In a recent IRS Memorandum from the Office of the Chief Counsel (ILM 201606027, the "Memorandum"), the IRS concluded that common "bad boy guarantees" may cause otherwise nonrecourse loans to be treated as recourse loans for tax purposes. Such treatment may prevent non-guarantor investors in real estate development and other partnerships from being allocated losses in excess of their invested capital that they otherwise would have expected and could, if retroactively applied, result in adverse tax consequences to such investors. 1
A partner's tax basis in a partnership interest includes the partner's share of partnership liabilities, and the partner's share of partnership losses includes its allocable share of deductions attributable to such liabilities.2 A partner's share of partnership liabilities for these purposes depends in large measure on whether the liabilities are treated as recourse (i.e., where one or more partners bear the economic risk of loss through a guaranty or otherwise) or nonrecourse for such purposes. Tax basis and losses attributable to recourse liabilities generally are allocated to the partners who bear the associated economic risk of loss, while such basis and losses attributable to nonrecourse liabilities generally are allocated among the partners in proportion to the partners' invested capital or interests in profits.
Example: X and Y contribute $9 million and $1 million, respectively, to a partnership. The partnership borrows an additional $40 million and acquires a depreciable asset for $50 million. If the liability is nonrecourse, then X typically would be allocated 90% of all partnership losses. However, if Y (and not X) is treated as bearing the economic risk of loss with respect to the liability, then X would be allocated 90% of the first $10 million of losses, but Y would be allocated all losses in excess of $10 million.
The Memorandum presents a possible change in the IRS's thinking about the impact of bad boy clauses on a loan's character as a nonrecourse liability. Under applicable regulations, if a partner's obligation is subject to contingencies that make it so unlikely that the obligation will ever be discharged, then the obligation is disregarded and the loan is effectively treated as nonrecourse debt. Historically, taxpayers have treated otherwise nonrecourse loans as nonrecourse for basis and loss allocation purposes even if there was a bad boy guarantee (e.g., guarantees typically given by a developer and certain others which provide for personal liability against the borrower, a guarantor or both upon the occurrence of certain enumerated "bad" acts). This was based on the view that the events creating liability under customary bad boy guarantees were contingent obligations that were so unlikely to occur that they should be disregarded when determining who bore the economic risk of loss.
In the Memorandum, the IRS disagrees with the view that certain customary bad boy events were "not so unlikely to occur" as to be disregarded. Therefore, the IRS concludes that the guaranteeing partner bore the risk of loss and should be allocated the entire basis from the debt.3 The events triggering recourse under the facts of the Memorandum were:
- "the co-borrowers fail to obtain the lender's consent before obtaining subordinate financing or transfer of the secured property,
- any co-borrower files a voluntary bankruptcy petition,
- any person in control of any co-borrower files an involuntary bankruptcy petition against a co-borrower,
- any person in control of any co-borrower solicits other creditors to file an involuntary bankruptcy petition against a co-borrower,
- any co-borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding,
- any person in control of any co-borrower consents to the appointment of a receiver or custodian of assets, or
- any co-borrower makes an assignment for the benefit of creditors, or admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due."
The Memorandum also concludes that the right of the guaranteeing partner to effectively seek reimbursement from the other partners is not sufficient to make the non-guaranteeing partners personally liable with respect to the obligation such that they would be deemed to bear some of the economic risk of loss with respect to the debt, because the other partners could have their ownership interests diluted in lieu of providing cash reimbursement to the guarantor partner and thus their contribution obligations were not fixed. However, if a reimbursement obligation of the non-guarantor partners is fixed and not optional (unlike the facts in the Memorandum, as interpreted by the IRS), then the liability should be treated as recourse to each partner to the extent of the reimbursement obligation.4
The Memorandum is an informal document which does not have the force of law and is not precedential. However, it may be reflective of the IRS's current position on this issue. The Memorandum has been highly criticized by the tax community, and we understand that members of the tax community have engaged the IRS in discussions on this matter. At this time, we expect that transactions will go forward as in the past as we await further guidance from the IRS. However anyone contemplating (or who already has) a structure with bad boy guarantees should be aware of this potential issue.
1 References to partnerships and their partners include limited liability companies (and other entities) treated as partnerships for tax purposes and their members.
2 Deductions generally are attributable to partnership liabilities to the extent of net losses in excess of the partners' invested capital.
3 The Memorandum's analysis was premised on accepting the taxpayer's contention that the guarantor would be liable for repayment only if one of the enumerated bad acts were to occur. However, the Memorandum notes that in its view the guarantor was liable for repayment in all events even if one of the enumerated events did not occur.
4 The IRS has issued proposed regulations that set forth certain net worth and other requirements for a guaranty or reimbursement obligation to be given effect in determining who bears the economic risk of loss..
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.