Tax Treatment of “Bad Boy Guarantees” Challenged by Recent IRS Memorandum

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I. OVERVIEW -

A recently released legal memorandum by the Internal Revenue Service (IRS) Office of Chief Counsel, CCA 201606027 (the “Memorandum”), concluded that a so-called “bad boy guarantee” provided by a sponsor of a real estate partnership should cause an otherwise non-recourse financing to be treated as recourse for partnership tax purposes. This Memorandum has come as a surprise to many in the real estate community as taxpayers typically have treated otherwise non-recourse loans as non-recourse for basis and loss allocation purposes even if there was a bad boy guarantee, given the low risk that the events triggering the guarantee obligation would occur. Although the Memorandum is limited to its facts and is not precedential, it remains to be seen whether the Memorandum reflects a broader position by the IRS on the treatment of otherwise non-recourse loans subject to bad boy guarantees.

II. BACKGROUND -

Real estate partnerships and limited liability companies (LLCs) typically use a combination of equity and nonrecourse loans to finance the cost of acquiring and developing real estate. Under the terms of the non-recourse loans, lenders can only look to the property securing the borrowing, rather than the investors or sponsors, to satisfy defaults under the loans. To reduce their exposure, lenders often require a so-called “bad boy guarantee” from one or more partners (typically, the sponsor) of the partnership, which guarantee is only triggered upon the occurrence of certain stated conditions. These conditions typically consist of deliberate actions by the fund or the sponsors such as the filing of a voluntary bankruptcy petition. Since the sponsor generally has the ability to ensure that the partnership refrains from these actions, the conditions are rarely violated and bad boy guarantees are rarely triggered in practice.

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