Partners sometimes use guarantees to try to shift the ratio in which debt at the project or partnership level is put in the “outside bases” of partners.

The IRS is taking aim at such efforts.

The greater the share of such debt assigned to a partner, the greater capacity the partner has to be allocated losses and distributed cash without having to pay taxes on the cash distributions.

Each partner has both a “capital account” and an “outside basis.” These are two ways of measuring what each partner put into the partnership and is allowed to take out. When a partner’s outside basis hits zero, then any further losses the partner is allocated end up suspended; they can only be used to shelter future income the partner is allocated by the partnership. The partner must also report any further cash it is distributed as capital gain.

A partner’s outside basis starts as the sum of three items: any cash the partner contributed to the partnership, its tax basis in any property contributed, plus a share of any debt at the project or partnership level.

Most debt in the project finance market is nonrecourse debt. This must be shared by partners according to complicated rules, but most of it ends up being shared in the same ratio as the partners are allocated partnership income. If the ratio for allocating income will flip after a target yield is reached, the partners can choose either set of percentages. Alternatively, they can use the ratio in which the partners are expected to share in depreciation on the part of the project cost paid for with the debt.

Recourse debt is put entirely in the outside basis of the partner who is ultimately liable to repay the debt. Thus, a partner might guarantee repayment of the debt as a way of putting it entirely in the partner’s outside basis.

Another example of recourse debt is where a partner or an affiliate is both a partner and a lender. The partner is considered ultimately exposed to the loss if the debt is not repaid, thus making the debt recourse to the partner.

The IRS issued temporary regulations in early October that attack “bottom-dollar guarantees.” A bottom-dollar guarantee is a guarantee that is illusory because someone else has promised to reimburse the partner or the real burden is split among other parties by using tiered or upstream entities, legal subordination or similar tools.

The IRS will ignore such guarantees put in place on or after October 5, 2016. A guarantee that a partner is obligated to provide under a binding contract signed earlier will not be affected.

Bottom-dollar payment obligations must be disclosed on IRS Form 8275.

The IRS said it may end up recognizing a guarantee for a “vertical slice” of debt at the project or partnership level, even if the rest of the guarantee is considered illusory because someone else will reimburse the partner, in cases where the reimbursement falls short of covering the full debt.

It is not a problem to have the partnership agree to reimburse the partner if the partner has to pay the guaranteed debt. This will not make the guarantee illusory. It assumes other partners will not have to contribute to fund the reimbursement.

The IRS also released a list of seven factors in October that suggest a partner guarantee to pay debt at the project or partnership level is not real. The factors are merely proposed. The IRS will use them starting after the proposed regulations are republished in final form.

The factors include that there are no commercially reasonable contractual restrictions to “protect the likelihood of payment,” including, for example, restrictions to prevent the guarantor from shedding assets for less than full value or making cash distributions to equity owners, the guarantor is not required to produce commercially reasonable evidence  of its financial condition “either at the time the payment obligation is made or periodically,” the partner can terminate the guarantee before the debt is repaid, or the debt terms are no better with the guarantee than without.