this factor if there is a valid economic reason for the termination, such as leasing of a building.
- The primary obligor holds assets that limit the likelihood of the obligation being called.
- The obligation does not permit the creditor to promptly pursue the partner in the event of default.
- The terms of the partnership’s liability would be the same without the guarantee.
- There is a lack of executed documents with respect to the obligation within a commercially reasonable period of time.
The final regs do provide a transition rule—if a partner has, on Oct. 5, 2016, a recourse liability that provided basis under the rules in effect at that time, there is some relief from the new rules. This relief expires in seven years.
Tax Return Disclosure
The partnership must disclose the following on Form 8275 for the year that the bottom dollar obligation is undertaken:
- A caption identifying the disclosure as a bottom dollar payment obligation under Section 752;
- An identification of the type of obligation – guarantee, indemnity, reimbursement or obligation to restore capital;
- The amount;
- The parties;
- If the obligation is recognized in Reg. Section 1.752(b)(3), which covers the exception (the 90% rule, proportionality, etc.); and
- The facts and circumstances that allow the obligation to be recognized as providing basis.
Where do we go from here?
These bottom dollar regs appear to be comprehensive and effective in limiting basis to those circumstances where partners truly have an economic risk of loss. Practitioners should be aware of these final rules and advise their clients accordingly. Most importantly, practitioners should be aware of the requirement for disclosure on Form 8275 when these bottom dollar payment obligations arise. The Form 8275 is particularly important when the exceptions to the bottom dollar characterization apply.
The overall 752 regs are more comprehensive than the discussion above, which only relates to the final regs regarding bottom dollar payment obligations. Given the new requirement for tax basis capital accounts to be presented on the Form K-1 for Form 1065, tax professionals should be aware of all aspects of the 752 regs when advising their clients.