It’s Not That Simple
The rules that govern the taxation of partners and partnerships are among the most complex in the Internal Revenue Code. This reflects, in part, the great flexibility that is afforded to partners in structuring their economic arrangements.
This complexity is often manifested in a difference of opinion between a taxpayer and the IRS regarding the income tax treatment of a particular item or arrangement. Sometimes, what may appear as a straightforward issue takes an unexpected turn, as one taxpayer recently discovered.
The disagreement between a partnership (the “Taxpayer”) and the IRS arose out of their differing conclusions as to whether a particular indebtedness was recourse or nonrecourse to the partnership. The resolution of this seemingly simple question would have important ramifications for the taxation of the partners.
Taxpayer was an LLC, taxable as a partnership for federal tax purposes.
Taxpayer was organized to purchase specified real property, and then to construct, market, and sell homes that it built on that property (“Property”). Taxpayer’s operating agreement provided that Taxpayer was a special purpose entity (“SPE”), which (i) was organized solely for the purpose of owning the Property, (ii) would not engage in any business unrelated to the ownership of the Property, and (iii) would not have any assets other than those related to the Property.
The Indebtedness & Its Cancellation
Taxpayer relinquished its last unsold parcel of real property from the Property to Bank in a non-judicial foreclosure. Bank had a loan to Taxpayer that was secured by the Property (“Senior Loan”). Bank cancelled the entire Senior Loan as part of the non-judicial foreclosure.
During Tax Year, Corporation, another of Taxpayer’s lenders, cancelled its outstanding loans (“Notes”) to Taxpayer. Notes were created in connection with loans made to Taxpayer in order to develop Property, and were secured by the Property, but were subordinated to the Senior Loan from Bank. They were further secured by a general assignment of Taxpayer’s rights, title, and interest in and to the Property; a general assignment of Members’ rights, title, and interest in and to the Property; pledges of their membership interests in Taxpayer; and unlimited, unconditional, and irrevocable guarantees by each Member of Taxpayer.
Notes did not contain express language providing that they were recourse or nonrecourse to Taxpayer, nor did they did expressly state whether Taxpayer, as borrower, would be unconditionally and “personally” liable for repayment if the collateral securing Notes was insufficient to fully repay the outstanding balance on Notes with interest. Because Notes constituted junior debt, Corporation did not receive any proceeds from the non-judicial foreclosure.
Taxpayer reported the income from the discharge of indebtedness from the cancellation of Notes as cancellation of debt (“COD”) income for the Tax Year, which was allocated among its Members. To the extent of their respective insolvencies, in accordance with the COD rules, Members excluded the COD from their gross income and, in turn, reduced certain tax attributes.
The IRS questioned whether the COD income should be reclassified as an amount realized from the sale or other disposition of the Property. It reasoned that, if the Notes that were discharged in connection with the disposition of Property were nonrecourse to Taxpayer, the full amount of the discharged debt would be included in the amount realized and, thus, the transaction would result in gain or loss, and not COD income. One result of this reclassification at the partnership level would be that Taxpayer’s Members would be unable to exclude part of the income under the COD rules at the partner level.
Some Tax Basics
The gain from the sale or other disposition of property is the excess of the amount realized over the property’s adjusted basis. Generally, the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.
The amount realized on a sale or other disposition of property that secures a recourse liability, on the other hand, does not include amounts that would be COD income. Accordingly, when property encumbered by recourse indebtedness is transferred in satisfaction of a debt secured by the property, the transaction is bifurcated into (i) an amount realized on a sale and (ii) an amount of COD income. The amount realized on sale is the fair market value (“FMV”) of the property, and any excess of the debt over FMV is COD income. The difference between the FMV of the property and its basis is recognized as gain or loss, and the excess of the debt discharged in the transaction over the FMV of the property is COD. The amount of COD could be excludible from income under the COD rules if the taxpayer were insolvent.
The sale or other disposition of property that secures a nonrecourse liability discharges the transferor from the liability. For property encumbered by nonrecourse indebtedness, the amount realized on its disposition includes the entire amount of the debt on the property. In determining gain or loss, the FMV of property is treated as not less than the amount of nonrecourse indebtedness to which the property is subject (the actual FMV does not matter). No part of such a transaction represents COD income and the exclusions under the COD rules do not apply to the transaction.
