IRS Reverses Its Aggressive 'Bad Boy' Loan Position

The US Treasury Department

WASHINGTON, DC—In a legal memo released on April 15 ^th , the Internal Revenue Service backed away from the implications of an internal memo written by the Internal Revenue Service’s Office of Chief Counsel and published in February of this year.  The about face came after a meeting with The Real Estate Roundtable and their tax and loan counsel in March. Essentially what has happened is that the IRS has come to recognize that a lender routinely uses this provision to protect itself against a scenario in which the borrower or guarantor undertakes “bad acts” that would somehow prevent the lender from repossessing the property in a default, according to a client brief by Thomas Lawson and Alan J. Tarr of Loeb & Loeb LLP. It also came to understand that such bad acts are against the financial self-interest of the borrower or guarantor and thus very unlikely to occur, according to the Loeb & Loeb advisory. “Accordingly, the guarantee should not affect the character of the liability as being nonrecourse, for either tax basis or at-risk purposes.” How It Started The IRS’ original memo was in response to a specific inquiry about the tax treatment of so-called bad boy loan guarantees, which are routine in the industry. Up until the release of this memo, it had been widely assumed that these guarantees do not change the nonrecourse treatment of the debt for tax purposes. Indeed, the guarantees are boilerplate provisions in CMBS loan documents and many commercial real estate loans, the Real Estate Roundtable noted. In the memo released in February 2016, IRS astounded the industry by concluding that “certain bad-boy guarantees effectively converted a nonrecourse real estate loan to a recourse loan.” The IRS had been particularly concerned with an “admission of insolvency” provision, which allows lenders to pursue guarantors directly if the borrower admits to being insolvent. If the IRS had formally adopted this position it could have forced the conversion of billions of dollars in commercial real estate and CMBS loans from non-recourse to recourse, creating huge unexpected tax liabilities for real estate investors. A Meeting With the IRS Chief Counsel At the March meeting, the industry task force arrived with an industry position paper and a presentation on the legal and practical evolution of the particular bad boy guarantee at issue in the memorandum, according to a client advisory by Joseph Philip Forte, John Garraty and Gregory McKenzie of Kelley Drye & Warren LLP. Forte was part of the delegation meeting with ]IRS Chief Counsel William Wilkins. According to the advisory:

The participants explained to the IRS, among other matters, that the bad boy guaranty 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 guaranty.

The IRS Reverses Itself The memo released on April 15 reversed the position in the original memo. Kelley Drye & Warren wrote that:

The new memorandum acknowledged that a carve-out or bad boy guarantee is a device to prevent the borrower from taking actions which violate the terms of the loan in a manner which might harm the value of the property or interfere with the lender’s exercise of remedies. The IRS concluded that the adverse financial impact to the guarantor resulting from the prohibited acts would be contrary to the guarantor’s self-interest, making the acts and resulting personal liability very unlikely to occur. The IRS acknowledged that the bad boy acts were all voluntary acts of the guarantor, not matters which a lender could use to enforce personal liability in the absence of specific voluntary actions. Therefore, the New Memorandum concludes that a bad boy guarantee does not cause a non-recourse loan to become recourse unless one of the enumerated bad boy acts actually occurs.