• Bad Boy (Guaranties), What You Gonna Do?
  • April 13, 2016 | Authors: Douglas Turner Coats; Y. Jeffrey Spatz
  • Law Firm: Gordon Feinblatt LLC - Baltimore Office
  • THE IRS APPEARS TO CHANGE ESTABLISHED PRACTICE REGARDING ALLOCATION OF NONRECOURSE DEBT

    On February 5, 2016, the Internal Revenue Service (the “Service”) Office of Chief Counsel released memorandum 201606027 (the “Memorandum”) which appears to be contrary to the generally-accepted view that nonrecourse debt will be allocated among all partners of a partnership, or members of a limited liability company (“LLC”) that is treated as a partnership for tax purposes, in accordance with their profit-sharing percentages, even if the manager or key-principal gives a “bad boy” carve out guaranty.

    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 investing 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. Recourse debt, which is debt for which a partner bears the economic risk of loss, on the other hand, 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 his allocable share of partnership losses. A partner’s at-risk amount is increased for his 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. In such a case, 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.

    Pursuant to the Memorandum, the Service appears to disagree with the generally-accepted position stated above. In the Memorandum, an LLC (taxed as a partnership) obtained nonrecourse financing for which a member provided what appears to be a customary bad boy guaranty. The Service addressed the issue of whether the guaranty would cause the nonrecourse debt to become recourse debt, thus preventing the other members from including any share of the debt in their basis or at-risk amounts.

    The Service determined that because the guaranty would be enforced by the lender if the borrower defaulted or threatened to default, the “conditions” were not so remote, and, thus, it was sufficient to cause the entire debt to be recourse debt, which would be allocable entirely to the guaranteeing member for basis and at-risk purposes. In making its determination, the Service concluded that the conditions which would trigger payment under the bad boy guaranty did not constitute “contingencies” as intended by the Regulation. Such a conclusion is contrary to established practice involving real property commercial lending transactions, and, thus, the Service’s position in the Memorandum is troublesome.

    One of the puzzling aspects of the Memorandum is the Service’s statement that the bad boy events should not be properly viewed as conditions precedent that must occur before the lender is entitled to seek repayment from the guaranteeing member. The Memorandum further states in footnote 2 that a failure of the borrowing LLC to repay the loan, “by itself,” likely would be sufficient to trigger a payment obligation under the bad boy guaranty. If a payment default by the LLC (without any bad act by the guaranteeing member) is all that is necessary to trigger a payment under the bad boy guaranty, then perhaps the loan documents in the Memorandum do not represent customary terms regarding bad boy guarantees under real property commercial lending transactions. In other words, one possible way to interpret what would otherwise appear to be a position inconsistent with well-established practice would be that the loan documents examined by the Service do not contain customary bad boy guaranty provisions. If this is the case, then perhaps the Memorandum’s holding is not so troublesome. The Memorandum does not contain a copy of the loan documents and, therefore, it is difficult to make such an interpretation.

    It is also interesting to note that the Memorandum lists the seven triggers for liability under the guaranty, which are also listed in the second paragraph of this article, and yet that list does not include a failure of the borrowing LLC to repay the note. However, as stated above, the Memorandum concludes that a failure of the borrowing LLC to repay the loan, “by itself,” would likely trigger liability under the guaranty. Thus, another possible interpretation for the Memorandum would be a misunderstanding of the circumstances that would trigger the bad boy guaranty provisions examined by the Service.

    The Memorandum may not be used or cited as precedent, but its conclusion is perplexing as it seems to run contrary to generally-accepted practice. The Memorandum is being highly criticized in the tax community, and many practitioners feel that its conclusion is wrong. We will continue to monitor this issue. Any real estate professional entering into a non-recourse financing with some, but not all, partners or members signing a “bad boy” guaranty should consult with tax and legal advisors to structure their entity with this issue in mind.