In Chief Counsel Advice (CCA) 201606027, the Service concluded that provisions in a nonrecourse real estate loan to a partnership that impose personal liability on a partner upon the occurrence of certain events caused the loan to be recourse to the partner for Section 752 and Section 465 purposes. The CCA's rationale, if a correct interpretation of the relevant legal documents and the applicable law, could have significant implications under Section 752 and Section 465 regarding the treatment of what are sometimes referred to as "bad-boy" provisions in loan agreements.

Facts

X is a limited liability company taxed as a partnership in the business of acquiring existing hotels, renovating them, installing personal property to improve the properties' utility as hotels, and holding and maintaining the premises. X does not manage the hotels' day-to-day operations; it delegates that function to a subsidiary that contracts with a third-party provider.

X is owned by three individuals, A, B, and C. Per the operating agreement, in the event X needs additional capital, C, or an affiliate (the Lender) may elect to loan funds to X for its business purposes (C loans), but is under no obligation to do so. C may at any time convert such C loans into additional capital. If C elects to make C loans to X, A and B also have the opportunity to make similar loans in accordance with their respective ownership percentage interests in X. Similarly, if C makes additional capital contributions to X, then A and B also have the opportunity to make additional capital contributions.

If C's ownership percentage exceeds a set threshold and C determines that X still needs additional capital, C may send A and B a demand notice to contribute their ownership percentage interests of the required capital. If A or B fails to make the contribution, C may elect to either loan X the amount that the Defaulting Member failed to contribute and treat that as a loan to the Defaulting Member or to reduce the ownership percentage interest of the Defaulting Member.

Similarly, if any Member makes a Guaranty Contribution, the other Members must contribute their ownership percentage interest of the Guaranty Contribution to X. If they fail to do so, the contributing member may elect to loan X the amount that the Defaulting Member failed to contribute and treat that as a loan to the Defaulting Member or reduce the ownership percentage interest of the Defaulting Member.

The Operating Agreement states that, if any Member fails to contribute any cash or property when due, the Member will remain liable to X. Further, if a Member of X elects or is required to become personally obligated for financing or any other undertaking, the Members agree to enter into a contribution agreement under which all Members agree to allocate the risks of the personal obligations in accordance with their ownership percentage interests in X.

In Year 1, some of the corporate subsidiaries of X, as co-borrowers, executed a senior promissory note. Although the CCA does not expressly say so, presumably X also executed the note. C executed three personal guarantees of the senior promissory note, the first of which was at issue in the CCA. According to the CCA:

"The first guarantee, entitled "Guaranty of Recourse Obligations," ... provides that C "hereby unconditionally, absolutely and irrevocably, as a primary obligor and not merely as a surety, guarantees to Lenders the punctual and complete payment of the entire amount of the Guaranteed Obligations upon demand by [Y, as agent for the Lenders]" (the "First Guarantee"). Section 1(b) of the First Guarantee provides that the term "Guaranteed Obligations" means, among other things, the entire outstanding principal amount of the Loan, together with all interest thereon and all other amounts due and payable under the Loan Documents in the event that:

1. the co-borrowers fail to obtain the lender's consent before obtaining subordinate financing or transfer of the secured property
2. any co-borrower files a voluntary bankruptcy petition
3. any person in control of any co-borrower files an involuntary bankruptcy petition against a co-borrower
4. any person in control of any co-borrower solicits other creditors to file an involuntary bankruptcy petition against a co-borrower
5. any co-borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding
6. any person in control of any co-borrower consents to the appointment of a receiver or custodian of assets, or
7. any co-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."

The Second Guarantee states that C, as a primary obligor and not merely as a surety, guarantees the punctual and complete payment of all required amortization payments under the promissory note, up to a specified amount. The required amortization payments represent amounts required to be paid as necessary to maintain minimum yields on the underlying obligation. The Third Guarantee, a completion guarantee, states that C will guarantee part of the loan as a primary obligor and not merely as a surety, and that C will personally guarantee repayment of any amounts expended to complete the renovation of the hotels.

Additionally, some subsidiaries executed two other promissory notes (the Z mezzanine notes) secured by security trust agreements subject to guarantees substantially similar to the first and second guarantees of the senior promissory note described above. The Z mezzanine notes are secured by security trust agreements on the hotels.

