Liability Relief and Liquidating Distributions From a Partnership

In previous articles liability relief from a partnership has been discussed.  Generally, liability relief from a partnership is deemed a distribution to the partner who has been relieved of the liability.  But, what happens when a partner is relieved of liability at the liquidation of the partnership?  Can liability relief be deemed a liquidating distribution to a partner in a partnership?  The article below has been prepared by a tax attorney in Denver, Colorado from The McGuire Law Firm to provide additional information regarding this issue.  Please remember to consult your tax attorney or business attorney directly regarding any related issues.

In regards to the question asked above, the answer is yes.  Just as with normal partnership distributions, liquidating distributions include not only money, but any relief from partnership liabilities.  Under Internal Revenue Code Section 752, a deemed distribution of cash or money is attributable to recourse liability relief when the deemed distributee (partner being relieved of liability) would no longer bear the economic risk of loss for the recourse liability of the partnership as a tax partner.  Often the question arises, when is a withdrawing partner relieved of a liability?  The general rule may be that a partner has immediate liability relief for any of the partnership liabilities that the continuing partnership maintains.  Under Private Letter Ruling 9622014, a selling partner will include guaranteed partnership liability in their amount realized when the purchasing partner indemnified the partners, even though the lender actually refused to release the withdrawing partner from the liability.  Thus, there was a deemed distribution even though technically the withdrawing partner would have still been liable to the bank under the terms of the bank loan.

What happens when the partner or partners receive a series of liquidating distributions?  When a partnership liquidates and the distributions are made through a series of liquidating distributions, recourse and non-recourse liability relief may not occur until the final distribution is received.  The reasoning behind this matter is that a withdrawing partner remains a tax partner of the partnership until the final distribution is received from the partnership.

If you are considering withdrawing from a partnership or liquidating a partnership, it is important to under the tax implications of the distributions from the partnership you will receive and how debt relief can be treated.  You can speak with a Denver tax attorney by contacting The McGuire Law Firm.  The McGuire Law Firm provides a free consultation with a Denver Tax Attorney to all potential clients.

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Deemed Cash Contribution to Partnership Via Assumption of Liability

Under Internal Revenue Code section 752(a) an increase in a partner’s share of partnership liabilities, or an increase in a partner’s individual liabilities by reason of the assumption by such partner of a partnership liability or liabilities, shall be considered as a contribution of money by such partner to the partnership.  Because the assumption of a liability is treated as a contribution of money by the partner, the partner’s basis in the partnership will increase under Internal Revenue Code section 722 by the amount of the deemed cash contribution.

IRC 752(a) would appear easy enough right?  Not exactly!  The issue of what constitutes a liability and thus can increase a partner’s basis can become quite complex and one should refer to the section 752 Treasury Regulations, of which certain sections are discussed below.

Section 1.752-2(a) of the Treasury Regulations states generally that, “A partner’s share of a recourse partnership liability equals the portion of  that liability, if any, for which the partner or related person bears the  economic risk of loss.”  Thus, the regulations are focusing on economic risk, and more or less, what a partner is exposing themselves too when assuming the liability.  To view a partner’s economic risk of loss, the regulations assume a deemed liquidation of the partnership whereby the partnership liquidates, all assets are sold for nothing and the partner who has assumed the debt is more or less left to deal with the creditor or creditors- Thus what is the real risk to the partner if the partnership were liquidated and gone, and unable to pay the liability or liabilities assumed by the partner?  Specifically, the regulations state:

“Except as otherwise provided in this section, a partner bears the economic risk  of loss for a partnership liability to the extent that, if the partnership  constructively liquidated, the partner or related person would be  obligated to make a payment to any person (or a contribution to the  partnership) because that liability becomes due and payable and the  partner or related person would not be entitled to reimbursement from  another partner or person that is a related person to another partner.  Upon a constructive liquidation, all of the following events are deemed to  occur simultaneously:

All of the partnership’s liabilities become payable in full;

With the exception of property contributed to secure a partnership liability  (see section 1.752-2 (h)(2)), all of the partnership’s assets, including  cash, have a value of zero;

The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the  creditor’s right to repayment is limited solely to one or more assets of  the partnership);

All items of income, gain, loss, or deduction are allocated among the partners; and

The partnership liquidates.”

Now that we know how the regulations view economic risk, what constitutes an assumption of a liability?  Under Treasury Regulations section 1.752-1(d), a partner is considered to have assumed a liability to the extent that the partner is personally obligated to pay the liability. Furthermore, section 1.752-1(d)(2) provides a requirement that the person to whom the liability is owed, has knowledge of the assumption and can directly enforce the partner’s obligation for the liability, and no other partner or person that is a related person to another partner would bear the economic risk of loss for the liability immediately after the assumption.

Thus, a partner can increase their partnership basis via a deemed cash contribution when they assume a partnership liability, and bear the risk of economic loss from such assumption.  To discuss partnership formation and related issues, you can contact The McGuire Law Firm.  The above article is solely to provide general information and should not be construed as tax or legal advice.  The McGuire Law Firm does not provide legal advice via the internet.

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