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Another relatively recent variance from the treatment of DREs as "tax nothings" can be found in the Section 752 regulations, which deal with the allocation of partner-level tax basis arising from partnership-level debt. Under these complex rules, partnership debt is generally allocated to the partner or partners, if any, that bear the ultimate "economic risk of loss" for the debt. For example, where a partnership debt is guaranteed by a partner, that partner generally would be allocated the debt's entire associated tax basis. In determining which partner bears the economic risk of loss, the rules provide a general assumption that a partner is financially able to perform under any guarantee agreement irrespective of the partner's actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. 54 As a result, tax planners were able to insert virtually valueless DREs as guarantors of partnership debt to secure the associated debt basis for use by the ultimate owners of the entities.

Final regulations published on 10/11/06 significantly modified this approach for all partners holding partnership interests through a DRE. 55 Under Reg. 1.752-2(k)(1), where a partner holds his partnership interest through a DRE, the DRE's obligations are taken into account when determining the partner's economic risk of loss for the partnership-level liability only to the extent of the net value of the DRE as of the date on which the partnership determines the partner's share of partnership liabilities. 56 In the event that one or more DREs have payment obligations with respect to one or more liabilities of a partnership, the partnership must allocate the net value of each DRE among the liabilities in a reasonable and consistent manner, taking into account the relative priorities of those liabilities. 57

This special treatment of DREs in this context has been criticized by some commentators in that it uniquely singles out DREs when, in fact, any pass-through entity that limits the liability of its owners can be used to accomplish similar results without a similar net value limitation. 58 Nonetheless, the special treatment exists and represents another danger in simply ignoring a DRE as nonexistent during the course of tax planning.

State Tax Treatment of DREs.

Despite the fact that almost every state generally respects the federal classification of an SMLLC as a DRE for income tax purposes, several states impose an entity-level tax or fee on LLCs, including SMLLCs. 59 The types of taxes or fees imposed, and the SMLLCs subject to the tax, vary widely from state-to-state. Practitioners should inquire into a state's entity-level tax on SMLLCs, and possibly other DREs, before proceeding with planning opportunities in that state.

Unlike the general conformity with federal law classification for income tax purposes, most states treat LLCs, including SMLLCs, as separate legal entities with respect to registration fees, sales and use taxes, employment taxes, and property taxes. As a result, LLCs are generally subject to liability for these taxes and fees. Additionally, most states require an SMLLC to file its own separate sales and use tax return, notwithstanding the fact that for state income tax purposes the SMLLC is disregarded. 60 On the other hand, many states allow an SMLLC and its owner to elect to file a consolidated sales and use tax return, if certain conditions are met. 61 Consequently, practitioners should analyze a DRE's tax and filing obligations state by state, so that they can fully apprise their clients of all potential taxes and fees a particular state may impose.

Grantor Trust Considerations

As mentioned briefly above, opinions differ as to whether a wholly grantor trust is considered a disregarded entity. In Rothstein, 62 the Second Circuit Court of Appeals implicitly held that a wholly grantor trust was not disregarded for all income tax purposes, because the grantor received a cost basis for assets purchased from the trust. In Rev. Rul. 85-13, 1985-1 CB 184,

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