If you own an interest in a partnership, each year you receive a K-1 form on which partnership activity is reported to you (the partner) for your share of that year’s activity. Within the K-1 there is a section that shows each partner’s share of liabilities for that year. There are three different types of liabilities that are allocated: nonrecourse, qualified nonrecourse financing and recourse. These liabilities are important components of calculating a partner’s basis both for making tax free distributions and also for deducting partnership losses (at-risk). Internal Revenue Code Section 752 covers the treatment of liabilities for a partnership, while Section 465 covers the loss limitation rules related to amounts at-risk (limitations on deducting partnership losses).
Recourse liabilities are those that any partner bears the economic risk of loss with respect to the liability.This economic risk of loss is present only if any partner or any person related to a partner would be obligated to make a payment to the creditor or a partnership contribution upon a constructive liquidation of the partnership under certain hypothetical circ*mstances. Recourse liabilities can provide basis for distributions and can also generate basis for purposes of the at-risk rules.
For purposes of the Section 752 rules, nonrecourse liabilities are those liabilities of the partnership for which no partner bears the economic risk of loss. Only the creditor bears the economic risk of loss with respect to a nonrecourse liability. The most common type of nonrecourse liability is a loan for which property is pledged as security for repayment and for which the lender's only remedy in the event of a default is to foreclose on the property.Nonrecourse liabilities can provide basis for distributions, but generally do not provide basis for purposes of the at-risk rules.
Qualified nonrecourse financing generally includes financing for which no one is personally liable for repayment that is borrowed for use in an activity of holding real property and that is loaned or guaranteed by a federal, state or local government or that is borrowed from a “qualified” person. Qualified persons include any person actively and regularly engaged in the business of lending money, such as a bank or savings and loan association. While the Section 752 rules provide that a partner's share of partnership nonrecourse debt adds to that partner's basis in the partnership interest, a partner's share of nonrecourse debt generally does not generate basis for purposes of the Section 465 at-risk rules. Under an exception, a partner's share of partnership debt that meets the definition of qualified nonrecourse financing does generate at-risk basis for that partner. Under the exception, a partnership itself may be liable for repayment of the debt, without disqualifying the debt as qualified nonrecourse financing, if the partnership is the only party liable, each partnership with personal liability holds only real property and the lender only has the right to proceed against the real property in the event of the default.
Within the three main groups of liabilities, there are several other classifications that can impact the basis calculations. An “exculpatory liability” is a liability that is nonrecourse in that no partner or person related to a partner has any economic risk of loss for the liability, but that is not secured by specific partnership property. In effect, an exculpatory liability is a recourse liability to the partnership as an entity because all of the partnership's assets are potentially at risk but a nonrecourse liability with respect to the partners. Exculpatory liabilities are an issue for LLCs and LLPs but not for garden-variety partnerships. This is because LLCs and LLPs can have liabilities that are recourse to the entity but for which no member or partner is personally liable (i.e., exculpatory liabilities). In contrast, garden-variety partnerships do not have exculpatory liabilities because there is always at least one general partner that is personally liable for all liabilities that are recourse to the entity.
As discussed earlier, a liability is recourse or nonrecourse to the extent partners do or do not bear an economic risk of loss. Consequently, if one or more partners bear the economic risk of loss with respect to a portion of a liability, but there is a portion for which no partner bears any economic risk of loss, the liability is “bifurcated”. The portion for which one or more partners bear an economic risk of loss is treated as a recourse liability for basis purposes and allocated exclusively to the partner or partners who bear that risk of loss. The remainder is treated as a nonrecourse liability.
Under a de minimis rule, a partner is not deemed to bear the economic risk of loss for a nonrecourse partnership loan from that partner (or that partner's affiliate) if the partner's interest in each and every item of income, gain, loss, deduction, or credit is 10% or less over the partnership's life, and if the loan constitutes qualified nonrecourse financing under the at-risk rules. The determination of whether a debt is qualified nonrecourse financing for this de minimis rule is made without regard to the type of activity for which the debt is used. The rule allows the non-lender partners to continue being allocated basis from the nonrecourse loan owed to another partner (or partner affiliate) so long as the lender partner is predominantly a creditor rather than a partner. Debt qualifying under this de minimis rule is treated as a true nonrecourse liability.
The character of a liability as recourse or nonrecourse (and determining the partners' share of the liability for basis purposes) depends not only on the partner's relative rights and obligations, but also on those of persons related to partners, i.e., partner affiliates. In determining basis, the rights and obligations of these partner affiliates are attributed to the related partners.
This means such debt is treated as if it is owed to the partner affiliated with the lender (or guarantor). Thus, when a partnership liability is nonrecourse but is owed to a lender (or guarantor) affiliated with a partner, the partner affiliated with the lender (or guarantor) is treated as having 100% of the economic risk of loss and is allocated all of the liability for basis purposes. A favorable de minimis rule (discussed earlier) may apply when partner affiliates make nonrecourse loans to a partnership or guarantee a partnership's nonrecourse loan.
Navigating through the complex rules of partnership debt basis can be very challenging. Please contact your Dermody, Burke and Brown tax advisor to help guide you through this process.
The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.
