The rise of limited liability companies (LLCs) classified as partnerships for federal income tax purposes challenges traditional assumptions concerning the treatment of recourse and nonrecourse liabilities under Subchapter K. The complex rules of sections 704(b) and 752 give little attention to liabilities that are recourse to the entity under section 1001 but for which no member bears the economic risk of loss under section 752. In comparison to traditional general or limited partnerships, however, LLCs are much more likely to incur such "exculpatory" liabilities because of the limited liability shield under state law. Although exculpatory liabilities are functionally quite similar to traditional nonrecourse liabilities secured by all of an LLC's assets, literal application of the section 704(b)/752 regulations with respect to such liabilities is fraught with difficulties.
This article seeks to disentangle the treatment of exculpatory liabilities under the nonrecourse allocation rules and suggests several needed reforms. Although the conceptual model underlying the section 704(b)/752 regulations is derived from section 1001 and Tufts v. Commissioner, the drafters failed to clearly articulate and rationalize the manner in which the nonrecourse allocation rules deviate from the section 1001 standard. Consequently, uncertainty persists concerning the precise boundaries between the nonrecourse definitions of sections 704(b), 752, and 1001. Ultimately, such uncertainty can be dispelled only if the section 704(b)/752 regulations construct a theory of nonrecourse allocations that is explicitly independent of the section 1001 standard.
Karen C. Burke, Exculpatory Liabilities and Partnership Nonrecourse Allocations, 57 Tax Law. 33 (2003), available at http://scholarship.law.ufl.edu/facultypub/561