The “Doomsday Simulation”: Why Your Recourse Debt Allocations Might Fail under Audit.

Allocations of partnership recourse liabilities under the section 752 regulations are not an exercise in labels (“recourse” vs. “nonrecourse”) or documentation alone (e.g., “there’s a guarantee, so the guarantor gets the debt”). They are, fundamentally, a disciplined inquiry into who bears the economic risk of loss (EROL) and therefore should be treated as having an increased outside basis (and potential gain recognition on decreases) under IRC § 752(a) and (b). The reason the constructive liquidation framework is critical is that it forces the analysis into a consistent, economic end-state: if everything goes wrong, who is actually left holding the bag? The regulations answer that question through a “deemed worst day” model rather than relying on surface-level deal terms.

The operative rule is in Treas. Reg. § 1.752-2(b)(1): a partner’s share of a recourse liability equals the portion for which the partner (or a related person) would be obligated to make a payment if the partnership constructively liquidated. This is not merely conceptual—§ 1.752-2 requires you to run a structured hypothetical that assumes the partnership’s assets become worthless (with specific mechanics for calculating deemed gains/losses and certain limited-recourse-to-asset situations). Importantly, the regulations also emphasize that all relevant obligations can matter in the EROL calculus, including guarantees, indemnities, reimbursement agreements, capital contribution obligations, and deficit restoration obligations that exist under the partnership agreement (tied back to the 704(b) capital account framework).

A practical step-by-step constructive liquidation process (suitable for workpapers) generally looks like this, consistent with Treas. Reg. § 1.752-2(b): (1) Identify each partnership liability and determine whether it is recourse “to the extent” a partner/related person bears EROL (with any remainder treated as nonrecourse under the broader § 752 regime). (2) Inventory all payment obligations relevant to the liability (guarantees, indemnities, contribution obligations, DROs, state-law obligations, etc.). (3) Apply the constructive liquidation assumptions: value assets at zero (subject to the regulation’s special handling where the creditor’s recourse is limited solely to specific assets), deem a taxable disposition, and deem liquidation of the partnership. (4) Compute who would have to pay the creditor (or contribute to the partnership) and in what amount after taking into account the waterfall, capital account maintenance and liquidation principles, and any reimbursement/indemnity chains. (5) Test recognition of each obligation under the regulations’ “obligations recognized” standard—only recognized payment obligations count for EROL allocation. (6) Allocate the recourse liability accordingly and document how the resulting § 752 allocations tie to outside basis movements under IRC § 752(a)/(b).

The most common—and costly—pitfall is assuming that a guarantee automatically means the guarantor is allocated the recourse debt. The regulations expressly require a determination of the extent of the payment obligation that is recognized and would actually be triggered in the constructive liquidation, considering all facts and circumstances and related contractual/statutory arrangements. In practice, a guarantee may be weakened or neutralized by (i) reimbursement rights against the partnership or other partners, (ii) indemnities running in the opposite direction, (iii) caps, limitations, or conditionality that make the obligation not meaningfully “at risk,” or (iv) capital account/704(b) mechanics that would shift the economic burden elsewhere upon liquidation. The constructive liquidation model is exactly what prevents a superficial “guarantee = allocation” shortcut from producing an allocation that does not reflect real EROL.

A second set of pitfalls arises from workpaper incompleteness: failing to capture all obligations and their interaction (particularly tiered indemnities, side agreements, or state-law contribution obligations), and failing to reconcile the analysis to the partnership’s liquidation economics and the capital account maintenance regime. Another recurring error is treating the entire liability as recourse simply because some partner bears some EROL; the rules are explicitly “to the extent” allocations, which matters when only a portion of the debt is effectively backstopped. Finally, many teams under-document the “obligations recognized” analysis; if you cannot support why an obligation should be respected as a meaningful payment obligation in the hypothetical liquidation, you are effectively building a § 752 allocation on sand.

The danger of getting this wrong is not academic. Section 752 allocations drive outside basis, which directly affects (i) loss utilization limitations, (ii) taxability of distributions, and (iii) gain/loss on disposition; an incorrect “guarantee-driven” recourse allocation can inflate basis and enable loss claims or tax-free cash distributions that do not hold up on examination, while the reverse can trigger unexpected gain when liabilities are reallocated away. A constructive liquidation approach—done rigorously and documented—creates a defensible bridge between legal form and economic substance, and it is the most reliable way to avoid the false comfort of “there’s a guarantee, so the debt is allocated.” If you want, I can also provide a one-page checklist/workpaper template that aligns each step above to the specific reg paragraph citations and the typical document requests needed to support the conclusion.