The Current State of Leveraged Partnership Structures and Liability Allocations

Jorge Otoya, CPA and Jim Dubeck
Published Date:
Nov 1, 2017

One of the many benefits of using partnerships to conduct business is that a partner can include its allocable share of partnership liabilities in the tax basis of its partnership interest (“outside basis”). The inclusion of partnership liabilities in a partner’s outside basis is beneficial for a number of reasons, including determining whether a partner is able to deduct partnership losses, calculating the amount of gain a partner recognizes upon a distribution of money from a partnership, and for conducting transactions between partners and the partnership, such as disguised sales. Accordingly, the manner in which a partnership allocates partnership liabilities among its partners is exceedingly important. 

Liability allocations are also important for disguised sale purposes, especially when forming a partnership with the contribution of leveraged assets or making a debt-financed distribution.  For example, in certain situations, a partner that contributes appreciated property to a partnership can receive a debt-financed distribution within 90 days of contribution without triggering any disguised sale gain. The desired gain deferral is achieved as long as the partnership liability funding the distribution is fully allocated to the contributing partner. This type of transaction, commonly referred to as a leveraged disguised sale, prompted the U.S. Department of the Treasury to change all the partnership liability allocation rules. This article will summarize the background leading up to last year’s changes to Treasury regulations dealing with partnership liability allocations and leveraged disguised sales, as well as the proposed repeal of these changes.


Partnerships allocate liabilities to its partners depending on whether the liability is classified as a recourse or non-recourse liability. A partnership liability is a recourse liability to the extent that a partner or a person related to a partner (a related person) bears the “economic risk of loss” (EROL) for the liability. Generally, a partner or related person bears the EROL to the extent that it has a “payment obligation” determined under a hypothetical liquidation of the partnership, assuming the assets of the partnership are worthless and partnership liabilities become due and payable. A presumption of these rules is that the partner or partners with a payment obligation will satisfy the obligation irrespective of the person’s net worth, unless the arrangement is deemed to be abusive under a set of anti-abuse rules.  Nonrecourse liabilities are those partnership liabilities for which no partner or related person bears the EROL.  These types of liabilities are allocated based on a three-tiered system generally following how partnership income or gain would be allocated among the partners upon the disposition of partnership assets.

One of the fundamental principles of the partnership liability allocation rules is administrative simplicity.  For recourse liabilities, taxpayers and the IRS rely on underlying economic agreements that evidence a partner’s EROL. A determination that a partner or the partnership will satisfy its obligations under these agreements is not required. Without these simplifying assumptions, the allocation of partnership recourse liabilities would be substantially more difficult and subjective. Despite this relative simplicity, however, some subjectivity remains. For example, when one partner executes an agreement that indemnifies another partner that has guaranteed a partnership liability, certain anti-abuse rules apply. These rules require interpretation of the indemnity arrangement provisions for tax purposes that might differ significantly with common business and legal practice. The tax rules contain certain anti-abuse rules to thwart arrangements whose principal purpose is avoiding or creating partner EROL through indemnities when the facts and circumstances indicate otherwise. These anti-abuse rules were harshly applied in a 2010 Tax Court decision involving a leveraged disguised sale.   

Canal Corporation and Subsidiaries v. Commissioner, 135 TC 199

In Canal v. Commissioner, a U.S. corporation, Canal, was seeking to dispose of its tissue business that it held in one of its subsidiaries, referred to as WISCO.  Georgia Pacific (GP) also held a tissue business and expressed interest in purchasing WISCO. Canal and GP’s tax counsel structured the transaction to defer the gain on disposition through the use of a leveraged disguised sale structure. 

Under this structure, WISCO and GP contributed their respective tissue businesses to a newly formed partnership (PRS). PRS obtained a loan from Bank of America (BOA) and used the proceeds to make a special distribution to WISCO, who transferred the loan proceeds to Canal. GP guaranteed the BOA loan, and WISCO indemnified GP with respect to its guarantee—but with certain conditions that limited the risk that WISCO would be called upon to satisfy the indemnity.  Canal intended that the indemnification would provide WISCO with the EROL on the loan so that WISCO would be allocated the total amount of that liability for tax purposes. The intended result was to defer gain recognition from the disposition of Canal’s tissue business. In applying the liability allocation anti-abuse rules, however, the Tax Court held that WISCO’s indemnification of GP lacked commercial reality, resulting in gain recognition from a disguised sale. 

