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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.
PROBLEMS AND SOLUTIONS UNDER
FINAL SECTION 704(b) and 752 REGULATIONS* By
Michael G. Frankel, Esq.
Coopers & Lybrand L.L.P.
Charles H. Coffin, Esq.
General Electric Company
Schenectady, New York Forty-FirstWilliam & Mary Tax Conference
Hot Topics in Real Estate,And More
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
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.
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
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
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,
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.
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...
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