Liabilities and Risk of
the basis of the partnership interest in the following manner:
Because a liability
has a direct influence on the amount of basis that a partner
is deemed to hold, a determination of what is a partner's share
of liabilities must be made. In making this determination, two
considerations must be addressed:
Is the liability in question a recourse or nonrecourse liability?
This is important because different sets of sharing rules
are used depending upon the type of liability.
How are both recourse and nonrecourse liabilities allocated
among the partners? This is important because assorted rules
and profit sharing ratios may exist for different items of
partnership income and deductions.
Risk of Loss
The basic approach used
in addressing both of these issues reflects Congress' goal in
the Tax Reform Act of 1984 of ensuring that the partner who receives
the basis with respect to a partnership liability also bears the
economic risk of loss for the liability. Regulations effective
for liabilities incurred or assumed on or after January 30, 1989,
have undertaken this directive and instituted the ultimate responsibility
test, which at times appears to resemble more closely a term of
art. The thrust of this test is to determine who bears the ultimate
financial responsibility for payment of a partnership liability.
If it can be established that a partner will have to satisfy a
liability out of his/her own funds, it is a recourse liability.
If no partner will have to defray the cost of a liability out
of his/her own funds, if the partnership fails to do so, then
the liability is said to be a nonrecourse liability. If a liability
has nonrecourse and recourse characteristics, the debt will be
treated as two different liabilities.
Reg. Sec. 1.752-1
Determining recourse liabilities
that recourse liabilities are allocated to the partner
who bears the recourse burden. Nonrecourse liabilities
are shared by all partners (including limited partners)
according to profit sharing ratios.
A liability is recourse
to the extent that a partner bears the economic risk of loss if
the liability is not discharged by the partnership. To determine
the risk of loss, the Regulations adopt a hypothetical worst-case
scenario called a "constructive liquidation," which is often referred
to as the "atom bomb test' (constructive liquidation). Gain Under
constructive liquidation, the following scenario is deemed to
partnership assets are worthless and disposed of in a taxable
transaction for zero consideration.
partnership liabilities are due and payable in full.
partnership allocates all gains and losses with respect to
the disposition according to the partner's capital accounts.
partners interests in the partnership are liquidated.
A partner then would
bear the economic risk of loss to the extent that, after constructive
liquidation, the partner would be obligated to pay a creditor
or make a contribution to the capital of the partnership. A
partnership contribution obligation generally occurs when a
partner is required to restore a negative capital account balance
as a result of the constructive liquidation. Accordingly, the
partner is generally allowed to include that amount of his/her
potential liability in the basis of his/her partnership interest.
This required contribution is taken into account before the
balance of the liabilities are pro rated. Reg.
Determining the Risk of Loss
and Y are partners in the XY partnership, each sharing
profits and losses 50 percent and each obligated to
restore any negative capital account balances. The only
asset of the partnership is land with a basis and fair
market value of $60,000. X has a basis in the partnership
interest of $10,000 and Y's basis is $50,000. If the
partnership borrowed $80,000 on a recourse basis to
purchase a building, the debt would be allocated $60,000
to X and $20,000 to Y determined as follows:
||Loss on land
||Loss on building
Due to the atom bomb test (constructive
liquidation), the land and building are deemed worthless
and sold for $0, generating the losses. Partner X is
obligated to contribute $60,000 while partner Y only
is obligated to contribute $20,000. Thus, the liabilities
are allocated accordingly.
In making the determination
of who bears economic risk of loss, the partnership agreement
and a wide variety of conventions used by lenders must be taken
into consideration. The label of a loan will not determine which
partner bears the ultimate risk of loss. The loan must be analyzed
to determine who, in fact, bears the risk of loss.
may incorporate any one of the following practices into the
instrument that can change how the loan will be treated for
essence what each of these techniques does is go beyond the constructive
liquidation test and determines who ultimately will be liable
for satisfying the liability from his/her own funds. If a partner
has any right to a reimbursement or if relief exists under the
debt instrument, to that extent, the partner does not bear the
risk of loss. These techniques will be discussed in more detail
A partner will not bear
the economic risk of loss to the extent that he/she (or a related
party) is entitled to 1999-03-31 52 3B Determining the Risk of
Loss receive a reimbursement. In this context, a reimbursement
is an obligation of another partner or the partnership that effectively
relieves that economic risk of loss to that partner. Potential
reimbursement from an unrelated third party (such as an insurance
company) does not effect a partner's share of recourse liability.
A loan from a partner
is always viewed as a recourse loan. From an economic viewpoint,
a partner could never make a nonrecourse loan to a partnership
because, by definition, a nonrecourse loan is one in which no
partner is personally liable. If the partnership is unable to
repay its loan, the partner has lost the personal assets that
were advanced. Therefore, the Regulations always treat the lending
partner (whether limited or general) as bearing the full risk
of loss to the extent of the loan. If a partner should sell assets
to the partnership for a personal note that wraps around a nonrecourse
mortgage to an unrelated party, the wrapped note (unrelated party)
is treated separately. In this case the Regulations do not treat
the partner as having risk of loss on the nonrecourse mortgage
to the unrelated party.
Reg. Sec. 1.752-2(c)
A partner will not
be considered to have the economic risk of loss for a nonrecourse
loan made by the partner if:
partner's interest in each item of partnership income, gain,
loss, deduction or credit is 10 percent or less, and
loan constitutes qualified nonrecourse financing under the
at risk rules of Section 465(b)(6). Reg.
Related party loans
A recourse liability
must be allocated to a partner to the extent that a person related
to the partner bears the risk of loss. This rule can have the
effect of converting a nonrecourse liability into a recourse liability
if a partner is related to the lender. The Regulations define
a related party by adopting (with substitutions) the rules of
Section 267(b) and 707(b)(1). The Regulations substitute an 80
percent or more ownership test for the 50 percent test in those
sections, and brothers and sisters are not considered to be related
persons. The attribution rules of Section 267(c) also apply.
As a result of the
related party rules, one should note the bottom line effect
on certain, limited partnerships. The impact may be to shift
allocation of a liability away from limited partners who would
ordinarily share in the basis increase attributable to an otherwise
If a partner guarantees
a partnership nonrecourse liability, it will be allocated to that
partner as if it were a recourse liability. This rule applies
equally to general and limited partners. If a partner has agreed
to guarantee a partnership's recourse liability, the risk of loss
does not necessarily lie with the partner due to the rights of
Under the theory
of subrogation, the guarantor is entitled to stand in the shoes
of the lender after making the payment to the lender. Thus,
the guarantor may sue the partnership after making payment and
recover the funds from all the general partners. Accordingly,
the general partners bear the risk of loss and all share in
the basis allocations.
To ensure that a
guarantor partner receives the entire basis for any recourse
loans that are guaranteed, the partner must generally waive
any recovery rights. Generally, this would include:
rights to subrogation
to treat any payments to the lender as capital contribution
to indemnify any other partners that might be required to
discharge a recourse obligation. Reg.
Sec. 1.752-2(o) Example (4)
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