1. Tax News and Developments
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Client Alert
October 20, 2016
New IRS Regulations End Bottom-Dollar
Guarantees for Partnerships -- Action Advised
New IRS regulations spell the immediate end of bottom-dollar guarantees,
indemnities and other similar obligations ("BDGs") that are a key tool to protect
partners from recapture of vast amounts of historical tax deductions. Although
there is a limited grandfather rule for a portion of existing BDGs, all taxpayers
using such guarantees should immediately consider the implications of these new
rules on prior and new transactions, particularly in the context of umbrella
partnership real estate investment trust ("UPREIT") structures.
A BDG is generally a guaranty of the least risky portion of a liability or debt.
BDGs have been commonly used in various partnership transactions for many
years. The new temporary regulations aimed at BDGs were issued concurrently
with new regulations that change many of the rules for partnership debt allocation
under Code Section 752 and the rules concerning disguised sales involving
partnerships under Code Section 707. These changes to the rules concerning
partnership debt allocation address fundamental aspects of partnership taxation
and are worthy of significant attention since their long-term tax ramifications will
be profound. For a detailed discussion on these new rules, see Tax News and
Developments Client Alert New Regulations Significantly Change Partnership
Disguised Sale and Debt Basis Rules distributed on October 20, 2016.
This client alert focuses solely on the new IRS temporary regulations which were
intended to eliminate BDGs. Significant attention must be immediately given
to any existing BDGs so as not to trip up on the limited and complex
transition rules and inadvertently trigger recognition of gain. This client alert
summarizes the background law and context of BDGs, the new IRS regulations
aimed at BDGs, and a number of advised courses of action, some of which
should be taken as soon as possible.
Background Law and Context
Partnership Debt Allocation
Section 752 sets forth the rules for determining a partner's share of partnership
liabilities and provides different treatment for partnership liabilities that are
recourse and nonrecourse. A partnership liability is recourse to the extent that any
partner or related person bears the economic risk of loss ("EROL") for that
liability. A "constructive liquidation test" (the so-called "atom bomb test") is used to
determine EROL, in which the partnership's assets are assumed to be worthless,
the liabilities due and payable, and the partnership liquidated. Those partners and

2. Baker & McKenzie
2 Tax News and Developments – Client Alert October 20, 2016
related persons who would have payment obligations in such case are
determined to bear EROL.
Bottom-Dollar Guaranties
BDGs were often used to shift the allocation of partnership debt for purposes of
transactional planning by causing a partner to have EROL, so that debt would be
allocated to that partner. Over time, the IRS has come to view BDGs not as
genuine commercial payment obligations but, instead, as tax-motivated ploys
which the IRS viewed as "abusive" even if the guarantor was taking economic
risk. The IRS has taken this view because there is usually minimal real economic
risk involved in making BDGs, notwithstanding that BDGs are personal guaranties
with full recourse, since the security for the relevant liability is usually unlikely to
depreciate to such degree that the BDG requires an actual outlay. (However, as
the Lehman Brothers bankruptcy proved, even a remote risk could eventually turn
out to be significant.)
The 2014 Proposed Regulations
In 2014, the IRS issued proposed regulations concerning section 752
(the "2014 Proposed Regulations") that were, among other things, the IRS's first
attempt to put an end to BDGs. Certain aspects of the 2014 Proposed
Regulations were roundly criticized, including in particular the proposed rule that a
payment obligation would not be recognized under section 752 unless seven
stated factors were satisfied. Some of these factors were aimed directly at
disqualifying BDGs from being recognized as creating EROL under section 752.
The New 2016 Temporary Regulations
Non-Recognition of Bottom-Dollar Payment Obligations ("BDPOs")
On October 5, 2016, the IRS issued new temporary regulations, which also serve
as the contemporaneously issued proposed regulations (collectively the "New
2016 Temporary Regulations") that consolidate certain broadly defined
guarantees, indemnities, and similar arrangements as "bottom-dollar payment
obligations" ("BDPOs"). Under the New 2016 Temporary Regulations, BDPOs are
expressly not recognized under section 752 for purposes of determining whether
a partner has EROL with respect to a liability, absent grandfathering or application
of certain limited exceptions. Although this is a departure from the all-or-nothing
litany of factors approach in the 2014 Proposed Regulations, the IRS made this
rule effective immediately via temporary regulations.
The definition of BDPOs in the New 2016 Temporary Regulations is exceedingly
broad. All guarantees are treated as BDPOs which do not create EROL unless
they meet certain requirements. Generally, in order for a guarantee to be
recognized, the partner or related person must be liable up to the full amount of
such partner's or related person's payment obligation if, and to the extent that,
any amount of the partnership liability is not otherwise satisfied. In addition, an
arrangement using tiered partnerships, intermediaries, tranches of liabilities, or
similar arrangements to convert a single liability into multiple liabilities pursuant to
a plan with a principal purpose of avoiding the BDPO non-recognition rule for a
liability or payment obligation is still treated as within the scope of the BDPO
definition.

