Allocations of nonrecourse deductions and the minimum gain chargeback.

The Treasury recently issued final regulations for the allocation of partnership deductions related to partnership liabilities. Regardless of how these items are allocated, the allocation must have substantial economic effect before the allocation will be respected. If the partnership has recourse

liabilities, substantial economic effect is easy to achieve because the partners are personally liable for the debt. If the amount of recourse deductions exceed a partner's capital account, the partner is obligated to restore a deficit. However, if the partnership has nonrecourse deductions, none of the partners bear the economic risk because none of the partners are personally liable. As a result, nonrecourse deductions cannot be allocated on the basis of economic risk; they must be allocated according to the partner's interest in the partnership. The new regulations have a procedure for achieving substantial economic effect for nonrecourse deductions. The key to substantial economic effect is the proper maintenance of capital accounts. The purpose of this article is to discuss these regulations, to explain how they differ from the temporary regulations and to demonstrate how the allocation relates to the proper maintenance of capital accounts.

Minimum Gain Defined

The method used for allocating nonrecourse deductions is the use of a procedure referred to as a "minimum gain chargeback." Minimum gain is defined as the excess of the nonrecourse liability over the adjusted basis of the property it encumbers. Accordingly, if property were sold for the amount of the debt, gain would be recognized on the difference.(1) The theory behind this procedure stems from the argument that, although partners are not personally liable for nonrecourse liabilities, a partner who receives an allocation of a nonrecourse deduction will ultimately be required to recognize a corresponding amount of gain. Minimum gain increases as the adjusted basis of the property decreases. Minimum gain decreases as the amount of the debt decreases.

Example: Frank and Amy form the FA Partnership with each contributing $10,000. The partnership uses the $20,000 capital contributed and a $100,000 nonrecourse loan to purchase equipment worth $120,000. The partnership takes a $24,000 depreciation deduction in the first year, allocating half to each partner. After the allocation, each partner has a capital account with a $2,000 deficit ($10,000-$12,000). Neither partner is obligated to restore the deficit. However, the equipment has an adjusted basis of $96,000 ($120,000 - $24,000). If the equipment were sold for the $100,000 loan balance, the partnership would recognize a $4,000 gain that would be allocated equally to Frank and Amy. This $4,000 minimum gain is enough to restore the deficit for both partners.

In any taxable year, the amount of partner nonrecourse deductions with respect to nonrecourse debt equals the net increase during the year in minimum gain attributable to the nonrecourse liability. The amount of the deductions must be reduced by any distributions of the loan proceeds to the partner bearing the economic risk of loss from the liability.(2) If the amount of minimum gain is not sufficient to cover all of the nonrecourse deductions, nonrecourse deductions will first be allocated to the depreciation deduction with respect to property subject to the nonrecourse debt. The rest of the nonrecourse deductions are allocated on a pro rata basis among the other nonrecourse deductions.(3)

Example: Assume the same facts as in the above example. In addition to the depreciation deduction, the partnership has $10,000 in interest expense. At the end of the first year there is $4,000 in minimum gain. Accordingly there are $4,000 in nonrecourse deductions, all of which are allocated to the depreciation expense.

Proper Maintenance of Capital Accounts

Maintaining proper capital accounts is the key to substantial economic effect. In order to be properly maintained, capital accounts must meet the following requirements:

1. Liquidations must be made according to positive capital account balances.

2. If a capital account has a negative balance, the partner must:

a. be unconditionally obligated to restore the negative balance, or

b. agree to a qualified income offset.

3. Beginning on the first taxable year of the partnership in which there are nonrecourse deductions (and thereafter throughout the entire term of the partnership) the partnership agreement must provide for allocations in a manner that is reasonably consistent with allocations having substantial economic effect of some significant partnership item attributable to property secured by the nonrecourse loan.

4. Beginning on the first taxable year the partnership has nonrecourse deductions or distributions of proceeds of nonrecourse debt are allocable to an increase in partnership minimum gain (and throughout the term of the partnership), the partnership agreement must contain a provision complying with the minimum gain chargeback provisions.