Recourse Debt or Not?
In general, for purposes of determining gain, a loan is recourse if the borrower is personally liable for the debt, and nonrecourse if the borrower is not personally liable for the debt. In other words, it depends on whether a creditor’s right of recovery is limited to a particular asset of the borrower. If a creditor’s right of recovery is limited to a particular asset securing the liability, the liability is nonrecourse. If a creditor’s right of recovery extends to all assets of a taxpayer, the liability is recourse.
In the case of a debtor that is a partnership, whether the partnership’s debt is recourse or nonrecourse is determined at the partnership level. Similarly, the nature of each partner’s share of income, gain, loss, deduction, or credit of the partnership is determined at the partnership level.
The Source of Confusion
For purposes of determining a partner’s basis in a partnership, IRS Regulations provide that a partnership liability is recourse to the extent that any partner bears the economic risk of loss for that liability, and a partnership liability is a nonrecourse liability to the extent that no partner bears the economic risk of loss.
The Regulations provide that a partner’s share of a recourse partnership liability equals the portion of that liability for which the partner bears the economic risk of loss, and a partner bears the economic risk of loss to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment and is not entitled to reimbursement from another partner. The Partnership Regulations recognize various payment obligations, including guarantees and other contractual obligations imposed outside the partnership agreement.
Taxpayer argued that Notes were recourse to it because its Members were personally liable for repayment under their guaranty agreements. Taxpayer reasoned that Members’ guarantees are payment obligations that represent an economic risk of loss to Members and, as a result, Notes met the definition of “recourse” loans under the Regulations. Taxpayer’s position was that these regulations also determined if partnership debt was characterized as recourse or nonrecourse to a partnership for purposes of determining gain from a disposition of property.
The IRS disagreed. The Regulations, it said, were limited to determining a partner’s basis in its partnership interest. The definition of a recourse liability found therein did not extend to issues under the gain recognition rules. The primary authority for this conclusion, the IRS said, was found in the regulatory text which states that the definitions found therein applied for purposes of determining basis.
The IRS stated that a partner’s guarantee of partnership debt, and thus the classification of that debt as recourse or nonrecourse under the Regulations, would not affect the determination of whether the debt was recourse or nonrecourse to the partnership for purposes of determining gain.
The IRS ended by stating that the determination of whether the Notes in the instant case were recourse or nonrecourse for gain determination purposes required a factual analysis of the operating and loan documents and any relevant state law. It referred this factual analysis back to the examining agent.
Taxpayer’s status as an SPE, its operating documents, and the loan documents limited Taxpayer’s assets to those related to developing Property. Any and all assets held by Taxpayer necessarily related to Property, and thus secured Notes. The lenders, therefore, had no further recourse against Taxpayer once Property and the assets related to Property were exhausted when the senior lender foreclosed on the property.
In addition, even though Notes lacked language expressly imposing an unconditional personal liability for repayment on the Taxpayer, Notes were secured by all assets Taxpayer would ever have. Notes also were secured by a pledge of Members’ interests in the Taxpayer and a general assignment of Members’ rights in and to Property. Thus, in the event of default, a lender could have acted on Members’ pledges and acquired Members’ rights in Taxpayer and thus acquire all assets held by Taxpayer.
Consequently, when dealing with an LLC that is also a SPE, all assets of the entity necessarily secure the loans used to acquire or construct such assets when Members pledge their interests in the entity to secure a loan. Express personal liability language may not be necessary to make the debt recourse to an entity under these facts. The combination of Members’ pledges, general assignment of rights, and guarantees, in addition to the loan being secured by all assets of the Taxpayer as a result of its status as a SPE, may be sufficient for the loan to be recourse to the entity.
One More Thing
It is not unusual, in tax practice, to come across a concept that has neither been directly addressed by Congress, nor fully developed by the IRS or the courts. In those instances, practitioners will often look to other areas of tax jurisprudence to see if any elements of the concept, or analogous concepts, have been better developed and, so, may provide some guidance. However, as the present case illustrates, the practitioner must step carefully.