November 09, 2006
Taxpayers holding partnership and limited liability company interests often use special purpose entities for a number of reasons, including a desire to specially allocate partnership liabilities so as to increase tax basis and permit the targeted allocation of deducible losses. On October 10, 2006, the IRS and the Treasury Department issued new regulations that restrict this type of special allocation.
Under general principles of partnership taxation, each partner is permitted to include in the basis of its partnership interest its proportionate share of partnership liabilities. This inclusion provides tax benefits that are not available in other forms of investments, such as S corporations. For example, the inclusion increases the amount of cash and other property distributions that the partner can receive from the partnership on a tax-deferred basis. It also increases the amount of losses that some partners can deduct in the current year.
The rules for allocating partnership liabilities among the partners are intricate. Generally, the rules divide partnership liabilities into two categories: (1) those for which a partner or its affiliate bears the economic risk of loss, and (2) those for which no partner or affiliate bears the economic risk of loss. Liabilities that fall into the first category are allocated entirely to that partner. Liabilities that fall into the second category are split-up and allocated among each of the partners based on certain sharing rules. It is the first category of liabilities that are the subject of these new regulations.
It is not unusual for a taxpayer to form a special purpose entity (SPE) to hold its partnership investments. As such, it is the SPE rather than the taxpayer that is the "partner" under state law. This structure is frequently used with limited partnerships, where a taxpayer will form a SPE to serve as general partner. By doing so, taxpayers hope to insulate themselves from the liabilities to which general partners often are subject under state law.
It also is not unusual for the SPE to be formed as a single-member limited liability company. As such, it is disregarded for federal income tax purposes; this means that the taxpayer (rather than the SPE) is deemed to be the partner for income tax purposes. With this tax treatment, parties sometimes form SPEs to guarantee all or a portion of the partnership's liabilities in order to specially allocate the liabilities to the SPE - and hence, to the taxpayer. This technique often is employed where the SPE has few, if any, separate assets that are reachable by the partnership's creditors. It creates the appearance of economic risk of loss (and the special allocation of partnership liabilities) while limiting the taxpayer's true economic exposure.
For years the tax regulations have contained an anti-abuse provision that permits the IRS to disregard arrangements where the facts indicate that a principal purpose was to create the appearance of the economic risk of loss where the substance is otherwise. The new regulations retain the existing anti-abuse rule for SPEs other than disregarded entities (e.g., corporations). However, the IRS and the Treasury Department apparently concluded that the principal purpose standard was inappropriate for SPEs formed as disregarded entities, because the new regulations further restrict the amount of partnership liabilities that can be specially allocated to these entities.
Specifically, the new regulations provide that a SPE formed as a disregarded entity may only be allocated partnership liabilities equal to the "net value" of the SPE, determined based on the fair market value of the SPE's assets that are subject to claims by creditors under local law (including the SPE's enforceable rights to contributions by its owner) but excluding the SPE's interest in the partnership. In effect, the new regulations recognize the SPE's status as a legal entity under local law, and limit the special allocation of partnership liabilities to the fair market value of the SPE's separate assets that are reachable by creditors of the partnership.
Of course, the owner of the SPE classified as a disregarded entity can guarantee or pledge additional assets as security for partnership liabilities, and thereby continue to receive a special allocation of partnership liabilities under the economic risk of loss test described above. Absent such a guarantee or pledge, taxpayers can no longer use these entities to specially allocate partnership liabilities unless the SPE has true economic value that is reachable by the partnership's creditors under state law. This requires a careful analysis of the partnership's debt obligations, along with a periodic determination of the SPE's "net value."
Special transition rules apply to liabilities incurred or assumed (or subject to a binding contract in effect) prior to October 11, 2006. If you have any questions regarding the application of these new regulations, please contact: