Better Late Than Never – The IRS Issues Final Regulations on the Allocation of Recourse Partnership Liabilities After More Than a Decade

I.   Introduction

On November 29, 2024, the United States Internal Revenue Service (the “IRS”) released final regulations (Final Regulations) relating to the allocation of recourse partnership liabilities under section 752 of the Internal Revenue Code of 1986, as amended (the “Code”). The Final Regulations finalize the 2013 proposed regulations and provide guidance principally on (1) the allocation of recourse liabilities between partners that share economic risk of loss (EROL) for the same liability, (2) the treatment of recourse liabilities in tiered partnership structures, and (3) the application of related party rules to the allocation partnership recourse liabilities. 

II.   Background

Under Code section 752, partners in an entity taxable as a partnership include their shares of the partnership’s liabilities in their federal income tax bases in their partnership interests. To determine a partner’s share of partnership liabilities, the partnership must allocate its liabilities among its partners.  Because a partner’s share of partnership liabilities is included in the partner’s tax basis, these allocations impact the determination of, among other matters, whether the partner will recognize gain on a distribution from the partnership and is allowed to claim deductions for allocable losses of the partnership.

Treasury Regulations (Regulations) Sections 1.752-1 through 1.752-3 distinguish between two categories of partnership liabilities, recourse and nonrecourse. A partnership liability is considered “recourse” for purposes of Code section 752 if a partner bears the EROL for that liability, regardless of whether the liability is considered recourse or nonrecourse under local law. All other partnership liabilities are considered “nonrecourse.” Under Regulations Section 1.752-2, a partner bears the EROL if the partner or a related person: (1) would have a payment obligation if the partnership underwent a constructive liquidation discussed in the Regulations, (2) is a lender to the partnership, (3) guarantees payment of interest on a partnership liability, or (4) pledges property as a security for the partnership liability. The partners who bear the EROL for a recourse liability include that liability in the tax basis of their partnership interests to the exclusion of all other partners. However, before the issuance of the 2013 proposed regulations, it was unclear how a partnership should allocate its recourse liabilities when multiple partners were considered to bear the EROL for the same liability. The Final Regulations clarify the allocation of recourse liabilities among the partners who bear the EROL, as well as the application of the related party rules and tiered partnership structures to the allocation of recourse liabilities.

III.   Overlapping Economic Risk of Loss.

In cases where multiple partners bear the EROL for the same liability, the Final Regulations resolve the overlapping EROL using a proportionality rule. Under this rule, each partner’s share of a recourse liability is calculated by multiplying the total amount of the recourse liability by a fraction, of which the numerator is the partner’s individual EROL and the denominator is the total economic risk of loss borne by all partners. For example, assume that a partnership incurs a $2,000 liability, partner A personally guarantees the entire liability, and partner B pledges $500 of assets as security for the liability. Partner A has EROL of $2,000, partner B has EROL of $500, and the total risk of loss is $2,500.  Under the proportionality rule of the Final Regulations, partner A is allocated $1,600 of the recourse liability ($2,000 x ($2,000/$2,500)) and partner B is allocated $400 of the recourse liability ($2,000 x ($500/$2,500)). A increases the tax basis of A’s partnership interest by $1,600 and B increases the tax basis of B’s partnership interest by $400.

IV. Tiered Partnerships

Previously, it was unclear how to allocate a recourse liability held by a lower-tier partnership (LTP) if a partner in the LTP was also a partner in an upper-tier partnership (UTP) and that partner bore the EROL for the liability of the LTP. The Final Regulations now provide a two-step process for allocating recourse liabilities in this situation. First, the partnership determines which partners of both the LTP and UTP bear the EROL for the liability and allocates the liability using the aforementioned proportionality rule. Second, the partnership allocates to the UTP the sum of (1) the liabilities for which the UTP itself bears the EROL and (2) the liabilities for which each partner of the UTP bears the EROL, but excluding any partner of the UTP who is also a partner of the LTP. For example, assume that A and B are equal partners in partnership X and that partnership X and A are equal partners in partnership Y.  Partnership X is an UTP of partnership Y, which is a LTP. Partnership Y incurs a $2,000 liability that both A and B personally guarantee. Ignoring partnership X, under the proportionality rule, A and B would each be allocated $1,000 of the recourse liability. Under the Final Regulations, partnership Y allocates $1,000 of the recourse liability to A. Partnership Y then allocates the remaining $1,000 of the recourse liability to partnership X because B, a partner of partnership X, bears the EROL and B is not a partner in partnership Y (partnership X does not itself bear the EROL for any liabilities of partnership Y). Because A is a partner in both partnership X and partnership Y, he is ignored in determining what liabilities of partnership Y are considered recourse to partnership X. Accordingly, partnership X allocates its entire share of the $1,000 liability of partnership Y to B.

