Violating Certain “Bad Boy” Guarantees Can Trigger Recourse Liabilities

Editor: Howard Wagner, CPA

The bad-boy guarantee is a typical arrangement in real estate loans. When a borrower takes a nonrecourse loan to purchase real estate, the lender can foreclose only on the real estate; it cannot go after the borrower. To reduce risk for the lender, these arrangements often contain a bad-boy guarantee.

The bad-boy guarantee is a promise by the borrower not to violate certain conditions, such as fraud and items related to bankruptcy. If the bad-boy guarantee is violated, the lender can go after the guarantor, meaning the loan becomes recourse. The question remains, however, whether a bad-boy guarantee changes the otherwise nonrecourse liability (shared by all partners) to a recourse liability (allocated to only the guarantor).

Sec. 752(a) provides that any increase in a partner’s share of the liabilities of a partnership is considered a contribution of money by the partner to the partnership. Regs. Sec. 1.752-2 provides that a partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability.

Under Sec. 465(b)(6), notwithstanding any other provision of the Internal Revenue Code or regulations, a taxpayer engaged in the activity of holding real property is considered at risk with respect to the taxpayer’s share of any qualified nonrecourse financing that is secured by real property used in the activity. Qualified nonrecourse financing means any financing that is not convertible debt that is borrowed from a qualified person or federal, state, or local government or instrumentality, or is guaranteed by any federal, state, or local government with respect to the activity of holding real property and with respect to which no person is personally liable for repayment.

CCA 201606027

IRS Chief Counsel Advice (CCA) 201606027, released Feb. 5, 2016, concluded that a bad-boy guarantee could cause a nonrecourse real estate loan to be treated as recourse.

In the CCA, a managing member of a real estate partnership made bad-boy guarantees to a third-party lender when obtaining financing for property renovations and operations. In the CCA, the IRS determined that this guarantee was sufficient to treat the debt as a recourse liability for the managing member even though no events had occurred to trigger the guarantee. Because the debt was treated as a recourse liability of the managing member, the partnership’s losses were allocated to the managing member, and none were allocated to the other partners. This allocation was contrary to the generally held interpretation of contingent guarantees, which is that the debt should not be allocated to the member until an event occurred to trigger the contingent guarantee. If the bad-boy guarantee did not result in recourse debt allocated to the managing member, the debt would have been treated as qualified nonrecourse real estate debt, and all partners would have shared in the partnership’s losses.

AM 2016-001

Legal advice issued by IRS Associate Chief Counsel, Advice Memorandum (AM) 2016-001, released on April 15, 2016, concluded that a partner’s guarantee of a partnership’s nonrecourse obligation that is conditioned on the occurrence of certain carve-out events will not cause the debt to fail to qualify as nonrecourse liability of the partnership (unless and until the event occurs and the guarantor becomes personally liable for the partnership debt).

The following bad-boy guarantees, also known as carve-outs, listed in AM 2016-001, will not cause an otherwise nonrecourse liability to be treated as recourse for purposes of Sec. 752 until the contingency occurs:

• The borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property;
• The borrower files a voluntary bankruptcy petition;
• Any person in control of the borrower files an involuntary bankruptcy petition against the borrower;
• Any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower;
• The borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding;
• Any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or
• The borrower makes an assignment for the benefit of creditors or admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due.

Conditions other than those listed must be analyzed on a case-by-case basis. AM 2016-001 states:

The “nonrecourse carve-out” provisions should be interpreted consistent with that purpose and intent in mind. Consequently, because 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, it is unlikely that the contingency (the bad act) will occur and the contingent payment obligation should be disregarded under [Regs. Sec.] 1.752-2(b)(4).

Regs. Sec. 1.752-2(b)(4) provides that a payment obligation is disregarded if, after taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligations will ever be discharged. If a payment obligation would arise after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs.

Conclusion

Under AM 2016-001, the existence of a bad-boy guarantee should not cause nonrecourse or qualified nonrecourse liabilities to be treated as recourse to the guarantor until the identified event occurs to trigger the guarantee. Although CCA 201606027 was not withdrawn, the IRS appears to have corrected its decision in AM 2016-001. Partnerships will need to analyze bad-boy guarantees not listed in AM 2016-001 to determine how the liabilities should be allocated on the partnership return.

EditorNotes

Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.