THE IRS REVERSES ITS PRIOR TROUBLESOME RULING
REGARDING ALLOCATION OF NONRECOURSE DEBT
Implicitly overruling its conclusion in memorandum 201606027 dated February 7, 2016 (the "Prior Memorandum") on March 31, 2016, the Internal Revenue Service (the "Service") Office of Chief Counsel released memorandum 2016-001 (the "Memorandum") which concludes that nonrecourse debt for which a taxpayer has provided a customary "bad boy" carve-out guaranty will not be treated as recourse debt for purposes of allocating the debt among the partners' basis and at-risk amounts. As this conclusion is consistent with established practice involving commercial real property lending transactions, the Memorandum would not be of significance except for the fact that it reverses the Service's conclusion in the Prior Memorandum, even though the Memorandum does not mention the Prior Memorandum. See our article on the Prior Memorandum in the April, 2016 issue of Relating to Real Estate.
Unlike the Memorandum, the Prior Memorandum stated that a bad boy guaranty would cause a nonrecourse debt to be treated, for federal income tax purposes, as a recourse debt with respect to the taxpayer providing the bad boy guaranty. This means that the entire amount of the debt would be included in the basis and at-risk amount of the guarantor, with no increase to the basis and at-risk amounts of the other members. The position taken in the Prior Memorandum has been widely criticized in the tax community because it appeared to be contrary to generally-accepted practice regarding the tax treatment of nonrecourse debt subject to a bad boy guaranty. The Memorandum, therefore, will be appreciated by tax practitioners because it should erase the uncertainty created by the Prior Memorandum and confirm established practice involving commercial real property lending transactions.
Real estate acquisitions are often structured with one or more syndicators or active managers ("Manager") and multiple less-active or passive investors ("Investors"). In many such arrangements, a portion of the equity needed is provided by the Investors, and the Manager receives an ownership interest without funding its pro rata share of the investment. The remaining capital required is raised through financing. This financing is often done through a non-recourse loan.
The lender making the loan will typically require that the Manager sign a bad boy guaranty that will make the Manager liable in the event of certain scenarios, which may include the following examples, or others: (1) the borrower fails to obtain the lender's consent before obtaining subordinate financing, or transfer of the secured property, (2) the borrower files a voluntary bankruptcy petition, (3) a Manager files an involuntary bankruptcy petition against the borrower, (4) a Manager solicits other creditors to file an involuntary bankruptcy petition against the borrower, (5) a Manager consents to an involuntary bankruptcy, (6) a Manager consents to the appointment of a receiver or custodian of assets, or (7) a Manager makes an assignment for the benefit of creditors or admits in writing that it is insolvent or unable to pay its debts as they come due.
One of the benefits of using a partnership, or an LLC treated as a partnership, for a real estate venture is the ability of the partners to increase the basis in their partnership interest in an amount equal to their allocable share of the nonrecourse debt, which is debt for which no partner bears the economic risk of loss. Nonrecourse debt is generally allocated among the partners in accordance with their interests in the entity's profits. On the other hand, recourse debt, which is debt for which a partner bears the economic risk of loss, is allocated solely to the partner who bears such economic risk of loss. Thus, the distinction between recourse debt and nonrecourse debt is critical in determining the basis of a partner's interest in a partnership. If an LLC is used and it is treated as a partnership for tax purposes, the discussion of partners in a partnership in this article relates to members in the LLC.
The distinction is also critical in determining a partner's at-risk amount in a partnership, which is another hurdle that must be overcome before a partner can utilize an allocable share of partnership losses. A partner's at-risk amount is increased for that partner's share of "qualified nonrecourse financing," which is defined to mean debt incurred in the activity of holding real estate from a lender in the business of lending money, for which no partner bears the economic risk of loss. Thus, debt that would otherwise be considered as qualified nonrecourse financing will not be treated as such if a partner bears the economic risk of loss with respect to the debt.
Partnership nonrecourse debt can become recourse debt with respect to a partner if that partner provides a personal guaranty with respect to the debt. Treasury Regulation Section 1.752-2(b)(4) (the "Regulation"), however, states that a payment obligation will be disregarded if, taking into account all the facts and circumstances, the payment obligation is subject to contingencies that make it unlikely that the partner will ever have to make the payment. Additionally, the Regulation states that if a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs. In other words, even though a partner signs a personal guaranty with respect to nonrecourse debt, for purposes of allocating the debt among the partners, the personal guaranty will not transform the nonrecourse debt into recourse debt for the guaranteeing partner if the facts indicate that it is unlikely that the guaranteeing partner will ever have to make a payment under the guaranty, or until such event occurs. If for the foregoing reasons the debt is not converted into recourse debt for the guaranteeing partner notwithstanding the personal guaranty, the entire amount of the debt will be treated, for income tax purposes, as nonrecourse debt, generally allocable to all of the partners.
Most tax practitioners have historically taken the position that bad boy guaranties do not cause the nonrecourse debt to be converted into recourse debt for purposes of the rules discussed above. Relying on the Regulation, the general view has been that bad boy guaranties are disregarded for tax purposes because the payment obligation is subject to contingencies that will make it unlikely that the partner will ever have to pay under the guaranty. The only way the payment obligation would typically arise is if the guaranteeing partner allows the partnership to engage in one of the bad boy actions. Because the Manager controls the partnership, and allowing the partnership to take such action would trigger personal liability for the guaranteeing partner, it is generally viewed as unlikely that the guaranteeing partner would allow the partnership to engage in one of the prohibited acts. As such, it is unlikely that the guaranteeing partner would ever actually pay under the guaranty. Thus, notwithstanding a bad boy guaranty, the debt was traditionally treated as nonrecourse debt which generally is allocable to all of the partners.
Despite the traditional practice described above, the Prior Memorandum determined that the conditions that would trigger liability under a typical bad boy guaranty were not so remote as to constitute "contingencies" under the Regulation, thus causing the nonrecourse debt to be recourse debt with respect to the guarantor. This would result in the entire amount of the debt being allocated entirely to the guarantor for basis and at-risk purposes. Fortunately, the Service issued the Memorandum which reverses the troublesome conclusion of the Prior Memorandum.
In the Memorandum, the Service observed that the fundamental business purpose behind a bad boy guaranty is to prevent actions by the borrower or the guarantor that would make satisfaction of the debt more difficult. Further, because it is in the economic self-interest of the guarantor to avoid allowing the borrower to commit such bad acts and, thus, subjecting the guarantor to personal liability, the guarantor is very unlikely to voluntarily commit such bad acts. After noting such fundamental business purpose, the Service then concluded that the provisions of a bad boy guaranty should be interpreted, for partnership tax purposes, consistent with such purpose. Consequently, because it is not in the economic interest of the guarantor to allow the borrower to commit the bad acts described in a typical bad boy guaranty, the payment obligation under a typical bad boy guaranty should be viewed as a contingency and, therefore, disregarded under the Regulation until such time as the contingency actually occurs.
Neither the Prior Memorandum nor the Memorandum may be used or cited as precedent, but the release of the Memorandum should quell any anxiety caused by the strange conclusion of the Prior Memorandum. For questions, please contact Doug Coats (410-576-4002) or Jeff Spatz (410-576-4124).