Self liquidating loan example
A “bad boy” guarantee is triggered only upon the occurrence of certain events that would jeopardize the lender’s ability to be repaid from the partnership’s assets and that are within the control of the sponsoring or managing partner.“bad boy” events often include the partnership’s voluntary bankruptcy filing, the managing partner’s filing of an involuntary bankruptcy petition against the partnership, etc.The meeting was held on March 8 at the IRS in Washington, and was attended by Mr. At the meeting, Joe Forte described the legal and practical evolution of the particular “bad boy” guarantee at issue in the Memorandum.The participants explained to the IRS, among other matters, that the “bad boy” guarantee is a device to prevent the borrower from taking certain voluntary actions, such as a bankruptcy filing, and the guarantor is very unlikely to ever take any of the prohibited actions or have liability on the guarantee.If this position had become established law, real estate investors would have had to recapture billions of dollars in losses from previous years and would not have been able to share in losses in excess of their equity capital going forward.
In response to the Memorandum, a small task force from the Real Estate Roundtable, including Joe Forte of Kelley Drye & Warren LLP, drafted an industry position paper and met with IRS Chief Counsel William Wilkins to share the real estate community’s concerns.For purposes of determining whether a partner bears the economic risk of loss with respect to a partnership liability under the tax basis rules of Section 752 of the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury Regulations thereunder, all statutory and contractual obligations relating to the liability are taken into account, including, for example, a partner guarantee of partnership debt. Further, if an “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.” Treas.  Most real estate partnerships use a combination of equity and non-recourse financing to fund their real estate acquisition and/or development activities.However, a guarantee obligation will be disregarded “if, taking into account all the facts and circumstances, the obligation is subject to .” Treas. In this context, non-recourse financing means the lender will look only to the assets of the partnership and not to the partners to repay the loan, except that the lender often requires the sponsoring or managing partner to give a so-called “bad boy” guarantee.In practice, “bad boy” guarantees are rarely triggered because the trigger events are within the control of the party providing the guarantee, and it generally would make no sense for the guarantor to voluntarily expose himself to full liability on the loan. An LLC, treated as a partnership for tax purposes, and its subsidiaries borrowed funds from a lender on a non-recourse basis to support their real estate activities.One of the LLC’s members (the “NRG Member”) provided a customary “bad boy” guarantee, obligating him to repay the loan in full if the LLC failed to obtain the lender’s consent before obtaining subordinate financing or transferring the secured property, if the LLC filed a voluntary bankruptcy petition, or if the NRG Member colluded or cooperated in an involuntary bankruptcy petition of the LLC.
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The Memorandum ignored customary real estate industry practice and concluded that for purposes of allocating partnership tax basis among the LLC’s members, the NRG Member’s guarantee caused the LLC’s financing to constitute a recourse liability under Section 752 of the Code, thereby requiring the liability to be allocated entirely to the NRG Member and therefore depriving the LLC’s other members of any share of the liability in computing their tax basis in the LLC.