Temporary regulations issued in October 2016 relating to disguised sales and bottom-dollar payment obligations—specifically, Reg. secs. 1.707-5T(a)(2) and 1.752-2T(b)(3), respectively—were scheduled to expire on October 4, 2019 (the Temporary Regulations). In June 2018, Treasury and the IRS issued proposed regulations to remove the Temporary Regulations relating to the allocation of liabilities for disguised sale purposes under Reg. sec. 1.707-5T(a)(2) and to reinstate the prior final Section 707 disguised sale regulations that were in effect prior to the Temporary Regulations (the 2018 Proposed Regulations).
On October 4, 2019, Treasury and the IRS issued two sets of final regulations (the Final Regulations (TD 9877; TD 9876)). The Final Regulations amend Reg. sec. 1.752-2(k) to disregard a payment obligation of any partner or related person if the facts and circumstances determine that there is not a commercially reasonable expectation that the payment obligor will have the ability to make the required payments. The Final Regulations also adopt the Temporary Regulations relating to bottom-dollar payment obligations, with some changes (the Bottom-Dollar Payment Obligation Final Regulations), and adopt with modifications proposed regulations issued in October 2016 (the 2016 Proposed Regulations) adding (1) an anti-abuse rule in Section 752 under which a payment obligation is ignored if a plan to circumvent or avoid the obligation exists and (2) a list of factors to the Section 704(b) regulations to indicate when a plan to circumvent or avoid a deficit restoration obligation (DRO) exists. The Final Regulations also adopt the 2018 Proposed Regulations relating to the allocation of liabilities for disguised sale purposes without change (the Disguised Sale Final Regulations).
The Final Regulations remove the Temporary Regulations. Effective dates are discussed below.
Given the significant number of changes since the earlier regulations, including the reinstatement of some of the original Disguised Sale regulations, PwC has designed a two-page reference tool to help navigate these changes. Please find that reference tool here.
As explained above, the reversion to prior law in the Disguised Sale Final Regulations allows greater flexibility, but partners and partnerships should exercise caution in analyzing whether payment obligations relating to assumed indebtedness would be respected under applicable case law and under the Bottom Dollar Payment Obligation Final Regulations. Partners and partnerships should continue to monitor underlying liabilities in seeking to prevent a refinancing or other modification from causing the obligation to fall out of the grandfathered rules in the Bottom Dollar Payment Obligation Final Regulations. By adopting the factors from the 2016 Proposed Regulations into an anti-abuse rule, the Treasury Department and the IRS reaffirmed that payment obligations should be recognized only if undertaken pursuant to arm’s-length commercial terms.
The Final Regulations also may invalidate certain DROs that previously had been disregarded only for purposes of determining economic risk of loss. Taxpayers should consider amending partnership agreements containing such DROs. Taxpayers should be aware that the Final Regulations with respect to DROs do not provide for a transition or grandfathering rule, unlike the regulations for Bottom Dollar Payment Obligations.
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