A few weeks back we discussed the allocation of a partnership’s income and losses among its partners. Specifically, we considered the requirement that an allocation to a partner must have substantial economic effect if it is to be respected by the IRS. The determination of whether an allocation has substantial economic effect for tax purposes, we said, involves a two-part analysis: first, the allocation must have economic effect; and second, the economic effect of the allocation must be substantial.
In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or – for purposes of this week’s post – an economic burden that corresponds to the allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.
In addition, the economic effect of the allocation must be substantial, meaning there must be a reasonable possibility that the allocation will substantially affect the dollar amounts to be received by the partners, independent of the allocation’s tax consequences.
A partner’s share of a loss or deduction that is attributable to a recourse partnership liability is based upon the portion of that liability, if any, for which the partner bears the economic risk of loss.
In general, a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner 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 would not be entitled to reimbursement from another partner.
The determination of the extent to which a partner has an obligation to make a payment is based on the facts and circumstances at the time of the determination. All statutory and contractual obligations relating to the partnership liability are taken into account for purposes of making this determination, including:
(i) Contractual obligations outside the partnership agreement, such as guarantees, indemnifications, reimbursement agreements, etc.; and
(ii) Obligations to the partnership that are imposed by the partnership agreement, including, for example, the obligation to make a capital contribution.
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.
A partner’s obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner is entitled to reimbursement from another partner.
The IRS Office of Chief Counsel recently issued an advisory that considered the application of these rules in the case of a loan to a partnership (i) under the terms of which one of the partners personally guaranteed the partnership’s obligation to satisfy the loan in the event of, among other events, the partnership admitting in writing that it was insolvent or unable to pay its debts when due, or its voluntary bankruptcy or acquiescence in an involuntary bankruptcy, and (ii) whose partnership agreement provided that, in the event that the guaranteeing partner made a payment under the guarantee, the guaranteeing partner had the right to call for the non-guaranteeing partners to make capital contributions and, if they failed to do so, to treat ratable portions of the payment as loans to those partners, to adjust their fractional interests in the partnership, or to enter into a subsequent allocation agreement under which the risk of the guarantee would be shared among the partners.
The Facts & Circumstances
Partnership (P) had three members: A, B, and C.
P’s partnership agreement (the “Agreement”) stated that no Partner was obligated to make capital contributions to P; in the event additional capital was needed for P’s business, C could elect to loan funds to P or make additional capital contributions. If C elected to do so, A and B would be given the opportunity to make similar loans or capital contributions in accordance with their respective ownership interests.
Additionally, in the event C’s contributions exceeded a certain amount, and C determined that additional capital was still needed for P’s business, A and B would have to contribute their share of the required capital to P within a specified number of days of receiving notice from C. Failing such contribution, C could elect to loan to P the amount that a defaulting partner failed to contribute, which loan would be treated as a loan to that partner. If C elected to make such a loan, the other, non-defaulting partner would be given an opportunity to make a similar loan in accordance with its respective ownership interest, or C could elect to adjust downward the ownership percentage interest of each defaulting partner.
The Agreement stated further that in the event any partner failed to contribute any cash or property when due, such partner would remain liable therefor to P, which may institute proceedings in any court of competent jurisdiction. Furthermore, in the event P’s financing or other undertakings required any partner to become personally obligated (including execution of guarantees of indebtedness, etc.), the partners would enter into a contribution agreement pursuant to which all partners agreed to allocate the risks of such personal obligations in accordance with their ownership interests in P.
The “Bad Boy” Guarantee
P borrowed funds for the purpose of acquiring and renovating real property. It executed a note (“Note”) that was secured.
C executed three personal guarantees of the Note, each subject to different terms. The first guarantee provided that C “unconditionally, absolutely and irrevocably, as a primary obligor and not merely as a surety, guarantee[d] to Lenders the punctual and complete payment of the entire amount of the [guaranteed obligations] upon demand by [the agent for the lenders].” These obligations included, among other things, the entire outstanding principal amount of the Note, together with all interest thereon and all other amounts due and payable under the Note in the event that:
(1) P failed to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property,
(2) P filed a voluntary bankruptcy petition,
(3) any person in control of P solicited other creditors to file an involuntary bankruptcy petition against P,
(4) P consented to or otherwise acquiesced in an involuntary bankruptcy or insolvency proceeding,
(5) any person in control of P consented to the appointment of a receiver or custodian of assets, or
(6) P made an assignment for the benefit of creditors, or admitted in writing or in any legal proceeding that it was insolvent or unable to pay its debts as they came due.
