Final Code Sec. 752 Regulations Increase Compliance Burdens for Taxpayers Owning Partnership Interests Through Disregarded Entities

In October 2006, the IRS and the Treasury Department issued final regulations under Code Sec. 752 concerning the allocations of partnership liabilities to a taxpayer that owns a partnership interest through a disregarded entity, such as a single-member LLC, a qualified subchapter S subsidiary, or a qualified REIT subsidiary. The term "disregarded entity" is used to describe an entity that is disregarded as a separate entity from its owner. For federal tax purposes, the activities of a disregarded entity are treated in the same manner as a sole proprietorship, branch, or division of the owner. For state law purposes, however, a single-member LLC, a qualified subchapter S subsidiary, or a qualified REIT subsidiary is treated as a separate entity, in that the owner of the disregarded entity, in its capacity as the owner, is not personally liable for the debts or obligations of the disregarded entity.Code Sec. 752 allows a partner to include in the adjusted basis of its interest in the partnership the partner's share of partnership liabilities. In general, a partner's share of a partnership's recourse liabilities is the amount by which the partner bears the economic risk of loss for the liabilities. Under the Code Sec. 752 regulations, a partner is treated as bearing the economic risk of loss for a partnership liability if and to the extent that the partner or a related person would be required to make a payment (or has a "payment obligation") if the partnership were unable to repay the liability and the partner would not be entitled to reimbursement from anyone for the partner's payment obligation.The 2006 amendments to the Code Sec. 752 regulations were issued to clarify the application of the existing Code Sec. 752 regulations concerning the extent to which a partner is treated as bearing an economic risk of loss for a partnership liability based on a payment obligation of a disregarded entity. Because a disregarded entity and its owner are treated as a single entity, it might seem reasonable to treat a payment obligation of a disregarded entity as being the payment obligation of the owner. However, the liability shield that the disregarded entity provides to a partner should be a factor in determining whether and to what extent a partner bears an economic risk for the payment of a partnership liability. If the partnership would be unable to pay its liabilities, the disregarded entity would be able to meet its payment obligation only to the extent of the net fair market value of its assets at the time the partnership liability becomes due and payable. Unless the owner of the disregarded entity separately had guaranteed or otherwise incurred a payment obligation for the same liability, the owner would not be required to pay any amount of the disregarded entity's unsatisfied payment obligation.If a partner owns an interest in a partnership through a disregarded entity and the disregarded entity has a payment obligation with respect to a partnership liability, the 2006 amendments to the Code Sec. 752 regulations measure the partner's economic risk of loss for the partnership liability by reference to the net fair market value of the disregarded entity. While the regulations are based on a firm analytical framework, they are likely to create significant administrative burdens and compliance burdens. Under the 2006 amendments, the partnership must revalue the assets held by the disregarded entity every time there is a "valuation event."Taxpayers easily can avoid the burdens imposed by the 2006 amendments to the Code Sec. 752 regulations by holding an interest in a partnership through an entity that is classified as a partnership for federal tax purposes. Because of the ease with which the 2006 amendments can be avoided, it is likely that the amendments merely will create a trap for the unwary. This column discusses the final regulations and questions whether they should be withdrawn or amended to prevent abuse.