On April 15, 2016, the IRS released a generic legal advice memorandum (the “GLAM”) in which it provided an important clarification on the tax treatment of typical “nonrecourse carve-out” or “bad boy” guarantees commonly provided in commercial real estate financing transactions.
Real estate partnerships (including limited liability companies treated as partnerships for tax purposes) typically use a combination of partner equity and non-recourse financing to fund the cost of purchasing and developing real property. Under the terms of such non-recourse loans, lenders can only look to the property securing the debt, rather than the owners of the partnership, to satisfy the obligations under the loans. However, lenders often require a so-called “nonrecourse carve-out” or “bad boy” guarantee from one or more partners (typically, the project sponsor), which guarantee would be triggered upon the occurrence of certain acts. These acts typically consist of deliberate actions by the partnership or the sponsors, such as the filing of a voluntary bankruptcy petition. In practice, these acts rarely occur, because the acts are in the control of the guaranteeing partner who would have personal liability for the debt as a result of such acts.
Earlier this year, the IRS had determined in Chief Counsel Advice 201606027 (the “CCA”) that a bad boy guarantee caused an otherwise nonrecourse debt to be treated as recourse with respect to the guaranteeing partner for purposes of applying the partnership basis allocation rules and the at-risk rules. The IRS’s position was widely criticized by tax and real estate professionals. The characterization of nonrecourse debt that is subject to a customary bad boy guarantee as recourse financing shifts debt-related basis and deductions away from the non-guaranteeing partners and to the guaranteeing partner, which is contrary to how real estate partnerships have generally allocated basis and deductions.
Reversing its position in the CCA, the IRS concludes in the GLAM that if a guaranteeing partner’s obligation is conditioned on the occurrence of certain “nonrecourse carve-out” or “bad boy” acts, until such time as one of those bad acts actually occurs and causes the guaranteeing partner to become personally liable for the debt under local law, the guarantee will not cause an otherwise nonrecourse debt obligation to be characterized as recourse debt for purposes of applying the partnership basis allocation rules and will not cause the debt to fail to qualify as “qualified nonrecourse financing” for purposes of the at-risk rules. The GLAM identifies the following “nonrecourse carve-out” events:
- 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; and
- 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.
According to the GLAM, by including these provisions the lender seeks to protect itself from the risk that the borrower or a guaranteeing partner in control of the partnership will undertake acts that are within its control but would diminish or impair the value of the property securing the loan. The GLAM reasons that because it is in the economic self-interest of the partnership and guaranteeing partner to avoid committing those bad acts and subjecting themselves to liability, they are highly unlikely to voluntarily commit such acts. The GLAM concludes that, unless the facts and circumstances indicate otherwise, because it is unlikely that such bad acts would occur, the contingent obligation (the guarantee) should be ignored until one or more such events actually occurs.
The IRS also noted that one form of common nonrecourse carve-out -- to admit in writing or in any legal proceeding that the borrower is insolvent or unable to pay its debts as they come due events -- could, at least in some unusual circumstances, be interpreted to give the lender the ability to cause the partnership or guaranteeing partner to commit one of the bad acts. For example, upon a default by the partnership, a lender could bring suit for a deficiency and in the course of that litigation, or in a subsequent collection action, seek to force a written admission of insolvency in the course of discovery. Similarly, if the loan agreement required the borrower to provide the lender with periodic written financial reports, and those reports revealed that the borrower was insolvent, the lender might argue that those reports constituted a written admission of insolvency. Any such interpretation could result in an acceleration of the treatment of the debt as recourse to the guaranteeing partner.
Despite this concern, the GLAM states that in the commercial real estate finance industry, nonrecourse carve-out provisions are not intended to allow the lender to require an involuntary action by the partnership or guaranteeing partner, or to place the partnership or guaranteeing partners in circumstances that would require them to involuntarily commit a bad boy act. Rather, the fundamental business purpose behind such carve-outs and the intent of the parties to such agreements is to prevent actions by the partnership or guaranteeing partner that could make recovery on the debt, or acquisition of the security underlying the debt upon default, more difficult. Thus, typical nonrecourse carve-out provisions that allow the partnership or guaranteeing partner to avoid committing the specific bad acts will not cause otherwise nonrecourse debt to be treated as recourse.
Although the GLAM may not be used or cited as precedent, the GLAM confirms what tax practitioners and real estate investors have believed all along, that typical bad-boy guarantees will not ordinarily cause an otherwise nonrecourse debt obligation to be characterized as recourse debt for purposes of applying the partnership basis allocation rules and the at-risk rules.