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3 Tax News and Developments – Client Alert October 20, 2016
Exceptions to Treatment as a BDPO and the Exception to
Non-Recognition of BDPOs
The New 2016 Temporary Regulations provide limited exceptions. A payment
obligation is not within the scope of the BDPO definition merely because
(1) a maximum amount is placed on the partner's or related person's payment
obligation (i.e., a cap on an otherwise respected BDPO is permissible),
(2) a partner's or related person's payment obligation is stated as a fixed
percentage of every dollar of the partnership liability to which such obligation
relates (so-called "vertical slice" obligations), or (3) there is a right of proportionate
contribution running between partners or related persons who are co-obligors with
respect to a payment obligation for which each of them is jointly and severally
liable. A BDPO is still recognized as creating EROL if a partner or related person
has a payment obligation that would be recognized under these new rules (an
"Initial Payment Obligation") but for the effect of an indemnity, reimbursement
agreement, or similar arrangement, and, taking into account such indemnity,
reimbursement agreement, or similar arrangement, the partner or related person
is liable for at least 90 percent of the partner's or related person's Initial Payment
Obligation.
The One Way Anti-Abuse Rule and Disclosure Requirements
There is also a one-way anti-abuse rule ("heads the IRS wins, tails the taxpayer
loses") in the New 2016 Temporary Regulations, applicable only at the discretion
of the Commissioner, in which a partner is considered to bear EROL
notwithstanding BDPO characterization. Presumably the IRS is going to be on
the look-out for arrangements or contractual obligations that do create real EROL
but are being treated as BDPOs in a manner that the IRS finds abusive. In
furtherance of this hunt and pursuit, the New 2016 Temporary Regulations require
a partnership to disclose to the IRS all BDPOs on an IRS Form 8275, Disclosure
Statement, attached to the partnership return for the tax year in which a BDPO is
undertaken or modified.
Limited and Complex Transition Relief for Existing BDPOs
A limited 7-year grandfather status for existing BDPOs is provided in the New
2016 Temporary Regulations. If a partner has a share of a recourse partnership
liability immediately prior to October 5, 2016 under the rules existing before the
New 2016 Temporary Regulations (a "Transition Partner"), the partnership
("Transition Partnership") may choose not to apply the New 2016 Temporary
Regulations to the extent the amount of the Transition Partner's share of liabilities
under the previous rules exceeds the amount of the Transition Partner's adjusted
basis in its partnership interest at such time (the "Grandfathered Amount"). The
Transition Partnership may continue to apply the previous rules in effect prior to
October 5, 2016 with respect to a Transition Partner to the extent of the Transition
Partner's adjusted Grandfathered Amount for the seven-year period beginning
October 5, 2016. The transition relief is significantly limited because (i) the
Grandfathered Amount only includes the share of liabilities in excess of adjusted
basis, and (ii) it does not apply to all partners of a Transition Partnership, but only
to Transition Partners of a Transition Partnership.
There are a number of rules that further tighten the availability of the 7-year
grandfather period. A Transition Partner that is itself a partnership, S corporation,
or a disregarded entity ceases to qualify as a Transition Partner if the direct or
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4 Tax News and Developments – Client Alert October 20, 2016
indirect ownership of that Transition Partner changes by 50 percent or more.
Moreover, a Transition Partner's Grandfathered Amount is reduced by (i) upon the
sale of any property by the Transition Partnership, an amount equal to the excess
of any gain allocated for tax purposes to the Transition Partner by the Transition
Partnership over the product of the total amount realized by the Transition
Partnership from the property sale multiplied by the Transition Partner's
percentage interest in the partnership, and (ii) an amount equal to any decrease
in the Transition Partner's share of liabilities other than by operation of clause (i).
Any modification of existing debt or refinancing creates a significant risk of the
loss of grandfathered status. If that were to happen, significant recapture of any
negative tax capital accounts is likely to be triggered. That is usually a very bad
outcome. Although commercial debt is often refinanced or modified, extreme care
must now be taken with respect to existing partnership debt if there are any
grandfathered BDPOs.
Urgent Advised Courses of Action
• With respect to currently proposed transactions:
o all guarantees, indemnities, and arrangements should be examined
to determine whether they fall into the broad definition of BDPOs;
o any contemplated use of BDPOs in a partnership transaction needs
to be re-evaluated and likely restructured; and
o any arrangements or contractual obligations that may be subject to
the anti-abuse rule should be examined and likely restructured since
subsequent re-characterization under the one-way anti-abuse rule in
the future would likely have significantly deleterious tax ramifications.
• With respect to currently existing partnerships:
o as soon as possible, all existing BDPOs must be identified and
application of the limited transition relief should be assessed;
o ongoing care and attention must be paid to avoid inadvertently
triggering the recognition of gain prior to the end of the 7-year
grandfather period by, for example, modifying or refinancing existing
partnership debt;
o ongoing care and attention must be paid to avoid or plan for loss of
status as a Transition Partner or reductions to Grandfathered
Amounts (any adjustments to the amounts grandfathered on
October 5, 2016 should be closely tracked and monitored); and
o a plan should be formulated to address the forthcoming loss of any
applicable transition relief and grandfather status in 7-years.
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For additional information please
contact the authors of this Client Alert or
any member of Baker & McKenzie’s
North America Tax Practice Group.
Richard M. Lipton
+1 312 861 7590
richard.Lipton@bakermckenzie.com
Steven R. Schneider
+1 202 452 7006
steven.schneider@bakermckenzie.com
Samuel P. Grilli
+1 312 861 2522
samuel.grilli@bakermckenzie.com
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