IRS Says, No More Bottom-Dollar Guarantees: What Every Partner Needs to Know
Bottom-dollar guarantees are coming to an end as a way for partners to increase their tax bases in a partnership or limited liability company. Temporary Regulations issued by the Internal Revenue Service (“IRS”) in October 2016 state that bottom-dollar guarantees can no longer be used to increase your basis in your partnership interest unless they are covered by special transition rules.
That means that if you’ve made any such guarantees and the underlying debt is modified, you’ll have to restructure the guarantees in order to avoid having them be disregarded under these new rules. A seven-year phase-in period gives you time to take a closer look at how the new rules affect you and what your alternatives are.
What Is a Bottom-Dollar Guarantee?
Because guaranteeing a debt carries an economic risk of loss, partners have traditionally tried to structure guarantees in a way that minimizes their own personal stakes in that risk. In a bottom-dollar guarantee, a partner is only obligated to pay back any part of the debt if the creditor collects LESS than a guaranteed minimum amount. As long as the creditor receives the amount of the original principal that was subject to the guarantee, a partner doesn’t have to pay back any other part of the debt, even if the partnership defaults.
Here’s an example: Let’s say a partnership holds an asset worth $10,000,000 and takes out an $8,000,000 loan against the property. Partner A guarantees $1,000,000 of the $8,000,000 debt. The partnership only repays $900,000 before it defaults on the debt and the property becomes worthless. If Partner A’s guarantee is structured as a bottom-dollar guarantee, she is only required to pay $100,000 to the bank – the difference between the partner’s guaranteed share of the debt and the amount the bank has already been paid. The result is that the creditor only collects $1,000,000 and loses $7,000,000.
Bottom-dollar guarantees matter, because up until now they have been used as a way to increase a partner’s basis in a partnership while limiting the amount of personal risk he or she takes on. Your basis in your partnership interest includes your share of partnership liabilities and affects:
- Amount of gain or loss you recognize on the sale of your partnership interest
- Amount of partnership losses, expenses and credits you can claim on your income tax return (subject to other limitations that may apply, such as passive activity loss rules)
- Extent to which partnership distributions are taxable
The determination of a partner’s share of liabilities for tax purposes is not as straightforward. Factors such as local law, who the creditor is, and any guarantees or indemnifications that a partner has made with respect to the debt all potentially affect his or her share of partnership liabilities.
State law normally provides that general partners are liable for their share of all partnership liabilities that are not specifically non-recourse. Because they bear the economic risk of loss, they are normally allocated any liabilities that are not properly allocable to other partners.
In contrast, limited partners and limited liability company members are not liable for any partnership liabilities, unless they specifically guarantee the debt. Partners who either loan money to a partnership (either directly or through a related party) or guarantee a debt are generally allocated that debt, as they bear the economic risk of loss.
The ability to increase one’s basis by guaranteeing a portion of the partnership’s debt has provided partners with effective tax-planning opportunities in the past. In many cases, partners who would otherwise be forced to recognize taxable income or who couldn’t take advantage of their share of partnership losses, expenses or credits because of a lack of basis could create or increase basis for themselves by guaranteeing a portion of partnership debt.
Bottom-dollar guarantees have often been used to increase a partner’s basis (and defer income recognition) when a partnership borrowed money to make distributions to its partners. The strategy has also been used when two partnerships merged or when new partners entered a partnership, causing the existing partners’ shares of liabilities (and therefore their bases) to be reduced.
Going back to our example, the old rules allowed Partner A to include the entire $1,000,000 of her bottom guarantee in her share of liabilities for determining basis in the partnership. However, new temporary and proposed regulations issued on October 5, 2016, have changed the rules. The regulations provide that bottom-dollar guarantees are ignored in determining a partner’s share of liabilities if they relate to new debt (or existing debt that is modified or refinanced). New debt is debt incurred after October 5, 2016, which was not subject to a written binding contract as of October 4.
An exception to the new rules applies to a guarantee that covers at least 90% of the debtor’s obligation; however, we don’t expect that exception to provide relief to many partners. What is more likely to apply is a provision that considers multiple debts to be one if they are part of the same “plan, transaction, arrangement,” per the new regulations. The result of this rule is that if a partnership structures its debt to consist of multiple notes, some of which are subordinate, with partners only guaranteeing the subordinated debt, the guarantee would be treated as a bottom-dollar guarantee that is then disregarded.
