In tax law (and, in fact, law in general) confusion may reign because words are often given a specific definition in a particular context—such as when dealing with a particular statute or regulation. That limited scope may exist even though an identical term is used in a very similar context—such as the same term having different (though somewhat related) meanings for two different provisions of the Internal Revenue Code.
In Chief Counsel Advice 201525010 the IRS looks at the issue of “nonrecourse debt” under the tax law and the fact that the term is used in two very different contexts.
- Whether a debt will be considered nonrecourse (and thus effectively part of the proceeds of a disposition of the property) for purposes of determining gain or loss on sale for foreclosed or similarly disposed of property for purposes of IRC §1011 or
- Whether a debt will be treated as a nonrecourse debt for purposes of the allocation of debt to basis in a partnership pursuant to IRC §752.
If the first question is answered in the affirmative and the lender cancels the debt at the time of or after the foreclosure-like event (quite often because there simply weren’t sufficient other assets available to satisfy the debt) then the taxpayer has cancellation of indebtedness income under IRC §61(a)(12), potentially excludable from income under §108.
The question posed in the memorandum to be answered by the National Office was simple, and one that practitioners may very well have run into during the real estate collapse in 2008 and avalanche of foreclosures of property held by partnerships in the years immediately following that collapse of the market:
For purposes of determining if a limited liability company taxed as a partnership has cancellation of debt income under § 61(a)(12) or gains from dealings in property under § 61(a)(3) upon foreclosure of its property, do the regulations under § 752 determine if the indebtedness is recourse or nonrecourse to the partnership?
And the simple answer is no—or, in slightly more detail:
The regulations under § 752 do not determine if a debt is recourse or nonrecourse to a partnership for purposes of determining whether, upon foreclosure of the property, the partnership has cancellation of debt income under § 61(a)(12) or gains from dealings in property under § 61(a)(3).
In the specific situation addressed in the situation an LLC, electing to be taxed as a partnership, had acquired real property secured by mortgages on the property. The LLC had no assets other than those related to the property. However the mortgages on the real estate were just standard mortgages and did not limit the lender to only taking back the secured property if the terms of the mortgage (such as making the payments) were not adhered to and the value of the property was less than the balance of the obligation outstanding at that time. However the members of the LLC gave guarantees on various of those notes.
The LLC ended up defaulting on the mortgages and gave up the property. The property was seized as part of a non-judicial foreclosure under state law and some note holders received nothing as they held junior obligations and the value of the property was insufficient to satisfy those holding the first lien positions. The lenders cancelled those debts.
The LLC reported cancellation of indebtedness income for these amounts and members of the LLC excluded a portion of this cancellation from their income pursuant to IRC §108(a)(1)(B), reducing tax attributes as provided for in IRC §108(b). But a portion of the cancelled debt exceeded the attributes available for reduction, resulting in a permanent tax benefit to those members.
The IRS agent questioned, when looking at the agreements, whether the debts might be nonrecourse debts. In that case the balance of the notes would have been added to the proceeds received from the foreclosure, either reducing the loss claimed or even creating or increasing a gain on disposition. In that situation §108 would not be applicable and no attribute reduction nor permanent tax benefit would arise.
The taxpayers were arguing that the question of whether the debt was recourse or nonrecourse must be decided solely based upon the regulations under §752. The members in question argued they had guaranteed the debts in question and had no right of reimbursement from any other party. Thus, they argued, they bore the economic risk of loss. Under the §752 regulations the debts were to be treated as recourse.
The National Office disagreed that §752’s answer was going to govern whether the debt was nonrecourse for purposes of triggering cancellation of debt and the resultant ability to exclude a portion that amount from income. So, the memorandum concluded, the taxpayers were in error in arguing that the analysis stopped once the §752 analysis of “recourse” vs. “nonrecourse” was complete.
However the memorandum did not conclude the debts were nonrecourse, specifically noting that the case that the agent appeared to wish to rely upon did not clearly support a finding that the facts in this case gave rise to a nonrecourse classification. In fact, the memorandum certainly implies that, to the extent the National Office has a feeling regarding which way the matter will be resolved in this case, it likely would be to still find the debts as recourse.
The case illustrates the importance of confirming how broad the definition is that you are using and the risk of assuming just because you “know” the rules that determine an item in one tax context, that those same rules apply in another. The general rule is that if there exists a specific definition applicable to a situation (as there does for debts under §1001 for determining if they are part of the sales proceeds) then that rule is going to apply even if the same term is defined elsewhere under the Code.
If a provision specific definition does not exist, things can get trickier. Sometimes the Court will “borrow” a definition from another provision if it appears reasonable to do so—but advisers must always check the case law to determine if this has been done or, more importantly, if there is case law distinguishing the use in the other section from the one the adviser is looking at.
If there exists no case law then things get more interesting—care must be taken to determine if “reusing” the definition appears reasonable. But if, as in this case, there already exists an alternative definition that is directly on point then, unless the adviser is resolving a clear ambiguity not addressed in the applicable definition that might be handled in the other provision, the adviser needs to apply the definition found that directly applies to the Code section involved.