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.