A transition rule allows partners to continue to claim basis for a portion of the amount of their bottom-dollar guarantees until the related debt is either modified or refinanced. When debt is either modified or refinanced, and a bottom-dollar guarantee applies to both the old and the new debt, the transition rule may allow basis to be claimed until October 4, 2023.
The amount subject to this transition rule is the amount of debt that is needed by the partner to avoid having a negative basis as of October 4, 2016 (referred to as the transition amount). The transition amount will be reduced for changes in the partner’s share of partnership recourse liabilities. It will also be reduced if the amount of gain recognized by the partner on the disposition of partnership property exceeds his interest in the amount the partnership realizes on the sale.
In addition, the new regulations require that all bottom-dollar guarantees be reported to the IRS in the year that they are either entered into or modified.
Because commercial debt normally has a term of 10 years or less, and the transition rule is only effective until 2023, most partners with existing bottom-dollar guarantees will face the consequences of the regulations by then. By planning in advance, you can either take steps to mitigate the effects of this regulatory change or prepare for the tax liability that‘s coming.
The first step is to determine what the potential impact of this change means for each partner, based on the transition amount and when the debt is scheduled to be retired, refinanced or modified. Determining the transition amount usually works best as a joint exercise between the partner and partnership, unless the partner acquired the partnership interest solely as a result of contributing cash to the partnership, since basis is determined at the partner level and can be based in part on transactions that the partnership was not a party to (i.e., inheritance or purchase from another partner). Armed with this knowledge, the partnership and individual partners can determine the steps they want to take to defer or eliminate the consequences of the rule change. The calculation of the transition amount should be maintained throughout the transition period in order to properly take advantage of the transition rules provided in the regulations.
You do not need to be concerned with the new regulations, as long as three criteria are met:
- Partnership debt subject to your bottom-dollar guarantee is not refinanced or modified.
- You are not allocated any gain on the sale of partnership assets.
- Your share of partnership liabilities is not reduced.
If the partnership debt is refinanced or modified, you can continue to get credit for the liabilities when determining basis through October 4, 2023, if you continue your guarantee.
A bottom-dollar guarantee that applies to more than 90% of the total debt will continue to be respected even beyond October 4, 2023. A partner will also continue to be allowed basis for a guarantee of debt that is subject to a cap or maximum payout to the creditor, as long as it is not a bottom-dollar guarantee. The regulations also specifically permit a partner to be allocated debt based on a “vertical slice” guarantee. A vertical slice guarantee is when a partner guarantees a portion of each dollar of the debt.
For example: A partnership holds an asset worth $10,000,000 encumbered by bank debt of $8,000,000. Partner B guarantees a vertical slice of 10% of the debt. The partnership only repays $800,000 before its property becomes worthless and it defaults on the debt. Partner B would be required to pay $720,000 to the bank (8,000,000 – 800,000 = 7,200,000; 10% of which is 720,000). The creditor ends up collecting a total of $1,520,000 and losing $6,480,000. Because the guarantor in this case is required to pay if the partnership defaults on any portion of the debt, it is not considered a bottom-dollar guarantee. Therefore, 10% of the liability is allocated to the guaranteeing partner and increases his basis in the partnership.
It’s important that partners contemplating such a change in their guarantees realize that this will cause them to increase their risk of economic loss should the partnership fail to satisfy its debt in whole.
Partnerships whose partners have bottom-dollar guarantees in place should act now to determine each partner’s transition amount. These amounts and the dates on which those guarantees are expected to be refinanced should be communicated to the affected partners, so they can begin considering whether they want to change the nature of their guarantees or prepare for the tax bill they may face on October 5, 2023.
Renegotiating your bottom-dollar guarantees is likely going to be complicated – especially when trying to figure out the options for mitigating your own financial costs and risks. Not renegotiating them may be more expensive though.
If you want some help talking through your options and comparing the outcomes, start the conversation and reach out to your local Cherry Bekaert advisor. He or she can help you go through different scenarios and compare the numbers in each case, so you can find the best solution. If you come away from the conversation with even one new idea, it will have been worth your time.