November 15, 2015

To Prevent Adverse Tax Consequences, Make No Bones About the Classification of Your Loans

Betty J. Boyd

Recourse or nonrecourse: that is the question . . . for the IRS, when it comes to determining the tax consequences of a partnership loan agreement to the individual partners, upon the foreclosure of the partnership’s collateral property. Why does this matter? The bare bones answer is that, when the lender forgives all or part of the outstanding loan and forecloses upon the collateral property, the partnership is considered to receive income. Partners need to report this income on their tax returns. However, if the partnership loan is recourse, they may exclude the cancellation of debt income (and not pay tax on this income), to the extent of their respective insolvencies. We will call this the “insolvency exception.” On the other hand, if the partnership loan is nonrecourse, the partners may not use this insolvency exception.

In Office of Chief Counsel Memorandum No. 201525010 (Release Date June 19, 2015), the IRS posited its views on this matter. This article presents a primer on the applicable law and examines the IRS’ position in this recent memorandum.

Recourse Loan vs. Nonrecourse Loan: What Is the Difference?

The Internal Revenue Code (IRC) is silent on what makes a loan recourse or nonrecourse, except for the purposes of determining a partner’s basis in his or her partnership interest. IRC Section 752 defines a recourse partnership loan as one in which a partner or related person bears the economic risk of that liability. A partner or related person bears the economic risk of that liability if that individual would be obligated to repay the loan, if the partnership were to constructively liquidate. In other words, if the worst partnership liquidation scenario were to occur, rendering all the partnership assets worthless and all the partnership liabilities fully due and payable – that partner or related person would ultimately be responsible to repay the loan, without receiving any entitlement to reimbursement from another partner or related person. By contrast, IRC Section 752 defines a nonrecourse partnership loan as a liability in which no partner or related person bears the economic risk of loss. Rather, the lender bears the risk of loss, when a partnership takes out a nonrecourse loan.

The “partnership taxpayer” in Memorandum No. 201525010 relied on the definitions under IRC Section 752, in reaching the conclusion that the partnership taxpayer had a recourse loan, when a lender discharged a partnership loan and foreclosed upon the collateral property. The partnership taxpayer was a California Limited Liability Company; or more specifically, a special purpose entity (SPE), created for the sole purpose of purchasing a specified piece of real property (“collateral property”) for its development and sale.

The partnership taxpayer borrowed funds to purchase the collateral property, which secured the debt. Beyond the collateral property, the partnership taxpayer had no other assets. The relevant partnership loan documents did not specify whether the loan was recourse or nonrecourse. In addition, these same loan documents did not specify that the partnership taxpayer was unconditionally and personally liable for the repayment of the loan if the collateral property was insufficient to fully repay the loan. However, the individual partners previously signed unlimited, unconditional, and irrevocable guarantees to repay the partnership taxpayer’s loan should the collateral property be insufficient to fully repay the loan. For purposes of the definition of a partnership recourse loan, IRC Section 752 recognizes guarantees and other contractual agreements outside the partnership agreement as well as payment obligations imposed by state law. Accordingly, when the lender discharged the loan and foreclosed upon the collateral property, the partnership taxpayer reported cancellation of debt (or COD) income. The partners, in turn, applied the insolvency exception and did not pay tax on this income, to the extent of their respective insolvencies.

But the IRS took the position that the taxpayer partnership’s debt may be nonrecourse and, therefore, the partnership may not have COD income; but a capital gain, to the extent the discharged debt exceeded their basis in the collateral property. Commissioner v. Tufts, 461 U.S. 300 (1983) (holding that a taxpayer’s amount realized in the disposition of property includes the amount by which a nonrecourse debt exceeds the property’s FMV). In reaching its position, the IRS relied upon Great Plains v. Commissioner, T.C. Memo 2006-276, where the tax court utilized a “facts and circumstances” test to determine that a debt was nonrecourse. Like the partnership taxpayer in the memorandum, the partnership in Great Plains was also a SPE that pledged all its project assets as collateral, in exchange for a loan. Although the tax court in Great Plains referenced the IRC Section 752 definitions of recourse and nonrecourse debt, it did not apply these definitions to the case – instead, it used a “facts and circumstances” test. The court concluded that the debt must be nonrecourse to the partnership, as there were no other assets beyond the collateral to satisfy the debt.

