The IRS Office of Chief Counsel recently released legal memorandum 201606027 (the “IRS Memorandum” or “Memorandum”) that calls into question two fundamental and well-established aspects concerning the tax treatment of investors in real estate limited partnerships and limited liability companies that utilize non-recourse financing. The Memorandum concludes that a customary carve-out “bad boy” guarantee given by an LLC member in connection with the LLC’s real estate non-recourse financing was sufficient to cause the financing (a) to constitute a “recourse” liability for purposes of determining the members’ tax basis in the LLC and (b) to fail to be a “qualified non-recourse financing” under the at-risk investment rules. As a consequence, the non-guaranteeing members of the LLC were deprived of the necessary tax basis and at-risk investment to claim losses from the LLC in excess of their capital contributions. If this position becomes established law, real estate investors would have to recapture billions of dollars in losses from previous years and could not share in losses in excess of their equity capital going forward.
Background
To claim tax losses from a partnership (including an LLC taxed as a partnership), a partner must have sufficient tax basis and “at-risk” investment in his partnership interest. In a typical real estate partnership, a partner’s tax basis and at-risk investment is derived from his equity contribution plus his share of partnership “recourse” liabilities and his share of “non-recourse” liabilities (in the case of computing tax basis) and his share of “qualified non-recourse financing” (in the case of computing at-risk investment). Recourse liabilities are those for which a partner bears the economic risk of loss, whereas non-recourse liabilities are those for which no partner bears the economic risk of loss. Likewise, a qualified non-recourse financing is a financing meeting certain conditions, including that no partner has personal liability for its repayment. Recourse liabilities are allocated only to the partner who bears the risk of loss with respect to the liability, while non-recourse liabilities and qualified non-recourse financings are generally allocated among the partners in accordance with the manner in which they share partnership profits.
For purposes of determining whether a partner bears the economic risk of loss with respect to a partnership liability under the tax basis rules of Section 752 of the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury Regulations thereunder, all statutory and contractual obligations relating to the liability are taken into account, including, for example, a partner guarantee of partnership debt. However, a guarantee obligation will be 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.” Treas. Reg. § 1.752-2(b)(4) (emphasis added). Further, if an “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.” Treas. Reg. § 1.752-2(b)(4). Until the release of the IRS Memorandum, it was widely believed that a carve-out bad boy guarantee was a “contingent liability” and should be disregarded for purposes of determining whether the guarantor bore the economic risk of loss for the underlying debt because in practice it is unlikely that the guarantee would ever be triggered.[1]
Most real estate partnerships use a combination of equity and non-recourse financing to fund their real estate acquisition and/or development activities. In this context, non-recourse financing means the lender will look only to the assets of the partnership and not to the partners to repay the loan, except that the lender often requires the sponsoring or managing partner to give a so-called “bad boy” guarantee. A bad boy guarantee is triggered only upon the occurrence of certain events that would jeopardize the lender’s ability to be repaid from the partnership’s assets and that are within the control of the sponsoring or managing partner. Bad boy events often include the partnership’s voluntary bankruptcy filing, the managing partner’s filing of an involuntary bankruptcy petition against the partnership, etc. In practice, bad boy guarantees are rarely triggered because the trigger events are within the control of the party providing the guarantee, and it generally would make no sense for the guarantor to voluntarily expose himself to full liability on the loan.
IRS Memorandum 201606027
Facts
The IRS Memorandum dealt with the following summarized facts. An LLC, treated as a partnership for tax purposes, and its subsidiaries borrowed funds from a lender on a non-recourse basis to support their real estate activities. One of the LLC’s members (the “NRG Member”) provided a customary carve-out or “bad boy” guaranty, obligating him to repay the loan in full if the LLC failed to obtain the lender’s consent before obtaining subordinate financing or transferring the secured property, if the LLC filed a voluntary bankruptcy petition, or if the NRG Member colluded or cooperated in an involuntary bankruptcy petition of the LLC.
Analysis of IRS Memorandum 201606027
The Memorandum is dated October 23, 2015 and was released by the IRS on February 5, 2016. It was authored by the IRS Office of Chief Counsel. The Memorandum ignored customary real estate industry practice and concluded that for purposes of allocating partnership tax basis among the LLC’s members, the NRG Member’s guarantee caused the LLC’s financing to constitute a recourse liability under Section 752 of the Code, thereby requiring the liability to be allocated entirely to the NRG Member and therefore depriving the LLC’s other members of any share of the liability in computing their tax basis in the LLC. The IRS Memorandum also concluded that the NRG Member’s guarantee caused the LLC’s financing not to constitute a “qualified non-recourse financing.”
In reaching its conclusion that the LLC’s financing constituted a recourse liability under Section 752, the Chief Counsel reasoned that the mere enforceability of a guarantee under local law is generally sufficient to cause the guarantor to be treated as bearing the risk of loss for the guaranteed liability and that because the NRG Member could potentially be called upon to discharge his guarantee obligations before an actual payment default by the LLC, the trigger events contained in the guarantee were not “conditions precedent” that had to occur before the lender was entitled to seek repayment from the NRG Member.[2] While it may be true that a trigger event under the guarantee could occur, and thus the NRG Member’s payment obligation likewise triggered, before an actual payment default by the LLC, it is difficult to see how the trigger events should not be viewed as conditions precedent to the NRG Member’s payment obligations because in the absence of the occurrence of any trigger event, the NRG Member would not be obligated to make a payment, and the NRG Member had every incentive not to cause a trigger event since by doing so he would voluntarily expose himself to full personal liability on a troubled loan. The Chief Counsel attempts to bolster its position by arguing that even under Section 1.752-2(b)(4) of the Treasury Regulations (dealing with contingent obligations), the trigger events do not constitute “contingencies” that would make the NRG Member’s payment obligation unlikely to occur.[3] It fails, however, to address the second part of that regulation, which requires a contingent payment obligation to be disregarded if it would only arise at a future time after the occurrence of an event that is not determinable with “reasonable certainty.”[4] Given that carve-out bad boy guarantees, including the one at issue in the IRS Memorandum are triggered, if at all, only upon the occurrence of specified future events, which industry experience reveals rarely occur, it is unclear why further analysis was not given to this provision. For example, voluntary bankruptcies and collusive involuntary bankruptcies almost never occur because of a guarantor’s full recourse liability under standard carve-out guarantees.
