The Final Regulations Under Irc Sections 704(B) And 752: Envisioning Economic Risk Of Loss Through A Glass Darkly

I. INTRODUCTIONWhen a partnership borrows money and spends the proceeds on a deductible expenditure, which partners may deduct the partnership expense? When a sole proprietor(1) borrows one hundred dollars to pay wages to an employee, the Internal Revenue Code (IRC) allows the sole proprietor a deduction for compensation expense.(2) Allowance of the deduction makes sense because the sole proprietor made the wage payment and will have to forfeit his personal assets to the extent he defaults on his one hundred dollar loan. Thus, the sole proprietor taxpayer bears the economic cost of the payment that gives rise to the deduction. Similarly, if a corporation(3) borrows one hundred dollars to pay wages to an employee, the IRC allows the corporation a deduction for compensation expense.(4) Again, this makes sense because the corporation made the payment, and the creditor can attach the corporation's assets, rather than the assets of its shareholders, if the corporation fails to repay its one hundred dollar loan.(5) Thus, the corporate taxpayer bears the economic cost of the payment that gives rise to the deduction. If a partnership(6) borrows one hundred dollars to pay wages, however, two problems arise. First, because the partners, and not the partnership, pay tax on partnership income,(7) the partnership must determine which partners should receive allocations of the compensation expense.(8) Second, because the creditor can reach through the partnership and attach some of the partners' personal assets if the partnership does not repay its one hundred dollar loan,(9) general partners may actually bear the economic cost of the one hundred dollar payment while limited partners, if any, may not.(10) In order to be consistent with the sole proprietor and corporate scenarios, the partnership should allocate the deduction to the partner taxpayers that bear the economic cost of generating the deduction.(11)Until recently, consistency in deducting losses between partnerships and other business forms did not exist. Partnerships enjoyed extensive flexibility in allocating items of income and loss among partners, and only limited guidance existed regarding the determination of which partners could include partnership liabilities in the bases of their partnership interests.(12) Prior to 1976, the IRC imposed few limits on the allocation of items of partnership income and loss among partners.(13) The IRC disallowed only those special allocations, allocations that did not parallel the partners' interests in partnership capital or profits, motivated by tax avoidance.(14) However, the IRC did limit the extent to which a partner could deduct partnership losses by the amount of his investment, or basis, in the partnership. (15)While the IRC allowed partners to increase their bases in their partnership interests by their share of partnership liabilities, the regulations provided only simplistic rules for the allocation of partnership liabilities among the partners.(16) Recourse liabilities of the partnership, those for which at least one partner personally bore risk of repayment if the partnership defaulted, increased the bases of general partners according to the general partners' respective interests in partnership losses.(17) Nonrecourse liabilities of the partnership, generally loans secured by mortgages on real property for which no partner bore a personal obligation to repay if the partnership defaulted, increased the bases of both general and limited partners according to the general and limited partners' respective interests in partnership profits.(18) By changing the profit and loss ratios of the partners, the partnership could shift liabilities among the partners and, thus manipulate the partners' bases in their partnership interests that directly affected the deductibility of the allocated losses.(19) The following example illustrates the abuses possible under the old loss and liability allocation rules.EXAMPLE 1--General partner, G, and limited partner, L, form a limited partnership that divides profits and losses equally. …