Module 3

Liabilities and Basis

Section B... Recourse Liabilities

Selected Readings

Please browse the following statutory provisions


Code Sections



Liabilities under the Final Regulations

A partner's share of partnership liabilities affects the basis of the partnership interest in the following manner:

  • An increase in partnership liabilities increases a partner's basis in the partnership.
  • A decrease in partnership liabilities decreases a partner's basis in the partnership. IRC Sec. 752(a)

Before partners' can share in partnership liabilities for basis purposes a determination must be made as to which of the partnership's obligations will be treated as liabilities

Liability Defined

Although the final 752 regulations do not specifically define the term "liability," the definition of a liability in the previously issued temporary regulations probably provides a good working definition of the term. For purposes of 752, under former Temp. Treas. Reg. 1.752-1T(g), an obligation is considered a liability only to the extent that incurring or holding the obligation gives rise to:

  1. Basis in property (including cash) owned by the obligor,
  2. A deduction that is taken into account in computing taxable income of the obligor, or
  3. An expenditure that is not deductible in computing the obligor's taxable income and is not properly chargeable to capital. Treas. Reg. 1.752-1(g). See Treas. Reg. 1.752-1T(k), Example (2).

Liabilities of Cash Method Partnerships, Etc.

Accounts payable. For partnership taxable years beginning prior to September 19, 1988, partnership liabilities include the partnership's obligations for repayment of trade accounts, notes, and accrued expenses even if those items are not recorded on the partnership's books due to its use of the cash method of accounting. Rev. Rul. 60-345, 1960-2 C.B. 211. For partnership taxable years beginning after September 18, 1988, such obligations will not be considered partnership liabilities of a cash basis partnership for purposes of 752. Rev. Rul. 88-77, 1988-2 C.B. 128.

Contributions of accrued liabilities. Contributions made after March 31, 1984, of accrued but unpaid liabilities (e.g., accounts payable) by a cash method partner to a partnership will be treated similarly to 357(c) items in a corporate tax context. Thus, those items should not be treated as liabilities for purposes of 752. Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Reform Act of 1984 (P.L. 98-369), 215 (the "Staff Report").

Deferred income. Unrestricted progress payments received by a partnership using the completed contract method of accounting represent deferred income rather than a partnership liability. Rev. Rul. 73-301, 1973-2 C.B. 215. However, a partnership's prepaid subscription income constitutes a partnership liability. TAM 9823002.

Tiered Partnerships

A limited partner's basis for his or her interest in a first tier limited partnership includes that partner's share of the second tier partnership's liabilities which are allocated to the first tier partnership. Rev. Rul. 77-309, 1977-2 C.B. 216.

Contributions to Capital Versus Loans

Loans to partners. A partner's receipt of money from a partnership under an obligation by the partner to repay the funds constitutes a loan, and thus a liability of the partnership, rather than a distribution. To the extent such obligation is canceled, the obligor partner will be considered as having received a distribution at the time of the cancellation. Treas. Reg. 1.731-1(c).

Loans by the general partner. Nonrecourse loans by the general partner to either the limited partners or the partnership may constitute capital contributions to the partnership by the general partner, rather than loans. Rev. Rul. 72-135, 1972-1 C.B. 200.

Convertible debt. A nonrecourse loan by an unrelated third party to a partnership, secured by the partnership's property and convertible at the option of the lender into an interest in the partnership's profits may be treated as a capital contribution rather than as a loan. Rev. Rul. 72-350, 1972-2 C.B. 394.

Advances to the partnership by the partners considered equity. Advances to a partnership by a partner have been held to be capital contributions (rather than loans) where the loans were noninterest-bearing, unsecured, subordinated debt. Hambuechen v. Commissioner, 43 T.C. 90 (1964).

Advances to the partnership by the partners considered loans. Advances to a partnership by a partner were held to be loans (rather than capital contributions) where repayments were made regularly, notes were given, the advances were not subordinated, and the partnership's capitalization was not abnormal. Kingbay v. Commissioner, 46 T.C. 147 (1966).

General Validity of Debt Issues

In certain circumstances the IRS has taken the position that a debt does not exist for tax purposes. Critical factors in this determination are whether or not the debt is nonrecourse and whether the value of the collateral can support the purported debt. This determination is generally made when the debt is incurred.

Invalid Debt


In Estate to Franklin, 64 T.C. 752, (1975), aff'd, CA-9, the Tax Court determined that nonrecourse debt used to purchase real estate in a sale-leaseback transaction was not valid debt. The rent payments were constructed to cover the debt service and the Court found the purchase price to be significantly inflated.

In Rev. Rul. 78-79, 1978-1 C.B. 62, the Service held that a nonrecourse note issued for the purchase of a patent was not valid debt. The note represented 99.75% of the purchase price. The Service determined that the fair market value of the patent was not shown to even approximate the amount of the nonrecourse note. Further, the transaction seemed to be designed to generate amortizable basis in the patent. .


Valid Debt


In Manuel D. Mayerson, 47 T.C. 340 (1966), the taxpayer acquired a building with a minor down payment (approximately 3%), the balance due on a nonrecourse note which could be paid off at any time but required interest only payments during its 99-year term with a balloon payment at the end. The Court upheld the purchase because the value of the property appeared to support it and was negotiated at arm's-length.

