IRS Reevaluates "Bad Boy" Carve-Outs

Before providing a non-recourse loan to a Limited Liability Company (LLC) – i.e., one for which the LLC members do not bear the risk of economic loss – a lender often will require the LLC's managing member to provide a "bad boy" guaranty promising to pay the debt upon the occurrence of certain events, such as a bankruptcy. Prior to February 2016, loans containing bad boy carve-outs were customarily treated as nonrecourse obligations for purposes of calculating the guaranteeing member's liabilities and determining its tax basis under Internal Revenue Code sections 752 and 465, respectively. Such treatment was based on certain exceptions contained in Treasury Regulation §1.752-1(b).

On Feb. 5, 2016, the Internal Revenue Service (IRS) released Chief Counsel Advice 201606027 (the CCA), which concluded, among other things, that a bad boy carve-out did not qualify a loan for the exceptions detailed under §1.752-1(b), and that the inclusion of such a carve-out rendered the loan recourse with respect to the guaranteeing member. Consequently, guaranteeing members thereafter would have to include such obligations in determining their liabilities and tax basis. Needless to say, the real estate industry received the CCA with a collective grimace.

That grimace eased into a slightly confused grin on April 15, 2016 upon the release of IRS Advice Memorandum 2016-001 (the AM), which appears to countermand the CCA. The pertinent provision of the AM reads as follows: "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 section 752 and §1.752-1(a) until such time as the contingency actually occurs" (AM, p. 3). According to the AM, then, the inclusion of a bad boy carve-out in a loan will not, by itself, cause a nonrecourse debt to become recourse.

As of this update, the IRS has not withdrawn the CCA. Nevertheless, industry players are generally relying on the AM as a reversal, clarification and sanction of their customary use of bad boy carve-outs.

Surfers vs. Property Owners: Appellate Court Rules on Martin's Beach Case

In 2014, an association called Friends of Martin's Beach (Friends), composed of surfers and surfers' friends and advocates, asked the County of San Mateo Superior Court to grant them the right to traverse certain privately owned property in order to access the primo waves at Martin's Beach. The plaintiffs made the following two principle arguments:

  • Article X, Section 4 of the California Constitution, which seeks to preserve the public's right to access the state's "navigable waters," should prevent the defendant property owner from barring public access to the beach.
  • The fact that previous owners of the property encouraged public access, including permitting the use of a road across the property and erecting a billboard inviting the public to use the beach, constitutes a dedication of those portions of the property under common law.

The trial court rejected both arguments, granting all of the defendant's motions for summary judgment in the case. Friends appealed. On April 27, 2016, in Friends of Martin's Beach v. Martin's Beach 1 LLC et al., the California Court of Appeal affirmed the trial court rejection of the plaintiff's constitutional argument, but reversed the trial court's ruling relating to the question of dedication. The appellate court ruled that the facts alleged by the plaintiffs, if proved, were sufficient to support a cause of action for a common law dedication, despite the absence of any written agreements or recorded documents.

The defendants are expected to appeal the appellate ruling, and there is no word yet as to when the trial court will take up the issue of common law dedication.

Los Angeles Looks to Update its General Plan

As we have reported previously, two different groups are seeking ballot initiatives to address the fact that Los Angeles's zoning code needs a major overhaul. The initiatives seem to have spurred the city to take action. On April 13, 2016, Mayor Eric Garcetti and several members of the city council announced plans to revise major portions of the city's general plan, which has not been updated in more than two decades and is not adequate to handle the current development boom in Los Angeles.

Under the proposal, the city will hire 28 new city planners who will be tasked with updating the city's 35 community plans, which are the planning documents that are used to control developments and construction projects in the city's various neighborhoods. The goal is to have the new community plans in place within 36 months after funding is approved.

Updating all of the community plans at once is certain to bring to a head the heated debate about development. Currently, because the community plans are so outdated, the city frequently grants developers' increases in height and density to allow the types of taller buildings that are springing up throughout Los Angeles. It is that practice of granting variances from existing zoning rules that was the impetus for the ballot initiatives, and Mayor Garcetti is hopeful that by drafting updated codes that would avoid the need for such variances, the zoning activists will withdraw their ballot measures. It remains to be seen whether he will be able to forge a consensus about how development should occur in the city.