In Year 3, A claimed a pass-through loss and a pass-through net operating loss (NOL) deduction from X, claiming that he was entitled to deduct the losses because the business activity generating the loss was funded with "qualified nonrecourse financing" within the meaning of Section 465(b)(6) and that C's First Guarantee for the debt should be disregarded under Section 1.752-2(b)(4) and Section 1.465-27(b)(4)(i) because the First Guarantee is a "contingent" liability. There are no other amounts for which A could be considered at-risk with respect to the business activity of X.

Law and analysis

It appears that A needed the debt in question to be treated as a nonrecourse liability under Section 752 and as qualified nonrecourse financing under Section 465(b)(6) to be able to claim the loss at issue.

Reg. Section 1.752-2(a) provides that a partner's share of a recourse partnership liability equals the portion of that liability, if any, for which the partner or related person bears the economic risk of loss. "Reg. Section 1.752-2(b)(1) provides generally that, except as otherwise provided, a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner."

In general, all payment obligations of a partner or related person are taken into account in this analysis. Reg. Section 1.752-2(b)(4) however, provides special rules for certain contingent payment obligations. That provision states:

"Contingent obligations. A payment obligation is 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. 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."

The Service rejected the taxpayer's argument that C's obligations under the First Guarantee were "contingent" under this provision, and should therefore be disregarded or not taken into account until the event (e.g., voluntary bankruptcy) occurs. The Service stated:

"In this case, we view the "conditions" listed in section 1(b) of the First Guarantee as circumstances under which the lender may enforce the guarantee to collect the entire outstanding balance on the loan, beyond an actual default by X on its obligations. As such, we do not believe these "conditions" are properly viewed as conditions precedent that must occur before Y is entitled to seek repayment from C under the guarantee. In addition, we believe it is reasonable to assume that one or more of these conditions, more likely than not, would be met upon a constructive liquidation of X under section 1.752-2(b)(1). Accordingly, we believe that these "conditions" do not fall within the definition of "contingencies" as intended by section 1.752-2(b)(4)."

The Service therefore concluded that the promissory notes described above were recourse partnership liabilities allocable to C, the guaranteeing partner, and not to either A or B.

Section 465(a)(1) (by reference to Section 465(c)(3)(A)) allows losses incurred by an individual engaged in certain activities only to the extent of the amount by which the individual is at risk (within the meaning of Section 465(b)) for such activity at the close of the tax year. Section 465(b)(2)(A) allows partners to include partnership liabilities in their at-risk amounts if they are personally liable for the debt. Under Section 465(b)(4), taxpayers are not at risk for amounts protected against loss through nonrecourse financing. Generally, a limited partner who guarantees partnership debt is not at risk if the limited partner has a right to seek reimbursement from the partnership and the general partner for any amounts that the limited partner is called upon to pay under the guarantee.

Section 465(b)(6)(A) contains an exception to these rules when a nonrecourse liability satisfies the definition of qualified nonrecourse financing. Section 465(b)(6)(A) includes in a taxpayer's amount at risk the taxpayer's share of any qualified nonrecourse financing which is secured by real property used in such activity. A liability will be qualified nonrecourse financing under Section 465(b)(6)(B)(iii) when, among other conditions, no person is personally liable for repayment.

The Service concluded that the First Guarantee was sufficient to cause the guaranteeing partner, C, to be considered personally liable for the guaranteed debt obligations of X, preventing the guaranteed debt obligations of X from constituting "qualified nonrecourse financing" within the meaning of Section 465(b)(6)(B) and Section 1.465-27. A and B, as non-guaranteeing members of X, were not considered at-risk with respect to any such amounts as a consequence of the First Guarantee.

The taxpayer alternatively argued that, even if the First Guarantee causes C to be treated as personally liable for the guaranteed debt of X, the Operating Agreement nevertheless operates to cause A and B to be treated as personally liable (i.e., to bear the ultimate economic risk of loss for purposes of Section 752, and to be payors of last resort in a worst case scenario for purposes of Section 465) with respect to their proportionate share of the guaranteed debt, because A and B are obligated under that provision to reimburse C in proportionate amounts for any payments that C makes under the guarantees.

