Impact of Guarantees on Treatment of Partnership Debt Discussed in Memorandum

The IRS took a look at a number of issues related to liabilities and at-risk rules related to partnership interest in the Chief Counsel Advice 201606027.  The advice relates to a partnership that acquired existing hotels and renovated them, but did not operate the hotels.  One of the partners executed a guarantee on the otherwise nonrecourse debt that could be triggered if certain conditions were met. 

The partnership agreement also provided that, should the partner who signed the guarantee actually make a payment under the guarantee, that partner could make a call for non-guaranteeing partners to make capital contributions.  If a partner failed to make that payment, either the partners’ fractional interest in the partnership would be adjusted downward, the amount would be treated as a loan to those partners or enter into a subsequent allocation agreement under which the risk of guarantee would be shared among the partners.

As likely is clear to many readers, a number of questions come to mind regarding this partnership.  The memorandum looks at the following four questions:

  • Is the operation of the partnership’s acquisition and renovation of the hotels an “activity of holding real property” under §465(b)(6)(A) that would allow it to have “qualified nonrecourse debt” that would not be subject to the at-risk rules that would otherwise limit partners’ ability to claim losses on basis arising from that debt?
  • Does the guarantee by the one partner transform the debt in question from non-recourse debt to recourse debt under §752?
  • If the debt would be converted to recourse debt, does the right of the guarantor to issue a call for contributions under the terms provided give all of the partners economic risk of loss for purpose of allocating the debt under the recourse debt allocation rules?

The memo concludes that the activity in question does qualify as an “activity of holding real property” that would allow certain nonrecourse debts to be treated as qualified nonrecourse debts that sidestep the at risk rules that would normally be triggered by a nonrecourse debt.  Although the memorandum does not actually provide a detailed analysis of the why it comes to this conclusion, it certainly seems to make sense given the fact that the partnership does not actually operate the hotels.

However all that finding does is potentially allow partners to treat their allocation of qualified nonrecourse debt as not limited by the at-risk rules of §465.  But the other issues raise the question of whether, given the guarantee arrangement, the debt in question actually is nonrecourse debt.

What about the guarantee of the nonrecourse debt by the LLC member?  Generally if any partner has “economic risk of loss” with regard to a debt then the debt is considered a recourse rather than nonrecourse debt. 

The memorandum describes the application of the regulations regarding the existence of an “economic risk of loss” as follows:

Section 1.752-2(b)(1) provides generally that, except as otherwise provided, a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner.

The memorandum goes on to describe how it is determined if a partner has such an obligation to make a payment:

Section 1.752-2(b)(3) provides that the determination of the extent to which a partner or related person has an obligation to make a payment under § 1.752-2(b)(1) is based on the facts and circumstances at the time of the determination. All statutory and contractual obligations relating to the partnership liability are taken into account for these purposes, including (i) contractual obligations outside the partnership agreement such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or other partners, or to the partnership; (ii) obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership, and (iii) payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state law, including the governing state partnership statute. To the extent that the obligation of a partner to make a payment with respect to a partnership liability is not recognized under § 1.752-2(b)(3), § 1.752-2(b) is applied as if the obligation does not exist.

However, the memorandum notes that under Reg. §1.752-2(b)(4) a contingent liability to make payments is not considered if it either:

  • Is subject to contingencies that make it unlikely that the obligations will ever actually be discharged or
  • A payment obligation would not arise until the occurrence of a future event that is not determinable with reasonable certainty.

In the latter case, the obligation is not considered until such time as the event actually takes place.

The memorandum concludes that a bona fide guarantee given to a lender that is enforceable under local law generally will create an obligation that give rise to economic risk of loss.  As the memorandum notes:

As a threshold matter, a bona fide guarantee that is enforceable by the lender under local law generally will be sufficient to cause the guaranteeing partner to be treated as bearing the economic risk of loss for the guaranteed partnership liability for purposes of § 1.752-2(a). For purposes of § 1.752-2, we believe it is reasonable to assume that a third-party lender will take all permissible affirmative steps to enforce its rights under a guarantee if the primary obligor defaults or threatens to default on its obligations.