In its memorandum, the IRS concluded that the IRC Section 752 definition of a partnership recourse loan is limited to the determination of a partner’s basis, because Treasury Regulation 1.752-1(a) specifically states that these definitions of recourse and nonrecourse liabilities apply to only that section. The Section 752 allocation tests and the general partner basis principles address the issue of whether a debt is recourse or nonrecourse to the partners – and not to the partnership. The two are mutually exclusive.

It is possible for a debt to be recourse to an individual partner, for Section 752 purposes and, yet, be nonrecourse to the partnership borrower. The IRC Section 704b regulations present this possibility but the Code section does not define this classification of liability. Case law, however, defines nonrecourse debt as debt in which the creditor’s right of recovery is limited to the collateral, or the particular asset securing the liability. In an event of default, the lender cannot pursue the borrower if the debt is nonrecourse debt, because the borrower is not personally liable for the debt. By contrast, a creditor’s right of recovery, for a recourse debt, extends beyond the collateral, to all assets of the borrower, because the borrower is personally liable. The key to these definitions is the borrower’s personal liability or, in the case of the partnership taxpayer, the partnership itself. This is the essence of the rule applied by the tax court in Great Plains.

Although the IRS did not provide a definitive answer to whether the partnership taxpayer’s loan was recourse or nonrecourse in its memorandum, it pointed to a couple of key facts that suggested the loan may be nonrecourse to the partnership taxpayer: First, the partnership taxpayer was an SPE and, therefore, had only one asset, which was the collateral property, to which the lender was limited to, upon default of the loan (the lender had no access to any other partnership assets that were unrelated to the collateral property). Second, the partnership loan documents lacked any express language imposing any unconditional personal liability of the partnership taxpayer. Unlike the partnership taxpayer, the IRS did not consider the individual partners’ personal guarantees of the partnership’s loan as a key fact that determined whether the partnership loan was recourse or nonrecourse to the partnership taxpayer.

Recourse Loan vs. Nonrecourse Loan: What Are the Tax Consequences?

It is at the partnership level – and not at the partners’ individual level – where the character of income is determined. Regardless of the loan classification as recourse or nonrecourse, when a partnership borrows funds, it is not considered to be income to the partnership (and, in turn, to the partners), because the acquisition of borrowed funds is offset by the obligation to repay them. However, when the lender discharges the loan and forecloses upon the property, the partnership has acquired an economic benefit. Different tax consequences will result, depending on the classification of the loan as recourse or nonrecourse.

When a loan is recourse, both COD income and a capital gain (or loss) can result. When the lender cancels all or a portion of the loan and forecloses upon the collateral property, the tax consequences are analyzed in two steps. First, the property is considered to be sold or disposed for its fair market value. This can result either in a capital gain or loss (by taking the difference between the property’s FMV and the partnership’s adjusted property basis; see IRC Section 1001(a)).

Second, the property’s sale proceeds are considered to repay the outstanding debt (resulting in possible COD income). If the face amount of the canceled debt is greater than the property’s FMV, then the difference will be treated as COD income. If the face amount of the canceled debt is equal or less than the property’s FMV, then no COD income is realized.

When the partnership reports the COD income and the capital gain on the partners’ respective Schedule K-1s, the partners may use the insolvency exception (at the partner level), to exclude the COD income to the extent of their respective insolvencies (i.e., to the extent that the partners’ respective liabilities exceed their respective assets). However, they cannot apply the insolvency exception to their capital gains, because the insolvency exception does not apply to the capital gains that pass through to the partners.

To illustrate these principles, suppose Partnership R&R took out a $2 million recourse loan to purchase property costing $1.5 million and to make $500,000 worth of improvements to the property. Unfortunately, the property’s fair market value plummets to $1 million, after a few years, and the partnership is unable to repay the outstanding balance. For ease of calculation, suppose no principle payments were made on the loan. Suppose further that the improvements have been fully depreciated, meaning that the partnership took annual deductions on the improvements, resulting in a $500,000 basis reduction, or an adjusted basis of $1.5 million. When the lender forgives this loan and forecloses upon the property, the tax consequences would be as follows:

The first step would be treated as a property disposition: The $1.5 million property’s basis minus the property’s $1 million fair market value yielding a $500,000 capital loss.

The second step would be treated as using the property’s sale proceeds (the property’s FMV) to repay the loan balance (which may result in COD income): The outstanding $2 million loan balance minus the property’s $1 million fair market value (deemed sale proceeds) resulting in $1 million COD income. As explained above, notice that the face amount of the canceled debt is greater than the property’s FMV, resulting in COD income.