Recourse versus Nonrecourse

Because a liability has a direct influence on the amount of basis that a partner is deemed to hold, a determination of what is a partner's share of liabilities must be made. In making this determination, two considerations must be addressed.

  1. Is the liability in question a recourse or nonrecourse liability? This is important because different sets of sharing rules are used depending upon the type of liability.
  2. How are both recourse and nonrecourse liabilities allocated among the partners? This is important because assorted rules and profit sharing ratios may exist for different items of partnership income and deductions.

The basic approach used in addressing both of these issues reflects Congress' goal in the Tax Reform Act of 1984 of ensuring that the partner who receives the basis with respect to a partnership liability also bears the economic risk of loss for the liability. Regulations effective for liabilities incurred or assumed on or after January 30, 1989, have undertaken this directive and instituted the ultimate responsibility test, which at times appears to resemble more closely a term of art. The thrust of this test is to determine who bears the ultimate financial responsibility for payment of a partnership liability. If it can be established that a partner will have to satisfy a liability out of his/her own funds, it is a recourse liability. If no partner will have to defray the cost of a liability out of his/her own funds, or if the partnership fails to do so, then the liability is said to be a nonrecourse liability. If a liability has nonrecourse and recourse characteristics, the debt will be treated as two different liabilities. Reg. Sec. 1.752-1

Determining recourse liabilities

A recourse liability is any liability for which any partner (or person related to a partner) bears the economic risk of loss for the liability. A partner's share of recourse liabilities equals the portion, if any, of the economic risk of loss for such liability that is borne by that partner (or persons related to such partner) if the liability is not discharged by the partnership. To determine the risk of loss, the Regulations adopt a hypothetical worst-case scenario called a "constructive liquidation," which is often referred to as the "atom bomb test' (constructive liquidation). Treas. Reg. 1.752-1(a)(1).

Under constructive liquidation, the following scenario is deemed to occur:

  1. All partnership assets are worthless and disposed of in a taxable transaction for zero consideration.
  2. All partnership liabilities are due and payable in full.
  3. The partnership allocates all gains and losses with respect to the disposition according to the partner's capital accounts.
  4. The partners interests in the partnership are liquidated. Reg. Sec. 1.752-2(b)(1).

A partner then would bear the economic risk of loss to the extent that, after constructive liquidation, the partner would be obligated to pay a creditor or make a contribution to the capital of the partnership. A partnership contribution obligation generally occurs when a partner is required to restore a negative capital account balance as a result of the constructive liquidation. Accordingly, the partner is generally allowed to include that amount of his/her potential liability in the basis of his/her partnership interest. This required contribution is taken into account before the balance of the liabilities are pro rated. Reg. Sec, 1.752-2(b)(1).

Example 1

X and Y are partners in the XY partnership, each sharing profits and losses 50 percent and each obligated to restore any negative capital account balances. The only asset of the partnership is land with a basis and fair market value of $60,000. X has a basis in the partnership interest of $10,000 and Y's basis is $50,000. If the partnership borrowed $80,000 on a recourse basis to purchase a building, the debt would be allocated $60,000 to X and $20,000 to Y determined as follows:

Beginning basis
$ 50,000
Loss on land
Loss on building
Ending deficit

Due to the atom bomb test (constructive liquidation), the land and building are deemed worthless and sold for $0, generating the respective losses. Partner X is obligated to contribute $60,000 while partner Y only is obligated to contribute $20,000. Both are required to restore their negative capital account balances. Thus, to that extent, the liabilities are allocated accordingly.

Study Questions Make your selection by clicking the appropriate response letter.


How do partnership liabilities affect a partner's basis in the partnership?
An increase in partnership liabilities has no effect on basis, it only affects a partner's capital account.

An increase in partnership liabilities reduces a partner's basis in the partnership interest.

A decrease in partnership liabilities reduces a partner's basis in the partnership interest.
A decrease in partnership liabilities increases a partner's basis in the partnership interest.


Which of the following statements is not true concerning the determination of a partners basis with respect to liabilities incurred or assumed?
If a debt is recourse and nonrecourse, the debt will be treated as two liabilities.

If a debt is recourse and nonrecourse, it will be treated as nonrecourse.

On a nonrecourse liability, no partner will have to defray the cost out of his/her own funds.
A general partner is responsible for a recourse debt.


Which of the following statements is true concerning the requirements of the atom bomb test (constructive liquidation) of Regulation 1.752-2?
All partnership liabilities are deemed due and payable.
All assets, except cash, are considered to be worthless.

Only the limited partner's interest in the partnership is deemed liquidated.
No partner is required to restore a negative capital account.


Which of the following statements is not true concerning debts of the partnership?
A Nonrecourse debts are shared by limited and general partners.
B If a debt has recourse and nonrecourse characteristics, it is treated as two separate debts.

C Nonrecourse debts are shared by partners according to their loss sharing ratios.
D Recourse debts are allocated to the partner who bears the recourse burden.

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