5.pdf - College of William Mary Law School William Mary Law...

This preview shows page 1 out of 50 pages.

Unformatted text preview: College of William & Mary Law School William & Mary Law School Scholarship Repository William & Mary Annual Tax Conference Conferences, Events, and Lectures 1995 Partnership Workouts: Problems and Solutions Under Final Section 704(b) and 752 Regulations Michael G. Frankel Charles H. Coffin Repository Citation Frankel, Michael G. and Coffin, Charles H., "Partnership Workouts: Problems and Solutions Under Final Section 704(b) and 752 Regulations" (1995). William & Mary Annual Tax Conference. 300. Copyright c 1995 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository. PARTNERSHIP WORKOUTS: PROBLEMS AND SOLUTIONS UNDER FINAL SECTION 704(b) and 752 REGULATIONS* By Michael G. Frankel, Esq. Coopers & Lybrand L.L.P. Dallas, Texas Charles H. Coffin, Esq. General Electric Company Schenectady, New York Forty-FirstWilliam & Mary Tax Conference Hot Topics in Real Estate,And More Williamsburg, Virginia December 1 - 2, 1995 Copyright 1995 by Michael G. Frankel and Charles H. Coffin. All rights reserved. *Portions of this article previously were published in the Winter 1993 edition of Journalof PartnershipTaxation Partnership Workouts: Problems And Solutions Under Final Section 704(b) And 752 Regulations To many tax advisors, Sections 704(b) and 752' are the heart and soul of Subchapter K of the Internal Revenue Code. These statutory provisions embody the essence of the "aggregate" theory of partnerships and partners. They are also the provisions that served to fuel the tax shelter industry by permitting real estate investments to be "leveraged" for tax purposes. Although the statutory language of Sections 704(b) and 752 has not changed since the passage of the Tax Reform Act of 1976, the regulations promulgated under these sections have been proposed, reproposed and otherwise revised at least 10 times during the past decade.- These changes have introduced a variety of new terms and ' All references herein to sections are to sections of the tntert,al Revenue Code of 1986, as amended. 2 Regulatory guidance for applying the 1976 amendment to Section 704(b) was not available until 1983, when the Treasury Department issued proposed regulations. See Prop. Treas. Reg. § 1.704-1(b) (1983), 48 Fed. Reg. 9871 (1983). These regulations were eventually finalized on December 24, 1985, and further amended on September 8, 1986. See Treas. Reg. § 1.704-1(h) (1986), 50 Fed. Reg. 53420 (1985), 51 Fed. Reg. 32061 (1986). A portion of these regulations, contained in Treas. Reg. § 1.704l(b)(4)(iv) (1986), addressed allocations of deductions attributable to nonrecourse liabilities ("Former 704(b) Regulations'). On December 30, 1988, and November 21, 1989, the Treasury Department issued temporary regulations substantially revising the nonrecourse allocation rules in the Former 704(b) Regulations ('Temporary 704(b) Regulations"). See Treas. Reg. §§ 1.704-1T(b)(0) to -IT(b)(5) (1989), 53 Fed. Reg. 53161 (1988), 54 Fed. Reg. 48096 (1989). On December 27, 1991, the Temporary 704(b) Regulations, at long last, were finalized with minor modifications ('Final 704(b) Regulations). See Treas. Reg. § 1.704-2, 56 Fed. Reg. 66978 (1991). Prior to 1988, rules for allocating nonxecourse liabilities among partners were contained in Treas. Reg. § 1.752-1(e) (1960) ('Former 752 Regulations"). On December 29, 1988, the Treasury Department issued temporary regulations replacing the Former 752 Regulations. These temporary regulations were amended on November 21, 1989, and July 31, 1991 (as amended, *Temporary752 Regulations"). See Treas. Reg. §§ 1.752-0T to -4T (1991), 53 Red. Reg. 53143 (1988), 54 Fed. Reg. 48094 (1989), 56 Fed. Reg. 36702 (1991). Final regulations were eventually issued on December 23, 1991 ('Final 752 Regulations"). See Treas. Reg. §§ 1.752-I to -4, 56 Fed. Reg. 66348 (1991). JOURNAL OF PARTNERSHIP TAXATION concepts and have transformed what has always been a complex area of the tax law into one where many tax advisors have simply given up and do not even attempt to understand, much less comply with, the intricate and highly technical rules that are at the core of these regulations. For those of us who have not given up, we have found ourselves continuously amending and reamending partnership agreements (as well as our standard forms) to address the changes that have been thrust upon us during this time period. In some instances, the ink has barely dried when new regulations were issued and further conforming changes were needed. Fortunately, with the promulgation last December of the Final 752 Regulations and the Final 704(b) Regulations, it appears that a long regulatory journey is almost concluded. As that journey ends, however, another arduous trek begins: mastering the intricacies of the final regulations and understanding their intended and unintended impact on partnerships and their partners. These different sets of regulations have spawned