In new CCA 201525010, the IRS addressed the issue of whether a general “exculpatory” debt of an LLC is recourse or non-recourse for purposes of classifying debt-relief as potential cancellation of debt (COD) income. Recourse treatment means the debt forgiveness creates COD income. Non-recourse means the debt relief is treated as proceeds from the sale of the underlying property. In this case the taxpayer wanted COD treatment because they were eligible for a special COD income exclusion.

Ultimately the IRS said that there is authority both for and against treating exculpatory debt of a single purpose LLC as recourse debt for COD purposes. However, the IRS concluded that in making this determination, the Section 752 partnership regulations were not relevant and the answer turned on the more general test as to whether the debt was recourse or non-recourse to the LLC itself (as opposed to looking at whether the members were at risk through their member guarantees).

Details

In the ruling, the real estate LLC had a first and second mortgage, with the second mortgage lender also having guarantees and interest pledges by the LLC members. The loan documents required the LLC to be a single purpose entity (SPE). The loan documents did not specifically say the loan was recourse or non-recourse. But by being an SPE, the assets were necessarily limited, although technically all LLC assets were at risk for the second mortgage that was at issue.

After a non-judicial foreclosure by the first mortgage lender, the second mortgage lender forgave its debt. The LLC members reported the debt forgiveness as COD income, and excluded a portion of the income under the Section 108 insolvency exception. Both the taxpayers and the IRS acknowledged that if the loan was recourse, the loan forgiveness was COD income, but if it was non-recourse, the forgiveness was treated as disposition proceeds from the underlying real estate. In this case the taxpayer asserted recourse treatment, because it could exclude the income under the Section 108 insolvency exception.

The taxpayers argued that the debt must be recourse for COD purposes because it was recourse under the Section 752 partnership debt sharing rules because there were member guarantees. The taxpayer noted that this result was implied in the Great Plains Gasification Associates v. Commissioner Tax Court memorandum decision. In the CCA, the IRS concludes that the implication in that case is erroneous and the more general “Section 1001” rules apply to determine whether the loan is recourse or non-recourse. Having said that, the IRS said that there was legal support under the general Section 1001 rules for treating such SPE exculpatory debt as either recourse or non-recourse and further factual development of the specific case was needed.