By Kenneth H. Bridges, CPA, PFS August 2014
Similar to S-corps, amongst the advantages of the partnership format for tax purposes (which includes most LLCs) is the ability to pass the tax losses through to the owners (for use on their personal returns) and to make tax-free distributions to the owners.
As with S-corp shareholders, the ability of a partner to deduct the losses or receive distributions tax-free is limited to their “basis” in the partnership. Unlike S-corp shareholders, however, partners can include in their basis not only their capital contributions and undistributed K-1 profits, but also their share of the partnership’s liabilities. This is a potentially significant advantage, as it can enable a partner to enjoy a substantial long-term tax deferral by deducting tax losses well in excess of their investment or receiving tax-free distributions in excess of their investment.
Under current rules, “recourse liabilities” (i.e. those for which a partner bears personal risk) are allocated to the partner who bears the economic risk of loss, and “nonrecourse liabilities” (i.e. those for which no partner is personally at risk) are generally allocated based on profit sharing percentages (with flexibility here). Proposed IRS regulations would change these rules.
Under the proposed new rules, a payment obligation would be treated as a recourse obligation of a partner only if it fully meets six requirements:
- The partner (if an entity) must maintain a commercially reasonable net worth for the entire term of the payment obligation or be subject to restrictions on the transfer of assets for nominal consideration;
- The partner must periodically document its financial condition;
- The term of the payment obligation must not end before the term of the partnership liability;
- The obligation must not require that the partnership hold liquid assets that exceed the obligor’s reasonable needs;
- The partner must receive arm’s-length consideration in exchange for assuming the payment obligation; and
- In the case of a guarantee or indemnity, the partner must be liable up to the full amount of the obligation.
The last requirement above effectively prevents “bottom-dollar guarantees” from being recognized as payment obligations.
Nonrecourse liabilities would have to be allocated in accordance with the partners’ relative interests in the liquidation value of the partnership.
The characterization of a liability as recourse or nonrecourse is important not only from the perspective of how such gets allocated amongst the partners, but also because of the “at-risk rules”, which limit the ability to deduct a loss to the partner’s at-risk amount. A partner’s at-risk amount is essentially the same as his basis, except that generally you can include in at-risk only recourse debt and “qualified” non-recourse debt, the latter basically being real estate loans from a professional lender like a bank.
The new rules will not take effect until the regulations are finalized, and the proposed regulations provide a transitional relief period of up to seven years for existing allocations.
While, as discussed above, the inclusion of partnership liabilities in a partner’s basis can provide substantial tax deferral benefits, it must be kept in mind that “phantom income” (i.e. taxable income in excess of cash being received) can result later down the road. So great care must be taken in planning for the potential eventual unwinding of the deferral, and in making sure that the tax benefit received on the front end at least equals or exceeds the tax likely to be incurred when the deferral is unwound.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.