The IRS and Treasury issued final regulations on October 4, 2019, that changed the rules on deficit restoration obligations. In short, the regulations address when a partner can, or cannot, disregard the obligation to restore their deficit balance in a capital account. In particular, the regulations discuss how bottom dollar payment obligations or a plan to circumvent a deficit restoration obligation could render the obligation invalid for income tax purposes.
Why are Deficit Restoration Obligations Important?
Deficit restoration obligations can be used to allocate recourse debt to a partner. When this occurs, two things are possible. It can potentially:
- Protect the partner from recognizing income if their capital account goes negative (due to distributions), or
- Give the partner basis in order to take losses.
In a valid deficit restoration obligation, the partner is obligated to make a payment to the partnership for the deficit balance in the partner’s capital account following the liquidation of their interest in the partnership.
Regulation 1.704-1(b)(2)(ii)(c)(4)(A) provides that a deficit restoration obligation is not respected (meaning it will not be considered recourse debt to the partner) if it’s considered a bottom dollar payment obligation, is not legally enforceable, or if facts and circumstances indicate a plan to circumvent or avoid the obligation.
Bottom Dollar Payment Obligation
What is a “bottom dollar payment obligation”? It is a payment obligation such as a guarantee, indemnity or similar arrangement (as noted above could also be an obligation to make a capital contribution or restore a deficit capital account upon liquidation) other than one in which the partner or related person is liable up to the full amount of his or her payment obligation, if, and to the extent that, any amount of the partnership’s liability is not otherwise satisfied.
The Regulations note the following example of a bottom dollar payment obligation:
A, B, and C are equal members of a limited liability company, ABC, that is treated as a partnership for federal tax purposes. ABC borrows $1,000 from Bank. A guaranteed payment of up to $300 of the ABC liability if any amount of the full $1,000 liability is not recovered by the Bank. B guarantees payment of up to $200, but only if the Bank otherwise recovers less than $200. Both A and B waive their rights of contribution against each other.
Because A is obligated to pay up to $300 if, and to the extent that, any amount of the $1,000 partnership liability is not recovered by Bank, A’s guarantee is not a bottom dollar payment obligation and it will be considered recourse debt to A.
Because B is obligated to pay up to $200 only if and to the extent that the Bank otherwise recovers less than $200 of the $1,000 partnership liability, B’s guarantee is a bottom dollar payment obligation and is not considered recourse debt to B.
Plan to Circumvent or Avoid a Deficit Restoration Obligation
Final Regulation 1.704-1(b)(2)(ii)(c)(4)(B) provides a list of factors to indicate when a plan to circumvent or avoid a deficit restoration obligation exists, including the following non-exclusive factors:
- The partner is not subject to commercially reasonable provisions for enforcement and collection of the obligation,
- The partner is not required to provide commercially reasonable documentation regarding their financial condition,
- The obligation ends or could, by its terms, be terminated before the liquidation of the partner’s interest in the partnership or when the partner’s capital account is negative, and
- The terms of the obligation are not provided to all the partners in the partnership in a timely manner.
With these final regulations in place, if you have existing deficit restoration obligations, now is the time to examine them to verify they meet the new parameters. The rules apply to all deficit restoration obligations, even those entered into before October 4 of this year.
Contact Kim Palmer at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.