- Bottom Dollar Guarantees - It Appears That The Good Times Are Over For Good
- December 19, 2016 | Author: Douglas Turner Coats
- Law Firm: Gordon Feinblatt LLC - Baltimore Office
The Treasury Department and the Internal Revenue Service (the “Service”) have recently issued temporary regulations that substantially reduce the ability of partners to allocate partnership liabilities among themselves by effectively eliminating what once was a common technique.
The allocation of partnership liabilities is important because a partner’s share of liabilities provides tax basis in the partner’s partnership interest. Tax basis is critical to a partner, as it determines the amount of allocable losses from a partnership that a partner can utilize, and determines the amount of cash distributions that a partner can receive without recognizing taxable income.
There are two types of debt to allocate: recourse debt and nonrecourse debt. Recourse debt is allocated to the partner who bears the economic risk of loss for the debt, while nonrecourse debt (debt for which no partner bears the economic risk of loss) is allocated under a three-tier system in which often all partners receive some allocation of the debt. In order to increase a partner’s share of debt, while minimizing the risk that the partner would actually be required to pay on the debt, a partner may execute a “bottom dollar guarantee,” which guarantees the least risky portion of the overall debt.
For example, with respect to a partnership debt of $1,000,000, a partner may provide a personal guarantee to the lender that requires the partner to pay on the guarantee only in the event the lender is not able to recover more than $100,000. In other words, once the lender has been repaid more than $100,000, the partner will have no personal liability under the guarantee. For tax purposes, however, even though the partner is guaranteeing only the “bottom” $100,000 of the entire $1,000,000 debt, such a guarantee, prior to October 5, 2016, would have increased that partner’s basis by $100,000.
In January of 2014, the Treasury Department and the Service issued proposed regulations (the “2014 Proposed Regulations”) intended to curtail the use of bottom dollar guarantees to shift the allocation of partnership liabilities among partners. The Service believes that bottom dollar guarantees serve no commercial or business purpose and are used solely to create basis for a particular partner’s interest in a partnership.
On October 5, 2016, the Service withdrew the 2014 Proposed Regulations and issued temporary regulations (the “2016 Temporary Regulations”) which effectively eliminate the tax benefit of a bottom dollar guarantee. The 2016 Temporary Regulations create a new term, “Bottom Dollar Payment Obligation,” which is an obligation that will not be respected for tax purposes. A Bottom Dollar Payment Obligation is any payment obligation other than one in which the partner would be liable up to the full amount of the obligation if any amount of the partnership liability is not satisfied.
Unlike the 2014 Proposed Regulations, the 2016 Temporary Regulations will recognize payment obligations that are stated as a fixed percentage of every dollar of the partnership liability, meaning that such obligations will not be treated as a Bottom Dollar Payment Obligation and, therefore, will continue to provide a tax benefit for the partner providing such a payment obligation. This type of payment obligation is sometimes referred to as a “vertical slice” obligation, as opposed to a “horizontal slice” obligation (which refers to the bottom dollar guarantee in the example described above).
The 2016 Temporary Regulations also affect in two ways the use of indemnification agreements. First, such agreements can cause what would otherwise be a qualifying payment obligation to be a Bottom Dollar Payment Obligation. Second, an indemnification agreement itself may be a Bottom Dollar Payment Obligation if the payment obligation which is being indemnified is a Bottom Dollar Payment Obligation.
The effects of the 2016 Temporary Regulations are illustrated with the following example. Assume Albert, Bob and Carol are equal partners of a partnership that borrows $1,000. Albert guarantees payment of up to $300 of partnership debt if any amount of the $1,000 debt is not recovered by the lender. Bob guarantees payment of up to $200, but only if the lender recovers less than $200 of the $1,000 debt. Carol provides no guarantee.
Because Albert is obligated to pay up to $300 if any amount of the $1,000 debt is not recovered by the lender, Albert’s guarantee is not a Bottom Dollar Payment Obligation, which means it is recognized for tax purposes. Thus, $300 of the $1,000 partnership debt will be treated as recourse debt to Albert.
Because Bob is obligated to pay up to $200 only if the lender recovers less than $200 of the $1,000 debt, Bob’s guarantee is a Bottom Dollar Payment Obligation, which means it is not recognized for tax purposes. Thus, none of the $1,000 debt will be treated as recourse debt to Bob.
Thus, of the $1,000 partnership debt, $300 will be allocated to Albert as recourse debt and the remaining $700 will be allocated to Albert, Bob, and Carol as nonrecourse debt.
To illustrate the effect of an indemnification agreement, assume the same facts as above, except that Carol agrees to indemnify Albert up to $100 in the event Albert has to pay under his guarantee, and Carol agrees to indemnify Bob fully in the event he pays under his guarantee.
Because Albert’s guarantee would be recognized for tax purposes but for the effect of Carol’s indemnification, and because Carol is obligated to pay Albert up to the full amount of her indemnity if Albert pays any amount under his guarantee, Carol’s indemnity of Albert’s guarantee is not a Bottom Dollar Payment Obligation. This means that Carol’s indemnity will be recognized for tax purposes.
However, because Carol’s indemnity is recognized for tax purposes, Albert will be treated as being liable for $200 only to the extent that any amount beyond $100 of the $1,000 partnership debt is not satisfied. Thus, Albert is now not liable if any amount of the $1,000 debt is not satisfied. Accordingly, Albert’s guarantee (solely because of Carol’s indemnity) is now a Bottom Dollar Payment Obligation, meaning that it is not recognized for tax purposes.
Because Bob’s obligation is not recognized for tax purposes (as it is a Bottom Dollar Payment Obligation even without regard to Carol’s indemnity), Carol’s indemnity of Bob’s guarantee is not recognized for tax purposes.
Thus, of the $1,000 partnership debt, $100 will be allocated to Carol as recourse debt and the remaining $900 will be allocated to Albert, Bob, and Carol as nonrecourse debt.
Temporary regulations have the same effect as final regulations during the time they are in effect, so taxpayers must now be aware of the 2016 Temporary Regulations, which apply to partnership liabilities incurred, and payment obligations imposed, on or after October 5, 2016.
Thus, when it comes to bottom dollar guarantees, it appears that the good times are over for good.