Why are allocations of Partnership Liabilities so complicated?

Partnership liabilities are complicated BUT they are important and can lead to over-payment of tax if done wrong!

Under Section 704, a partner in a partnership may only utilize a loss allocated to that partner to the extent of the partner’s “basis” in the partnership interest. This is generally equal to the amount of cash plus the adjusted tax basis of any property contributed by the partner to the partnership.

Unique to subchapter K, a partner includes in his tax basis his share of the partnership's liabilities. This is accomplished by virtue of Section 752, which provides that a partner’s allocable share of the liabilities of the partnership is treated as a cash contribution to the partnership. Conversely, Section 752 also provides that any reduction in a partner’s share of the liabilities of the partnership is treated as a cash distribution to the partner. This deemed distribution may create taxable gain to the partner if it exceeds the partner’s outside basis in his interest.

Determining a partner’s allocable share of the liabilities of the partnership is often critical, as it may enable the partner to utilize a loss or take a tax-free distribution that would otherwise be unavailable. But how do we do it?

Step 1: Identify the Type of Liability

The first step towards properly allocating partnership liabilities is to understand the nature of the three liabilities listed on Schedule K-1.

a)    Recourse Liability

b)    Nonrecourse Liability

c)    Qualified Nonrecourse Liability (QNR)

Step 2: Identify the Type of Partnership

Those three definitions are only useful when understood in conjunction with the types of limited legal liability associated with certain forms of partnerships. Let’s take a look.

Step 3: Allocating Liabilities

The short-hand version is:

“Allocate recourse liabilities according to loss ratio, and nonrecourse liabilities according to profits ratio”, but let’s see:

Allocation of Nonrecourse Debt

The regulations require that nonrecourse liabilities be allocated according to three steps:

1.    First, to the extent of partnership minimum gain,

2.    Next, to any partner that contributed appreciated property to the partnership secured by a liability to an amount equal to the excess of the liability over the tax basis of the property at the time of contribution. (Section 704(c) gain)

3.    Lastly, to each partner based on profit ratio.

Step 1: Partnership Minimum Gain

First, nonrecourse liabilities must be allocated to each partner equal to the partner’s share of “partnership minimum gain.” This will only apply if the partnership owns depreciable property secured by the nonrecourse loan.

“Partnership minimum gain” is the amount by which the principal balance of the nonrecourse loan exceeds the depreciable basis of the property. It is coined as such because under Section 1001, if the partnership simply transfers the property back to the lender for no additional consideration other than the extinguishment of the debt, the partnership will be treated as if it sold the property for the principal amount of the loan, thus giving rise to gain.

Step 2: Section 704(c) Gain

Under Step 2, if a partner contributed appreciated property to the partnership that secured the liability, the contributing partner must be allocated the liability to the extent of the excess of the liability over the tax basis at the time of the contribution.

Step 3: Profit Ratio

If there is no minimum gain or Section 704(c) gain, the allocation of nonrecourse liabilities is straightforward. If the loan was made directly by a partner or if the partner personally guaranteed the liability, that portion of the nonrecourse liability should be treated as a recourse liability and allocated specifically to that partner. Any remaining nonrecourse liability should be allocated according to the rules above. If there is no minimum gain or Section 704(c) gain to be allocated, the entire nonrecourse portion of the gain should be allocated according to the profits ratio.

Summary

After all of that, here are a few shortcuts:

·         General partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level. Thus, it will be rare to see a number on the "nonrecourse liability" line of Schedule K-1. Allocate according to hypothetical loss analysis.

·         Limited partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level, but only to the general partners. Allocate recourse liabilities solely to the general partners unless a limited partner has a deficit capital account or guarantees the debt. Once again, it will be rare to have an allocation of a "nonrecourse liability," on Schedule K-1, and, it would follow, equally rare to have an allocation of any liability to a limited partner.

·         LLC: all liabilities are nonrecourse unless personally guaranteed by a partner, made by a partner, or the partner enters into a DRO. If there is no guarantee, loan from a partner, or DRO, there should never be a recourse liability allocated on Schedule K-1.

It’s complicated….and more than we have space to cover here. To know more, contact John L Mottram CPA LLC or contact John Mottram directly by telephone, text or email at 214-543-1855 or jlm@mottramcpas.com.