Bottom Dollar Guarantees – Time is Running Out on a Powerful Tax Planning Idea
One of the many tax advantages of a partnership (including limited liability companies treated as partnerships for tax purposes) over other forms of doing business is the fact that the tax basis in a partner’s partnership interest (“outside basis”) includes the partner’s share of partnership liabilities. Outside basis is important in determining how much of an allocated loss can potentially be deducted and whether a distribution of cash (including marketable securities distributed by a partnership other than an investment partnership) is taxable.
The way to determine a partner’s share of liabilities is set forth in lengthy and complex regulations. In general, a partnership’s recourse liabilities1 are allocated to the partners to the extent they are economically at risk to repay the liability if the partnership cannot satisfy the debt. Nonrecourse liabilities (any liability for which no partner has any economic risk of loss) are shared based on a 3-tiered formula set forth in the regulations. A common example of a nonrecourse liability is a typical real estate mortgage.
When a partner (or a person related to a 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 economic risk of loss is the guarantor, the entire amount of the guaranteed debt would be 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 does have 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 it so as to avoid gain recognition (because, for example, a cash distribution exceeds the partner’s outside basis). A powerful tax planning idea that has been used to get the partner the much-needed outside basis is by having the partner agree to a “bottom dollar guarantee.” Under the current rules, 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, a bottom dollar guarantee 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. It should be noted that to give the bottom dollar guarantee substance, the guarantor should receive adequate consideration in exchange for the guarantee (such as a reduction in the interest rate on the loan).
For example, assume a lender loans $1 million on a nonrecourse basis and the loan is secured by a parcel of land worth $1.2 million at the time of the loan. A top dollar guarantee assures the lender that it will receive $1 million. As soon as the value of the property drops to below $1 million, the partner is potentially at risk. If, however, a partner agrees to a $100,000 bottom dollar guarantee, the partner is merely guaranteeing the lender that it would receive no less than $100,000. This means that the guarantor has no economic exposure until the value of the land drops from $1.2 million to $100,000. However, under the current rules, the partner will get allocated more partnership debt because of the bottom dollar guarantee despite the lesser economic risk.
Recently issued proposed regulations would no longer treat a partner as bearing the economic risk of loss on a liability because of a bottom dollar guarantee. This new rule, once finalized, would be applicable to liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after the date the final regulations are published.
Time is running out to take advantage of this tax planning idea. Speak with your Gettry Marcus executive for more information about bottom dollar guarantees.
1 A recourse liability is any liability for which at least one partner, or a person related to a partner, has economic risk of loss for the repayment for the liability.