Case addresses the sec. 752 anti-abuse regs.

• Author: Patch, David

The recent decision of the Tax Court in Canal Corp., 135 T.C. No. 9 (2010), may provide some insight into when a partner's potential obligation to pay partnership debts will be disregarded in determining liability allocations.

A partner's share of partnership liabilities is important for a number of reasons. Liabilities are included in the basis of a partner's interest in the partnership and, in certain circumstances, the partner's at-risk basis in the partnership's activity. That may enable the partner to avoid loss limitations under Secs. 465 and 704(d). It may also allow the partner to withdraw funds from the partnership without triggering at-risk loss recapture (Sec. 465(e)) or gain on excess distributions (Sec. 731(a)). And, as in the Canal case, the allocation of liabilities may have a direct bearing on whether certain transactions are treated as disguised sales (Sec. 707(a) (2)(B) and Regs. Sec. 1.707-5).

Regulations under Sec. 752 provide that a partner's share of a recourse partnership liability equals the portion of that liability, if any, for which the partner or related person bears the economic risk of loss (Regs. Sec. 1.752-1(a)(1)). A partner generally bears the economic risk of loss for a partnership liability to the extent that the partner or a related person would be obligated to pay the liability if the partnership were unable to do so (Regs. Sec. 1.752-2(b)(l)). All statutory and contractual obligations relating to the partnership liability are taken into account for this purpose, including state law, the partnership agreement, and contractual obligations outside the partnership agreement such as guarantee or indemnification agreements (Regs. Sec. 1.752-2(b)(3)). Furthermore, it generally is assumed that all partners and related persons who have obligations to make payments will actually perform those obligations, regardless of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (Regs. Sec. 1.752-2(b)(6)). However, two specific rules limit this assumption.

First, the payment obligation of a business entity that is disregarded as an entity separate from its owner, such as a single-member limited liability company or qualified subchapter S subsidiary, is taken into account only to the extent of its net value. Net value is defined as the fair market value of all assets owned by the disregarded entity that may be subject to creditors' claims under local law less obligations other than for the debts of the partnership (Regs. Sec. 1.752-2(k)). This limitation does not apply to any entity that is not disregarded, so such an entity is subject to the general assumption that it will meet its obligations regardless of its net worth.

The second limitation--and primary focus of this item--is an anti-abuse rule contained in Regs. Sec. 1.752-2(j). Under this rule, an obligation of a partner or related person to make a payment may be disregarded or treated as an obligation of another person if facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the partner's economic risk of loss with respect to that obligation or create the appearance of the partner or related person bearing the economic risk of loss when in fact the substance of the arrangement is otherwise. Further, an obligation of a partner to make a payment is not recognized if the...