extensive commentary. See, e.g., Presant & Loffman, *The Final Partnership Noarecourse Debt Allocation Regulations," 65 Taxes 67 (Feb. 1987); Brumbaugh & Hauschild, "Treatment of Partnership Allocations Attributable to Non.recourse Indebtedness,' 3 J. Partnership Tax. 99 (Summer 1986); Brumbaugh & Coleman, "Nonrecourse Debt Regulations Resolve Most Special Allocation Issues," 4 J. Partnership Tax. 21 (Spring 1987); Frankel & Coffin. "New Section 752 Regulations Clarify Treatment of Partnership Liabilities,* 6 J. Partnership Tax. 179 (Fall 1989); Frankel & Coffin, 'Treatment of Allocations Attributable to Loans Under New 704(b) Regulations," 6 J. Partnership Tax. 294 (Winter 1990); Lord, "Amendments to Recent Liability Regulations Clarify Ambiguities and Provide Consistency," 7 J. Partnership Tax. 115 (Summer 1990); Pickron, "New 752 Prop. Regs. Simplify Rules for Allocating Partnership Liabilities," 75J. Tax. 358 (Dec. 1991). For a general discussion of the Final 752 Regulations, see Pickron, 'Final Rules on Allocation of Partnership Liabilities Still Leave Unanswered Questions,* 761J. Tax. 272 (May 1992); Presant, Loffman & Abramowitz. "The Final Regulations Under Section 752," 19 J. Real Est. Tax. 267 (Summer 1992); Cuff, "Allocating Partnership Liabilities" 70 Taxes 303 (May 1992). For a general discussion of the Final 704(b) Regulations, see Hamill, "Final Regulations Concerning Liabilities Join Substantial Economic Effect Rules," 9 J. Partnership Tax. 99 (Summer 1992).11 is beyond the scope of this Article to discuss all of the various changes that were made to the Section 704(b) and 752 regulations between 1983 and 1991. 3 Due to several technical problems, it appears that further minor modifications likely will be made to the Section 704(b) regulations. NEW PARTNERSHIP RULES The authors believe that the impact, reach and continuing uncertainties of these regulations can be best explained and illustrated through a series of scenarios involving a troubled partnership which is seeking to deal with its financial problems by undergoing a debt or equity restructuring. This Article initially sets forth factual assumptions common to typical post-1991 workouts and debt restructurings. Following a brief summary of the various effective date and transition rules in the Section 704(b) and 752 regulations, this Article then discusses five different scenarios to illustrate the manner in which the new regulations operate and affect workout transactions. Factual Assumptions Steven and Brian are natural persons. On June 16, 1983, Steven and Brian formed a general partnership ("Partnership") for the purpose of constructing an office building ("Building"). The Partnership's taxable year is the calendar year. Steven and Brian share equally all of the Partnership's profits, losses and distributions. Each partner has the right under the partnership agreement to initiate a capital call to fund any operating deficit incurred by the Partnership. If, however, either partner fails to fund his share of any such capital call, his interest in the Partnership is diluted pursuant to a formula prescribed in the partnership agreement. During 1983, an unrelated lender ("Lender") made a fully nonrecourse loan ("Nonrecourse Loan") to the Partnership the proceeds of which were used to finance the development of the Building, which was placed in service on January 1, 1984. As of January 1, 1993, the outstanding principal balance of the Partnership's nonrecourse debt is $5 million, the Partnership's adjusted tax basis in the Building is $2 million, each partner's adjusted tax basis in his partnership interest is $1 million, and each partner's capital account has a deficit balance of $1.5 million. Due to local market conditions, the Partnership's cash flow has declined and the Partnership requires additional capital to fund its operating expenses and debt service obligations. JOURNAL OF PARTNERSHIP TAXATION Effective Dates, Transition Relief' There are a number of ways the Partnership and its partners could attempt to manage their financial difficulties. The initial tax issue in virtually every partnership workout or debt restructuring, however, is which set or sets of Section 704(b) and 752 regulations would apply to the partnership and its restructured liabilities. As the discussion of different scenarios below illustrates, dramatically different tax consequences may result from the application of different versions of these regulations. Unfortunately, the effective date and transitional relief rules of the Section 704(b) and 752 regulations are perhaps their most complex provisions. This part of the Article summarizes the rules most relevant to post-1991 workouts and debt restructurings. Section 752 Regulations. As a general matter, a partnership liability will be subject to a different set of Section 752 regulations depending on when the liability was incurred or assumed by the partnership. For example, the Former 752 Regulations generally apply to liabilities incurred or assumed prior to January 30, 1989. The Temporary 752 Regulations generally apply to liabilities incurred or assumed on or after January 30, 1989, but prior to December 28, 1991.' The Final 752 Regulations generally apply to liabilities incurred or assumed on or after December 28, 1991.6 Unfortunately, significant exceptions and caveats to these general rules complicate the analysis of any partnership workout or debt restructuring. Partnerships may elect to apply the Final 752 Regulations to all pre-existing liabilities that otherwise would be grandfathered. This election is effective as of the beginning of the first taxable year ending 'These rules are summarized on Apendices A through D to this Article. Treas. Reg. § 1.752-4T(a) (1991). 