IRS Reverses Position on ‘Bad Boy’ Carve-Outs
Author: Scott Humphrey
On April 15, 2016, the IRS Office of Chief Counsel released legal advice on the treatment of “bad boy” carve-outs common in real estate loans. Contrary to recent advice, the Office of Chief Counsel concluded by default that nonrecourse carve-outs wouldn’t change a loan’s character from nonrecourse to recourse.
It’s common for traditional nonrecourse real estate financing to contain carve-outs converting nonrecourse loans to recourse. These clauses are provided to make sure the borrower doesn’t knowingly put a lender in a secondary credit position or their collateral at risk. Common clauses include:
- Obtaining subordinated debt without the lender’s permission
- Voluntary bankruptcy filing
- Borrower admits in legal proceeding it’s insolvent
Providing financial statements to a lender is a normal industry requirement, and the Office of Chief Counsel has advised this isn’t an admission of insolvency. While a legal advice memorandum may not be used as precedent, the memo uses the court case of D.B. Zwirn Special Opportunities Fund, L.P. v. SCC Acquisition, Inc. to further support the position. According to the IRS, “ ... it is not in the economic interest of the borrower or the guarantor to commit the bad acts ... in the typical nonrecourse carve-out ... .” Therefore, the carve-out doesn’t convert the nonrecourse liability to recourse, which only violates the nonrecourse clauses.
The classification of debt as nonrecourse or recourse may not appear to be important, but it could cause income recognition on the contribution of encumbered property, determine tax income allocations and provide basis for distributions or to deduct losses for partnerships.
If you have any questions about how debt allocations can affect your business, contact your BKD advisor.