Payments to Proceed Under Construction Contract Found by IRS to Constitute Partnership Liabilities Under §752

The contracting partnership (which had two construction companies as partners) asking for the ruling in PLR 201608005 was looking to see if certain payments the contractor received prior to actually beginning work on portion of a project could be considered partnership liabilities.

The contract in question referenced two types of payments to be made by the customer.  One type of payment would be made under standard progress payment terms—if the partnership was in compliance with the contract at the time each payment milestone was reached, a payment would be due.  These payments were not the ones the contractor was asking to be ruled as liabilities.

The other type of payment was a “Notice to Proceed” payment that the customer was to make when it gave the partnership notice to proceed to the next phase of construction.  These payments were made before the completion of the work and, in fact, before any expenses were incurred by the partnership on that phase of the project.

Additional terms are described as follows in the letter ruling:

Before P is entitled to receive payments under the contracts and, explicitly, to receive the Notice to Proceed payments, P is required to provide certain guarantees and also to deliver to O irrevocable standby letters of credit. The letters of credit secure P’s obligations to perform under the contracts and cover O’s damages in the event of non-performance or default by P. The amount of the letters of credit securing P’s obligations roughly corresponds to the amount of the Notice to Proceed payments.

The contracts provide that if P fails to prosecute the work in a diligent and efficient manner, or if P abandons the project or repudiates any of its obligations, a default occurs. In that event, O is entitled to several remedies, including seeking specific performance (that is, obtaining judicial enforcement requiring P to make good on its obligation to perform the work) and recovery from P of costs, damages, losses, and expenses (that is, requiring P to make good on its obligation to cover O’s damages in the event of nonperformance). Specifically, the contracts allow O to draw-down directly against the letters of credit in the event of a default by P.

The partnership is reporting income from the contract on the percentage of completion basis of accounting.

If the payment creates a liability it would serve to increase the partner’s basis in the partnership under IRC §722.  Under IRC §752(a) an increase in a partner’s share of liabilities is treated as a contribution by the partner of cash to the partnership.  So if these payments create liabilities, the increased basis would allow for the partners to either deduction losses that otherwise would be basis limited or receive distributions tax free that otherwise would become taxable.

As is often true with the tax law, a liability for this purpose is subject to its own special definition as provided by the Code and Regulations.  Specifically, Reg.§1.752-1(a)(4)(i) provides that a liability is:

An obligation is a liability for purposes of section 752 and the regulations thereunder (§ 1.752-1 liability), only if, when, and to the extent that incurring the obligation—

(A)      Creates or increases the basis of any of the obligor’s assets (including cash);

(B)      Gives rise to an immediate deduction to the obligor; or

(C)      Gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital.

Thus, the item must be an “obligation” to meet this test, a concept that is defined as the regulation continues [Reg. §1.752-1(a)(4)(ii)]:

For purposes of this paragraph and § 1.752-7, an obligation is any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code. Obligations include, but are not limited to, debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps.

The letter ruling does conclude that a liability exists to the customer, even though no specific loan took place.  The ruling considers this similar to the case of closing a short sale obligation described in Revenue Ruling 95-26 where the fact that an obligation exists to deliver back the borrowed securities was found to lead to a partnership liability under IRC §752.  Thus the ruling concludes:

…P’s obligations under the contracts to proceed with performing work and to incur costs in performing the work, and the corresponding obligations to satisfy O’s remedies in the event P were to default or suspend work, constitute liabilities under section 752 upon and to the extent P receives the Notice to Proceed payments but has not yet reported the related income.