The memorandum goes on to conclude that when an LLC member guarantees the debt of the LLC, he/she becomes “like” a general partner in a limited partnership.  Unlike a limited partner who guarantees debt, this member has no recourse against a real general partner, but rather has to look to the assets of the LLC itself for any recovery of payments on the guarantee.

The memorandum therefore continues:

Therefore, in the case of an LLC treated as a partnership or disregarded entity for federal tax purposes, we conclude that an LLC member is at risk with respect to LLC debt guaranteed by such member, but only to the extent that

(1)  the guaranteeing member has no right of contribution or reimbursement from other guarantors,

(2)  the guaranteeing member is not otherwise protected against loss within the meaning of § 465(b)(4) with respect to the guaranteed amounts, and

(3)  the guarantee is bona fide and enforceable by creditors of the LLC under local law.

But this guarantee serves to remove the debt from treatment as qualified nonrecourse debt for the other LLC members.  As the memorandum continues:

Under § 465(b)(6)(B)(iii), a liability is qualified nonrecourse financing only if no person is personally liable for repayment.  When a member of an LLC treated as a partnership for federal tax purposes guarantees LLC qualified nonrecourse financing, the member becomes personally liable for that debt because the lender may seek to recover the amount of the debt from the personal assets of the guarantor. Because the guarantor is personally liable for the debt, the debt is no longer qualified nonrecourse financing as defined in § 465(b)(6)(B) and § 1.465-27(b)(1).

Further, because the creditor may proceed against the property of the LLC securing the debt, or against any other property of the guarantor member, the debt also fails to satisfy the requirement in § 1.465-27(b)(2)(i) that qualified nonrecourse financing must be secured only by real property used in the activity of holding real property.

The memorandum notes that if a guarantee was issued on a debt that was previously a qualified nonrecourse debt, the at-risk amounts for each of the members not part of the guarantee would be reduced, creating potentially a trigger of income recognition by the member. 

As well, the transaction would also raise issues with regard to basis, as the debt would effectively be reallocated to the member who provided the guarantee.

How about the capital call option should the guarantee be called upon?  Does that “save” the day by allowing a portion of the now recourse debt to be allocated to the other members?

This time the memorandum notes that this has to be considered based on the facts and circumstances, including economic realities.  As the memorandum notes:

We believe that Pritchett and Melvin stand for the proposition that the relevant inquiries when dealing with guarantees of partnership debt, for purposes of § 465, are whether the guarantee causes the guaranteeing partner to become the “payor of last resort in a worst case scenario” for the partnership debt, given the “economic realities” of the particular situation, and whether the guarantor possesses any “mandatory” rights to contribution, reimbursement, or subordination with respect to any other parties, as a result or consequence of paying on the guarantee, that would cause these other parties to be considered the “payors of last resort in a worst case scenario” with respect to that debt.

And, in this particular case, the memorandum concludes that in this case that test is not met.  As the memorandum notes:

We do not believe section 7.5(e) of the Operating Agreement imposes a mandatory payment obligation on A and B to make additional contributions to X if C is called upon to pay on C’s personal guarantees. Rather, section 7.5(e) permits C to call for additional capital from A and B, but if A and/or B chooses not to contribute additional capital, C’s remedies are limited to the remedies identified in paragraphs (i) and (ii) of that section. As a result, we do not believe the Operating Agreement gives C the right to bring an action against A and B to require them to contribute additional capital to X if they choose not to.  Further, because we believe C’s remedies are limited to paragraphs (i) and (ii) of section 7.5(e) if C calls for additional capital contributions from A and B if C is required to pay on C’s personal guarantee, we believe section 7.7 of the Operating Agreement is not applicable. In addition, because a separate contribution agreement was not entered into by the parties, section 7.9 is also inapplicable.

Accordingly, because neither remedy available to C under section 7.5(e) requires A or B to make additional contributions to X if C is called upon to pay on C’s personal guarantees, we conclude that A and B do not bear the ultimate economic risk of loss for the guaranteed debt of X for purposes of § 752.

What this case illustrates is the complexities that arise when dealing with LLC, debts and guarantees—risks that can be accidentally triggered when a client goes to renegotiate a debt or enter into a refinancing arrangement.  The potential to trigger an income even is very real—and it likely won’t be obvious to the client that this could be a result of their entering into a new or revised debt agreement, or just a separate guarantee that is given.