Basis for 'bad boys'.

• Author: Siddiqui, Muhammad Y.
• Position: Partnership taxation

The IRS has noted that including "bad boy" provisions in loan agreements is a common practice to protect the lender in the commercial real estate finance industry. (Bad boy provisions typically provide that liability for a nonrecourse loan will become recourse if the borrower engages in any of a number of "bad" acts, such as declaring bankruptcy.) If a partner's guarantee is triggered on the occurrence of certain nonrecourse carve-out events, the guarantee will not cause the obligation to fail to qualify as a nonrecourse liability of the partnership under Sec. 752 or as qualified nonrecourse financing for purposes of Sec. 465(b)(6), until one of the carve-out events actually occurs and causes the partner-guarantor to become personally liable for the partnership debt under local law. To better understand this clarification in Associate Chief Counsel Legal Advice AM 2016-001, it is necessary to take a look at the different types of liabilities.

Recourse liabilities may cause the partner to bear the economic risk of loss for the liability. This economic risk of loss exists only if any partner or any person related to a partner would be obligated to pay the creditor or make a partnership contribution upon a constructive liquidation of the partnership under certain circumstances. Recourse liabilities generally provide basis for partnership distributions and for at-risk rules.

Nonrecourse liabilities are those liabilities where only the creditor bears the economic risk of loss and, according to Sec. 752, are those partnership liabilities for which no partner bears the economic risk of loss. The most prevalent type of nonrecourse liability is a loan against which property is pledged as security for repayment and for which the lender's only remedy in the event of a default is to foreclose on the property. Nonrecourse liabilities may provide basis for partnership distributions, but they generally do not provide basis for the at-risk rules.

Qualified nonrecourse financing generally includes financing for which no one is personally liable for repayment, that is borrowed for use in an activity of holding real property, and that is loaned or guaranteed by a federal, state, or local government or is borrowed from a "qualified" person. Qualified nonrecourse financing secured by real property used in an activity of holding real property that is subject to the at-risk rules is treated as an amount at risk. Qualified persons include any person actively and...