The “leveraged partnership distribution” or “disguised sale” is a common tax savings technique used by real estate owners. Taxpayers pushed the envelope with these transactions by using “bottom dollar guarantees.” This led to guidance from the government making it more difficult to benefit from leveraged partnership distributions. The Treasury recently finalized regulations that say what works and what does not when it comes to leveraged partnership distributions. This presents an opportunity to consider the rules.
A Typical Disguised Sale
The leveraged partnership distribution is often referred to as a “disguised sale.” The typical disguised sale fact pattern looks something like this.
One individual owns real estate that has appreciated in value over time. He is getting older and risk adverse. He wants to bring on a third party to develop the real estate. The individual is in a high tax bracket and wants to avoid paying tax on the income.
He enters into a partnership with a third party developer. He contributes the property to the partnership in exchange for an interest in the partnership. The third party developer is given an interest in the partnership, but does not contribute property or money to the partnership.
The partnership has a bank lend it money with the real estate as collateral. The partnership then distributes most of the loan to the individual.
How does the partner file a correct tax return? Is the partnership distribution subject to income tax in the year the loan proceeds are received? If so, can the partner who received the loan proceeds hang on to the partnership interest until his death and his heirs get a stepped-up tax basis in the partnership property (even though this stepped up basis would allow the heirs to not pay tax on the sale of the partnership interest in the future–leaving no one to pay taxes)? The answer is “maybe.”
Partnership Tax, Generally
Contributions of property to partnerships are generally not taxable. The partners are not subject to tax when the partnership takes out a loan.
Distributions from partnerships are not taxable to the partners if they are in an amount less than the partner’s basis in the partnership.
The partners basis in the partnership typically starts with his contributions made to the partnership and, if the partnership borrows money, the amount of the loan that is recourse to the partner.
As applied to the disguised sale fact pattern above, you can see that the loan proceeds paid to the partner may not be taxable if it is less than the partner’s basis in the partnership. To make this work, the partnership may have been structured so that the individual is liable for some minimum amount of the partnership debt, so that this debt can be counted in the partner’s basis.
The Disguised Sale Rules
The disguised sale rules were intended to prevent transactions like this from escaping tax. Stepping back from the transaction, the transaction is a sale. It is not all that different from the real estate owner just selling his appreciated real estate to a third party.
The disguised sale rules basically treat the transaction as a sale between the partnership and the individual who contributed the partner, as if the individual was not a partner.
To be a considered a sale, several factors have to be considered. These are set out in the Code:
(i) the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer;
(ii) the transferor has a legally enforceable right to the subsequent transfer;
(iii) the partner’s right to receive the transfer of money or other consideration is secured in any manner;
(iv) any person has made a contribution to the partnership in order to permit the partnership to make the transfer of money or other consideration;
(v) any person has loaned the partnership the money or other consideration required to enable the partnership to make the transfer;
(vi) a partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer;
(vii) the partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be available to make the transfer;
(viii) partnership distributions, allocation or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property;
(ix) the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and
(x) the partner has no obligation to return or repay the money or other consideration to the partnership.
These factors can be planned around. One way to avoid these rules is to have the individual who contributes the real estate to be liable for the partnership debt in a way that is limited or not likely to ever cause him to actually have to repay the debt. This was often accomplished using a “bottom dollar” guarantee.
A “bottom dollar guarantee” is structured to limit the individual’s liability for the partnership debt by saying that the individual only guarantees a portion of the debt that cannot first be collected from others and the amount decreases over time as the debt is paid down to the bank.
Leveraged Partnership Distributions and Bottom Dollar Guarantees
The 2016 regulations essentially prevented taxpayers from using counting some guaranteed debt. It did so by disregarding the amount of the guarantee and allocating the debt basis according to each partners interest in the partnership.
The 2016 regulations also generally disregarded bottom dollar guarantees in computing the partner’s basis. This prevented taxpayers from counting debt basis for guarantees that were likely to never materialize.
The Treasury released proposed regulations in 2018 that rolled back part of the 2016 regulations. This allowed legitimate recourse debts to count as basis for the partner, rather than allocating the debt basis to the partners in accordance with their partnership interests. The 2018 regulations did not change the restriction on bottom dollar guarantees.
As noted above, the IRS recently made the 2018 regulations final. This means that leveraged partnership distributions are permissible, but those that use bottom dollar guarantees may not be. This confirms that the leveraged partnership distribution is a valid tax planning technique in some cases. This can provide comfort to those contemplating these transactions and something to point to for those whose transactions are under audit by the IRS for this issue.