Bottom Dollar Guarantees – Gone with the Wind
About 18 months ago, I issued an E-Blast that dealt with the fact that time was running out on using “bottom dollar guarantees” as a way to shift liabilities allocated to a partner who needs additional debt so as to “cover” negative tax capital accounts so as to avoid gain recognition.
Well, the Department of the Treasury issued temporary regulations on October 5, 2016 that, in effect, ended the viability of this planning idea.
In general, one of the many tax advantages of a partnership over other entities is that a partner’s share of partnership liabilities increases the partner’s outside basis (i.e., the partner’s tax basis in the partnership interest). Recourse liabilities are generally allocated to those partners to the extent they bear the economic risk of loss (“EROL”). Since, by definition, no partner bears the EROL with respect to a nonrecourse liability, such liability is allocated based on a formula set forth in the regulations.
To recap the pre-existing rules (that were discussed in the previous E-Blast), when a partner who owns at least 10% of the partnership (or a person related to such partner) guarantees a debt that is otherwise a nonrecourse liability, the guarantee converts the liability from being nonrecourse to recourse to the extent of the guaranteed portion of the debt. Because the only partner with EROL is the guarantor, the entire amount of the guaranteed debt gets allocated to the guarantor.
The typical guarantee is referred to as a “top dollar guarantee.” This is where the guarantor assures the lender that the entire loan will be repaid. In other words, the guarantor is potentially “on the hook” as soon as the value of the property securing the loan drops below the outstanding balance of the loan. While the guarantee causes an increase to the guarantor’s outside basis which would allow more allocated losses to be deducted and a greater amount of distributions to be received tax-free, the guarantor also has potential economic exposure as a result of the guarantee. Partners agree to top dollar guarantees generally because the lender requires a partner guarantee before it agrees to make the loan.
Situations arise, however, when a partner requires that more debt be allocated to a partner so as to avoid gain recognition (because, for example, a cash distribution exceeds the partner’s outside basis). Until the new regulations were promulgated, a powerful tax planning idea that had been used to get the partner the much-needed outside basis while limiting the guarantor’s economic risk was by having the partner agree to a “bottom dollar guarantee.” A bottom dollar guarantee causes the guarantor-partner to have economic risk of loss on the debt which thereby results in getting the guaranteed portion of the debt allocated to the guarantor. However, it subjects the partner to much less economic risk than does a top dollar guarantee because it only assures the lender that it will receive a minimum amount on the repayment of the debt.
The recently-issued temporary regulations provide that bottom dollar guarantees to which these regulations are applicable will no longer result in the guaranteeing partner as having the economic risk of loss with respect to such partnership debt. As such, a bottom dollar guarantor will no longer be treated as a “payment obligation” (i.e., having the EROL) as a result of the guarantee.
Under the new regulations, a bottom dollar guarantee includes the following:
- Re: guarantees or similar arrangements – any payment obligation other than one in which the partner or related person is, or would be, liable up to the full amount of such partner’s (or related person’s) payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied. Note, however, that a payment obligation will include a limited guarantee as long as the limited guarantee is “top dollar” (i.e., of the first dollars of unpaid debt).
- Re: indemnities or similar arrangements – any payment obligation other than one in which the partner (or related person) is or would be liable up to the full amount of such partner’s or related person’s payment obligation, if, and to the extent that, any amount of the indemnitee’s or benefited party’s payment obligation as defined in the regulations.
- An arrangement with respect to a partnership that uses tiered partnerships, intermediaries, senior and subordinate liabilities, or similar arrangements to convert what would otherwise be a single liability into multiple liabilities if, based on the facts and circumstances, the liabilities were incurred pursuant to a common plan, as part of a single transaction or arrangement, or as part of a series of related transactions or arrangements, and with a principal purpose of avoiding having at least one of such liabilities or payment obligations with respect to such liabilities being treated as a bottom dollar payment obligation as defined in the regulations.
In general, the new regulations are effective for liabilities incurred or assumed by a partnership, and payment obligations imposed or undertaken with respect to a partnership liability, on or after October 5, 2016. Liabilities incurred or payment obligations undertaken on or after October 5, 2016 may be grandfathered (and therefore subject to the old rules) if they were incurred pursuant to a written binding contract in effect prior to October 5.