Under the Section 752 regulations, partnership liabilities (including liabilities of LLCs that are taxed as partnerships) are allocated among the partners based on who bears the economic risk of loss.  If no partner is treated as bearing the economic risk of loss (i.e., would not have to come out of pocket to pay off partnership debts if the partnership property suddenly became worthless), then the liability is classified as non-recourse and is generally allocated among all the partners.  This allocation of liabilities is treated as a deemed cash contribution, increasing the partner’s basis in the partnership. 

In the attached memorandum, the IRS considered how bad boy guarantees impact the classification of a partnership liability, as recourse or nonrecourse.  Under the allocation rules, if an obligation to contribute money or satisfy a guarantee is considered too contingent or remote, it generally does not impact the allocation of the liabilities until the obligation is called upon.  Accordingly, the consensus in the tax community has been that bad boy guarantees do not result in a risk of loss, as the situations leading to the guarantee being called upon are too contingent and remote to come into play.  The liabilities subject to the bad boy guarantee are therefore typically classified as nonrecourse and allocated among all the partners.  In the memorandum, though, the IRS took a different position and said “certain contingencies such as the partnership admitting in writing that it is insolvent or unable to pay its debts when due, its voluntary bankruptcy, or its acquiescence in an involuntary bankruptcy, after taking into account all the facts and circumstances, are not so remote a possibility that it is unlikely the obligation will ever be discharged”.   More simply, the IRS’s position is that the bad boy guarantee should be taken into account from day one.  As a result, the guarantee causes the partnership liability to be classified as recourse and all the liability is allocated to the guarantor. 

Why does this reclassification matter?  A reallocation can have significant tax consequences, especially for partners in existing funds.  To the extent that a partner’s allocation of partnership liabilities is reduced, this reduction is treated as a cash distribution.  Thus, a reallocation of debt could result in many partners seeing their share of partnership liabilities being significantly reduced.  If the resulting deemed cash distribution exceeds the partners’ basis in the fund, the partners would have a taxable event to the extent of the excess.  In other words, this memorandum could suddenly result in large tax bills for many partners in existing funds. 

This memorandum is being highly criticized in the tax community, and most practitioners (including this one) feel that the decision is wrong. Nonetheless, this appears to be the IRS’s current position and must be taken seriously.  This is an issue that will have to be closely monitored, and anyone with bad boy guarantees in their structure need to be aware of this developing issue.

IRS Memorandum