The end result would be that this capital loss and COD income would flow to the individual partners. To the extent of their respective insolvencies, partners Rachael and Rick can exclude this COD income from their individual tax returns. (The insolvency exception applies at the individual partner level and not at the partnership level.) Rachael and Rick would not be able to use the capital loss to offset the COD income (beyond the $3,000 that Congress allows taxpayers to offset their ordinary income with capital losses). Therefore, the capital loss would not benefit Rick or Rachael unless they have other capital gains.

By contrast, when the loan is nonrecourse, the tax consequences are analyzed in a single step, which is a property disposition of the collateral property. The result is a possible capital gain, which is calculated by the difference between the outstanding loan balance and the partnership’s basis in the property. To illustrate, suppose Partnership N&N took out a $2 million loan similar to the example above, except that it was nonrecourse. When the lender forgives the loan and forecloses upon the collateral property, the tax consequences would be as follows: The collateral property would be treated as a property disposition of $2 million (face value of the canceled debt), resulting in a $500,000 capital gain (by subtracting the $1.5 million property basis from the $2 million face value of the debt) that flows to the individual partners.

In this second example, there is no COD income. Therefore, partners Nick and Nancy cannot use the insolvency exception (because it does not apply to capital gains). (With a nonrecourse loan, COD income would result if the lender canceled part or all of the debt and allowed the borrower to keep the collateral property; but this is rarely the case.) The exclusion provisions under Section 108 only apply to COD income and not to dealings in property. Thus, the partners are not able to exclude the recognition of capital gain from dealings in property when the debt is nonrecourse.

Recourse Loan vs. Nonrecourse Loan: What Is the Bare Bones Lesson?

For purposes of analyzing the tax consequences of a partnership’s loan, when the lender forecloses upon the collateral property, it is the “factual analysis of the operating and loan documents and any relevant state law” that determines the classification of a loan as recourse or nonrecourse (and not the IRC Section 752 definition). Whether partners benefit from a loan being classified as either recourse or nonrecourse, at the partnership level, depends on the solvency of the partners. Partners who are insolvent may desire the loan to be classified as recourse, so they can utilize the exclusion under IRC Section 108. On the other hand, partners who are solvent may desire the debt to be classified as nonrecourse, so they can benefit from the lower capital gain tax rate. However, it is almost impossible for partners to know what the future holds – whether they will be solvent or insolvent, or whether their venture will suddenly fail and the property will be foreclosed upon. Thus, parties often attempt to keep the status of a loan (as recourse or nonrecourse) vague, so as to allow the partners to postpone the final determination to the latest moment when their solvency position is clear.

However, Memorandum No. 201525010 makes it clear that the IRS will look at all the facts and circumstances surrounding the loan to determine the intent of the parties in making the loan recourse or nonrecourse (including whether, or not, the loan documents state that the partnership is personally liable for the loan should the collateral be insufficient to satisfy the debt). Consequently, the decision may already be fixed when the loan is made; and the taxpayers may be stuck with an unfavorable result.

Therefore, it is important to get with your tax advisors early and decide upon a course of action that is best for all involved. Most importantly, make the facts fit the desired result. If you want a partnership debt to be recourse, then make sure the partnership is personally liable beyond the collateral property securing the loan and make sure that the partnership has other properties or assets that do not secure the loan. On the other hand, if you want the partnership debt to be nonrecourse, then make sure the partnership will not be personally liable beyond the collateral securing the loan. It is also important that you ensure all agreements among all the parties match the facts. Remember, the IRS is never bound by the classification of a loan as recourse or nonrecourse in agreements to which it is not a party. The bare bones lesson, on loans, is that it’s the facts and circumstances that control, not the mere labeling of the debt as “recourse” or “nonrecourse.”

Additional Resources

For other materials on this topic, please refer to the following.

Business Law Section Program Library

Taxation of Transfers of LLC and Partnership Interests (PDF) (Audio)
Presented by: LLCs, Partnerships and Unincorporated Entities Committee
Location: 2013 LLC Institute Committee Meeting 

Business Law Section Committees

Taxation Committee

LLCs, Partnerships and Unincorporated Entities Committee 

The LLC & Partnership Reporter

IRS 2015–2016 Priority Guidance Plan
Volume 31, No. 2 November 2015

Betty J. Boyd

Betty J. Boyd represents clients before the IRS on tax controversy matters in the greater Los Angeles area.