In reaching its conclusion that the LLC’s financing did not constitute a “qualified non-recourse financing” under the at-risk rules of Section 465 of the Code, the Chief Counsel stated:
“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 . . . [and] the debt is no longer qualified nonrecourse financing . . . It should be noted that this conclusion generally will not be affected by a determination that the guarantee is a ‘contingent’ liability within the meaning of section 1.752-2(b)(4). Instead, the question is simply whether the guarantee is sufficient to cause the guarantor to be considered personally liable for repayment of the debt, based on all the facts and circumstances . . .”
Observations
Although the IRS Memorandum reflects a significant departure from the industry-wide practice with respect to the tax treatment afforded investors in real estate limited partnerships and limited liability companies, it should be recognized that the Memorandum is not precedential authority and cannot be relied upon by the IRS in other cases. With that said, however, it was released by the National Office of the Chief Counsel, so it may signal that the IRS intends to take a more aggressive approach in its treatment of carve-out bad boy guarantees. It will be important to track this development to see whether the IRS releases any further guidance supporting this position, or retreats in light of what is likely to be vocal opposition from the real estate industry. Speaking at a conference on February 23rd, an attorney-advisor for the Treasury Office of the Tax Legislative Counsel stressed that the Memorandum was limited to the particular taxpayer to whom it was issued and said that it was her understanding that the IRS focus in the Memorandum may have been on the specific carve-out exception relating to assignments made for the benefit of creditors or admitting to insolvency or inability to pay debts as they become due, although the Memorandum did not focus its analysis on this carve-out.
If the IRS does not withdraw or clarify the Memorandum, real estate investors will face uncertainty that goes to the heart of the economics of many investments. Investors could ignore the Memorandum on the theory that it is illogical, contrary to standard practice in the real estate financing market and unlikely to be sustained by the courts. They could also pressure lenders to forego carve-out guarantees, but that might be difficult since lenders also consider such guarantees to be standard industry practice. They could consider structuring guarantees that are arguably distinguishable from the IRS Memorandum, such as obtaining a guaranty from a non-member manager that has no interest in partnership or LLC profit and loss, although since such a manager is likely to be an affiliate of a transaction party, this approach might be vulnerable. Or they could attempt to structure carve-out guarantees as being limited to the actual loss incurred by the lender resulting from the trigger event, rather than full recourse on the loan, which might result in only a portion of the loan being treated as a recourse liability. Negotiating such a position, however, is unlikely to be successful, as lenders will insist on full recourse liability with respect to SPV violations, voluntary and collusive involuntary bankruptcy filings, and impermissible transfers and encumbrances of the secured property.
We will continue to track any developments relating to IRS Memorandum 201606027, including any further advancement or retreat by the IRS with respect to the conclusions reached in the Memorandum, and will circulate periodic updates to this Client Advisory as necessary.
Circular 230 Notice: Pursuant to Treasury Regulations, any U.S. federal tax advice contained in this communication is not intended and cannot be used for the purpose of avoiding tax-related penalties.
[1] See, e.g., McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, 4th Edition, Volume 1, p. 8-12 (“For example, an otherwise nonrecourse real estate loan is not transmuted into a recourse debt with respect to which the partners bear the economic risk of loss simply because they agree to pay the loan if the partnership . . . makes a voluntary bankruptcy filing.”).
[2] This reasoning appears to run counter to the conclusion reached in Example 8 of Section 1.752-2(f) of the Treasury Regulations, where a general partnership (and its general partners) agreed with the lender that an otherwise non-recourse loan to the partnership would become recourse (and thus an obligation of the general partners) if the partnership failed “properly to maintain” the property financed with the loan. The Example concludes that because there was no “reasonable certainty” that the partnership and its partners would have any liability resulting from the partnership’s failure to maintain the property, no partner bore the economic risk of loss with respect to the loan and the loan was therefore a non-recourse liability.
[3] The Chief Counsel points to Section 1.752-2(b)(1) of the Treasury Regulations, which sets forth the framework for determining generally whether a partner bears the economic risk of loss for a liability by asking whether if, following a hypothetical liquidation of the partnership, the partner would be obligated to make a payment to any person because that payment becomes due and payable and the partner would not be entitled to reimbursement from another partner. The Chief Counsel reasoned that under a hypothetical liquidation of the LLC, it would be more likely than not that one or more of the trigger events would occur. According to the Chief Counsel, therefore, the trigger events do not constitute contingencies under Section 1.752-2(b)(4).
[4] The IRS also suggests that the language of the guarantee would require the guarantor to satisfy its payment obligation merely upon a payment default by the partnership, without regard to whether any of the trigger events in the guarantee had occurred, perhaps puzzled over language in the agreement that described the guarantor as a “primary obligor.” See Footnote 2 of the IRS Memorandum.
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