The IRS Office of Chief Counsel recently released a memorandum (#AM2016-001) addressing the proper tax treatment of nonrecourse carve-outs (or bad boy guarantees) in the partnership context. According to the memorandum, such carve-outs will not cause the underlying debt to become recourse unless and until the triggering event actually occurs and the guaranteeing partner becomes personally liable for the debt.

Generally, all of a partner’s debt is included in his basis. However, basis limitation rules restrict how debt is allocated depending on whether the debt is recourse or nonrecourse. Nonrecourse debt is allocated in the same way that the partners are allocated profit. If the debt is recourse, the debt is allocated among the partners to the extent of each partner’s potential liability (i.e., to the extent a partner bears the economic risk of loss). Whether a partner bears the economic risk of loss is determined by analyzing whether, after the partnership constructively liquidated, the partner would be required to make a payment in respect of the subject liability. Treas. Reg. sec. 1.752-2(b)(1).  In making this analysis, a payment obligation is disregarded if it is subject to a contingency that is unlikely to occur. Treas. Reg. sec. 1.752-2(b)(4).

A partner may become personally liable for a partnership debt but only upon the occurrence of certain events. Some examples of these nonrecourse carve-out events include, among other things: (1) the partnership failing to obtain the lender’s consent before it obtains other financing or it transfers the underlying property; (2) the partnership filing or consenting to the filing of a petition in bankruptcy; (3) any person controlling the partnership filing or soliciting others to file an involuntary petition in bankruptcy; (4) any person controlling the partnership consenting to the appointment of a receiver; or (5) the partnership making an assignment for the benefit of its creditors or admitting in writing that the partnership is insolvent. These events also are known as “bad boy guarantees” because the occurrence of the events are within the control of the guarantor and occur only if the borrowing partnership takes action (or the guarantor causes the borrowing partnership to take action) that would diminish the partnership’s economic value.

There is very little law regarding the issue of when a springing personal guarantee causes an otherwise nonrecourse loan to become a recourse loan – i.e., whether the loan becomes a recourse loan only in the event that the triggering event occurs or whether the loan is deemed nonrecourse from the outset due to the taint of the personal guarantee. An old example from the Regulations provided that an otherwise nonrecourse loan would not be tainted if there was no reasonable certainty that the triggering event would occur. Accordingly, if the triggering event is uncertain to arise, the loan likely would be treated as qualified nonrecourse financing in its entirety.

According to the IRS, a debt would constitute a nonrecourse liability despite the existence of a bad boy guarantee unless and until one of the triggering events actually occurs and causes the subject to partner to become personally liable for the debt under local law. The IRS’ interpretation is based upon the notion that “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,” consequently, the contingency that would trigger a partner’s personal liability is unlikely to occur. The IRS further advised that this interpretation also would apply to the at-risk rules; i.e., debt will continue to be treated as qualified nonrecourse financing unless and until one of the triggering events actually occurs and causes the subject to partner to become personally liable for the debt under local law.

Real estate professionals should be aware of this guidance as nonrecourse carve-outs or bad boy guarantees often are employed in commercial real estate financing transactions. Although the IRS guidance specifically provides that it cannot be used or cited as precedent, the memorandum provides an indication of the current position of the IRS with regards to these issues.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.

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