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In a nonrecourse real estate loan to a partnership, the loan documents will often provide that if specific trigger events occur (a “nonrecourse carve-out”), personal liability will be imposed on the general partner or managing member and on a guarantor under a separate nonrecourse carve-out guarantee (a ‘“bad boy’ guarantee”).  A highly controversial IRS ruling on this common real estate financing feature recently caused concern in the real estate finance industry because the ruling called into question well-recognized tax rules relating to the use of nonrecourse debt in most real estate financing transactions.  Following strong opposition from the industry, the IRS withdrew its ruling.   This article summarizes the background and significance of the ruling and why the IRS decided to reconsider.

Section 1.752-2(b)(4) of the Treasury Regulations states: “If a payment 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.” Tax practitioners have viewed nonrecourse carve-out provisions that are triggered by the voluntary “bad acts” of a borrower, which include fraudulent actions or voluntary actions that adversely affect the value of collateral, impair or reduce its cash flow, or impede or delay a lender’s foreclosure of a mortgage, as within the scope of this provision, and therefore ignored until the triggering event occurs.

The IRS Office of Chief Counsel released legal memorandum 201606027 (the “IRS Memorandum” or “Memorandum”) that called 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 concluded that a customary “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 had become established law, real estate investors would have had to recapture billions of dollars in losses from previous years and would not have been able to 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).  Before the release of the IRS Memorandum, it was well-settled that a “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 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 “bad boy” guarantee, 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 attempted 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 failed, 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 “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 now because of a guarantor’s full recourse liability under standard “bad boy” 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 . . .”

Reaction to IRS Memorandum

Although the IRS Memorandum was not precedential authority and could not be relied upon by the IRS in other cases, it was released by the National Office of the Chief Counsel, so it signaled that the IRS may have intended to take a more aggressive approach in its treatment of “bad boy” guarantees.[5]  And if the IRS did not withdraw the Memorandum, real estate investors would face uncertainty that goes to the heart of the economics of many investments.  Investors could have ignored the Memorandum on the theory that it was illogical, contrary to standard practice in the real estate financing market and unlikely to be sustained by the courts.  They could also could have pressured lenders to forego “bad boy” guarantees, but that might have been difficult since lenders also consider such guarantees to be standard industry practice.  They could have considered structuring guarantees that are arguably distinguishable from the IRS Memorandum, such as obtaining a guarantee 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 have attempted to structure “bad boy” 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 have resulted in only a portion of the loan being treated as a recourse liability.  Negotiating such a position, however, was unlikely to be successful, as lenders would have insisted on full recourse liability with respect to Special Purpose Entity violations, voluntary and collusive involuntary bankruptcy filings, and impermissible transfers and encumbrances of the secured property.

This position would have prevented the non-guaranteeing members from being able to deduct partnership/LLC losses in excess of their equity contributions. Such a result would obviously have had a huge negative tax impact on thousands of past, present and future real estate partnerships and LLCs.

In response to the Memorandum, a small task force from the Real Estate Roundtable, including Joe Forte of Kelley Drye & Warren LLP, drafted an industry position paper and met with IRS Chief Counsel William Wilkins to share the real estate community’s concerns. The meeting was held on March 8th at the IRS in Washington, and was attended by Mr. Wilkins and eight other attorneys from the IRS.  At the meeting, Joe Forte described the legal and practical evolution of the particular “bad boy” guarantee at issue in the Memorandum. The participants explained to the IRS, among other matters, that the “bad boy” guarantee is a device to prevent the borrower from taking certain voluntary actions, such as a bankruptcy filing, and the guarantor is very unlikely to ever take any of the prohibited actions or have liability on the guarantee.

We believe the IRS was concerned that this admission of insolvency provision, which is included as a matter of course in the boilerplate language contained in most commercial loans, could be construed as giving a lender a “back door” means of enforcing recourse liability on the borrower or guarantor, without a voluntary “bad boy” action on the part of the borrower. The Real Estate Roundtable consulted with market participants and practitioners involved in negotiating and drafting nonrecourse carve-out provisions, including the admission of insolvency provision, to understand why it is in loan agreements, how the provision is understood by the parties and how it is enforced.

