The IRS has recently proposed regulations under Section 752 of the Code which, if finalized in current form, would radically change the use of guarantees in partnership transactions.1 Under these regulations, bottom guarantees would no longer be effective for tax deferral, and guarantors would have to meet stringent new net worth requirements. The regulations would have far-reaching consequences to many partnership transactions and are particularly relevant to REITs because they would eliminate customary approaches to structuring tax-deferred contributions of property.
UPREIT Transactions – Current Practices
Many REITs have adopted a partnership structure, referred to as an "UPREIT" or "umbrella" partnership, in which all of the REIT’s properties are held through a majority-owned partnership subsidiary. The UPREIT structure facilitates property acquisitions by providing a partnership vehicle into which property owners can contribute property on a tax-deferred basis. In contrast, a contribution of property directly to a REIT in exchange for REIT shares would be immediately taxable. The units of the UPREIT partnership are designed to have substantially the same economic entitlements as a share of the REIT. In addition, the units typically are exchangeable for REIT shares at the option of the holder (after a specified period), a feature that provides the unitholder with the opportunity for future liquidity.
Guarantees are used in UPREIT transactions to protect property contributors against immediate taxation when property is contributed to the UPREIT. For example, a contributor with a negative capital account can have taxable income as a result of the contribution, unless the contributor receives an allocation of partnership liabilities sufficient to cover the amount of the negative capital account. Entering into a guarantee of partnership debt is one way to receive such an allocation. Guarantees are also used to allow a property contributor to receive cash in a "debt-financed distribution," provided that the cash is traceable to a debt that the partner has guaranteed.2 So-called "bottom" guarantees have been particularly attractive to property contributors because they limit the amount of risk the guarantor must assume. Under a "bottom" guaranty, the guarantor effectively guarantees only the "last" dollars owed to the lender under a loan.
Example: A partnership owning a single parcel of real estate worth $120 million borrows $100 million under a nonrecourse loan. Partner A enters into a bottom guaranty of the loan in the amount of $20 million. Partner A will only have to make a payment to the lender if the partnership defaults and the lender realizes less than $20 million from the collateral. In this example, the bottom guarantor would only be called upon to pay if the real estate declines in value by more than $100 million.
Under regulations that have been in place since 1992,3 bottom guarantees are effective for tax purposes. Currently, the regulations allocate economic risk of loss for a partnership liability based on a worst-case scenario in which all partnership debts become due, all partnership assets are worthless, and each partner is presumed to satisfy its payment obligations under applicable law and contractual agreements. In the example above, under the worst-case scenario the real estate is considered to be worth zero, the debt of $100 million is due, the lender would receive nothing by foreclosing on the real estate, and Partner A would have to pay the lender the full amount of the $20 million guarantee. Under the existing regulations, Partner A would be allocated $20 million of the liability for tax purposes, subject to an anti-abuse rule. The anti-abuse rule applies when the facts and circumstances indicate a plan to avoid the obligations under the guarantee (such as a guarantee given by a thinly capitalized guarantor).4
New Rules for Guarantees under the Proposed Regulations
The Proposed Regulations would make sweeping changes to the existing rules for allocation of partnership liabilities. These changes result from concern by the IRS and the Treasury Department that some partners have entered into guarantees that are "not commercial" solely to achieve an allocation of a partnership liability for tax purposes. The proposed rules, if adopted, would constrain tax-motivated guarantee arrangements by requiring guarantees to contain specified "commercially reasonable" provisions and by imposing new net worth requirements on guarantors.
Six-Factor Test for Commercial Reasonableness
The proposed regulations set forth six criteria that must be met if a guaranty is to be respected. These criteria are intended to ensure that the terms of a guaranty are commercially reasonable and not designed solely to obtain tax benefits. All six of the following requirements must be satisfied:
- the Guaranty requires the guarantor to maintain a commercially reasonable net worth throughout the term of the guarantee or subjects the guarantor to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration
- the Guaranty requires the guarantor periodically to provide commercially reasonable documentation regarding its financial condition
- the Guaranty does not end prior to the term of the partnership liability
- the Guaranty does not require that the partnership directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of the partnership
- the guarantor receives an arm’s-length fee for making the guaranty, and
- the guarantor is liable up to the full amount of the guaranty, if and to the extent that any amount of the partnership liability is not otherwise satisfied (eliminates "bottom guarantees").
Net worth Requirements
Under the Proposed Regulations, partners (other than individuals or decedent’s estates) would have to satisfy a net value requirement. A partner’s guaranty would only be respected to the extent of the partner’s net value (excluding the value of the partnership interest). Thus, if a partner guarantees $20 million of a $100 million loan, the partner must have a net worth of $20 million in order for the guaranty to be fully respected. If the partner’s net worth is only $5 million, then the guaranty would only be respected to the extent of $5 million. Partners would also be subject to a requirement to provide information as to their net worth to the partnership on a timely basis.
Application to Future Transactions
The Proposed Regulations, if and when finalized, would pose significant barriers to structuring tax-deferred UPREIT transactions. Property contributors may be unwilling to guarantee debt without the protections against risk previously available using bottom guarantees, and may be unwilling or unable to satisfy the net value requirements. Further, a new anti-abuse rule would limit structuring to avoid the impact of the rules by using tiered partnerships or multiple tranches of liabilities to achieve the same effect as a bottom guarantee. UPREIT partnerships would have to pay arm’s-length fees to guarantors and periodically monitor their financial condition. As a result, UPREIT transactions may become less attractive than in the past. REITs entering into tax protection agreements with property contributors should consider the future impact of the Proposed Regulations with respect to the required provisions of guarantees and contributor net worth reporting requirements.
Effect on Existing Transactions and Guarantees
The Proposed Regulations are not proposed to be retroactive, so the six-factor test for guarantees and the net value requirements would only apply to guarantees entered into on or after the date the regulations become final or pursuant to a binding contract entered into prior to that date. Importantly, the Proposed Regulations provide a transitional rule under which the existing regulations can be applied for a seven-year period to partners with existing debt guarantees, up to a "grandfathered amount" equal to the partner’s negative capital account at the time the regulations are finalized, subject to certain adjustments. Thus, partners with existing grandfathered amounts could continue to enter into new bottom guarantees during the seven-year transition period (for instance, as existing guaranteed loans are refinanced) and would not be required to satisfy the net worth requirement during this period. REITs who have entered into tax protection agreements with property contributors should review existing contractual obligations to determine how the Proposed Regulations and transitional rules would impact their continuing obligations to provide contributors the opportunity to guarantee debt.
1 REG-119305-11 (January 29, 2014). References to "Code" refer to the Internal Revenue Code of 1986, as amended. References to "Section" refer to Sections of the Code.
2 Treasury Regulation Section 1.707-5(b).
3 Treasury Regulation Section 1.752-2.
4 Treasury Regulation Section 1.752-2(j). See Canal Corp. vs. Commissioner, 135 T.C.199 (2010).
Joan M. Roll and Timothy J. Leska