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Do Bad Boy Guarantees Impact LLC Loss Allocations?
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A controversial ruling by the IRS earlier this year called into question whether “bad boy guarantees” of some partnership nonrecourse loans would change the way losses are shared among an LLC’s owners. The IRS has now reversed itself on this issue; so it’s back to business as usual for partnership liability allocations.
History of bad boys
Real property is most commonly held in limited liability companies (LLCs) or other entities that shield the entity’s owners from personal liability for entity debts. Real estate loans typically require the borrower (LLC) to satisfy loan obligations using cash flow the LLC generates. In a worst-case scenario, assets owned by the LLC could be obtained by the lender to satisfy an unpaid loan obligation. Absent a provision in the loan documents or the LLC agreement, however, an LLC’s creditors would not have recourse against the LLC’s owners if the LLC was unable to satisfy its obligation to the lender.
Most loan documents require certain “nonrecourse carve-outs” (also known as bad boy guarantees). Under these provisions a member can be held liable for an entity’s debts if certain conditions are met. These conditions typically include the borrower obtaining additional loan financing without the lender’s prior consent, the borrower filing a voluntary bankruptcy petition, or the borrower consenting to an involuntary bankruptcy action or an assignment for the benefit of creditors (the state-law filing similar to a bankruptcy filing).
Allocating LLC losses
Losses from an LLC are generally passed through to its owners in proportion to the economic loss they would incur upon a disposition of the property followed by a liquidation of the LLC. Under these rules, losses are first allocated to the extent members have contributed capital into the LLC. Once an entity’s equity is exhausted, losses are next allocated to members who have repayment obligations (through the loan documents, guarantees, or provisions in the LLC agreement). To the extent no member is liable for unpaid loan amounts owed to creditors, losses are finally allocated pro-rata among the entity’s members.
For example, Big Properties, LLC is owned by three investors:
- A owns 50 percent
- B owns 30 percent
- C owns 20 percent
- A contributed $100k of capital upon formation of the LLC
- B contributed $60k
- C contributed $40k
C also made a subordinated loan to the partnership of $50k.
The LLC used these proceeds, plus a $750k nonrecourse loan from a bank, to purchase a $1 million rental building. Throughout the first few years of operations, the LLC incurred $350k of losses. The first $200k of loss was allocated to A, B and C based on their capital contributions ($100k to A, $60k to B, and $40k to C). The next $50k of loss was allocated to C (to the extent of his subordinated loan). The remaining $100k of loss was allocated pro rata to all members ($50k to A, $30k to B, and $20k to C), since it is the bank’s money (and not that of the members) that funded those losses.
In a legal memorandum released earlier this year, the IRS ruled that it would view bad boy guarantees as the creation of a payment obligation by the guaranteeing member. Consequently, if one member of an LLC signed a bad boy guarantee (but the other members did not), the underlying liability would be allocated to the guaranteeing member. While not specifically addressed by the ruling, the losses would then necessarily have to be re-allocated; this would shift losses away from the other members and to the guaranteeing member.
After throwing the real estate community into a state of angst, the IRS has now said “never mind.” It now realizes that these guarantees are unlikely to be invoked in a way that the guarantor will have to make payment on the guarantee. Without a payment obligation, the liability (and corresponding losses) need not be specially allocated to the bad boy guarantor. So we can go back to allocating the losses among the members of an LLC in a pro-rata fashion.
How we can help
The IRS’s ruling and subsequent reversal reminds owners how important it is to make sure all of the partnership’s agreements are properly written. This includes the operating agreement, loan documents, and guarantee agreements. The rules change quickly, and in this case so did the profit/loss allocations. CLA professionals can help you thoroughly understand how partnerships’ agreements work, how the IRS is currently treating them, and if your existing agreements provide the allocations you desire.