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IRS Clears Partnership Recourse Liability Rules After 11 Years of Uncertainty

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On December 16, 2013, the IRS issued proposed regulations on how to allocate partnership recourse liabilities based on which partner has the economic risk of loss (EROL), taking into account related-party status and tiered partnership relationships. Now, eleven years later, the IRS has finalized those rules based on comments received when the proposed rules were first released, explaining that “…the issues raised by the commenters continue to remain relevant.” The new rules address several key matters, as explained below.  

Why Liabilities Matter

Partners may only use losses when they have enough basis in their partnership interest to cover the amount of the loss. Cash and property contributed to the partnership are included in a partner’s basis along with a portion of the partnership’s liabilities. Thus, the method of allocation of partnership liabilities to each partner can have a significant effect on whether losses can be deducted and whether distributions to the partner will be taxed. 

Recourse v. Nonrecourse

The rules for allocating recourse and nonrecourse liabilities are different. First, the character of the liability must be determined. Recourse liabilities are defined in the regulations as liabilities “for which the partner or related person bears the economic risk of loss.” The common understanding of this phrase is based on whether a partner would be obligated to pay a creditor out of personal assets if all of the partnership’s assets were gone or were worthless, and the obligation became due and payable. 

Nonrecourse liabilities, on the other hand, are liabilities for which no partner or related person bears the economic risk of loss. 

Final Regulation Changes

The final regulations cover only recourse liabilities and address the following significant issue:

Direct v. Indirect EROL

The final regulations distinguish between direct EROL and indirect EROL. This distinction is important because the regulations allocate recourse liability directly to partners based on direct EROL in a number of situations. A person directly bears the economic risk of loss for a partnership liability if that person has a payment obligation and is a lender, guarantees payment of interest on a partnership nonrecourse liability or pledges property as a security. 

Overlapping Economic Risk of Loss

The final rules adopt the proportionality rule for allocations, where the EROL of a partner is the amount of the partnership liability multiplied by a fraction that has the partner’s EROL divided by the sum of EROL borne by all partners for that liability.  

Example: A and B are unrelated equal members of AB, a partnership. AB borrows $1,000 from Bank. A guarantees payment for the entire amount of AB’s $1,000 liability and B guarantees payment of up to $500 of the liability, if any amount of the full $1,000 liability is not recovered by Bank. Thus, A bears $1,000 of economic risk of loss for AB’s liability and B bears $500 of economic risk of loss for AB’s liability. Applying the proportionality rule, because the $1,500 aggregate amount of A and B’s economic risk of loss exceeds AB’s $1,000 total liability, the economic risk of loss borne by each A and B is calculated as: 

A: $1,000 multiplied by $1,000/$1,500, or $667 

B: $1,000 multiplied by $500/$1,500, or $333 

Tiered Partnerships

The final rules explain how a lower-tier partnership (LTP) must allocate a liability in cases where a partner of an upper-tier partnership (UTP) is also a partner of the LTP and that partner bears the EROL for the LTP’s liability. The LTP is required to allocate the liability directly to the partner that bears the EROL for the LTP’s liability. 

Example: A is a partner in UTP. UPT and A are partners in LTP. LPT borrows $5 million, guaranteed by A. Because A bears the economic risk of loss for LTP’s liability and is a partner in LTP,  the $5 million liability is directly allocated to A.  

Related Party Rules

The final rules clarify the related-partner exception contained in the 2004 case of IPO II v. Commissioner. That case disregards relatedness among partners when one partner bears the economic risk of loss. The regulations state, if a person who owns an interest in a partnership directly or indirectly is a lender or has a payment obligation for a partnership liability, then other persons owning interests directly or indirectly in that partnership would not be treated as related to that person for purposes of determining the EROL borne by each of them. 

Ordering Rule

The final regulations offer an ordering rule to clarify how the proportionality rule interacts with the multiple partner rule and how the multiple partner rule interacts with the related-partner exception. Here are the steps: 

  1. The first step is to determine whether any partner (direct or indirect) directly bears the EROL for the partnership liability and apply the related- partner exception. 
  2. After applying the related-partner exception, the next step is to determine the amount of EROL each partner is considered to bear when multiple partners are related to a person that directly bears the EROL for a partnership liability.  
  3. The final step is to apply the proportionality rule to determine the amount of EROL that each partner is considered to bear when the amount of EROL of multiple partners exceeds the amount of the partnership liability.

Conclusion

The regulations are effective on December 2, 2024. They clear up 11 years of uncertainty with regard to the proper allocation of partnership recourse liabilities. Because of the technical nature of these issues, it is important to consult with a trusted tax advisor like Frazier & Deeter to ensure proper liability allocations and proper basis increases for partnership interests. 

Contact us today for personalized guidance and ensure your partnership allocations comply with the latest IRS regulations. 

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