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.