In Tribune Media Co. v. Comm'r of Internal Revenue, the IRS stated that Tribune did not bear the economic risk of loss under the constructive liquidation test. Therefore, the IRS ruled that the senior debt was nonrecourse debt.
This determination by the IRS was overruled by The Tax Court, which stated the test “is whether Tribune must repay the senior debt creditors in a worst-case scenario.” To emphasize this point, the Tax Court stated, “No other party was liable for the debt, no partnership assets secured the loans, and if the debt were due in full in the world of a constructive liquidation, the senior debt creditors would seek repayment from Tribune and no other party.”
Section 752 – Economic Risk of Loss (EROL)
For purposes of determining the extent to which a partner or related person has a payment obligation and bears the economic risk of loss for a recourse liability, it is assumed that all partners and related persons actually perform on their obligations, irrespective of their net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. Reg. § 1.752-2(b)(6); Reg. §1.752-2(j)(3).
A partner’s or related person’s obligation to make a payment may be disregarded or treated as an obligation of another person if the facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the partner’s economic risk of loss with respect to the obligation or create the appearance that the partner or related person bears the economic risk of loss when, in fact, the substance of the arrangement is otherwise. Reg. § 1.752-2(j)(1).
In a constructive liquidation, all partnership assets are deemed to become worthless and all partnership liabilities become due and payable in full. The partnership is deemed to dispose of all its assets in a fully taxable transaction for no consideration.
Upon a constructive liquidation, all of the following events are deemed to occur simultaneously:
(i) All of the partnership's liabilities become payable in full;
(ii) With the exception of property contributed to secure a partnership liability, all of the partnership's assets, including cash, have a value of zero;
(iii) The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditors' right to repayment is limited solely to one or more assets of the partnership);
(iv) All items of income, gain, loss or deduction are allocated among the partners; and
(v) The partnership liquidates.
The classification and allocation of recourse liabilities is determined under Section 752 and the economic risk of loss. Upon constructive liquidation, recourse liabilities are allocated to the partner bearing the economic risk of loss. In theory, this partner would be obligated to make a payment or contribution to the partnership because the liability becomes due and payable and the partner isn’t entitled to reimbursement from another partner.
Effect of partnership liabilities on partner basis
1. Increase in a partner’s share of allocated liabilities allows the partner to receive tax-free distributions or to potentially deduct additional partnership losses.
2. Decrease in a partner’s share of allocated liabilities reduces basis and could result in a taxable deemed distribution when the partner’s tax basis capital is negative.
3. A deemed distribution is deemed to occur on the last day of the tax year, which may be a plus if the partnership has net income. Net income increases basis before the deemed distribution.
§752 basis – example
A is a 50% partner in ABC Partnership. At the end of 2022, A’s tax basis capital account is ($2,000).
During 2022, A’s share of allocated liabilities decreased from $3,500 to $1,000.
The reduction of A’s allocated liabilities is treated as a distribution of cash on the last day of 2022.
Immediately prior to the distribution, A’s tax basis was $1,500, which is the sum of A’s capital account of ($2,000) and liabilities of $3,500.
A’s reduction of liabilities is treated as a deemed distribution. The first $1,000 reduces A’s basis to $0; the remaining $2,500 is a taxable distribution in excess of basis.
Allocation of liabilities – recourse vs. nonrecourse
Allocation of liabilities to a partner under the §752 regulations depends on whether the liabilities are classified as recourse or nonrecourse to partners.
1. Recourse liabilities are allocated to the partner with economic risk of loss
2. Nonrecourse liabilities are generally allocated in accordance with the partners’ profits allocation
3. For §752 purposes, a liability is considered recourse as long as any partner bears the “economic risk of loss” for that liability
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Ian Ernst, Tax Manager
The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.