Good News on "Bad Boy" Guarantees; IRS Reverts to Prior Position in Recent Legal Advice Memorandum (ML Tax and Real Estate Alert)
On April 15, 2016, the IRS released a memorandum addressing the impact of so-called “bad boy” guarantees on the characterization of underlying partnership debt as recourse vs. nonrecourse under Section 752 of the Internal Revenue Code. “Bad boy” guarantees are principally used in nonrecourse real estate mortgage financing transactions, especially those utilizing commercial mortgage-backed securities or securitized financing, to protect a lender against certain bad acts that are either in the control of the borrower or are customarily viewed as events where liability should be shifted to the borrower and its principals (such as fraud, material misrepresentation, and environmental issues).
Reversing its position from guidance issued earlier this year, the IRS concluded that the “bad boy” guarantees considered generally do not cause the underlying partnership obligation to fail to qualify as a nonrecourse liability of the partnership until such time as one of the “bad boy” events actually occurs (causing the guaranteeing partner to become liable for the partnership debt).
Importantly, IRS indicated that the applicable tax analysis is ultimately dependent on all the relevant facts and circumstances. Therefore, taxpayers should carefully review their financing arrangements in the context of their overall transaction and applicable circumstances, even if the terms of such financing arrangements appear similar to the terms covered by the said memorandum.
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