The IRS has noted that including "bad boy" provisions in loan agreements is a common practice to protect the lender in the commercial real estate finance industry. (Bad boy provisions typically provide that liability for a nonrecourse loan will become recourse if the borrower engages in any of a number of "bad" acts, such as declaring bankruptcy.) If a partner's guarantee is triggered on the occurrence of certain nonrecourse carve-out events, the guarantee will not cause the obligation to fail to qualify as a nonrecourse liability of the partnership under Sec. 752 or as qualified nonrecourse financing for purposes of Sec. 465(b)(6), until one of the carve-out events actually occurs and causes the partner-guarantor to become personally liable for the partnership debt under local law. To better understand this clarification in Associate Chief Counsel Legal Advice AM 2016-001, it is necessary to take a look at the different types of liabilities.
Recourse liabilities may cause the partner to bear the economic risk of loss for the liability. This economic risk of loss exists only if any partner or any person related to a partner would be obligated to pay the creditor or make a partnership contribution upon a constructive liquidation of the partnership under certain circumstances. Recourse liabilities generally provide basis for partnership distributions and for at-risk rules.
Nonrecourse liabilities are those liabilities where only the creditor bears the economic risk of loss and, according to Sec. 752, are those partnership liabilities for which no partner bears the economic risk of loss. The most prevalent type of nonrecourse liability is a loan against which property is pledged as security for repayment and for which the lender's only remedy in the event of a default is to foreclose on the property. Nonrecourse liabilities may provide basis for partnership distributions, but they generally do not provide basis for the at-risk rules.
Qualified nonrecourse financing generally includes financing for which no one is personally liable for repayment, that is borrowed for use in an activity of holding real property, and that is loaned or guaranteed by a federal, state, or local government or is borrowed from a "qualified" person. Qualified nonrecourse financing secured by real property used in an activity of holding real property that is subject to the at-risk rules is treated as an amount at risk. Qualified persons include any person actively and regularly engaged in the business of lending money, such as a bank or savings and loan association.
While the Sec. 752 rules provide that a partner's share of partnership nonrecourse debt adds to that partner's basis in the partnership interest, a partner's share of nonrecourse debt generally does not generate basis for purposes of the Sec. 465 at-risk rules. Qualified nonrecourse financing secured by real property used in an activity of holding real property that is subject to the at-risk rules is treated as an amount at risk.
In the context of partnerships, the at-risk rules apply at the individual partner level. Not all partners, however, are subject to the rules. Determinations concerning partnership assets, investments, transactions, and the nature of liabilities that are necessary to determine the amounts at risk in an activity are made at the partnership level. Losses in excess of a partner's amount at risk are suspended and carried forward until the at-risk amount is increased. These suspended losses can be carried forward indefinitely. Unlike their treatment under the basis rules of Sec. 704(d), suspended losses may be used to offset any gain on the sale of a partnership interest (Prop. Regs. Sec. 1.465-66).
Sec. 465(b)(4) states that a taxpayer shall not be considered at risk for amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or other similar arrangements. The reference to "guarantees" should be put in a broader context of subsequent court decisions, although it should be noted that the IRS's position continues to be that set forth in Prop. Regs. Sec. 1.465-6(d): Guarantees do not increase at-risk basis until the taxpayer actually pays the guaranteed debt and has no right to reimbursement. The regulation states:
If a taxpayer guarantees repayment of an amount borrowed by another person (primary obligor) for use in an activity, the guarantee shall not increase the taxpayer's amount at risk. If the taxpayer repays to the creditor the amount borrowed by the primary obligor, the taxpayer's amount at risk shall be increased at such time as the taxpayer has no remaining legal rights against the primary obligor.
In a 1983 decision (Brand,81 T.C. 821 (1983)), the Tax Court held that the partners were not at risk for the amount of the partnerships' loans they guaranteed and could therefore not deduct losses in excess of their capital contributions. The court stated that "since a guarantor is entitled to reimbursement from the primary obligor, it is clear that Congress did not intend that a guarantor of a loan is personally liable for repayment of the loan within the meaning of [Sec.] 465(b)(2)(A)."
In considering at-risk issues, practitioners should always evaluate the substance of the transaction, bearing in mind that the at-risk rules were designed to prevent a taxpayer from deducting losses in excess of its actual economic stake in an activity.
In conclusion, the IRS in AM 2016-001 reversed prior guidance that treated a partner's guarantee of partnership nonrecourse debt as a noncontingent obligation that required treatment of the nonrecourse debt as recourse debt and that entitled the guarantor to basis in the partnership for the entire debt. The new guidance concludes that if the guarantee was conditioned on certain nonrecourse carve-out events that were unlikely to happen, the guarantee would not cause the debt to be treated as recourse debt under Sec. 752, unless and until the contingency actually occurs. For the same reasons, the IRS concluded that the contingent guarantees did not cause the guarantor to be at risk for the debt under Sec. 465.
Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.