In early 2014, Treasury issued complex proposed regulations dealing with the allocation of partnership recourse debt. These proposed regulations are a radical departure from the current rules. In fact, many commentators believe these regulations are not only over-reaching, but are a reaction to problems that don’t actually exist under current rules.

If adopted, these new rules could have a severe impact on a partner’s allocation of losses and investment tax credits. As many clean energy investments (a solar partnership flip structure, for example) are structured as partnerships, or as limited liability companies that are taxed as partnerships, these regulations are of great concern to clean energy developers and investors.

As of the print date, these proposed regulations do not have the current effect of law and, therefore, won’t affect current debt arrangements. They can also be withdrawn or modified in whole or in part before being finalized—but, they are a cause for concern.

Current law provides that, in general, an increase in a partner’s share of liabilities is considered a contribution of cash by that partner to the partnership. The opposite is also true in that a decrease in a partner’s share of liabilities is considered a distribution of cash to that partner. In addition, a partner is considered “at risk” for recourse liabilities. By increasing one’s “at risk” tax basis, an individual partner can deduct losses against this “at risk” amount. Because a decrease in the allocation of a liability is considered a distribution of money to the partner, a partner could have taxable income if his “at risk” tax basis is decreased.

Recourse liabilities, those in which a partner (or a related party) bears the risk of loss for the liability, are allocated to the partner bearing such risk. A partner bears the risk of loss for a specific debt if, based on a hypothetical analysis, the partnership’s assets are deemed worthless. Then, the liability becomes due, and the partner is obligated to pay such liability. This is a mechanical test, and so a partner’s net worth is not considered under this analysis.

Under the proposed regulations, however, a partner or related person guaranteeing a debt (and increasing his “at risk” basis) would need to meet seven tests—including a subjective net worth test, to be considered “at risk” for that debt. If a partner fails any of these tests, a liability (which under current rules would be recourse) could be considered non-recourse and, therefore, trigger potential tax consequences.

The seven tests
The test that a partner or related person guaranteeing a debt would need to meet are as follows:

1. The partner or related person is required to maintain a commercially reasonable net worth throughout the term of the debt obligation, or be subject to commercially reasonable restrictions on transfer of assets for inadequate consideration;
2. The partner or related person is required to periodically provide commercially reasonable documentation regarding his financial condition;
3. The term of the obligation must not end prior to the term the partnership liability;
4. The payment obligation does not require that the primary obligor, or any obligor with respect to the partnership liability, directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of the obligor;
5. The partner or related person received arm’s length consideration for assuming the payment obligation;
6. In the case of a guarantee or similar arrangement, the partner or related person is or would 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; and
7. In the case of an indemnity, reimbursement agreement, or a similar arrangement, the partner or related person is or would 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 indemnitee’s or other benefited party’s payment obligation is satisfied. 

The proposed regulations will apply to liabilities incurred or assumed on or after such are finalized. Therefore, it appears that current debt arrangements may be grandfathered under the regulations, although this isn’t entirely certain. 

The regulations also provide transitional relief to partners with negative capital accounts (say, a partner whose share of partnership liabilities under current law exceed his adjusted basis) and, thereby, soften the immediate impact of the new rules. Under the regulations, a partner with a negative capital account can continue to apply the current regulations for up to seven years to the extent of his negative capital account.

In short, Treasury is seeking to replace the current hypothetical liquidation test (a test that is well developed and understood by practitioners) with a test based, in part, on a subjective analysis of net worth and potentially onerous documentation requirements. Many clean energy investments are predicated on one partner guarantying debt to increase his “at risk” basis to deduct losses. These regulations could completely change this economic relationship.

The process to finalize regulations can be time-consuming and are subject to public comments, so it isn’t likely that adoption will occur in the near term. However, if the regulations are finalized as currently written, all partnerships, including clean energy partnerships, will need to evaluate their future debt guarantee arrangements to assure compliance with these complex, highly subjective new rules.

Thomas Astore, CPA JD is a Partner at Rodman & Rodman, P.C., and practice leader of the CPA firm’s “Green Team” Renewable Energy Practice.

Rodman & Rodman, P.C.
www.rodmancpa.com