Allocating debt when a disregarded entity is a partner.

• Author: Ellentuck, Albert B.

This case study has been adapted from PPC's Tax Planning Guide--Partnerships, 32d Edition (March 2018), by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, Twila A. Bollinger, William R. Bischoff, and Cheryl McGath, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).

Often, partnership interests are owned through a disregarded entity, such as a single-member LLC (SMLLC) or a qualified S corporation subsidiary, which will allow the entity's owner to be the partner for income tax purposes while effectively limiting liability for the partnership's underlying debts.

Regs. Sec. 1.752-2(k) provides that in determining the extent to which a partner who owns an interest through a disregarded entity bears the economic risk of loss for a partnership recourse liability, payment obligations of the disregarded entity (including a disregarded SMLLC) are taken into account under Sec. 752 only to the extent of the disregarded entity's net value as of the allocation date. (However, this rule does not apply to an obligation of a disregarded entity to the extent that its owner otherwise is required to make a qualifying payment with respect to the entity's obligation.)

The net value of a disregarded entity is the fair market value (FMV) of all its assets that may be subject to creditors' claims under local law, including the disregarded entity's enforceable rights to contributions from its owner and the FMV of an interest in a partnership, excluding the disregarded entity's interest in the partnership for which the net value is being determined and the net FMV of property pledged to secure a partnership liability. This amount is then reduced by all obligations of the disregarded entity (regardless of priority) that do not constitute Regs. Sec. 1.752-2(b)(l) payment obligations of the disregarded entity.

Timing of the net value determination

If a partnership interest is held by a disregarded entity, and the partnership has or incurs a liability, all or a portion of which may be allocable to the owner of the disregarded entity, the disregarded entity's net value must be initially determined on the allocation date. After the net value of a disregarded entity is initially determined, the net value must be redetermined if any of the following valuation events occur:

1. The disregarded entity receives a more than de minimis contribution of property (other than property pledged to secure...