Proposed Section 752 Regulations Would Prohibit Bottom Guarantees and Impose Net Worth Requirements in UPREIT Transactions

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Joan M. Roll, Esq., and Timothy J. Leska,

Pepper Hamilton LLP, Philadelphia, PA

The IRS has recently proposed regulations under §752, 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

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

New Rules for Guarantees under the Proposed

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

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

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.

Pepper Perspective

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.

For more information, in the Tax Management Portfolios, see
Starczewski, 714 T.M.
, Partnerships - Allocation of
Liabilities; Basis Rules,  and in Tax Practice Series, see
¶4030, Formation of a Partnership.

Copyright © 2014 Pepper Hamilton LLP

  1 REG-119305-11, 79 Fed. Reg. 4826 (1/30/14).

  2 Regs. §1.707-5(b).

  3 Regs. §1.752-2.

  4 Regs. §1.752-2(j). SeeCanal Corp. v.
, 135 T.C. 199 (2010).

Request Transfer Pricing Report