Advance construction payments create partnership liabilities

Plain-English summary

A partnership entered long-term contracts to design and build industrial facilities and received certain payments before performing the related work or reporting the income. The partnership secured its performance obligations with guarantees and standby letters of credit, while the owner could seek performance, damages, and draws on the letters of credit after a default. The IRS ruled that the partnership's obligations to perform the work, incur the costs, and satisfy the owner's remedies were liabilities under section 752. That treatment applied to the extent the partnership had received the advance payments but had not yet reported the related income.

Ruling snapshot

• Question: Do advance Notice to Proceed payments create partnership liabilities under section 752 before the related income is reported?
• Outcome: Yes, to the extent the payments have been received and the related income remains unreported.
• Key authorities: IRC §§ 722 and 752; Treas. Reg. § 1.752-1(a)(4); Rev. Rul. 95-26

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201608005                                              Third Party Communication: None
Release Date: 2/19/2016                                        Date of Communication: Not Applicable
Index Number: 752.00-00
                                                               Person To Contact:
------------------------------------                           ----------------------------,
---------------------------                                    ID No. -----------------
-----------------------------                                  Telephone Number:
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                                                               Refer Reply To:
                                                               CC:PSI:B01
                                                               PLR-121963-15
                                                               Date:
                                                               November 11, 2015




LEGEND

X                 =         ------------------------------------
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Y                 =         ------------------------------
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P                 =         ------------------------------------
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O                 =        --------------------------------------------------------------------------

a                 =        -----

b                 =        ---------------------------------


Dear ---------------:

      This responds to a letter dated June 25, 2015, and subsequent correspondence,
submitted on behalf of X, requesting a ruling that its receipt of Notice to Proceed
payments under certain long-term construction contracts give rise to liabilities for
purposes of section 752.


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FACTS

        Two construction companies, X and Y, formed a partnership P to enter into long-
term construction contracts to engineer, design, and construct certain industrial facilities
for the owner, O. Under the contracts, P is obligated to perform all work, meaning all
obligations, duties, and responsibilities required, including fabrication, construction,
commissioning, performance testing, and any other services or work required to be
furnished under the contracts. Further, the contracts spell out P’s obligations to achieve
substantial completion and final completion within specific timeframes. Each contract
provides that P will follow a construction schedule and achieve substantial completion in
approximately a years.

        As compensation for P’s full and complete performance of the work, O is to pay P
$b under each contract. During the period that the work is being performed, O is
required to make interim, or progress, payments to P in accordance with a payment
milestone schedule, provided that P is otherwise in material compliance with its
contractual obligations. Generally, under the payment milestone schedules, P is
entitled to progress payments for the portion of work relating to completion of each
payment milestone. Accordingly, over the term of the construction period, progress
payments, generally, are tied to the completion of certain work. However, there are
certain payments (the “Notice to Proceed payments”) to be made to P before the
completion of the work and before incurring costs in performing the work, at the time O
issues P certain notices to proceed with the next phase of construction.

        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.

      P reports income using the percentage of completion method under § 460.
Therefore, P reports income based on a comparison of contract costs incurred to
estimated total contract costs. Because most progress payments are linked to work
performed, and, correspondingly, to costs incurred, there generally is a correlation


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between the year in which payments are received and the year in which income is
reported. However, the Notice to Proceed payments are different—they are not linked
to contract performance and precede P’s reporting of the related income.

LAW AND ANALYSIS

       Section 722 provides that a partner’s basis is increased by the amount of money
the partner contributes to the partnership.

       Section 752(a) provides that any increase in a partner’s share of the liabilities of
a partnership shall be considered as a contribution of money by such partner to the
partnership.

Section 1.752-1(a)(4)(i) defines liability as follows:

       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.

Section 1.752-1(a)(4)(ii) defines obligation as follows:

       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.

         Revenue Ruling 95-26, 1995–1 C.B. 131, concludes that a partnership’s
obligation to deliver securities in a short sale transaction constitutes a section 752
liability under a definition of partnership liability similar to the definition quoted above.
The Revenue Ruling reasons that a short sale creates such a liability inasmuch as: (1) a
short sale creates an obligation to return the borrowed securities, citing Deputy v. Du
Pont, 308 U.S. 488, 497-98 (1940), 1940-1 C.B. 118; and (2) the partnership's basis in
its assets is increased by the amount of cash received on the sale of the borrowed
securities. Therefore, the Revenue Ruling concludes that the partners' bases in their
partnership interests are increased under section 722 to reflect their shares of the


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partnership's liability under section 752. In Salina Partnership LP v. Commissioner, T.C.
Memo 2000-352, the Tax Court examined the policy underlying section 752 and the
analysis of Revenue Ruling 95-26 and held that a partnership's obligation to close its
short sale by replacing borrowed securities represented a partnership liability within the
meaning of section 752.

CONCLUSION

       Based solely on the facts submitted and the representations made, we conclude
that 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.

       Except as specifically set forth above, we express no opinion concerning the
federal tax consequences of the facts described above under any other provision of the
Internal Revenue Code.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to X’s authorized representative.


                                           Sincerely,



                                           David R. Haglund
                                           David R. Haglund
                                           Chief, Branch 1
                                           Office of Associate Chief Counsel
                                           (Passthroughs & Special Industries)


Enclosures (2)

       Copy of this letter
       Copy of this letter for section 6110 purposes

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