Since before the Great Depression, the admission of insolvency provision has been routinely included as a specific event of default in mortgage loan documents as the state insolvency law analogue to the provision that makes filing a voluntary federal bankruptcy petition an event of default.[6]  Since the mid-1980s when the life insurance industry first introduced nonrecourse carve-out provisions for voluntary borrower bankruptcy filings into their loan documents, an admission of insolvency, as well as bankruptcy filing, have been among the voluntary bad acts of borrowers enumerated in nonrecourse carve-out clauses that trigger recourse to borrower and “bad boy” guarantors.

The essential bargain between borrower and lender that permits nonrecourse financing is that the lender agrees not to pursue recourse liability directly or indirectly against the borrower or its principals provided that the lender can comfortably rely on the assurance that the value of the financed property will not be diminished or impaired, or the cash flow from the property disrupted, or the lender’s realization on the property delayed or prevented by “bad acts” of the borrower.

As the admission of insolvency provision is the state insolvency law equivalent of the ““bad boy”” clause which acts as a disincentive to borrower’s voluntary bankruptcy filing, its principal purpose is to disincentivize the borrower from initiating a state-level insolvency proceeding under state statutes. An admission of insolvency by the borrower generally is a prerequisite to initiating a state law receivership, and the language in the admission of insolvency clause is similar or identical to the language found in state insolvency laws. As the term insolvency is not considered to be susceptible to exact definition and has been recognized as having several distinct meanings, it is often defined within a specific statutory scheme.[7]  Moreover, in the absence of an ability to obtain a discharge of its obligations under an insolvency statute, it is unlikely that any borrower would seek protection under state law instead of filing for bankruptcy. In the absence of an express, voluntary action on the part of the borrower, we do not believe that this provision is designed or intended to create a mechanism to force recourse liability on the borrower or any nonrecourse guarantor. We are aware of no case law in which a borrower or a “bad boy” guarantor was held liable for a debt under this provision.[8]

The mere fact that a borrower may be insolvent or unable to pay it debts does not trigger recourse liability under the admission of insolvency provision — it requires a voluntary written express statement of the borrower to the effect that it is insolvent or unable to pay its debts as they become due.[9]  In Zwirn, delivery of a financial statement showing liabilities exceeding assets was not considered such an admission. Thus, an admission of insolvency by the borrowers must be a voluntary affirmative act, similar to filing for bankruptcy protection.

On April 15, 2016 the IRS Office of Chief Counsel released a new memorandum (“New Memorandum”) reversing the position taken in the original Memorandum. The New Memorandum acknowledged that a “carve-out” or “bad boy” guarantee is a device to prevent the borrower from taking actions which violate the terms of the loan in a manner which might harm the value of the property or interfere with the lender’s exercise of remedies. The IRS concluded that the adverse financial impact to the guarantor resulting from the prohibited acts would be contrary to the guarantor’s self-interest, making the acts and resulting personal liability very unlikely to occur. The IRS acknowledged that the “bad boy” acts were all voluntary acts of the guarantor, not matters which a lender could use to enforce personal liability in the absence of specific voluntary actions. Therefore, the New Memorandum concludes that a “bad boy” guarantee does not cause a non-recourse loan to become recourse unless one of the enumerated “bad boy” acts actually occurs.

Although withdrawal of the original Memorandum had been anticipated by the real estate industry as a result of the meeting with the IRS, issuance of the New Memorandum removes a cloud over the tax treatment of “bad boy” guarantees. Nonetheless, lenders counsel creating new “bad boy” full recourse guarantee events, and borrower and guarantor’s counsel reviewing “bad boy” full recourse carve-out events in proposed loan documents should consider the possible ramifications of the new guarantee provision on the qualified nonrecourse financing tax status of the transaction and possible heightened risk of borrower bankruptcy.

[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) of the Treasury Regulations.

 

[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.

 

[5]               Speaking at a conference on February 23, 2016, 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.

 

[6]               Barth v. Backus, 140 N.Y. 230, 35 N.E. 425 (1893).

 

[7]               See 30 N.Y. Juris. 2d § 193, p. 229 (2006).

 

[8]               See D.B. Zwirn Special Opportunities Fund, L.P. v. SCC Acquisitions, Inc., 902 N.Y.S.2d 93 (App. Div. 2010).

 

[9]               See Magten Asset Mgt. Corp. v. Bank of N.Y., 15 Misc. 3d 1132(A) (Sup. Ct. 2007).

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