The IRS’s Analysis
Partner A claimed a pass-through loss for the current year as well as a pass- through net operating loss (NOL) deduction from P. A claimed that he was entitled to the NOL deduction without limitation, in part because C’s guarantee was a “contingent” liability.
The IRS explained that a partner’s share of a recourse partnership liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss, and noted that 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 obligations 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.
As a threshold matter, the IRS stated that a bona fide guarantee that was enforceable by the lender under local law generally would be sufficient to cause the guaranteeing partner to be treated as bearing the economic risk of loss for the guaranteed partnership liability for purposes of these rules. The IRS asserted that a third-party lender would take all permissible affirmative steps to enforce its rights under a guarantee if the primary obligor defaulted or threatened to default on its obligations.
In this case, the IRS viewed the “conditions” listed in C’s guarantee as circumstances under which the lender would enforce the guarantee to collect the entire outstanding balance on the loan, beyond an actual default by P on its obligations. It rejected the assertion that these “conditions” were properly viewed as conditions precedent that must occur before the lender was entitled to seek repayment from C under the guarantee. The failure of P to repay the loan, by itself, likely would be sufficient to trigger the guarantee, the IRS stated. In addition, the IRS believed it was reasonable to assume that one or more of these conditions, more likely than not, would be met upon a constructive liquidation of P. Accordingly, these “conditions” did not fall within the definition of “contingencies.”
For these reasons, the IRS concluded that the Note was a recourse partnership liability allocable to the guaranteeing partner (C), and not to either A or B.
The IRS next considered whether, even if the guarantee was respected as a full and bona fide guarantee that would cause C to be treated as personally liable for the guaranteed debt of P, the Agreement nevertheless operated to cause A and B to be treated as personally liable (i.e., to bear the ultimate economic risk of loss) with respect to their proportionate share of the guaranteed debt, because A and B were obligated to reimburse C in proportionate amounts for any payments that C made under the guarantees.
For purposes of determining the extent to which a partner has a payment obligation and the economic risk of loss, it is assumed that all partners who have obligations to make payments actually perform those obligations, irrespective of their actual net worth.
The IRS did not agree with A’s interpretation of the Agreement, disagreeing that it imposed a mandatory payment obligation on A and B to make additional contributions to P if C was called upon to pay on C’s personal guarantees. Rather, the IRS said, it permitted C to call for additional capital from A and B, but if A and/or B chose not to contribute additional capital, C’s remedies were limited to the remedies identified – either a loan to A and B or a reduction in their ownership interests. Moreover, the partners never entered into a separate contribution agreement with respect to the guarantee. As a result, the IRS did not believe the Agreement gave C the right to bring an action against A and B to require them to contribute additional capital to P if they choose not to. Accordingly, because neither remedy available to C required A or B to make additional contributions to P if C was called upon to pay on C’s personal guarantees, the IRS concluded that A and B did not bear the ultimate economic risk of loss for the guaranteed debt of P.
If a partner guarantees an obligation of the partnership and the guarantee is sufficient to cause the guaranteeing partner to bear the economic risk of loss for that obligation, the guaranteed debt is properly treated as recourse financing for purposes of applying the partnership tax allocation rules.
It is possible, for this purpose, that certain contingencies – such as the partnership’s admitting in writing that it is insolvent or unable to pay its debts when due, its voluntary bankruptcy, or its acquiescence in an involuntary bankruptcy – after taking into account all the facts and circumstances, may not be so remote a possibility (as the IRS determined above) that it is unlikely the obligation would ever be discharged.
Query, however, whether a lender would make a bona fide loan under such circumstances.
To the extent a guaranteeing partner has the right under the partnership agreement to call for the non-guaranteeing partners to make capital contributions and, if they failed to do so, to treat ratable portions of the payment as loans to those partners, or to adjust their fractional interests in the partnership, these right alone generally would not be sufficient to make the non-guaranteeing partners personally liable with respect to the guaranteed debt.
The “right” to enter into an allocation agreement, under which the guarantee would be shared among the partners, similarly would not create a recourse liability as to the non-guaranteeing partners. Of course, if the partners do enter such an agreement, then the non-guaranteeing partners will be allocated a share of the deductions and losses attributable to the recourse debt.
Again, it’s best not be surprised, ever. If recourse treatment is intended, then partners (like A, above) need plan for it and must be prepared to bear the economic consequences from which the desired tax result flows.