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Back to the Future: IRS Reinstates Traditional Distinction Between Recourse Liabilities and Nonrecourse Liabilities Under the Disguised Sale Rules, for Now

Firm Thought Leadership

On June 18, 2018, the IRS released a notice of proposed rulemaking reinstating the pre-January 3, 2017 regulation that, in applying the disguised sale rules under Section 707, generally allocates “recourse” liabilities in the same manner they are allocated under Section 752, taking into account the partners’ economic risk of loss. Although the proposed rule is effective from the date 30 days after it is finalized, taxpayers are permitted to rely upon the pre-January 3, 2017 regulation, retroactive to January 3, 2017. However, Treasury and the IRS are still studying the underlying issues, and it is possible that future (presumably prospective) final rules could be different than the pre-January 3, 2017 regulation.

The notice of proposed rulemaking withdraws proposed Treasury Regulation § 1.707-5(a)(2) (and related proposed examples under subsection (f)) immediately, proposes to withdraw the identical temporary regulation (collectively, the “withdrawn rules”), and proposes to re-adopt the pre-January 3, 2017 regulation. The withdrawn rules were a controversial part of a complex package of proposed, temporary and final regulations issued on October 5, 2016, providing new rules under Sections 704, 707 and 752. That package included many disguised sale and liability allocation rules that are unaffected by the new notice of proposed rulemaking, including general guidance on the application of the exceptions to the disguised sale rules, a rule allocating nonrecourse debt under the disguised sale rules solely under the general “partners’ interests in partnership profits” standard, temporary rules attacking “bottom dollar payment obligations” and proposed rules for determining when a partner will be treated as having a “plan to circumvent or avoid a payment obligation” under Section 752.

The withdrawn rules generally allocate a partnership liability for purposes of applying the disguised sale rule as if the liability were a nonrecourse liability (i.e., under the general “partners’ interest in partnership profits” rule), except to the extent the partner would be allocated a smaller amount by allocating the liability to other partners in accordance with their economic risk of loss under the rules for recourse liabilities. As part of its general review of significant tax regulations issued on or after January 1, 2016, the Trump Administration on April 21, 2017, issued Executive Order 13789, which directed Treasury to review such tax regulations and take concrete actions to alleviate the burden of regulations that met certain criteria. In response, Treasury issued a report, published on October 16, 2017, identifying the withdrawn rules as among the rules that were under study and might be withdrawn.

The reinstatement of the pre-January 3, 2017 regulation will provide taxpayers with greater flexibility in planning to avoid gain under the disguised sale rules pending the release of final regulations, subject to limitations imposed by other aspects of the October 2016 package of regulations. The ability to retroactively apply the reinstated pre-January 3, 2017 regulation also provides benefits, but also has the potential to cause disputes regarding transactions that were negotiated, and tax returns already filed, on the basis of the withdrawn rules. Retroactive application of the pre-January 3, 2017 regulation may introduce state income tax conformity issues in some states and it may require taxpayers that amend their federal income tax returns to also amend corresponding state income tax returns. If you have questions regarding any of these considerations, including the consequences of the proposed rule, please contact any of the authors of this update.

 

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