It is common for LLCs operating (and taxed) as real estate partnerships to obtain nonrecourse financing secured only by the real estate owned by the LLC. Liabilities of an LLC taxed as a partnership are allocated to the member that bears the economic risk of loss with respect to the debt. Debt allocated to a member increases the member’s basis in the LLC interest, which permits the member in many cases to deduct additional losses. In the case of nonrecourse financing, absent guarantees or other arrangements among the members that would impact risk of loss, no member individually bears the economic risk of loss, so the liability can be allocated among all of the members.
In connection with many nonrecourse financings, banks often look to one or more members of an LLC for repayment of the debt on the occurrence of certain events, such as fraud, misapplication of funds, bankruptcy or unauthorized transfer of the property. The prevailing view in the real estate industry is that guarantees of this type, generally referred to as “bad boy” guarantees, do not shift the economic risk of loss to the guaranteeing member because the payment obligation under the guarantee is contingent.
In a recent Chief Counsel Advice (CCA 201606027), the IRS introduced significant uncertainty to the generally accepted treatment of bad boy guarantees. The IRS concluded, based on a review of the LLC’s operating agreement and the underlying facts and circumstances, that the possibility of the guaranteeing member becoming liable on the LLC’s debt was not so remote to permit the debt to be considered non-recourse, thereby eliminating the allocation of the debt among the non-guaranteeing members.
Although the CCA is not precedential authority and cannot be relied upon by the IRS as such, it is a significant departure from current practice in the industry. It may indicate that the IRS intends to take a more aggressive approach with respect to “bad boy” guarantees.
For more information, please contact Emily Dorisio in our Lexington, Ky. Office at 859-899-8714.