In AM 2016-001 (a generic legal advice memo), the IRS concluded that a partner's guarantee of a partnership's nonrecourse obligation that was contingent on the occurrence of certain "nonrecourse carve-out" events will not prevent the obligation from qualifying as a nonrecourse liability under Section 752 or qualified nonrecourse financing under Section 465(b)(6) unless and until such an event occurs. AM 2016-001 reverses the position taken by the IRS in CCA 201606027, which was the subject of Tax Alert 2016-353.

Background

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 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."

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. 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.

Guarantees of partnership nonrecourse obligations sometimes are conditioned upon the occurrence of one or more "nonrecourse carve-out" events, such as transferring the property without lender consent, filing voluntary bankruptcy and cooperating in an involuntary bankruptcy. These contingencies are designed to protect the lender against so called "bad acts" by the borrower.

In Chief Counsel Advice (CCA) 201606027, the Service concluded that provisions in a nonrecourse real estate loan to a partnership that imposed 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. In CCA 201606027, the guarantor would become liable for repayment of the loan on a recourse basis 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.

In CCA 201606027, the Service concluded that these provisions caused the loan to be recourse for purposes of both Section 752 and Section 465. The Service stated:

"In this case, we view the "conditions" listed … as circumstances under which the lender may enforce the guarantee to collect the entire outstanding balance on the loan, beyond an actual default by [the partnership] on its obligations. As such, we do not believe these "conditions" are properly viewed as conditions precedent that must occur before [the lender] is entitled to seek repayment from [the guarantor] 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 [the partnership] under [S]ection 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)."

Please see Tax Alert 2016-353 for more discussion.

Recent guidance

In AM 2016-001, the Service reversed its conclusion in CCA 201606027. AM 2016-001 analyzed the identical nonrecourse carve-out provisions and concluded that they did not cause the loan to be treated as recourse for purposes of Section 752 or as other than "qualified nonrecourse financing" for purposes of Section 465 (the result desired by the taxpayer in CCA 201606027). The Service concluded that, because it is in the economic self-interest of the borrowers and guarantors to avoid committing the enumerated bad acts and subjecting themselves to liability, they are very unlikely to voluntarily commit such acts.

In reaching this conclusion, the Service specifically discussed the significance of the last nonrecourse carve-out, which imposed recourse liability if the borrower "admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due." The Service discussed whether this provision might, in effect, imposefull recourse liability, because the lender could force such an admission in a collection proceeding, or because the borrower's written financial reports might be viewed as constituting such an admission. The Service noted that, in D.B. Zwirn Special Opportunities Fund, L.P. v. SCC Acquisitions, Inc., 902 N.Y.S.2d 93 (App. Div. 2010), a lender had argued that the borrower's financial reports constituted an admission prohibited by a substantially identical clause. The Zwirn court concluded that the borrower's written financial reports did not constitute a prohibited admission, stating that "if the parties had intended to make defendant liable upon being in financial distress, language stating the same could easily have been included in the contract." The Service agreed with the Zwirn court'sanalysis, and concluded thatunless the facts and circumstances indicate otherwise, a typical "nonrecourse carve-out" provision that allows the borrower or guarantor to avoid committing the bad act will not cause an otherwise nonrecourse liability to be treated as recourse until such time as the contingency actually occurs. This holds true for both Section 752 and Section 465 purposes.

Implications

As in the prior guidance, the CCA does not discuss whether the recourse/nonrecourse distinction under partnership rules might have consequences under Section 1001. For example, if a bad boy guarantee is triggered and the note changes from nonrecourse to recourse, would that change be a significant modification resulting in a debt-for-debt exchange under Reg. Section 1.1001-3 or would the Service assert that the partnership rules are not determinative for this purpose?

The Service's reversal of its position in CCA 201606027 is both welcome and appropriate. We believe the analysis and conclusion in AM-2016-0001 are correct. If the Service had maintained its position in CCA 201606027 that typical nonrecourse carve-out provisions cause a loan to be treated as recourse for Section 752 and 465 purposes, many partnerships with secured real estate loans would have been adversely affected in a way that we believe is inconsistent with existing regulations and sound tax policy. EY personnel participated in high level meetings with the IRS National Office to explain these concerns, and AM 2016-001 is evidence that the IRS listened carefully to these concerns from industry stakeholders and practitioners.

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