IRS Clarifies That a Typical “Bad Boy Guarantee” Will Not Cause an Otherwise Nonrecourse Financing to Be Treated as Recourse

On April 15, 2016, the IRS released a generic legal advice memorandum (the “GLAM”)1 providing an important and helpful clarification of the treatment of a guarantee of a partnership nonrecourse liability when the guarantee is conditioned on certain typical “nonrecourse carve-out” events (commonly referred to as “bad boy guarantees”).

“Bad boy guarantees” are common in commercial mortgage financing transactions. The lenders generally require a partner (or its affiliate) in control of a real estate partnership to guarantee, upon the occurrence of certain “bad acts” that are within the control of the partnership or the guarantor, the partnership debt, effectively making the events that trigger the guarantee less likely to occur.

Earlier this year, the IRS released Chief Counsel Advice 201606027 (the “CCA”)2 treating a real estate partnership debt with a partner providing a common “bad boy guarantee” as recourse debt allocable to the guaranteeing partner and the guaranteeing partner as personally liable for the partnership debt for purposes of the at-risk rules. The CCA was based upon the premise that upon a constructive liquidation of the partnership, it is reasonable to assume that one or more of the triggering conditions, more likely than not, would be met, in which case the guaranteeing partner would be personally liable for the partnership debt. The CCA was widely criticized and caused confusion among practitioners and taxpayers. Such treatment of a real estate partnership debt could limit the ability of the non-guaranteeing partners to claim losses with respect to their partnership interest or, in some cases, could result in gain recognition.

Contrary to the conclusion of the CCA, the GLAM makes clear that if a partner’s guarantee is conditioned on the occurrence of certain typical “nonrecourse carve-out” events described below, the guarantee will not cause the debt to fail to qualify as a nonrecourse debt and as “qualified nonrecourse financing” for purposes of the at-risk rules, in each case, until such time as one of those events actually occurs and causes the guarantor to become personally liable for the partnership debt.

The GLAM identifies the following typical “nonrecourse carve-out” events: (1) the borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property; (2) the borrower files a voluntary bankruptcy petition; (3) any person in control of the borrower files an involuntary bankruptcy petition against the borrower; (4) any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower; (5) the borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding; (6) any person in control of the borrower consents to the appointment of a receiver or custodian of assets; and (7) 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.

The GLAM further clarifies that the “nonrecourse carve-out” provisions should be interpreted consistent with their fundamental business purpose and the intent of the parties 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, giving as an example a case where the court read a carve-out provision very narrowly to deny enforcement.3

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, the GLAM concludes that it is unlikely that the contingency (the “bad act”) will occur. Accordingly, the GLAM concludes that, 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 determining the allocation of partnership liabilities. Similarly, the GLAM concludes that such guarantee will not cause the nonrecourse financing to fail to qualify as “qualified nonrecourse financing” for purposes of the at-risk rules.

While the GLAM may not be used or cited as precedent, the GLAM confirms that the IRS views a nonrecourse carveout guarantee consistently with its business rationale and with the expectations of the parties to the financing transaction.