The Service disagreed, stating that the Operating Agreement did not impose a mandatory payment obligation on A and B to make additional contributions to X if C is called upon to pay on C's personal guarantees; rather, according to the Service, it allowed C to request additional capital. If A and/or B chose not to contribute additional capital, C's remedies were limited and did not give C the right to bring an action against A and B to require them to contribute additional capital to X if they chose not to do so. Accordingly, A and B did not bear the ultimate economic risk of loss for the guaranteed debt of X for purposes of Section 752.

Separately, the Service also ruled that acquiring existing hotels, renovating them, installing personal property to improve the properties' utility as hotels, and holding and maintaining the premises, but not managing day-to-day operations, qualifies the partnership as engaged in an "activity of holding real property" within the meaning of Section 465(b)(6)(A).

Implications

The Service failed to discuss in its analysis Reg. Section 1.752-2(f), Example 8, which illustrates the application of the rule in Section 1.752-2(b)(4) that 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. Example 8 states:

Example 8. Contingent obligation not recognized

"J and K form a general partnership with cash contributions of $2,500 each. J and K share partnership profits and losses equally. The partnership purchases an apartment building for its $5,000 of cash and a $20,000 nonrecourse loan from a commercial bank. The nonrecourse loan is secured by a mortgage on the building. The loan documents provide that the partnership will be liable for the outstanding balance of the loan on a recourse basis to the extent of any decrease in the value of the apartment building resulting from the partnership's failure properly to maintain the property. There are no facts that establish with reasonable certainty the existence of any liability on the part of the partnership (and its partners) for damages resulting from the partnership's failure properly to maintain the building. Therefore, no partner bears the economic risk of loss, and the liability constitutes a nonrecourse liability. Under Section 1.752-3, J and K share this nonrecourse liability equally because they share all profits and losses equally."

The contingent obligation in Example 8 is the type of obligation typically referred to as a "bad boy" recourse carve-out. On the basis of Example 8, many practitioners have concluded that "bad boy" recourse carve-outs that relate to specific commissions or omissions on the part of the taxpayer do not cause an otherwise nonrecourse loan to be recourse for Section 752 purposes or other than qualified nonrecourse financing for Section 465 purposes. Unless the First Guarantee is triggered by any failure of X to repay the loan, the carve-outs at issue require specific actions to be undertaken (or not undertaken) by C prior to him being held personally liable on the underlying debt. Generally, a loan agreement's requirement of a specific act (e.g., filing for bankruptcy) or omission (failing to maintain the property securing the debt) in order to trigger an obligation will result in the obligation being subject to a contingency to which Section 1.752-2(b)(4) applies.

The Service's rejection of the taxpayer's contingency argument is troubling because the Service does not explain why the conditions in clause (b)(1) of the First Guarantee are not sufficient to cause the guarantee to be treated as a payment obligation that would arise only at a future time after the occurrence of an event that is not determinable with reasonable certainty, in which case the obligation should be ignored for Section 752 purposes until the event occurs. The basis for the Service's conclusion is not apparent from the information provided in the CCA. Moreover, it is difficult to determine which of the individual conditions were critical to the Service's conclusion or what the relevance would be of one or more of those conditions in a different factual circumstance.

The conclusion of the Service, that the loan in question is not qualified nonrecourse financing under Section 465(b)(6), follows from its conclusion that the loan is a recourse loan for Section 752 purposes, i.e., the non-guaranteeing partners are not "payors of last resort in a worst case scenario."

The CCA's conclusion that a guarantee can result in the guaranteeing partner being at risk under Section 465 even before payment under the guarantee is inconsistent with Prop. Reg. Section 1.465-6(d), which was issued in 1979 and has never been finalized. Nevertheless, that conclusion is consistent with case law, and the Service has previously reached the same conclusion in other guidance. See, e.g., FSA 200025018.

Although a CCA does not have precedential value, it may reflect the view of the Government on this issue and, in circumstances involving agreements containing similar carve-out provisions, taxpayers should be aware of potential challenges by the Service on the basis of the arguments laid out in the CCA.

The CCA does not mention whether the distinction between recourse and nonrecourse for purposes of Sections 752 and 465 might also apply for other provisions that use those terms, such as Sections 1001 and 108. Practitioners have struggled with the distinction between recourse and nonrecourse debt when faced with debt of disregarded entities, including special purpose entities.

———————————————