V. Related Parties

Code section 752 provides that a liability is recourse to a partner if that partner or a related person bears the EROL. For this purpose, the related party rules of Code sections 267 and 707 (with modifications) apply in determining who is related to a partner. The final Regulations modify the application of the section 267 and 707 related party rules in four respects.

First, the Final Regulations disregard the constructive ownership rules of Code Section 267(c)(1), which treat partners and shareholders as owning their proportionate shares of partnership interests owned by a partnership or corporation, whenever a corporation directly bears the EROL for a partnership liability or a LTP directly bears the EROL of a liability of an UTP. For example, assume that individual A is a limited partner in partnership X, corporation C is the general partner of partnership X, individual A owns all the outstanding stock of corporation C, and partnership X has a $2,000 liability.  Because corporation C directly bears the EROL of partnership X’s $2,000 liability, individual A is not treated as related to corporation C even though A owns all the outstanding stock of C, and C will be allocated all of partnership X’s $2,000 liability. As another example, assume A and B are partners in partnership X, that A and partnership X (an UTP) are partners in partnership Y (a LTP), and that partnership X has a $2,000 liability guaranteed by partnership Y. Under the Final Regulations, neither A nor B will be treated as constructively owning any interest in partnership Y by virtue of being partners of partnership X, and consequently, partnership X will not be treated as related to A for the purpose of allocating the liabilities of partnership Y.

Second, the Final Regulations provide that the partnership attribution rule of Code section 1563(e)(2) does not apply in determining whether two corporations are treated as related because they are members of the same controlled group under Code section 267(f).

The third rule provides that when a person owns an interest in a partnership, directly or indirectly through one or more partnerships, and directly bears the EROL for a partnership liability, then other persons owning interests in the partnership, directly or indirectly through one or more partnerships, will not be treated as related to the person who bears the direct EROL. The Regulations give the following example. Individual A owns all the stock of corporations X and Y. Corporation Y and A are partners in partnership P, which has a $1,000 liability guaranteed jointly and severally by A and X (which is not a partner in partnership P). Because A directly bears the EROL for a partnership liability, corporation Y (which is a partner in partnership P) is not treated as related to A. Therefore, only A is treated as having the EROL for partnership P’s $1,000 liability.

The final related party rule imposed by the Final Regulations relates to situations where a person other than a partner directly bears the EROL of a partnership liability and that person is related to more than one partner. In such cases, the Final Regulations dictate that the partners will be considered related to the person bearing the EROL of the liability, and will be allocated the corresponding recourse liability, in proportion to their interests in partnership profits. For example, assume lender L makes a $2,000 loan to partnership X, partners A and B are related to L, A holds a 10% interest in partnership X’s profits, and B holds a 30% interest in partnership X’s profits. In this example, A and B are both treated as having the EROL for the $2,000 liability because they are related to L, and the liability is allocated $500 to A and $1,500 to B (their proportionate interests in partnership X’s profits).

The Final Regulations also contain an anti-abuse provision that applies if: (i) a partnership liability is owed to or guaranteed by an entity, (ii) a partner or person related to the partner owns a 20% or greater ownership interest in that entity, and (iii) the use of the entity as a lender or guarantor is to circumvent the application of the related party rules to the determination of whether a partner is treated as bearing the EROL of the liability.

VI. Effective Date and Transitional Rule

The Final Regulations apply to any liability incurred or assumed by a partnership on or after December 2, 2024 (Effective Date). Liabilities incurred prior to the Effective Date will not be subject to the Final Regulations, but a partnership may elect to consistently apply the Final Regulations to all liabilities regardless of when occurred. If a partnership liability in existence before the Effective Date is modified or refinanced after the Effective Date, then the Final Regulations do not apply to the refinanced liability to the extent of the amount outstanding on the Effective Date but will apply to additional amounts incurred after the Effective Date.