6 Treas. Reg. § 1.752-5(a). For this purpose, an existing liability is not treated as newly incurred or assumed by virtue of a constructive termination of the partnership under Section 708(b)(1)(B). See Treas. Reg. § 1.752-5(c). NEW PARTNERSHIP RULES on or after December 28, 1991 (i.e., 1991 for calendar-year partnerships), but must have been made on a written statement attached to the partnership's tax return for such taxable year.' It is unclear whether partnerships can make this election validly on amended returns. The Final 752 Regulations fail to specify whether the election must be attached to an original tax return, and the Internal Revenue Service ("IRS") has not indicated whether it will permit partnerships to use amended returns to make this election. Under the Temporary 752 Regulations, partnerships similarly could have elected to apply the Temporary 752 Regulations to all preexisting liabilities that otherwise would not have been subject to those regulations as of the beginning of the first taxable year ending after December 29, 1988 (as of January 1, 1988, for calendar-year partnerships).' In this context, the original version of the Temporary 752 Regulations also failed to specify whether elections could be made on amended 1988 returns, but the IRS nevertheless accepted elections on such returns.' Eventually, the Temporary 752 Regulations were specifically revised to permit the use of amended returns. If a partnership is unable or otherwise fails to elect to apply the Final or Temporary 752 Regulations, individual pre-existing liabilities nevertheless may become subject to one or the other versions of the new rules. The regulatory preamble to the Final 752 Regulations indicates that a pre-existing liability will be treated as exchanged for a newly incurred or assumed liability when it is "materially modified.""1 See Treas. Reg. § 1.752-5(b). 'Treas. Reg. § 1.752-4T(d)(1) (1991). 'See, e.g., PLR 9024078 (Mar. 21, 1990); PLR 9024031 (Mar. 15, 1990); PLR 9034034 (May 25, 1990). 10 See Treas. Reg. § 1.752-4T(d)(3) (1991). " 56 Fed. Reg. 66350 (1991). JOURNAL OF PARTNERSHIP TAXATION As a result, otherwise grandfathered liabilities may be subject to a different set of Section 752 regulations depending on the date of any "material modification." By way of illustration, if a pre-existing liability was materially modified on or after January 30, 1989, but prior to December 28, 1991, the debt would have become subject to the Temporary 752 Regulations on the date of the modification. If the same liability is again materially modified on or after December 28, 1991, it would then become subject to the Final 752 Regulations on the date of the second modification. Unfortunately, it is not clear what constitutes a "material modification" for Section 752 purposes. 2 The regulatory preamble to the Final 752 Regulations states simply that a guaranty of a liability by a partner or a related person will not be treated as a modification of the debt for this purpose. Another important exception to the general rules involves liabilities incurred on or after March 1, 1984, and prior to January 30, 1989.'" As a general matter, the Former 752 Regulations apply to these liabilities. Nevertheless, the Temporary 752 Regulations would apply retroactively to any such loan made to the partnership directly by a partner. If the loan was not made directly by a partner, but was guaranteed by him, the Temporary 752 Regulations would begin to apply to the loan as of the date of the partner's guaranty. This exception does not extend to loans made or guaranteed during this period by persons related to a-partner (rather than directly by the partner himself). The Former 752 Regulations continue to apply '2 IRS representatives have informally indicated that they will not provide any guidance regarding the meaning of material modification in this context until they have fully assessed all of the ramifications of the United States' Supreme Court's decision in Cottage SavingsAss'n v. Comm'r, I IIS. Ct. 1503 (1991). Caution therefore should be exercised by prudent tax advisors whenever a partnership debt is being restructured, because lender or borrower concessions of any kind may constitute material modifications of the debt under general income tax