By Emily Dorisio

The IRS issued a Memorandum on April 15, 2016 clarifying the treatment of nonrecourse debt subject to certain “bad boy” guarantees. The Memorandum takes a position contrary to the recent Chief Counsel Advice (CCA 201606027) and is more in keeping with the general view of the real estate industry. In CCA 201606027, the IRS surprised the real estate industry when it determined that the triggers for “bad boy” guarantees in connection with nonrecourse financing of an LLC taxed as a partnership were not contingencies that could be disregarded for purposes of determining whether the debt was nonrecourse or recourse for tax purposes. (See Internal Revenue Service Takes a Look at “Bad Boy” Guarantees).

In AM2016-001, the IRS noted that typical events that trigger a bad boy guarantee are within the control of the borrower or guarantor. Because it is in the guarantor or borrower’s economic self-interest to avoid committing those acts and subjecting themselves to liability, they are very unlikely to commit those acts. The triggering events mentioned are: (1) failing to obtain lender’s consent to subordinate financing or transfer of the secured property, (2) filling a voluntary petition in bankruptcy, (3) filing an involuntary petition of bankruptcy against a co-borrower by any person in control of a co-borrower, (4) soliciting other creditors to file an involuntary petition of bankruptcy against a co-borrower by a person in control of a co-borrower, (5) consenting to, joining in, a co-borrower’s involuntary bankruptcy or insolvency proceeding, (6) consenting to a co-borrower’s appointment of a receiver or custodian of assets or (7) an assignment for the benefit of creditors by a co-borrower or admission in writing or any legal proceeding that a co-borrower is insolvent or unable to pay its debts when due.

The IRS Memorandum concluded that debt will not lose its status as nonrecourse until the triggering event actually occurs. The position taken AM2016-001 is no more precedential than that of CCA 201606027, but it is certainly more favorable to the real estate industry and does offer some clarification. As always, caution should be exercised when drafting loan agreements for partnerships when “bad boy” guarantees are part of the mix to ensure appropriate classification of the debt.

For more information, please contact Emily Dorisio in our Lexington, Ky. Office at 859-899-8714.