The IRS, deciding that discretion is the better part of valor, has backed off a position staked out related to “Bad Boy” provisions in non-recourse loan documents in a Chief Counsel Advice, effectively reversing its position in Generic Legal Advice AM 2016-001. Now the IRS believes that, generally, such provisions will not convert the debt from nonrecourse to recourse debt, a result that would torpedo the expected tax effects of many real estate partnerships.
Original IRS Memorandum
In the memorandum that triggered an ensuing panic in the real estate community, 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 conditions included “the partnership admitting in writing that it is insolvent or unable to pay its debts when due, or its voluntary bankruptcy or acquiescence in an involuntary bankruptcy.”
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.
While the memorandum doesn’t mention the alternative position, real estate advisers have generally viewed the sorts of triggers found in this agreement to be of the type described in Reg. §1.752-2(b)(4) where the guarantee “is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged. 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.” If that were the case, the debt would remain a nonrecourse debt, not be converted to recourse.
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 event 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.
Initial Fallout from the Memorandum
An article appearing in Tax Notes on February 17, 2016  notes that the guarantee provisions given to the lender, referred to as “Bad Boy” provisions, have been used regularly by lenders providing financing to real estate partnerships. While the document is merely an IRS memorandum (and thus had only the standing that a legal memorandum by an experienced tax attorney would generally have), if the analysis is correct it is possible that a lot of debt has been “misallocated” in real estate structures.
However, on February 23, Ossie Borosh, attorney-adviser, Treasury Office of Tax Legislative Counsel was quoted by Tax Notes  as indicating that the real problem the IRS attorney had in this case was with just one of the conditions (“"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”) and that “I don’t know that this was intended to change anything about how in general these sorts of carveouts are viewed.”
IRS Issues Memorandum Specifically “Blessing” Most Bad Boy Provisions
Of course, while assurances by an IRS official that we “really aren’t going after bad boy provisions in general” are welcome, it’s even less “official” than the CCA that was published—and there’s the troubling concern that the IRS might eventually decide that maybe that memo was correct.
So the IRS decided at the end of March to issue a memorandum effectively arriving at a conclusion contrary to that given in CCA 201606027. In AM 2016-001 the IRS decided that generally such provisions will not result in conversion of the debt to recourse.
This memorandum specifically mentions the following provisions as ones considered “normal” in nonrecourse real estate financing:
Sometimes guarantees of partnership nonrecourse obligations are conditioned upon the occurrence of one or more of the following "nonrecourse carve-out" events:
(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) any person in control of the borrower files an involuntary bankruptcy petition against the borrower;
(4) any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower;
(5) the borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding;
(6) any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or
(7) the 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 notes the reason such provisions are found in such notes:
We understand that including some form of one or more of these “nonrecourse carve-out” provisions in loan agreements is a fairly common practice throughout the commercial real estate finance industry and has been for many years. By including these provisions, the lender seeks to protect itself from the risk that the borrower or a guarantor in charge of the borrower will undertake "bad acts" that will diminish or impair the value of the property securing the loan, that might disrupt the cash flow from the property, or that could delay, complicate or prevent the lender’s repossession of the property in the event of a default. An important aspect of these nonrecourse carve-outs is that the bad acts that they seek to prevent are within the control of the borrower or guarantor -- the borrower or a guarantor in control of the borrower can prevent them from occurring by, for example, obtaining the lender’s consent before seeking subordinate financing, or not acquiescing in an involuntary petition for bankruptcy. Because it is in the economic self-interest of borrowers and guarantors to avoid committing those bad acts and subjecting themselves to liability, they are very unlikely to voluntarily commit such acts.
Thus, such terms generally do not convert the debt to recourse in the view of the memo since they are highly unlikely to be triggered since the party that would have to act to trigger them would be acting against their own interests.
But what about the specific provision that Ms. Borosh had mentioned was the specific concern in the original memorandum? This memorandum goes through an analysis to now decide that this most likely is not an issue.
The memorandum explains the original concern as follows:
One of the common, “nonrecourse carve-out” events, however, deserves further discussion because it could be interpreted to give the lender, at least in some unusual circumstances, the ability to cause the borrower or guarantor to commit one of the bad acts, i.e., to admit in writing or in any legal proceeding that the borrower is insolvent or unable to pay its debts as they come due. For example, upon a default by the borrower, a lender could bring suit for a deficiency and in the course of that litigation, or in a subsequent collection action, seek to force a written admission of insolvency in the course of discovery. Similarly, if the loan agreement required the borrower to provide the lender with periodic written financial reports, and those reports revealed that the borrower was insolvent, the lender might argue that those reports constituted a written admission of insolvency.
However, the memorandum then goes on to note that lenders who have attempted to pursue such a position in court have generally been unsuccessful in prevailing using this logic, specifically citing the decision in D.B. Zwirn Special Opportunities Fund, L.P. v. SCC Acquisitions, Inc., 902 N.Y.S.2d 93 (App.Div. 2010). The memorandum concludes that the logic found in that opinion should apply generally.
Thus the memorandum concludes:
Consequently, because it is not in the economic interest of the borrower or the guarantor to commit the bad acts described in the typical “nonrecourse carve-out” provisions, it is unlikely that the contingency (the bad act) will occur and the contingent payment obligation should be disregarded under § 1.752-2(b)(4). Therefore, unless the facts and circumstances indicate otherwise, a typical “nonrecourse carve-out” provision that allows the borrower or the guarantor to avoid committing the enumerated bad act will not cause an otherwise nonrecourse liability to be treated as recourse for purposes of section 752 and § 1.752-2(a) until such time as the contingency actually occurs.
Such debt would be allocated using the rules for allocating nonrecourse, not recourse, debt for purposes of treating it as part of basis for the partners. Assuming the debt met the other requirements to be treated as qualified nonrecourse debt under the at risk provisions of IRC §465(b)(6) such debt would both provide basis for the deduction of losses from the real estate and the loss deductions would not be blocked by the at risk rules.
 “'Bad Boy' Guarantee Memo May Upend Real Estate Loan Allocations”, Tax Notes, February 17, 2016, 2016 TNT 31-2
 “Seventh Carveout in ‘Bad Boy’ Guarantee Memo Stood Out”, Tax Notes, February 24, 2016, 2016 TNT 36-