5. All other material allocations made by the partnership are in accordance with the regulations under Section 704(b).(4)

Example: Jimmy and Neil form the JN Partnership. Jimmy is the general partner and contributes $20,000. Neil is the limited partner and contributes $180,000. The partnership obtains an $800,000 nonrecourse loan to build a commercial office building on leased land. Neil is not obligated to restore a deficit in his capital account. The partnership agreement has a minimum gain chargeback provision. In each its first two years of operation, the partnership generates $95,000 in rental income. It has operating expenses of $80,000 in interest expense, $10,000 in lease expense and $90,000 in depreciation. This produces a net loss of $85,000 each year. Ninety percent of the loss is allocated to Neil and 10% is allocated to Jimmy. At the end of the second year, Neil has a capital account balance of $27,000; and Jimmy has a capital account balance of $3,000. At the end of the third year, the partnership has taken $270,000 in depreciation deductions. This gives the property an adjusted basis of $730,000. If the building were sold in satisfaction of the $800,000 debt, there would be a $70,000 gain. This is the partnership minimum gain. Accordingly, $70,000 of the $85,000 loss is treated as a nonrecourse deduction. The entire $70,000 is allocated to the depreciation. Ninety percent of the nonrecourse deductions are allocated to Neil and 10% are allocated to Jimmy. The allocations have substantial economic effect because of the minimum gain. In addition, the allocation meets requirement 3 stated above. The allocation of the nonrecourse deductions are consistent with the allocations of the rest of the loss attributable to the building. If the partnership had allocated 99% of the nonrecourse deductions to Neil and 1% to Jimmy, the allocations would fail this consistency test because the rest of the allocations are on a 90% / 10% basis.(5)

A partner's share if the partnership minimum gain equals:

1. The sum of nonrecourse deductions allocated to that partner (and all predecessors in interest) as well as distributions made to that partner (and all predecessors in interest) from proceeds of the nonrecourse loan; minus

2. The sum of that partner's (and predecessors in interest) aggregate share of decreases in partnership minimum gain.(6)

Example: Assume the same facts as in the above example. Since Neil is allocated 90% of the deductions, he also received 90% of the minimum gain. Jimmy receives the other 10%.

Minimum Gain Chargeback

What happens if there is no minimum gain or if the amount of minimum gain is reduced? The minimum gain chargeback requires that if there is a net decrease in partnership minimum gain for the year, the minimum gain chargeback applies and each partner must be allocated items of income and gain equal to the net decrease.(7)

Example: Kelly and Jonathan form the KJ Partnership, sharing profits and losses equally. The partnership obtains a $50,000 nonrecourse loan to purchase equipment worth $50,000. Depreciation in the first year is $10,000, giving the equipment an adjusted basis of $40,000. The minimum gain is also $10,000 ($50,000-$40,000). However, if the partnership makes a $10,000 principal payment on the loan the minimum gain is reduced to zero ($40,000 - $40,000). There is no minimum gain to allocate to the partners to restore a deficit capital account balance. Therefore, the partnership must allocate income sufficient to cover the decrease.

Warning: The new regulations differ from the temporary regulations issued earlier. Under the temporary regulations, the amount of minimum gain required to be allocated was the greater of:

1. The partner's share of the net decrease in minimum gain attributable to the distribution of property; or

2. The partner's negative capital account.

The temporary regulations applied only to the extent the property was sold or otherwise disposed of.

Under the new regulations, if there is a decrease in minimum gain, the minimum gain chargeback rules will apply regardless of whether or not the property is sold or otherwise disposed of.

There are, however, exceptions. If the net decrease in minimum gain is the result of a refinancing of the nonrecourse debt so that the debt becomes a recourse debt (in whole or in part) and the partner bears the economic risk of loss in the recourse debt, the minimum gain chargeback will not apply. In addition, if the decrease in the minimum gain is the result of capital contributions made by the partner to reduce the nonrecourse loan, the minimum gain chargeback rules will not apply.(8)

Example: Assume the same facts as in the above example. However, Kelly and Jonathan each contribute $5,000 to the partnership. The contributions are used to reduce the amount of the nonrecourse loan. The minimum gain chargeback rules will not apply.

Even if the minimum chargeback rules should apply, the Service may waive their application if such application would distort the economic arrangement among the partners. In order for the waiver to be granted, the partnership must be able to demonstrate the following:

1. The partners have made capital contributions or have received net income that have restored the previous nonrecourse deductions and the distributions attributable to proceeds of a nonrecourse loan; and

2. The minimum gain chargeback requirement would distort the partners' economic arrangement as reflected in the partnership agreement and as evidenced over the term of the partnership by the partnership's allocations and distributions and the partners' contributions.(9)

Note: The regulations also provide the Commissioner may, by revenue ruling, provide additional exceptions to the minimum gain chargeback requirement.(10)

