Business lawyers who work with LLCs and partnerships know firsthand that loans, guaranties and other debt-sharing agreements among members can have a significant effect on the tax results of the parties. While it is common to assign complex tax issues to the entity’s accountants, it is important for business lawyers to understand the basic tax rules in this area, including recent changes under new IRS regulations.
On October 4, the Internal Revenue Service published final, temporary and proposed regulations governing the tax treatment of liability allocations for partnerships and LLCs. These rules, under Internal Revenue Code Section 752 (the “new 752 Regs”), will greatly restrict certain debt-sharing arrangements that have often been used to produce tax-favorable results. The new 752 Regs will also create tax reporting and audit risks for many debt-funded partnerships.
Let’s start with a simple example. Success Company is an LLC taxed as a partnership with five equal members. Each member invests $1,000 for a 20-percent interest and the LLC posts a $5,000 loss after one year of operations.
The tax results are not surprising: Each member starts with a “tax basis” in his membership interest equal to his or her cost of the equity, or $1,000. The LLC allocates the $5,000 loss pro rata, or 20 percent to each member, in accordance with its LLC agreement. Each member claims a flow-through loss of $1,000, and this loss reduces each member’s tax basis to zero. A member who receives a $1,000 loss may be able to deduct it on his or her personal tax return.
Now assume that in the second year, the fifth member (Mr. Deep Pockets) decides to lend $5,000 to the LLC. The LLC again posts a net loss of $5,000. How is this loss allocated? Based on the original agreement, one might assume that the loss continues to be allocated pro rata — 20 percent to each member.
But the tax rules (under Section 752) step in to treat the loan from Mr. Deep Pockets as a deemed transfer of money from him to the LLC, thereby increasing the tax basis in his LLC interest by $5,000, just like a capital contribution. Also, because Mr. Deep Pockets is ultimately on the hook for an economic loss on this loan, the entire $5,000 loss in year two is allocated to him.
The same outcome would arise if the loan came from a bank and Mr. Deep Pockets provided a personal guaranty. In short, a partner or LLC member who lends money, or guaranties a loan, to the entity, and is thereby on the hook if the loan is not repaid, generally obtains a tax basis increase in his or her equity interest. As a result, a guarantor or lending partner has a right to receive and deduct additional losses generated by the loaned funds.
Since the 1990s, tax advisers have grown accustomed to using the Section 752 debt allocation rules in a manner to maximize the potential tax savings. They have done this, in many cases, by allowing the members and partners to enter into side agreements to guaranty and/or indemnify the ultimate lenders. In some cases, these side agreements are based on a very speculative risk of loss, and yet still deliver the tax benefits (or at least that is the position).
One particular example is a so-called “bottom dollar guaranty.” Thus, assume that in the example above, a bank makes the $5,000 loan in year two and Mr. Deep Pockets provides a guaranty of only the “last” $2,000, i.e., the bottom $2,000. Under prior law, Mr. Deep Pockets could take the position that if the entire project failed, he would be on the hook for $2,000 of the loss, and should therefore receive a tax basis and loss allocation benefit up to that amount.
The new regulations put an end to this. Under the new 752 Regs, a bottom-dollar guaranty is ignored for purposes of tax basis allocations. Furthermore, these types of guaranties now have an annual reporting requirement.
The new 752 Regs will cause rethinking for many debt-financed partnerships and LLCs, particularly in capital intensive projects such as real estate. The significant rule change is this: A partner or LLC member who guaranties a loan to the entity, or provides an indemnity or contribution promise, will only receive a corresponding tax basis benefit if the payment obligation covers the entire loan amount. This means that many contingent guaranties that used to provide tax benefits in the past will no longer make the grade.
The IRS has also issued new proposed regulations that call out many other kinds of tax-motivated planning in the area of contingent debt guaranties and capital contribution obligations. Thus, scrutiny in this area is expected to increase in the coming years.
The good news is that the new 752 Regs permit so-called “vertical slice” guaranties. Thus, if Mr. Deep Pockets guarantied 10 percent of the bank’s $5,000 loan in year two, he should be able to treat 10 percent of that debt in a favorable manner for tax purposes. The new rules also permit “top dollar” guaranties. So, if Mr. Deep Pockets guarantied the first $2,000 of a $5,000 loan, then he should receive the favorable tax results for his $2,000 guaranty.
The new 752 Regs are effective for debt arrangements entered into on and after October 5, 2016. Existing debt arrangements are eligible for a seven-year grandfather rule. Modifications of existing debt arrangements can trigger application of the new 752 Regs, so advisors need to be very careful in handling debt adjustments and workouts on existing projects.
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