The allocation of a partnership’s items of income, gain, deduction and loss among its partners 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 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 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. For example, if a partnership incurs debt to acquire property, and only some of its partners are ultimately responsible for the satisfaction of such debt, the depreciation deductions attributable to the acquisition indebtedness would be allocable only to those partners.
Bad Boy Guarantees
A few weeks ago, we discussed a pronouncement by the IRS regarding a partner’s guarantee of a partnership’s nonrecourse debt. The partner had provided a “bad boy guarantee,” and the ruling considered whether the guarantee would cause the debt to be treated as recourse to the partner. The outcome was important because the deductions attributable to a nonrecourse liability are generally allocated among all the partners in accordance with their interest in the partnership, while those attributable to a recourse liability are allocable only to those partners who bear the economic risk of loss for that liability.
The IRS determined that the circumstances under which the guarantee would be enforced were not “contingencies” and, so, it concluded that the guarantor-partner did bear the risk of loss, notwithstanding certain language in the partnership agreement that could have been construed as imposing an obligation on the other partners to reimburse the guarantor.
This week, the IRS released yet another memorandum regarding a partner’s guarantee of a partnership’s nonrecourse debt. As in the case of the earlier pronouncement, this memorandum addressed the treatment of a partner’s guarantee of a partnership nonrecourse liability when the guarantee was conditioned on certain “nonrecourse carve-out” events (or “bad boy guarantees”). Specifically, the IRS considered whether a partner’s guarantee of a partnership’s nonrecourse obligation, which was conditioned on the occurrence of certain “bad boy” events, would cause the obligation to fail to qualify as a nonrecourse liability of the partnership (i.e., would make it a recourse liability as to the guarantor). This time, however, the IRS reached a different conclusion.
In general, a partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. 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.
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.
Upon a constructive liquidation, all of the following events are deemed to occur simultaneously:
(i) all of the partnership’s liabilities become payable in full;
(ii) with the exception of property contributed to secure a partnership liability, all of the partnership’s assets, including cash, have a value of zero;
(iii) the partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor’s right to repayment is limited solely to one or more assets of the partnership);
(iv) items of income, gain, loss, or deduction are allocated among the partners; and
(v) the partnership liquidates.
The determination of the extent to which a partner or related person 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 these purposes, including (i) contractual obligations outside the partnership agreement such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or other partners, or to the partnership; (ii) obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership, and (iii) payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state law.
How Likely Are the Bad Acts?
Sometimes, guarantees of partnership nonrecourse obligations are conditioned upon the occurrence of one or more of the following “nonrecourse carve-out” events:
- The borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property;
- The borrower files a voluntary bankruptcy petition;
- Any person in control of the borrower files an involuntary bankruptcy petition against the borrower;
- Any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower;
- The borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding;
- Any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or
- The 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.
By including these provisions in a loan agreement, the lender seeks to protect itself from the risk that the borrower, or a guarantor in charge of the borrower, will undertake “bad acts” that will diminish or impair the value of the property securing the loan, that might disrupt the cash flow from the property, or that could delay, complicate or prevent the lender’s repossession of the property in the event of a default.
An important aspect of these nonrecourse carve-outs, the IRS noted, is that the bad acts that they seek to prevent are within the control of the borrower or guarantor—meaning that the borrower, or a guarantor in control of the borrower, can prevent them from occurring. Because it is in the economic self-interest of borrowers and guarantors to avoid committing those bad acts and subjecting themselves to liability, they are unlikely to voluntarily commit such acts.
Moreover, “nonrecourse carve-out” provisions are not intended to allow the lender to require an involuntary action by the borrower or guarantor, or to place borrowers or guarantors in circumstances that would require them to involuntarily commit a “bad act.” Rather, the fundamental business purpose behind such carve-outs, and the intent of the parties to such agreements, is to prevent actions by the borrower or guarantor that could make recovery on the debt, or acquisition of the security underlying the debt upon default, more difficult.
The “nonrecourse carve-out” provisions at issue, the IRS stated, should be interpreted consistently with that purpose and intent in mind. Consequently, because it is not in the economic interest of the borrower or the guarantor to commit the bad acts described in the typical “nonrecourse carve-out” provisions, it is unlikely that the contingency (the bad act) will occur and, so, the contingent payment obligation should be disregarded.
In sum, unless the facts and circumstances indicate otherwise, a typical “nonrecourse carve-out” provision that allows the borrower or the guarantor to avoid committing the enumerated bad act will not cause an otherwise nonrecourse liability to be treated as recourse for purposes of allocating among the partners the deductions and losses attributable to such liability, at least until such time as the contingency actually occurs.
Thus, the guarantee will not cause the obligation to fail to qualify as a nonrecourse liability of the partnership until such time as one of those events actually occurs and causes the guarantor to become personally liable for the partnership debt.
This memorandum represents a retreat from the position that the IRS staked out in its earlier pronouncement on “bad boy guarantees” and their effect on the tax treatment of partnership nonrecourse liabilities. It is also more in line with the IRS’s own regulatory rule 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.
This result should come as a relief to “investor-partners.” Even though IRS chief counsel memoranda cannot be cited as precedent, they do give us a glimpse into the IRS’s thinking on a particular issue. Consequently, such partners should be assured, in determining the economic consequences of their investment, that their allocations of partnership deductions attributable to nonrecourse debt should, generally speaking, be respected by the IRS.