Example: The JE Partnership consists of two partners, limited partner Ed and general partner Jared. Ed contributes $90 and Jared contributes $10 to the partnership. The partnership agreement has a minimum gain chargeback provision and provides all losses will be allocated 90% to Ed and 10% to Jared. The agreement says all income will be used to restore previous losses and thereafter will be allocated 50% to Ed and 50% to Jared. Distributions are made first to return original capital contributed and then are made equally. Final distributions are made according to capital account balances. The partnership borrows $200 on a nonrecourse basis and purchases an asset for $300. The partnership's only tax item for the first three years is $100 in depreciation for the asset. In the fourth year, the partnership earns $400 in operating income and allocates the first $300 to restore deficit balances in the capital accounts. The last $100 is allocated equally. The partnership also distributes $200 of available cash. The first $100 is distributed $90 to Ed and $10 to Jared. The last $100 is distributed equally. As a result of these transactions, Ed's and Jared's capital account balances at the end of the fourth year are as follows:

                                  Ed          Jared
Beg. Bal                          $90           $10
Loss (yrs 1-3)                  (270)          (30)
Bal. yr 3                      ($180)         ($20)
income allocation                 180            20
income allocation                  90            10
income allocation                  50            50
Bal after allocation             $140           $60
Distribution                       90            10
Distribution                       50            50
Ending bal yr 4                    $0            $0

In the fifth year, the partnership sells the property and recognizes a $300 gain. The partnership uses $200 of the proceeds to pay the loan. Unless a waiver is granted, the minimum gain chargeback rules would require the first $200 in gain to be distributed $180 to Ed and $20 to Jared. However, this would distort the economic arrangement which is now at the 50/50 stage. If the partnership has no other income to correct the distortion, it may request a waiver of the minimum gain chargeback rules so the gain could be allocated equally. However, the Commissioner has the discretion to grant the waiver. The waiver will not automatically be given.(11)

Example: Jason and Shannon are partners in the JS Partnership. Each contributes $25 and agree to share all profits and losses equally. The partnership agreement does not contain an unconditional obligation to restore deficits in capital accounts; but it does contain a minimum gain chargeback provision. The partnership borrows $100 in nonrecourse loans and purchases two assets, $50 in stock and $100 in depreciable property. The nonrecourse loan is secured by the depreciable property. The partnership generates $100 in depreciation over the next five years which is allocated half to Jason and half to Shannon. This means each partner has a capital account with a $25 deficit. The minimum gain is $100 ($100 - 0) which each partner shares equally. In the beginning of the sixth year, Jason guarantees the entire nonrecourse loan. As a result, the minimum gain is reduced to zero. The chargeback rules apply to Shannon. If the partnership has no income in the sixth year, the minimum gain chargeback will carry forward to future years until there is enough income to satisfy it. Jason is not subject to the $50 minimum gain chargeback because he is personally liable for the debt. Instead, he is allocated $50 in nonrecourse debt minimum gain. In year seven the partnership earns $100 in operating income and uses the money to repay the debt. This reduces the minimum gain to $50 which means that $50 of the income is allocated to Shannon. The other $50 is allocated to Jason.

Conclusion

The partnership may allocate deductions among the partners so long as the allocation has substantial economic effect. Deductions and losses attributable nonrecourse liabilities cannot have substantial economic effect because the partners do not ultimately bear the economic risk of loss. The regulations provide a way around this problem with the use of the concept of the minimum gain chargeback. Partners who receive allocations of nonrecourse deductions will be allocated income sufficient to cover the deductions. Except as otherwise provided, the new regulations apply to all transactions on or after December 28, 1991. The temporary regulations apply to transactions after December 29, 1988 but before December 28, 1991.

Footnotes

1 Reg. 1.704-2(d). 2 Reg. 1.704-2(i) 2. 3 Reg. 1.704-2(j). 4 Reg. 1.704-2(e). 5 Reg. 1.704-2(m) Example 1. 6 Reg. 1.704-2(g). 7 Reg. 1.704-2(f). 8 REg. 1.704-2(f)(2) and (3). 9 Reg. 1.704-2(f)(4). 10 Reg. 1.704-2(e). 11 Reg. 1.704-2(f) 7, example 1.

M. Jill Martin, JD, LLM, CPA, is a professor of accounting at Georgia Southern University in Statesboro, Georgia. She received her JD and LLM in taxation from Emory University. She is a member of the Georgia Society of CPAs, and has published in several accounting journals.