The IRS officially killed one partnership tax strategy—the use of so-called bottom-dollar guarantees—and removed temporary rules that restricted another.
The Oct. 4 final rules (T.D. 9877) clamping down on the strategy came just days after the Internal Revenue Service proposed updates to partnership forms that would make bottom-dollar guarantees easier to spot. In February, the agency added a new disclosure requirement to instructions for the Form 1065, for partners, that would help flag the tactic to examiners as well.
“To absolutely no one’s surprise, the regs make clear that the bottom dollar guarantee is still dead,” Glenn Dance, a partner at Holthouse Carlin & Van Trigt LLP in Los Angeles, said in an email. In a phone interview, he added that the rules will simply push tax professionals to get more creative, since the low-hanging-fruit strategy is now out of reach.
“It’s not like there’s no alternative. It’s just that the easy one’s gone,” said Dance, who was special counsel to the IRS Associate Chief Counsel in the Pass-throughs and Special Industries division until late 2017.
One Slashed, Another Set in Stone
After proposing to withdraw them in June 2018, the agency on Oct. 4 formally removed 2016 temporary regulations that made it more difficult for partners to boost their investment in the partnership by contributing debt without triggering a “disguised sale” to the entity, which would be subject to tax. Increasing their investment or contributions helps them take more deductions passed through the partnership.
The agency officially withdrew the temporary rules (T.D. 9876) as part of its regulatory fat-trimming effort under Executive Order 13789, which required the Treasury Department to seek out burdensome or complex tax regulations and put them on the chopping block.
But left in place are the now-final regulations combating the use of bottom-dollar guarantees, in which partners essentially guarantee partnership debt with the assurance that they would generally never have to pay it back. This would artificially increase their investment in the entity, or their basis, yielding tax benefits with no real economic risk.
“These obligations generally lack a significant non-tax commercial business purpose,” said the rules, which outline what is and isn’t a bottom-dollar guarantee. “Therefore, bottom dollar payment obligations should not be recognized as payment obligations.”
The IRS spurned “pretty much everything” public commenters requested, rejecting their calls for more flexibility in the bottom-dollar guarantee rules, said Steven Schneider, a partner at Baker McKenzie LLP in Washington who specializes in partnerships.
He cited one particularly tough standard under an anti-abuse rule to determine if payment obligations should be respected—whether the terms of the contract and therefore the interest rates would be the same in the absence of the partner’s guarantee. It could be practically impossible to show what the interest rate on the debt would’ve been under different circumstances, he added.
And tax professionals haven’t exactly kept quiet. At an Oct. 4 American Bar Association Tax Section event in San Francisco, IRS Chief Counsel Michael Desmond told Bloomberg Tax that he learned of their strong feelings about the rules in real time.
“That’s got quite a history to it,” he said. “People were reading off their BlackBerrys out in the hallway there, so I got a bit of an earful on that.”
In Line With Form Changes
The February update to the 1065 form required partners to disclose their negative capital account balances, or what they would have to pay if the partnership liquidated, if it isn’t already on the form the partnership sends to partners and the IRS, the Schedule K-1.
The proposed change to the Schedule K-1 would require partnerships to report partners’ capital accounts using tax basis, as opposed to other calculation methods, helping examiners see who is likely to be using the bottom-dollar guarantee strategy.
In a similar vein, the agency included a requirement that partnerships show gains and losses under tax code Section 704(c).
—With assistance from Allyson Versprille