The IRS issued temporary regulations on October 5, 2016, regarding “bottom-dollar payment obligations,” effective for liabilities incurred or assumed on or after October 5, 2016. For existing debt, there is a seven-year transition rule. These new rules may impact partners in a partnership who have entered into contractual payment obligations such as guarantees, indemnifications or reimbursement agreements to increase their basis in their partnership.
 
Entering into one of the agreements mentioned above provides the partner with an allocation of recourse debt IF that partner bears the economic risk of loss in the event the partnership’s assets became worthless and the debt is required to be paid in full. The tax benefits to taking on this risk include the opportunity for tax-free distributions (cash distributions from a partnership are only taxable to the extent the distribution exceeds the partner’s basis in its partnership interest, unless the disguised sale rules apply) and an allocation of taxable losses (losses are limited by basis and at-risk limitations and recourse debt increases both).
 
However, one of the obligations partners historically have used to obtain this recourse debt allocation, and minimize a portion of the risk, was a “bottom-dollar” guarantee. A bottom-dollar guarantee is a guarantee that the last dollars of a liability of the partnership only can be collected after all remedies against the primary obligor have been exhausted. The partner would only be liable to the extent the lender cannot first collect at least a portion from the partnership. To take a simple example, if a partnership incurs debt for $1,000 from the bank, the partner guarantees payment of up to $200, but only if the bank otherwise recovers less than $200. So, if the bank recovers $300 from the partnership, the partner has no payment obligation to the bank. If the bank recovers $50 from the partnership, the partner would be liable only for $150.
 
But things have changed since the new regulations were released in October. Bottom-dollar obligations are no longer considered recourse liabilities. As a result, bottom-dollar payment obligations will be treated as nonrecourse liabilities and allocated to all partners of the partnership under the nonrecourse allocation rules. The regulation defines bottom-dollar payment obligations as the same or similar to one of the three following obligations:

1. With respect to a guarantee or similar arrangement, 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.
2. With respect to an indemnity or similar arrangement, 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 that is recognized under this regulation is satisfied.
3. With respect to a partnership liability that used 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 bottom dollar payment obligation under (1) and (2) above.

The regulations provide exceptions for a vertical slice obligation (obligation is stated as a fixed percentage of every dollar of the partnership liability to which such obligation relates or if there is a right of proportionate contribution running between partners or related persons who are co-obligors with respect to a payment obligation for which each of them is jointly and severally liable) or if there is a maximum amount placed on the partner’s or related person’s payment obligation.
 
The regulations also provide that the partnership must disclose the bottom-dollar payment obligation on Form 8275 Disclosure Statement for the year in which the bottom dollar payment obligation is undertaken or modified. It must be made on this form; a whitepaper statement is not acceptable.
 
The surprising aspect of these regulations is that an economic top-dollar guarantee can actually be considered a bottom-dollar guarantee for tax purposes. The partner/guarantor could still be on the hook and economically at risk but not be allocated recourse debt.

 
The bottom line on bottom-dollar obligations is that any partner who currently has indemnification agreements, a guarantee of only a portion of the total debt, should contact their tax advisor to ensure these agreements will be respected under the new regulations.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.