Treasury’s Response

The Tax Court’s decision in Canal prompted the Treasury to issue proposed regulations in 2014 to prevent what it perceived as abusive leveraged partnership structures (the 2014 Proposed Regulations).  The 2014 Proposed Regulations, however, were not limited to leveraged disguised sales. They were much broader, fundamentally changing the partnership liability allocation rules.

One of the more controversial areas of the 2014 Proposed Regulations is a series of requirements that must be satisfied in order for a payment obligation to provide a partner with EROL. These requirements were intended to reflect current commercial lending practices.  In 2016, in response to comments received from the tax community, Treasury withdrew part of the 2014 Proposed Regulations and issued Temporary, Final, and Re-Proposed Regulations on partnership liability allocations.

In the 2016 Re-Proposed Regulations, Treasury modified the list of EROL requirements from the 2014 Proposed Regulations and included them in a revised anti-abuse rule as non-exclusive factors to be considered in determining whether a payment obligation should be respected.

For the purpose of the leveraged disguised sales rules, the 2016 Temporary Regulations generally classify all partnership liabilities as non-recourse liabilities that are only allocated among partners based on their share of partnership profits.  All the other non-recourse liability allocation methods are not applicable to transactions that fall within the definition of a disguised sale, including many leveraged partnership formation transactions as well as debt-financed distributions. 

The broad application of the 2016 Temporary Regulations increases the number of partnership formation transactions involving the contribution of encumbered property that would result in gain recognition. For example, assume A contributes property with a $50 tax basis and a $200 fair market value (FMV) that was recently encumbered with a $100 non-recourse liability in formation of a partnership with B, who contributes $200 of cash. The recent incurrence of the $100 liability encumbering A’s property is classified as a non-qualified liability for disguised sales purposes. Applying the 2016 Temporary Regulations for disguised sale purposes will result in an allocation of the $100 liability equally to A and B, causing a $50 shift of A’s liability to B.  As a result, A includes $50 of proceeds from a disguised sale, resulting in $37.50 of gain ($50 proceeds are 25% of the $200 property FMV and the utilization of 25% or $12.50 of the $50 basis). This result would be the same even if A agreed to fully guarantee the debt in order to prevent any of the liability from shifting to B. Under prior law, if A were to guarantee the debt, the liability would not shift to B and thus the guarantee would prevent A from recognizing disguised sale gain on formation of the partnership. Some practitioners believe that these rules hinder the formation of partnerships with highly leveraged assets and argue that the result is contrary to the pro-growth intent of the President and Congress. 

Treasury Department News Release SM-0172 (TDNR SM-0172)

On Oct. 4, 2017, Treasury released its report on planned upcoming actions proposing to partially revoke the 2016 Temporary Regulations.  Specifically, Treasury and the IRS indicate their belief that the 2016 Temporary Regulations applying to disguised sales should be proposed for revocation and that the prior regulations should reinstated. 


TDNR SM-0172 is welcome news for taxpayers. As discussed above, prior to the issuance of the 2016 Temporary Regulations, taxpayers had more flexibility to structure the contribution of encumbered property to a partnership on a tax-deferred basis. The previous provisions, along with revocation of the other partnership liability allocation rules, will allow partners to plan the formation of partnerships using the significantly more favorable rules that existed before the 2016 Temporary Regulations.    

otoyaJorge Otoya, CPA, is a director at Moss Adams in San Francisco. He has worked in public accounting since 1997. He provides clients with tax guidance and planning for their complex partnerships and related transactions, researches complex tax partnership transaction issues, consults and implements tax partnership strategies, develops and manages client relationships, and coordinates tax services from other parts of the firm. Jorge has many years of experience with Big Four and national firms, and is the president and founder of a CPE training website and partnership consulting practice for accounting professionals. He is a member of the AICPA and NYSSCPA, and serves on the Society’s Partnerships and LLCs Committee. 

Views expressed in articles published in Tax Stringer are the authors' only and are not to be attributed to the publication, its editors, the NYSSCPA or FAE, or their directors, officers, or employees, unless expressly so stated. Articles contain information believed by the authors to be accurate, but the publisher, editors and authors are not engaged in redering legal, accounting or other professional services. If specific professional advice or assistance is required, the services of a competent professional should be sought.