On April 15, 2016 the IRS reversed its controversial position that bad boy guarantees may convert nonrecourse debt into recourse debt. General Legal Advice Memorandum Number AM2016-001 released April 15, 2016 effectively withdrew Chief Counsel Advice Memorandum Number 201606027 issued on February 5, 2016 which concluded that “bad boy guarantees” may cause nonrecourse financing to become, for tax purposes, the sole recourse debt of the guarantor. Such a result could dramatically affect the tax basis and at-risk investment of the borrowing entity’s partners or members that do not provide a guaranty. Nonrecourse liability generally increases the tax basis and at-risk investment of all parties but recourse liability increases only that of the guarantor.
The February 5th IRS Memo concluded that certain events such as voluntary bankruptcy, collusive involuntary bankruptcy, unapproved junior financing and transfers or admitting in writing borrower’s inability to pay its debts as they become due were not sufficiently remote so as to satisfy the meaning of Treas. Reg.1.752-2(b)(3) which disregards payment obligations that are subject to contingencies that are unlikely to occur.
Most loan parties believe just the opposite. The fact that the guarantor usually directly or indirectly controls the borrower means that the likelihood of it allowing conduct that would trigger personal liability is extremely remote.
The February 5th IRS Memo seemed to assume that a bad boy guaranty is the functional equivalent of a payment guaranty. But the real purpose of a bad boy guaranty is to discourage those who control the borrower from allowing it to commit certain “bad acts” that are harmful to the interests of the lender. Unlike the case with a payment guaranty, unless the prohibited conduct occurs the guarantor is not liable for payment regardless of what other defaults exist or whether the loan is ever repaid.
A bad boy guaranty merely provides a nonrecourse lender with the leverage to make sure the mortgaged property, usually its only source of repayment after default, remains in good condition, stays free of unapproved liens or transfers and ensures that the borrower does not do anything that will interfere with the recovery of its collateral. Obtaining the right to impose potential recourse liability on those who can prevent these occurrences gives the lender a significant tool to prevent such harm, but falls far short of assuring repayment.
After an...
