Recent IRS actions have reopened a door to tax-efficient leveraged buyout transactions (LBOs) that it had previously proposed shutting. New proposed regulations (NPRM Reg-131186-17) change the “disguised sale” rules to allow allocating debt to a partner as long as that partner bears the economic risk of loss with respect to the debt.
Basic leveraged buyout transactions (LBOs)
The typical LBO consists of a founder or related entity contributing a business to a newly formed partnership owned by the founder and a private equity investor. The newly formed partnership obtains financing that the founding partner guarantees. The new partnership then distributes the debt proceeds to the founder as a debt-financed distribution in a tax-deferred manner. Under the regulations before January 2017, the founder’s guarantee of the debt kept this transaction from being recognized as a disguised sale.
The disguised sale rules generally apply when a partner receives a related distribution of money or property within two years of contributing property to the partnership. When a disguised sale is determined to have occurred, the affected partner(s) will have to recognize gain in the year of distribution. Exceptions to the rules have allowed for deferral of income recognition on debt-financed distributions in certain instances where the distribution doesn’t exceed the partner’s allocable share of the debt. For the past several years, the IRS proposed regulations that eliminated this exception.
IRS comes full circle on exception
IRS proposed regulations in 2016 (Prop. And Temp. Regulations 1.707-5) required that all debt be allocated based on a partner’s share of the partnership’s profits. Basically, for income tax purposes, the founder’s guarantee of the debt no longer had any effect on the amount of partnership debt allocated to him or her for disguised sale purposes. Therefore, the disproportionate debt-financed distribution to the contributing partner described above would result in “disguised sale” treatment and gain recognition even though the contributing partner guaranteed the debt. This effectively prevented tax-deferral on debt-financed distributions to a property-contributing partner in a leveraged transaction using guaranteed debt.
New IRS guidance released in October 2018 withdraws the 2016 guidance, placing the leveraged partnership transaction back in play. Generally, a debt-financed distribution to the contributing partner will no longer be subject to disguised sale treatment when the contributing partner guarantees the debt.Some debt-financed transactions that were treated as disguised sales may qualify for tax deferral. Parties to LBOs after January 3, 2017 should consider amending returns.
The recent changes apply to transactions that occur on or after January 3, 2017. Partnerships and partners that engaged in LBOs after the effective date and have already filed the related tax returns should consider amending their returns. Some debt-financed transactions that were treated as disguised sales may now qualify for tax deferral. In addition, these changes allow for more flexibility in structuring future LBOs to maximize the deferral of gain for the property-contributing partner. Also, the IRS has corrected the final regulations issued in 2016 (T.D. 9787 Correcting Amendment 2018) regarding treatment of non-recourse liabilities to clarify a potentially confusing statement regarding effective dates. The corrected effective date means that the parties will be required to allocate non-recourse debt under the rules in place prior to the final regulations if one of the transfers was made prior to October 5, 2016. Because of the two year presumption, in which related transfers made within two years are presumed to be a disguised sale, a subsequent transfer of money or property made up to October 5, 2018 may be impacted by this revised effective date and be calculated under prior rules.
Obviously, LBOs are something that the parties should plan in advance. In this case, the modification of the IRS position regarding debt guarantees requires some taxpayers to look backwards at returns already filed at the same time that it requires those planning an LBO to consider the changes. If you’d like more information about previous or planned LBO transactions, please don’t hesitate to contact us.