principles. See, e.g., IRC § 1001. IRS representatives have even suggested that the partial prepayment of a debt might constitute a material modification for Section 752 purposes. "3Treas. Reg. § 1.752-4T(b) (1991). NEW PARTNERSHIP RULES to these pre-January 30, 1989 related partner loans unless and until an overall election is made or the loan is materially modified on or after January 30, 1989.' Section 704(b) Regulations. The Final 704(b) Regulations generally apply only to taxable years beginning on or after December 28, 1991 (i.e., 1992 for calendar-year partnerships)."S Special transitional relief is available, however, to pre-existing partnerships. For partnerships formed on or after December 30, 1988 and prior to December 28, 1991, the Temporary 704(b) Regulations generally continue to apply, provided the partnership complied with the Temporary 704(b) Regulations prior to December 28, 1991.6 For partnerships formed prior to December 30, 1988, the Former 704(b) Regulations generally continue to apply, provided the partnership complied with the Former 704(b) Regulations prior to December 30, 7 1988.1 If not otherwise subject to the Final 704(b) Regulations, a partnership may elect to apply these regulations to its first taxable year ending on or after December 28, 1991 (i.e., 1991 for calendar-year '" 56 Fed. Reg. 66350 (1991) (regulatory preamble to the Final 752 Regulations). The regulatory preamble also makes clear that the Former 752 Regulations apply to all liabilities incurred or assumed prior to March 1, 1984, unless and until an election is made to apply a subsequent version of the Section 752 regulations or the loan is materially modified. This grandfather status applies, regardless of whether a partner directly made the loan prior to March 1, 1984, or a third party made the loan prior to March 1, 1984, and the partnerdirectly guarantees the loan on or after March 1, 1984. tS Treas. Reg. § 1.704-20)(1)(i). "Treas. Reg. § 1.704-20)(1)(ii). '7 Treas. Reg. § 1.704-20)(1)(iii). Although this regulation does not explicitly state that the partnership must have continued to comply with the Former 704(b) Regulations between December29, 1988 and December 28, 1991, continuing compliance presumably was intended. JOURNAL OF PARTNERSHIP TAXATION partnerships).'" This election must be made on a written statement attached to the partnership's tax return for such year. As with similar elections to apply the Final 752 Regulations to a partnership's pre- existing liabilities, it is not clear whether amended returns may validly be used to make this election.' 9 If a pre-existing partnership does not elect to apply the Final 704(b) Regulations, it nevertheless will become subject to the new regulations if its partnership agreement is materially modified on or after December 28, 1991.2' Upon such a modification, the Final 704(b) Regulations begin to apply for the taxable year of the modification and all years thereafter. 2 ' Additional transitional relief is accorded to partnerships, regardless of the date of their formation, for deductions attributable to certain liabilities grandfathered under the Section 752 regulations. Three exceptionally complex provisions of the Final 704(b) Regulations must be taken into account when allocating these deductions under the Final, Temporary and Former 704(b) Regulations. Unfortunately, the relief provided by these special rules for Section 704(b) purposes is not '" Treas. Reg. § 1.704-20)(4). Partnership formed prior to December 30, 1988, could also have elected to apply the Temporary 704(b) Regulations. See Treas. Reg. § 1.704-1T(b)(4)(iv)(m)(4) (1989). This election must have been made on the partnership's tax return for its first taxable year ending after December 29, 1988 (i.e., 1988 for calendar-year partnerships). '9 See text accompanying notes 8-10 supra. . See Treas. Reg. §§ 1.704-2(0)(1)(ii), -20)(1)(iii). In the case of a partnership formed prior to December 30, 1988, a material modification of its partnership agreement between December 30, 1988, and December 27, 1991, would have caused the Temporary 704(b) Regulations to apply. ifa f' partnership agreement is materially modified on a day other than the first day of the partnership taxable year, the change in the governing Section 704(b) regulations apparently occurs as of the first day of the year during which the material modification occurs. See, e.g., Treas. Reg. § 1.704-2(l)(1)(ii)(A). NEW PARTNERSHIP RULES entirely consistent with the Section 752 treatment of the corresponding liabilities."One provision, contained in Treas. Reg. § 1.704-2(1)(3), applies to nonrecourse liabilities incurred or assumed by partnerships prior to March 1, 1984, if the liability is directly made or guaranteed by a partner ("(l)(3) liabilities"). These liabilities are governed by the Former 752 Regulations, and direct partner guaranties (regardless of their effective dates) generally do not cause t...
View Full Document

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture