Allocation of Partnership Debt

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8906] RIN 1545-AX09

TITLE: Allocation of Partnership Debt

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the
allocation of nonrecourse liabilities by a partnership. The final
regulations revise tier three of the three-tiered allocation
structure contained in the current no recourse liability
regulations, and also provide guidance regarding the allocation of a
single no recourse liability secured by multiple properties.

DATES: Effective Date: These regulations are effective October 31,
2000. Applicability Date: For dates of applicability of these
regulations, see §1.752- 5(a).

FOR FURTHER INFORMATION CONTACT: Dan Carmody, (202) 622-3070 (not a
toll-free number).

SUPPLEMENTARY INFORMATION:

Introduction

This document revises §1.752-3 of the Income Tax Regulations (26 CFR
part 1) relating to the allocation by a partnership of nonrecourse
liabilities.

Background

On January 13, 2000, the IRS published in the Federal Register a
notice of proposed rulemaking [REG-103831-99 (65 FR 2084)] to
provide guidance relating to the allocation of nonrecourse
liabilities by a partnership. The IRS and Treasury received public
comments concerning the proposed regulations, and a public hearing
was held on May 3, 2000. After consideration of the comments
received, the proposed regulations are adopted as revised by this
Treasury decision.

Explanation of Revisions and Summary of Comments

1. In General

Treasury regulation §1.752-3 currently provides a three-tiered
system for allocating nonrecourse liabilities. The three-tiered
system applies sequentially. Under the first tier, a partner is
allocated an amount of the liability equal to that partner's share
of partnership minimum gain under section 704(b). See §1.704-2(g)
(1). Under the second tier, to the extent the entire liability has
not been allocated under the first tier, a partner will be allocated
an amount of liability equal to the gain that partner would be
allocated under section 704(c) if the partnership disposed of all
partnership property subject to one or more nonrecourse liabilities
in full satisfaction of the liabilities (section 704(c) minimum
gain). Under the third tier, a partner is allocated any excess
nonrecourse liabilities (i.e., nonrecourse liabilities in excess of
the portion allocable in.

the first and second tiers) under one of several methods (i.e.,
partner's share of profits or certain reasonably expected
deductions) that the partnership may choose. The proposed
regulations modified the third tier to allow an additional method
under which a partnership may allocate an excess nonrecourse
liability based on the excess section 704(c) gain (i.e., the excess
of the amount of section 704(c) built-in gain attributable to an
item of property over the amount of section 704(c) minimum gain on
that property) attributable to the properties that are subject to
the liability. In addition, for purposes of determining section
704(c) minimum gain under the second tier, the proposed regulations
provided that if a partnership holds multiple properties subject to
a single liability, the liability may be allocated among the
properties based on any reasonable method. A method is not
reasonable under the proposed regulations if it allocates to any
property an amount that exceeds the fair market value of the
property.

2. Allocation of Debt in Accordance With Reverse Section 704(c) Gain

One commentator noted that the additional method provided in the
proposed regulations under the third tier covers only built-in gain
on section 704(c) property, which includes built-in gain (i.e., book
value minus adjusted basis) attributable to contributed property,
but not built-in gain attributable to property subject to a
revaluation (pursuant to §1.704-1(b)(2)(iv)(f)) (i.e., reverse
section 704(c) gain). The commentator noted that this distinction is
not made in allocating nonrecourse liabilities in accordance with
section 704(c) minimum gain under the second tier and questioned the
policy reason for excluding the reverse section 704(c) gain in
applying the third tier.

In response to this comment, the final regulations provide that an
excess nonrecourse liability may be allocated under the third tier
in accordance with excess section 704(c) gain as well as excess
reverse section 704(c) gain (i.e., the excess of the amount of
reverse section 704(c) gain attributable to an item of property over
the section 704(c) minimum gain on that property) with respect to
property that is subject to such liability.

3. Interplay With the Disguised Sales Rules

One commentator noted that the proposed amendments to §1.752-3 would
impact the disguised sales rules relating to transfers of encumbered
property. The disguised sale rules treat a contribution of property
encumbered by a "non-qualified" liability (generally, a liability
incurred within two years of the contribution to the partnership
that is incurred in anticipation of such contribution) as a
disguised sale to the extent that the amount of the liability
exceeds the contributing partner's share of the liability
immediately after the contribution. Section 1.707-5(a)(2)(ii)
provides that a partner's share of a nonrecourse liability, for
purposes of the disguised sale rules, is determined by applying the
same percentage used to determine the partner's share of the excess
nonrecourse liability under §1.752-3(a)(3).

Because the proposed amendments to §1.752-3(a)(3) would allow excess
nonrecourse liabilities to be allocated according to an amount,
rather than a percentage, the potential for ambiguity exists. The
commentator suggested that the disguised sale rules should be
modified to define a partner's share of a nonrecourse liability by
cross-reference to §1.752-3(a), rather than limiting the definition
to the third tier. The commentator noted that maintaining separate
definitions for the same term was burdensome and confusing for
practitioners, and noted that the disguised sale. rules provide
consistency between sections 707(a) and 752 with respect to the
definition of a partner's share of a recourse liability by reference
to §1.752-2 without limitation.

The preamble to §1.707-5 explains that the cross-reference defining
a partner's share of nonrecourse liabilities is limited to the third
tier of §1.752-3(a) because the adoption of the full three-tier
approach in the disguised sale context would provide an inverse
relationship between the gain inherent in the contributed property
and the extent to which a disguised sale of the property results
from the encumbrance. See preamble (57 FR 44974). The contributing
partner's share of the liability under §1.752- 3(a) generally will
increase as the amount of built-in gain on the property increases,
which in turn would reduce the extent to which the contribution
would be treated as a disguised sale.

The same problem would exist if the proposed modifications to the
third tier were taken into account for purposes of §1.707-5(a)(2)
(ii). To the extent that excess section 704(c) gain exists with
respect to a property, the partnership could allocate excess
nonrecourse liabilities to the contributing partner. The greater the
built-in gain with respect to a property, the less likely it would
be that a disguised sale would result from the contribution. In
order to avoid this inappropriate result, the final regulations
clarify that the modifications made to the third tier do not apply
for purposes of §1.707- 5(a)(2)(ii). Thus, for purposes of the
disguised sale rules, the partner's share of nonrecourse liabilities
continues to be determined under the third tier by reference to the
partner's share of profits or certain reasonably expected
deductions.

4. Treatment of "Extra" Excess Section 704(c) Gain

Rev. Rul. 95-41 (1995-1 C.B. 132) holds that if a partnership
determines the partners' interests in partnership profits based on
all of the facts and circumstances relating to the economic
arrangement of the partners, excess section 704(c) gain is one
factor, but not the only factor, to be considered under §1.752-3(a)
(3). The preamble to the proposed regulations provides that this
holding will remain relevant where a partnership does not allocate
nonrecourse debt under the third tier based on the excess section
704(c) gain attributable to the property that is subject to the
debt. The preamble also provides that once a partnership has
allocated nonrecourse indebtedness pursuant to the rule in the
proposed regulations based upon excess section 704(c) gain, that
excess section 704(c) gain cannot again be considered in determining
a partner's interest in partnership profits.

One commentator asked, in situations where the amount of a liability
allocated to a partner under the third tier pursuant to the rule
contained in the proposed regulations is less than the partner's
share of excess 704(c) gain, whether the remaining excess 704(c)
gain should be taken into account for purposes of determining a
partner's interest in partnership profits under the third tier with
regard to other liabilities. The statement contained in the preamble
regarding the impact of the proposed regulations on Rev. Rul. 95-41
reflects a concern on the part of IRS and Treasury that taxpayers
might count the same excess section 704(c) gain in applying the rule
in the proposed regulations and then again in determining a
partner's interest in partnership profits under the third tier. To
the extent that a portion of excess section 704(c) gain. remains
after a liability has been fully allocated, there is no double-
counting, and the remaining portion of the gain should be taken into
account as one factor to be considered in determining a partner's
interest in partnership profits under §1.752- 3(a)(3) and Rev. Rul.
95-41.

5. Applicability of §1.752-3(b) to Third-Tier Allocations

The proposed regulations provide rules regarding the allocation of a
single liability among multiple properties. The proposed regulations
generally provide that if a partnership has multiple properties
subject to a single liability, for purposes of determining the
amount of section 704(c) minimum gain in applying the second tier,
the partnership may allocate to each property an amount of the
liability that, when combined with any other liabilities allocated
to the property, do not exceed the property's fair market value. The
portion of the liability allocated to each property will be treated
as a separate loan in determining the section 704(c) minimum gain
attributable to the property.

One commentator asked that the rule for allocating a single
liability among multiple properties under the second tier also apply
to third tier allocations. For purposes of the second tier, where
nonrecourse debt is cross-collateralized, it is necessary to
determine how much of the nonrecourse debt is attributable to each
partnership property, since debt is allocated among the partners
under that tier based upon the amount by which the debt attributable
to each specific property exceeds the tax basis of such property.
(See §1.704-3(a)(2), which provides that, except in limited
circumstances, section 704(c) applies on a property-by-property
basis.) Under the proposed modification to the third tier, any
remaining nonrecourse liability of the partnership could be
allocated to a partner up to the excess section 704(c) gain
allocable to the partner on property subject to that liability.
There is no need to bifurcate cross-collateralized debt under this
tier, since excess section 704(c) gain is not limited by the amount
of debt attributable to specific partnership property. So long as a
partner's share of excess section 704(c) gain is attributable to
property that is "subject to" the debt being allocated, the debt may
be allocated in accordance with that partner's share of such excess
section 704(c) gain. Multiple properties may be "subject to" the
same indebtedness. Bifurcating the debt among multiple properties so
that each property is treated as subject to only a portion of the
debt actually would limit taxpayers' flexibility and narrow the
scope of the proposed change to the third tier. Accordingly, the
commentator's recommendation is not adopted. However, the final
regulations add an example which clarifies the operation of this
rule.

6. Retroactive Effective Date

One commentator suggested that the regulations should apply on a
retroactive basis. This suggestion has not been adopted. However,
the final regulations respond to this recommendation by providing an
optional effective date for those taxpayers who wish to apply the
rules currently to liabilities incurred prior to the issuance of
these regulations.

7. Additional Comments Requested

The preamble to the proposed regulations requested comments
regarding the allocation of a single liability among multiple
partnerships. Although no formal. comments were submitted on this
issue, several commentators have indicated that additional guidance
regarding appropriate methods of allocating such liabilities would
be helpful. The IRS and Treasury again request comments regarding
this issue.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C.
chapter 6) do not apply to these regulations and, therefore, a
Regulatory Flexibility Analysis is not required. Pursuant to section
7805(f) of the Internal Revenue Code, the notice of proposed
rulemaking preceding these regulations was submitted to the Small
Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Christopher T. Kelley,
Office of Chief Counsel (Passthroughs and Special Industries).
However, other personnel from the IRS and Treasury participated in
their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Adoption of
Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as. follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.752-3 is amended as follows:

1. Paragraph (a)(3) is amended by adding three sentences immediately
before the last sentence in the paragraph.

2. Paragraph (b) is redesignated as paragraph (c).

3. New paragraph (b) is added.

4. Newly designated paragraph (c) is amended by revising the
introductory text and adding a new Example 3.

The revisions and addition read as follows: §1.752-3 Partner's share
of nonrecourse liabilities.

(a) * * *

(3) * * * Additionally, the partnership may first allocate an excess
nonrecourse liability to a partner up to the amount of built-in gain
that is allocable to the partner on section 704(c) property (as
defined under §1.704-3(a)(3)(ii)) or property for which reverse
section 704(c) allocations are applicable (as described in
§1.704-3(a)(6)(i)) where such property is subject to the nonrecourse
liability to the extent that such built-in gain exceeds the gain
described in paragraph (a)(2) of this section with respect to such
property. This additional method does not apply for purposes of
§1.707- 5(a)(2)(ii). To the extent that a partnership uses this
additional method and the entire amount of the excess nonrecourse
liability is not allocated to the contributing partner, the
partnership must allocate the remaining amount of the excess
nonrecourse liability. under one of the other methods in this
paragraph (a)(3). * * *

(b) Allocation of a single nonrecourse liability among multiple
properties--(1) In general. For purposes of determining the amount
of taxable gain under paragraph (a)(2) of this section, if a
partnership holds multiple properties subject to a single
nonrecourse liability, the partnership may allocate the liability
among the multiple properties under any reasonable method. A method
is not reasonable if it allocates to any item of property an amount
of the liability that, when combined with any other liabilities
allocated to the property, is in excess of the fair market value of
the property at the time the liability is incurred. The portion of
the nonrecourse liability allocated to each item of partnership
property is then treated as a separate loan under paragraph (a)(2)
of this section. In general, a partnership may not change the method
of allocating a single nonrecourse liability under this paragraph
(b) while any portion of the liability is outstanding. However, if
one or more of the multiple properties subject to the liability is
no longer subject to the liability, the portion of the liability
allocated to that property must be reallocated among the properties
still subject to the liability so that the amount of the liability
allocated to any property does not exceed the fair market value of
such property at the time of reallocation.

(2) Reductions in principal. For purposes of this paragraph (b),
when the outstanding principal of a partnership liability is
reduced, the reduction of outstanding principal is allocated among
the multiple properties in the same proportion that the partnership
liability originally was allocated to the properties under paragraph
(b)(1) of this section.

(c) Examples. The following examples illustrate the principles of
this section:

* * * * *

Example 3. Allocation of liability among multiple properties. (i) A
and B are equal partners in a partnership (PRS). A contributes $70
of cash in exchange for a 50- percent interest in PRS. B contributes
two items of property, X and Y, in exchange for a 50-percent
interest in PRS. Property X has a fair market value (and book value)
of $70 and an adjusted basis of $40, and is subject to a nonrecourse
liability of $50. Property Y has a fair market value (and book
value) of $120, an adjusted basis of $40, and is subject to a
nonrecourse liability of $70. Immediately after the initial
contributions, PRS refinances the two separate liabilities with a
single $120 nonrecourse liability. All of the built-in gain
attributable to Property X ($30) and Property Y ($80) is section
704(c) gain allocable to B.

(ii) The amount of the nonrecourse liability ($120) is less than the
total book value of all of the properties that are subject to such
liability ($70 + $120 = $190), so there is no partnership minimum
gain. §1.704-2(d). Accordingly, no portion of the liability is
allocated pursuant to paragraph (a)(1) of this section.

(iii) Pursuant to paragraph (b)(1) of this section, PRS decides to
allocate the nonrecourse liability evenly between the Properties X
and Y. Accordingly, each of Properties X and Y are treated as being
subject to a separate $60 nonrecourse liability for purposes of
applying paragraph (a)(2) of this section. Under paragraph (a)(2) of
this section, B will be allocated $20 of the liability for each of
Properties X and Y (in each case, $60 liability minus $40 adjusted
basis). As a result, a portion of the liability is allocated
pursuant to paragraph (a)(2) of this section as follows:

Partner Property Tier 1 Tier 2
A       X        $0     $0
Y                $0     $0
B       X        $0     $20
Y                $0     $20.13

(iv) PRS has $80 of excess nonrecourse liability that it may
allocate in any manner consistent with paragraph (a)(3) of this
section. PRS determines to allocate the $80 of excess nonrecourse
liabilities to the partners up to their share of the remaining
section 704(c) gain on the properties, with any remaining amount of
liabilities being allocated equally to A and B consistent with their
equal interests in partnership profits. B has $70 of remaining
section 704(c) gain ($10 on Property X and $60 on Property Y), and
thus will be allocated $70 of the liability in accordance with this
gain. The remaining $10 is divided equally between A and B.
Accordingly, the overall allocation of the $120 nonrecourse
liability is as follows:

Partner Tier 1 Tier 2 Tier 3 Total
A 		$0 	 $0 	$5 	   $5
B 		$0 	 $40    $75    $115

Par. 3. In §1.752-5, paragraph (a) is amended by adding three
sentences after the first sentence:

Section 1.752-5 Effective dates and transition rules. (a) In
general. * * * However, §1.752-3(a)(3) fifth, sixth, and seventh
sentences, (b), and (c) Example 3, do not apply to any liability
incurred or assumed by a partnership prior to October 31, 2000.
Nevertheless, §1.752-3(a)(3) fifth, sixth, and seventh sentences,
(b), and (c) Example 3, may be relied upon for any liability
incurred or assumed by a partnership prior to October 31, 2000 for
taxable years ending on or after October 31, 2000. * * *

* * * * *

Acting Deputy Commissioner of Internal Revenue
David A. Mader
Approved: 10/11/00
Acting Assistant Secretary of the Treasury
Jonathan Talisman

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